Saturday, November 14, 2020

Book Review #42: The Psychology of Money: Author: Morgan Housel

Most people approach money based on scientific principles. There are many formulae and theorems on how to invest and grow money. After the stock market crash of 2008, Morgan Housel, author of the book ‘Psychology of Money’,  observed that handling money is more of an art than science and the success in handling money depends on how one handles the emotions and stress associated with money.
Unlike hard sciences like Physics, money is not dependent on some universal rules, it has behavioral connotations. In 2008 Mr.Housel wrote a report titled ‘Psychology of Money’ that contained 20 behavioral aspects relating to Money. The book 'The Psychology of Money - Timeless Lessons on Wealth, Greed and Happiness' is an elaboration of the ideas that were briefly discussed in the 2008 report.
The book is structured across Introduction, 20 chapters followed by a postscript on the evolution of the American investor over the last century.  18 chapters discusses the behavioral aspects of money, the penultimate chapter is a summary of the principles discussed in the earlier chapters. Chapter 20 discusses how he invests his money.
This book expands the following five premises
One, money has behavioural implications. How you make money depends on how you handle your emotions. The main emotions are fear and greed. People with calm temperament and reasonable expectations will succeed in financial markets. It is important to keep your balance when the whole world is either in panic or in euphoria.
Two, the idea of money is unique to each individual. It depends on her upbringing, education and experiences in the early adult age. It also is dependent on their goals and the life stage. This means that no single opinion is applicable to every investor. That is why you should be wary about the advises given in the finance channels. One’s personal experiences with money may have zero impact on how the world behaves, but it will have 80% impact on how they think about money.
Mr.Housel digs deeper into this point in the postscript of the book where he dissects the evolution of American investor over the last century. In the early part of the century, America was more egalitarian and income inequality was minimal. Policies were adopted to get people to spend. Policies like low interest rates, low mortgage rates and easy credit availability boosted the economy. The decade of 70s saw economy crash. The generation became more scared and cynical. Income inequality started growing. As things stand, while economy has boomed, the income inequality is at its highest. The idea of money held by the early generation is different from that of the current generation like chalk and cheese.
Three, being wealthy is different from staying wealthy. The behaviours required for both are polar opposites. While you need to take risks to become wealthy, you need risk aversion to stay wealthy. The approach that made one wealthy will not work to stay wealthy. Most people do not realize this simple fact.
Four, huge wealth is generated through compounding. For compounding to work, you must give it time. Also compounding is highly influenced by ‘Tail Events’, those once in a life time events which one cannot anticipate. The only way to do both, giving time and benefiting from tail events, is to stay invested in the market. 
Five, history is a bad predictor of future in financial markets. The only lesson one should take from history is how successful people handled their emotions as things got difficult.
I am a fan of Morgan Housel. I try to read all the articles that he writes in his firm However I am a bit disappointed with this book. Except for occasional flashes of brilliance, the book is fairly pedestrian. He has written well, in simple language and short paragraphs (sometimes you get a feeling that you are reading a series of tweets), but that is Morgan Housel. He writes well.
To illustrate the point that handling emotions matter, author starts off the book with two examples, a janitor who died as a multi-millionaire and a brilliant businessman who lost all his money. The only difference was that the janitor accumulated shares of blue chip companies and let them compound without interruption, while the businessman frittered away all his money in conspicuous consumption.  
What is the value of money? The greatest value of money is its ability to give control over your time. It gives you options. And making and keeping money depends on how you control your emotions.
Simple, no?
Luck and risks are two sides of the same coin. We need to recognize their role in financial success. When we analyze the impressive financial performance of others we do not spend time in analyzing the role of luck in their success. It is possible that the successful person might have taken some risks that went his way. Conversely, when we see failure we do not acknowledge the risks that were taken and which did not go as per plan. Surprisingly when we analyze our performance, we attribute our success to our efforts and failure to external environment (Market crashed, what could I do?)
Greed, the feeling of never having enough, is another behaviour that could torpedo our financial roadmap. It is important to know when something is enough. Greed is driven by external benchmark rather than an internal direction. Greed is also driven by a fear of leaving something on the table.
Few people 'really' understand the counter-intuitive nature of compounding. The first hard drive was 3.5MB, the latest ones are 100 TB, which is about 35 million times more than the first one. In 1950 nobody would have predicted this. The wildest prediction would have been 300 GB which is almost 10000 times more than the first one. When compounding is not intuitive, we try to fit other reasons.
One advantage of staying for a long time in the market is that you get the benefit of tail event - anything that is huge, profitable and influential is a tail event. A tail event is where you make huge returns that augments the compounding story. The challenge is that the tail events entail huge risks too.
There is a discussion in the book about the difference between being rich and being wealthy. Being rich is related to current income, the more your CI, the richer you are, while being wealthy is related to how much money can help you to do what you want to do. That should be the objective, and how do you achieve that? By saving more, by spending below your earning. In the long-term, your savings is all that matter.
Do not chase returns. Having a wealth goal, and enough savings will take you there. Greed is one of the enemies of wealth creation. Greed converts an internal goal to an external one. You are always chasing the next return rather than deciding what returns you want and what wealth you want to create.
When investing always try to be reasonable rather than being rational. Wanting to 'minimize my regret'  is a good enough reason to invest conservatively. Don't compare yourself with Buffet and Lynch.
Factor of safety is very important. Author calls it 'Margin of Error'. Consider volatility in investing. Expect future returns to be lower than past returns and increase your savings and investment rates. Do not get into debt. Expect Murphy to strike, expect 'everything that can go wrong to go wrong'. Be paranoid.
Many people plan their money based on life goals. What they don’t  do not realize  is that the goals change, they change. What looked an exciting goal at one stage in life may not be relevant at another stage in life. The concept of 'End of history illusion' refers to the tendency of the people to overestimate their past changes and underestimate how much their personalities, desires and goals are likely to change in the future. The only goal of investing should be free time to do anything you want.
There are two things to keep in mind when making a long-term decisions. One, avoid extreme ends of financial planning. People adopt and adapt. Current extreme decision will constrain the future decision making. Take stock at every stage of life and take decisions that are best for that stage of life. A focus on moderation - moderate goals, moderate income - could help you stay the long-term course. Two, we should also accept the possibility of our minds changing. Don't hang on to sunk costs.
There is nothing like free lunch. You have to pay the price. The price you pay in investment is the volatility. You have to handle the emotions as the value of your investment falls. A person who pays anything before buying, balk at the price charged by the market. The reason is that the price comes after market raises the value of your investment. Instead of feeling like a price, the volatility loss feels like a fine for doing something wrong.
The above concept of prices of investment is from Chapter 15 That along with Chapter 16 and 17 are the best chapters in this book. This chapter discusses the bubbles. Bubbles happen as short term investors start chasing the prices and not the value. Author gives the example of CISCO. At one time the company was valued at 600 Billion Dollars an implicit growth rate at which company would have been valued bigger than US economy. This doesn't make any sense from an investor's perspective, but it makes all the sense from the perspective of a day trader who chases price and momentum. The duration of day trader is 20 hours or even 20 minutes. If a long-term investor decides to buy the stock of CISCO at that price, he would be making a big mistake.
The lesson is that the price and value of any investment is not fixed. It is dependent on the motives and mental makeup of the investor. One of the biggest mistakes that long-term investors make is in chasing the price. The rules are different for different types of investors. So if you are a long-term investor you should know what kind of investor you are, what kind of investments you are going to make and what kind of decisions you are going to make. Author gives an example of his vision statement. It states that 'he is a long-term investor who is optimistic about the future of the country'. He will invest in the stock market based on that view point.
While reading this chapter, I was thinking about value investors who came out of the market during the 2004-08 bull run. They said that there are no longer any value left in the market.
Pessimism is very easy to spread. Pessimists comes across as intellectuals. No one bothers to listen to people who are positive and optimistic. One of the reason why pessimism is very important is the historical evolutionary against loss aversion. There are three reasons why pessimism  about money is rampant. One, money is ubiquitous and hence any bad news about money spreads very fast. Two, pessimists often extrapolate the current bad situation to future without considering how markets adapt. If there is a crash, there is an expectation that markets will stay down for a long time. But if there is growth, people are always asking the question 'when is the next crash'. Pessimism sells. The third reason is that growth happens too slowly to notice while setbacks happen too quickly to ignore.
The example of Wright brothers is relevant here. In the late 19th century, common wisdom was that man cannot fly. It took five years for the world to take notice of their achievement. All these five years, they were flying all over Dayton, Ohio and no one bothered. Even after it was established that man can fly, the conventional wisdom in 1905 was man cannot transport cargo across the country. The first Cargo flight took off in 1909.
Growth is driven by compounding. It always takes time. None notices. Destruction happens due to single point of contact and that is always too big to ignore. Pessimism has an advantage that it reduces expectation. It narrows the gap between possible outcome and outcome you feel great about. This ensures that more things will fall in your favour, which makes you more happy. Paradoxically, that is the definition of optimism.
In summary, the key message in the book is that your psychology matters most in investing. Understand what you need, accept that you will change over the time, be flexible and take reasonable risks. Most importantly the value of money is the amount of free time it can give you and the best way is to use the power of compounding. Compounding works and it takes time.
So just shut up and stay in the market.

Friday, June 21, 2019

How do spinoffs create value?

Value investing is the process of buying securities that are trading at prices well below their intrinsic value and then waiting for the market to discover the value and raise the price in line with the value. As per the legendary value investor Seth Klarman, securities market can throw up many opportunities for the savvy investor to buy securities at significant discount to the intrinsic value.

Management actions like spinoffs present two benefits. One, they help the market close the gap between the price and the value by giving shares directly to the investors. Two, they send a clear message that management is shareholder friendly. 

Market regularly throws Value Investing opportunities

One such opportunity arises when company decides to spinoff its subsidiary into a new company. In the chapter 10 of the book Margin of Safety Mr.Klarman discusses the value investing opportunities provided by spinoffs.

Spinoff is the distribution of shares of a subsidiary company to the shareholders of the parent company. Spinoffs help parent company to divest businesses that no longer fits strategic objective. The goal of spinoff is to create parts with a combined market value greater than the present whole.

They present attractive opportunity since immediately after Spinoff, the shares of the spun-off companies are bound to trade at low prices as markets discover their value. Many shareholders of the Spinoffs sell their shares quickly since they follow the decisions of the management of the parent company. Sometimes the shareholders sell the spun-off company because they know nothing about the new company. Large institutional investors will sell spinoffs since they may be too small for them. Index funds will sell spinoffs since they are not a part of the index they are tracking.

In case of spinoffs, as the shareholders dump the shares immediately after the spinoff, the share prices get significantly depressed. Unlike other securities, the selling is not because the sellers know something more than the buyers, in many cases, the selling happens because the sellers know nothing. 

Wall street do not follow spinoffs. The analysts following parent company may not follow spinoffs that are in different industry. Sometimes management wants to keep the share prices down. Another reason spinoffs are valuable in the initial stages is because there is an information lag. Sometime opportunities exist in the parent company shares and not in spinoffs.

In summary, Spinoffs present a great value investing opportunity due to the following reasons.
  • Spinoffs help increase the market value of the group.
  • Shareholders are ignorant and tend to dump shares
  • Spunoff companies do not fit the strategic objective of the Institutional Investors and hence they dump the shares
  • Management wants to keep the share prices low
  • Not many analysts track spiinoffs

Spinoff opportunity is the most valuable in the first few weeks of trading.

Friday, June 14, 2019

Book Review #41: Margin of Safety: Author: Seth A. Klarman

This is the review of the book Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor written by Seth A Klarman

In the introduction to the book, Mr.Klarman sets out two goals for writing this book. One is to highlight the investment pitfalls so that the investors could avoid them. Two is to explain why value investing method works and often works spectacularly.

Value investing is the strategy of investing in security trading at an appreciable discount from underlying value. This approach has a long history of delivering excellent returns with limited downside risk. It requires a great deal of hard work, strict discipline and a long-term investment horizon. Few are willing to put that effort.

Friday, June 7, 2019

How do you value a business?

The practice of Value Investing, any investing for that matter, calls for valuing a business. The concept of Margin of Safety for instance, talks of buying a security when there is a significant gap between the price of a security and its intrinsic value.

The question is how do you define value? What are the different methods available to value a business. What are the pros and cons of each method? Which should be the method of choice? 

Chapter 8 of the book 'Margin of Safety' written by Seth Klarman talks of Business Valuation. The reported valuation numbers like book value, earnings and cashflow are best guesses of accountants. Also value is not static. It changes over time with different macro-economic factors. The business value cannot be precisely estimated, but the apparent precision offered by mathematical formulae like NPV and IRR can lull investors forgetting that these are based on assumptions of cash flow far into the future.The other assumptions in valuation could be regarding future, different intended uses of the asset and different discount rates used.

Three valuation methods that author finds useful are Net Present Value (NPV) - valuing the cashflows of a going concern, and its offshoot Private Market Value, the value paid by a sophisticated buyer of the business, Liquidation value - the expected proceeds if the company were to be sold off, an offshoot of which is Breakup value that values each components of the business separately and Stock Market Value - the estimated price at which a company will sell in stock market.

These valuation methods are illustrated in the diagram below.

Two aspects of valuation are Expected Growth in earnings and Discount Rate. If future cashflow is predictable, NPV can be very accurate. However cashflow depends on many factors like market share, the volume growth, pricing power, brand loyalty etc, each of which can be assumptions. 

Growth investors face many challenges One, they show higher confidence in their ability to predict future value than is warranted. Two, even small differences from one's estimate can have catastrophic consequences. Three, since many investors are focused on such companies, the prices may go up lowering the margin of safety. Four, investors tend to oversimplify growth into a single number, while it is based on many factors. Just as an example, earnings growth can come from more units being sold due to increase in population or it may also be due to increased usage by the existing customers. It could also be due to increased market share or due to price increases. While some of these are predictable, others are less so.

Investors by nature are overly optimistic of the future. Since future is unpredictable, value investors have to be conservative in their assumptions of growth as well as discount rates.

The other factor in valuation is the discount rate. The more conservative you are, the higher rate you will use to discount future cash flows. The discount rate should depend on Investor's preference of present consumption over future returns, his risk profile, the risk of investment under consideration and on the returns available from other comparative investments. However, investors often simplify and use 10% as discount rate.

When interest rates are low, investors pay high multiples assuming rates to remain low.

Once future cash flows are forecast conservatively and an appropriate discount rate is chosen, present value can be calculated. In theory, investors might assign different probabilities to numerous cash flow scenarios, then calculate the expected value of an investment, multiplying the probability of each scenario by its respective present value and then summing these numbers.

Given many valuation methodologies, which one should an investor choose? The answer to this question depends on the nature of the company the investor is evaluating.  NPV may be a good approach to value a company with stable cash flows, liquidation method may be used to value a company selling well below its book value, a mutual fund may be valued at stock market price. Sometimes you may used different methods for different units of a conglomerate. Ideally multiple methods should be applied and the lowest value chosen.

A wild card in valuation is the theory of reflexivity propounded by George Soros. It says that stock prices can influence the valuation, rather than the other way round. For example, an under-capitalized bank, trading at high multiple can raise cheap capital in the market based on its price multiple. On the other hand if the stock was trading at low multiples, it would not have been able to raise funds leading to bankruptcy. In this case, the stock multiple acted as the valuation cue for the bank. It could be true for a highly leveraged company with impending redemption. Good market perception can help it raise funds to honor the redemption. Sometimes managers accept the market value as a signal of the business value and may issue additional shares at values lower than market thereby worsening the situations. A bad market can depress prices lowering the liquidation value, thus becoming a self fulfilling prophesy.

The author gives reasons why valuation based on Earnings, Book Value and Dividend Yield are easily manipulated by crooked management. He suggests not to trust such valuations.

Friday, May 31, 2019

Difference between investors and speculators...

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In his book 'Margin of Safety', the legendary investor Seth Klarman explains the difference between investors and speculators. To investors stocks represent a fractional ownership of business. They transact securities that offer an attractive risk reward ratio. Investors believe that over the long run security prices tend to reflect fundamentals of the business. Investors in a stock expect to profit in at least one of the three possible ways. From free cash flow generated by the business which will be reflected in higher share price or will be distributed as dividends, from increase in multiples and by the narrowing the difference between price and value.

Speculators on the other hand, buy and sell securities based on the expected price action based on the behaviour of others. For them securities are a piece of paper. Speculators are obsessed with guessing the direction of stock prices. They use technical analysis to predict the direction of market. Many investment professional are speculators in the garb of investors. Investors have a chance to make money over the long-term, while speculators are likely to lose it over time.

The author tells the story of 'trading sardines' versus 'eating sardines' to explain speculation. It was observed that sardines were disappearing from their traditional waters in Monterey, California. The commodity traders bid them up and the price of a can of sardines soared. One day a buyer decided to treat himself to an expensive meal and actually opened a can and started eating. He immediately became ill and told the seller the sardines were no good. The seller said, "You don't understand. These are not eating sardines, they are trading sardines."

Like sardine traders, many financial-market participants are attracted to speculation, never bothering to taste the sardines they are trading. Speculation offers the prospect of instant gratification. Moreover, speculation involves going along with the crowd, not against it. There is comfort in consensus.

Viewing stocks as piece of paper precludes rigorous fundamental analysis. Neither rigorous analysis nor knowledge of underlying business is required. Speculators play the 'greater fools game'. Speculative activity can erupt in Wall Street at any time and is not identified as such till considerable money has been lost.

Even assets can be catagorized as investments or speculations. Both can be purchased from market and both fluctuate in price. The main difference is that investments throw cash flow, but speculations do not. For example, stock is an investment, gold and other collectibles are speculation. Value of speculations fluctuate solely based on supply and demand since they do not throw any cash flow.

In financial market it is important to be an investor and not a speculator. Successful investor is unemotional taking advantage of the opportunity provided by the greed and fear of others. They respond market with calculated reason. Investors use the opportunities provided by Mr.Market, without looking up to him for investment guidance. It is important for investors to differentiate the stock price fluctuation from underlying business reality.

Monday, April 22, 2019

Book Review #40: The Most Important Thing Author:Howard Marks

Book Name: The Most Important Thing:  Uncommon Sense for the Thoughtful Investor

Author: Howard Marks

Published by: Harper Business

ISBN: 978-9-35-302279-2 (Print)

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This book gets rating of 3/5

This is the review of the book 'The most important thing - Uncommon sense for the thoughtful investor', written by Howard Marks. Mr.Marks is a famous investor who is the co-founder of Oaktree Capital Management that he and his friends started in 1995. This book is an elaboration of various memos that Mr.Marks wrote to his investors over the years. Each memo deals with one thing that he considers to be the most important thing in investment. There are 19 'Most Important Things' covered in this book.

In comparison to other books that I have read in the genre of finance and investments, this is a much lighter read, devoid of any math. Personally I did not find a lot of value in this book since almost all of what I read in this book is covered in other books. However considering that this book has sold over 4.5 Million copies, it has to find a place in the list of finance books that I review as a part of my project.

Monday, April 15, 2019

LTCG on Equity Shares India: Example Calculations

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If you have purchased shares before 1st April 2018 and have sold them in the FY 2018-19, based on the date of purchase, you may be expected to pay Long Term Capital Gains Tax on the sale of those shares.The calculation of LTCG tax is complex with words like Fair Market Price and Cost of Acquisition being thrown in.

In this post I am trying to declutter the tax calculation with a few examples. Remember, these are based on my understanding. I am not an auditor and this is not professional advise. Kindly verify the numbers with your auditor.

The key to calculation of LTCG is the 'Cost of Acquisition'. This is calculated as per Formula 1 given below

Formula 1: Higher of Original Purchase  Price and ( Lower of the highest prices on 31-Jan-2018 and the Sales Price)

And LTCG is calculated as Formula 2:  [(Sales Value - Selling expenses) - (Cost of Acquisition + Purchase Expenses)

Little confusing. I request you to read the above two sentences again. First one talks about calculating the Cost of Acquisition and second one talks of using that value to calculate the LTCG.

Let us look at some examples:

Example 1: IPO Purchase and additional purchases in secondary market

Subbu got 199 Shares of  of Coal India allotted on 20-Nov-2018 at an IPO price of 233. Later he purchased 301 shares of Coal India on 22-Sep-15 at an average price of 339.65. The highest price of Coal India on 31-Jan-2018 was 304.55. He sold off the entire 500 shares on 24-Sep-18 at an average price of 278.55.

This set of transactions is eligible for LTCG. Let us calculate the LTC Gain or Loss.

Step 1. For 199 shares received in IPO

1. Original Purchase Price: 233
2. Price as on 31-Jan-2018: 304.55
3. Sales Price: 278.55
4. Lower of 2 and 3: 278.55
5. Cost of acquisition as per Formula 1: Higher of 1 and 4: 278.55
6. Purchase Expenses (Brokerage and Taxes): 0 (IPO purchase)
7. Selling Expenses (Brokerage and Taxes): 491.55
8. LTCG as per Formula 2: [(199*278.55 - 491.55) - (199*278.55+0)] : -491.55

Step 2: For 301 shares purchased on 22-Sep-19

1. Original Purchase Price: 339.65
2. Price as on 31-Jan-2018: 304.55
3. Sales Price: 278.55
4. Lower of 2 and 3: 278.55
5. Cost of acquisition as per Formula 1: Higher of 1 and 4: 339.65
6. Purchase Expenses (Brokerage and Taxes):877.88
7. Selling Expenses (Brokerage and Taxes): 742.98
8. LTCG as per Formula 2: ((301*278.55 - 742.98) - (301*339.65+877.88)) : -20012

Total LTC Gain / Loss: -20012 - 491.55 = -20503.55

Since this is a loss, no tax is applicable. 

2. Bonus Issue

Rahul purchased 100 Shares of Infosys on 12-Apr-2015 at a price of 1640 and the purchase expenses were 1000 rupees. on 22-Feb-2017, the company issued Bonus Shares at the rate of 1:1. The shares were trading at a high of 952 on 31-Jan-18. Rahul sold the 200 shares on 12-Nov-2018 at a price of 840. The selling expenses were 1200 rupees.

Step 1. For 100 shares purchased in secondary market

1. Original Purchase Price: 1640
2. Price as on 31-Jan-2018: 952
3. Sales Price:840
4. Lower of 2 and 3: 840
5. Cost of acquisition as per Formula 1: Higher of 1 and 4: 1640
6. Purchase Expenses (Brokerage and Taxes): 1000
7. Selling Expenses (Brokerage and Taxes): 1200
8. LTCG as per Formula 2: ((100*840-1200) - (100*1640+1000)) :-82200

Step 2: For 100 shares received as bonus shares

1. Original Purchase Price: 0
2. Price as on 31-Jan-2018: 952
3. Sales Price: 840
4. Lower of 2 and 3: 840
5. Cost of acquisition as per Formula 1: Higher of 1 and 4: 840
6. Purchase Expenses (Brokerage and Taxes):0
7. Selling Expenses (Brokerage and Taxes): 1200
8. LTCG as per Formula 2: ((100*840-1200) - (100*840+0): -1200

Total LTC Gain / Loss: -82200 - 1200 = -83400

Since this is a loss, LTCG Tax is not applicable

3. Mix of STCG and LTCG

Venkat purchased 500 Shares of IDFC Bank at a price of 30  and purchase expense of 150 on 01-Sep-15. He added another 300 shares of IDFC Bank on 03-Feb-18 at 40 rupees with a purchase expense of 120. He sold 800 shares of IDFC First Bank on 9-September 2018 at a price of 47 and selling expense of 200. The price of IDFC Bank on 31-Jan-18 was 42

Step 1. For 500 shares purchased on 01-Sep-15

1. Original Purchase Price: 30
2. Price as on 31-Jan-2018: 42
3. Sales Price:47
4. Lower of 2 and 3: 42
5. Cost of acquisition as per Formula 1: Higher of 1 and 4: 42
6. Purchase Expenses (Brokerage and Taxes): 150
7. Selling Expenses (Brokerage and Taxes): 125 (200 * 500/800)
8. LTCG as per Formula 2: ((500*47-125) - (500*42+150)) : 2225

Step 2: For 300 shares purchased on 03-Feb-18. This will be considered as STCG

1. Original Purchase Price:40
2. Sales Price:47
3. Purchase Expenses (Brokerage and Taxes):120
7. Selling Expenses (Brokerage and Taxes): 75 (200*300/800)
8. STCG as per Formula 2: ((300*47-75) - (300*40+120):1905

Total LTC Gain / Loss: 2225
Total STC Gain / Loss: 1905

Hope this clarifies. In case you have any crazy situations, do let me know. Let us work on it together. 

Since this is a profit, but the amount is less than 100000, LTCG tax is not applicable. However STCG Tax at the rate of 15% is applicable.