Timeless Principles of Stock Investing
Investing in stocks is the best way to create wealth. Many of us would have taken chances based on tips, recommendations, advisors, business channels etc. And, would have had hits and misses.
Like everything else in life, stock investing too is governed by certain fundamental principles. And it is not rocket science. Every investor can easily learn and apply these principles and create personal wealth, by following these fundamental principles of Investing.
Stock Shastra is an educative newsletter launched by us, at MoneyWorks4me.com, to achieve this mission – to help investors master the art and science of stock investing.
Here are the timeless, fundamental principles of investing:
Investing in stocks is essential to make your money work for you! But most of us have come to regard stock investing as something best left to the “experts” to handle. We invest in mutual funds, letting fund managers make our stock investing decisions. We wholly trust the advice of our brokers and act on it. We are afraid of venturing in it on our own.
Is stock investing really as difficult as it has been made out to be?
Investing in stocks is not as difficult as it has been made out to be. We can definitely do it on our own. But what do we do when we invest in stocks? We tend to pick stocks based on its P/E, Price/Book Value, Charts and other such criteria. These methods are completely inadequate because they over-simplify and lead you to take wrong decisions.
So, how can we avoid these mistakes and at the same time have a simple but robust way of investing in stocks?
Investing in stocks is all about buying a wonderful business and not just a stock. To find such a wonderful business it is essential to look at 3 important characteristics: An excellent financial track record, A Sustainable Moat and Respectable management. But, the way the financials of a company are made available, it becomes impossible to even make sense out of them, let alone analyse them.
So, how do we shortlist a company with excellent financial track record?
To shortlist a wonderful company with an excellent financial track record, you just need to look at 5 financial parameters over a period of 10 years. However, not all companies with a wonderful past can survive and grow in the future. It thus becomes critical to determine whether the company will continue to grow in the future.
So, how do you find out whether a company has what it takes to remain a winner in the future?
To invest in a wonderful company you need to look for a business with unbreachable moats. We said that these moats are Brand, Secret, Switching, Toll and Price. A company with these moats can become a winner in the long term. The first moat is brand.
So, why are brands a moat? And does it always translate into an excellent financial track record?
Some of the moats that we look for, to identify a wonderful business are Brand, Secret, Switching, Toll and Price. These moats can help a company remain a winner in the long term. A brand helps a business create loyal customers thus ensuring higher sales and profits. The second moat – Patents/Trade Secrets is another competitive advantage that a company can have.
So, how exactly does this moat work? And which companies in India have this moat?
A great brand and patents/trade secrets are a couple of competitive advantages that a company can have. These help a company increase its Sales and Profits making it a winner in the long-term. Another such competitive advantage which a company can have is an exclusive control over a product or area. This can translate into very good growth for the company.
But, in a free market how do companies end up having an exclusive control and how does it work for them?
In a highly competitive market, where companies struggle to get repeat business from the same client; what is it that helps a company lock in its customers for life? It is the advantage of having ‘High Switching Costs’. These costs are monetary, psychological, time and effort-based – which makes switching from the product almost impossible.
But, how do companies gain this advantage & how does it work for them? Which are the companies in India that have this advantage?
In today’s world of intense competition, companies are always looking for strategies to be unique. With this aim to be unique, what is that one powerful strategy that helps companies attract consumers and hence, stand out. It is the ability to price very low.
How can companies gain this advantage & mold it into a winning strategy for the long-term?
Which companies in India have this advantage?
Stock Shastra #10: Look for a trustworthy management, that respects the interests of minority shareholders
Having an excellent financial track record and a sustainable competitive advantage are 2 important characteristics to shortlist a wonderful company. But, one more characteristic is required to guarantee a future winner and that is a trustworthy management. You need to understand whether the company’s management is someone who will protect your (investors) interests and is someone you can trust your money with.
So what are the signs/clues for you, as an investor to check whether the management is trustworthy and respects the interests of the shareholders?
A company that has an excellent financial track record, sustainable competitive edge and a respectable management is indeed, a wonderful company worth owning. But, before investing you need to find the right value for the stock, in order to buy at the right price and get high returns.
So, what is the right value for a stock and how do you use this insight?
The MRP (Maximum Retail Price) of a stock is it’s right value and is a benchmark for selling the stock. But, the price at which you buy the stock will eventually determine your returns. Hence, in order to minimize your risks and earn great returns, you need to buy the stock at a discount from its MRP.
So, before buying stocks, what is the discount from MRP you should look for?
To mitigate risk and earn great returns, you need to buy a stock at 50% discount to its MRP and sell once it crosses MRP. But, there are certain considerations you need to keep in mind while selling; so that you don’t sell early and lose out on higher profits or sell later and lose some gains.
So, what are these considerations and how do they help you in deciding when to sell the stock?
To be successful in investing, you need to have the right mind-set. And the mind-set that will give the highest chance of success is that of somebody owning a fruit orchard. In contrast, having the mind-set of a fisherman or vegetable farmer is unlikely to work in stock investing.
Let’s see why?
Listening to experts is almost like an addiction for most stock investors. While many don’t even realize that they are addicted to this, others who have experienced that experts don’t win for them, are wondering how they can ever get out of it.
Let’s see how investors can get rid of their addiction of ‘listening’ to experts?
Information is like an antibiotic. An antibiotic over dosage can have varied effects on our health, from causing complications to being lethal. But what’s so disastrous about having an information overload.
Stock Shastra #16 helps you avoid the disastrous effects of Information Overload and help you take better stock investing decisions
Stock Shastra #17: Don’t forecast future stock prices, Analyze a Company’s ability to earn future profits
Forecasts are difficult to make especially those concerning the future. In today’s world stock investing has become synonymous to forecasting! But the key to successful investing is having an analytical approach towards your investment, rather than forecasting daily price movements based on market scenario and sentiments.
But how is forecasting any different from analysis?
When planning our stock investments, we cannot afford to have the same casual approach that we have while shopping. Because, going to the stock markets without a predefined list will leave a big hole in our pockets.
Let’s see how.
When the facts change, I change my mind, what do you do sir?’ – following this Keynesian quote in the stock markets may put you on the road to successful investing. But we humans are very reluctant when it comes to changing our views.
Let’s see why.
As intelligent shoppers we always look for great bargains. And we tend to do this while investing in stocks, as well! The most common way to identify great bargains in the stock market, is to look at stocks with a low P/E. Infact, it has become a favourite valuation metric to find hidden gems.
But, is it actually as effective as it has been made out to be?
At the end of FY 2003, Nestle India was trading at a P/BV of 19.85 and Indage Vintners at a P/BV of 0.18. Going by the market rule of thumb we should have invested in Indage Vintners while avoiding Nestle India to earn hefty investment returns.
But what would have been our actual returns had we followed this strategy? And does this strategy of investing in stocks by just looking at low P/BV actually work?
During FY 2001, Hindustan Unilever limited (HUL) paid a whopping 58% of its profits as dividends whereas Infosys paid just 11%!! Going by the general myth that investing in high dividend paying companies gives better returns, we should have invested in HUL and earned high returns while giving Infosys a miss.
But what would our returns look like after 10 years? Would we have laughed all the way to the bank with our investment in HUL or did Infosys actually nudge ahead? And does this strategy of investing in high dividend paying company actually work?
‘Risk toh Spiderman ko bhi lena padta hain’! Investing in the stock markets and risk go hand in hand. And to earn high returns we need to take high risk! At least that’s what most of us think. But taking higher risks increases our chances of losses, while what we should actually be doing is minimizing our downside potential!
So is there a method that could lower our risk and at the same time increase our returns?
An IPO is one of the most sought after event be it a novice just starting his investment career or a seasoned investor. Even though quite a few burn their hands and their pockets by investing in them, the next IPO is again the same story. Euphoria surrounding the IPO release, media buzzing with the ‘once in a lifetime investment opportunity’ stories and brokerage houses selling the issuing company rather than analyzing it! The end result is throngs of people rushing to get a piece of the IPO action believing it will lead to great returns.
So, is investing in an IPO worth it and should you join the mad rush?
Investors have a tendency to label some companies as ‘Good Companies’. This is usually based on the perception that its products are good and liked by everyone or it has reputed management. Predictably then, the investment advice that we often get is: ‘Buy ‘Good Companies’ and the investment returns will be high’. It seems quite logical that well managed companies should be worth more than poorly managed ones, doesn’t it?
But the question we investors should be really asking is, ‘Does investing in ‘Good Companies’ always guarantee you good returns?
We are constantly on the lookout for various strategies to profit from the stock market. Out of the numerous “lucrative strategies”, one that is frequently practiced is that of investing in stocks which appear to be cheap i.e. quoting at Rs. 10,20 etc. This strategy is usually supported by the argument that buying such cheap stocks enables you to buy more number of shares as compared to a stock trading at say Rs. 500 or Rs. 1000. Also, we tend to think that there is a higher possibility of a cheap stock turning out to be a multi-bagger than a Rs. 1000 stock.
So, does a low priced stock actually give us better returns than a high priced stock?
Investing in the stock markets is risky. And conventional wisdom says that the elderly among us should take as little risk as possible, keep their hard earned money safe and handy, etc. Thus, most of us are faced with this dilemma at some point of time in our life:
Should we reduce our investments in stocks as we grow older?
Every few months, Inflation becomes the bread and butter for newspapers and the media. Quite often it even leads to chaotic scenes in the parliament with the opposition causing a ruckus due to the high prices of everything and how it makes the common man suffer. We have all heard about inflation and have even felt its pinch on our pockets sometime or the other. But beyond its basic effect, inflation can also affect our investment in stock markets.
So, what exactly is inflation? Why is it caused and how does the Government control it? Above all how does it affect our investments and how can we protect ourselves from it?
Back in the 1980s people got an impressive return of over 12% on their deposits. The equation was simple: “Paanch saal mein paise double”. However, times have changed today. Now, the interest rate stands at a miserly 8% compared to the 12% seen earlier. Our economy has evolved a lot since those days; we are currently one of the fastest growing economies in the world. But the earlier time seemed so much better as you got higher returns!
So, what is the real deal? Was the high interest rate in 1980s a better situation than today? What is the relation between the growth of an economy and interest rates? How does the interest rate affect the stock markets? And above all what should your action plan be considering the impact of interest rate on stocks?
Stock market is a puzzle for most of us and our constant endeavor is to find a way to know where it is headed. We look for answers everywhere but fail to realize that one of the best solutions is actually always in front of our eyes. Surprised? Don’t be!
This simple solution is nothing but our own spending habits. Yes! The way we spend our money determines where the stock market is headed. Infact, taken together the total spending by everyone i.e. consumer spending has the power to drive the stock market and even the economy up or bring it down.
So, how does our spending habit exactly impact the stock market? And how could you put this simple solution to use in order to profit in the stock markets?
“Sensex tumbles 435 point on weak IIP data”…. “Sensex rallies on good IIP growth”. How many times have you woken up in the morning and read this news? Numerous we suppose. IIP data is one of the most eagerly awaited and important macro-economic data. This is because it gives you a very good picture of the supply side of the economy.
Infact, quite frequently it impacts the stock markets leading to a jump or drop in the Sensex. Unfortunately, not many of us are aware what IIP exactly is and how does it impact the stock market.
Here is all that you need to know about IIP & its impact on stock market and how you can use this knowledge to profit in the stock market.
We invest our hard-earned money in stocks hoping to make a decent return out of them. When the stocks we invest in do well, we feel good and even pat our own back. However, if they don’t do well, we are quick to pass the buck on some external factor, “Oh! It was the FIIs , they pulled the money out and before I knew it the stock was down 35%!”- a common conversation for budding investors with a sip of coffee. However understanding FII investments and their movement is not as difficult as it seems.
So, how does the FII movement affect the stock market? Why do they pump in or pull out money? And how can we go one up on the FIIs and profit in the Stock Market?
Exchange rate is something that we are bothered about only if we are going for a trip abroad or shopping online for something which is priced in dollars! We rarely think about how it affects the stocks we hold. In 2006-07 many people were invested in the ever-popular IT sector stocks. But even as they saw the stock market surging to 21000, they were baffled to see that the IT stocks that they held did not move. Experts pondered over it, discussed it and attributed this to the exchange rate and the appreciation of the rupee.
This was confusing. After all exchange rate is a mere number. How could it be the reason for IT stocks not doing well? However, the fact is that exchange rate is very important for many sectors and is infact a very good tool to analyze an economy and sectors like IT, Textiles etc.
So, what exactly does rupee appreciation or depreciation exactly mean? Why does the exchange rate keep fluctuating? And most importantly what impact does it have on the stock market?
The role that a Government plays in the development of the country is similar to that of a parent raising a child. The Government is responsible for the growth and development of the nation as well as for the welfare of the people. And the way this it achieves this is through the money that it spends i.e. Government Spending.
Government spending might not be a word that we are fully aware of but it can significantly alter the prospects of a particular sector and even the entire economy. In fact, it also helped revive our economy in 2008-09 after the sub-prime crisis led to a market crash.
So, how does the government spending impact the economy? Which sectors are benefited the most by higher spending? And how can we use this knowledge to make profitable investments?
If ever there was a Holy Grail for stock investors, then it surely would be the quarterly and annual report on the GDP! GDP report reveals all the facts about the economy, production, income, saving, investment; things which we feel are only for big shot economists and experts to deal with.
But just like investing in stock markets, understanding the dynamics of GDP is not rocket science. And understanding this economic indicator is all the more important because it reveals to us the health of our economy and has the power of shaping the course of the stock market.
So what exactly is GDP is and why is it important for us? And how can understanding it enable you to profit in the Stock market?
‘This is my sales target and I don’t care how we achieve it!’ – a common motto for many marketing managers, branch heads and CEOs just before a quarter or financial year ends. The motive – To show a rosy picture of the company’s financial position so that it can have a positive effect on the company’s stock price. All analysts and investors eagerly await the company’s quarterly results. If the company meets its sales guidance the company is rewarded and the stock price rises; if it fails to meet the guidance, the price is hammered. Very often this motivates the companies to manipulate their sales. Infact, sales or the top line is one of the easiest figures to manipulate with a number of techniques available to the manipulators.
So, what are these techniques? And is it possible to find out such companies through some early signs or red flags? Let’s have a look.
Every now and then when the profits of a company suffer, we hear management talk about the various “cost-cutting measures” that it is implementing. Infact during a downturn, when customer orders are hard to come by and revenue growth slows down, companies have no option but to control costs and sometimes cut them drastically to maintain profits. To do this companies reduce salaries and bonuses, cut down on marketing and advertising costs and lay off people. Infact sometime back we even had a pharma company go as far as cutting down on toilet paper to reduce costs! Unfortunately, some companies adopt a different approach to cut down costs and report higher profits : They simply manipulate their expenses.
So, what are the techniques used by these companies to manipulate their expenses? And what red flags can help us identify these possible manipulations?
The financial statements of a company are usually thought to be too complicated! And of all the numbers given on them, depreciation is perhaps the least understood number. We routinely overlook depreciation as just another item on the Profit and Loss statement and fail to realize its significance. However, this number is perhaps one of the easiest for companies to manipulate.
So, what exactly is depreciation and how do companies manipulate it? And what are the red flags available to investors to identify such companies?
Stock Shastra #39: How do companies manipulate Asset Valuation to project a strong financial health?
The balance sheet, also known as the statement of financial condition, offers a snapshot of the company’s health. It tells us how much a company owns (Assets), and how much it owes (Liabilities). Many analysts and investors look at the assets to judge a company’s financial health, as assets are the economic resources owned by a company and are used to operate its business. Some companies try to manipulate this part of the balance sheet in order to show a better picture of the company’s health.
So, why and how do companies manipulate their assets? And what are the red flags available to us investors to identify these manipulations.
As investors, we often pay more attention to the sales, net profit numbers on the profit and loss statement, while neglecting the balance sheet. After all balance sheet numbers are not as dynamic and interesting as the sales and net profit figures! But think again! The sales and net profit figures never tell us the entire story.
To know whether a company is fundamentally strong we must look at certain numbers on the balance sheet. In the last Stock Shastra we looked at the asset side of a balance sheet. The other side i.e the liabilities on a balance sheet tell us how much a company owes and how leveraged it is. In an attempt to showcase a healthier balance sheet companies often manipulate these liabilities.
So let’s find out what are the liabilities commonly manipulated? And how are these manipulations done?
“The cash flow statement is one of the least manipulated financial statements”. The other two financial statements viz. the Profit & Loss and Balance Sheet, are often subjected to many manipulations. However, while the cash flow statement does render more transparency, it too can be manipulated to a certain degree. And with analysts considering a sustainable cash-flow stream as the primary factor in determining the value of a company, the incentive to manipulate cash flows is greater.
In the last 3 Shastras we saw how the P/L account and Balance Sheet can be manipulated. Now, let’s have a look at how the cash flow statement, which is said to be the least manipulated out of the 3, can actually be tweaked.
Tata Steel acquires 100% stake in Corus Group; Vodafone purchases 67% stake owned by Hutchinson-Essar; Indian major Ranbaxy acquired by Japanese pharmaceutical company Daiichi Sankyo – these were headlines that were splashed across newspapers for days together at their time. Many companies find that the best way to grow is through mergers and acquistions. And investors usually take comfort in the idea that a merger will deliver enhanced market power. But, think again. Sometimes, the real picture might actually be different.
Infact, at times M&As might prove to be dangerous to shareholder value as the real purpose behind them could be to portray a fake picture of the company’s financial health.
So, how do companies manipulate financial statements through mergers/acquisitions? And what are the signs to spot such manipulations?
While many of us know how to go about analyzing a company, we tend to ignore the broader picture i.e. industry/sector analysis. However, analyzing an industry is important to understand a company’s business and performance as also gauge the opportunities and threats for future growth. Infact, investing in a ‘somewhat good’ company in a growth sector can give you better returns than investing in a very good company which is part of a sector that is slowing down. Thus, it is crucial to analyze an industry before you move on to individual companies.
But, how do you do this? What do you look for? Is there a framework to analyze industries?
One of the most favourite and highly tracked sector in any economy is the Auto sector given its importance to the economy. According to a recent report published by KPMG, the Auto sector has been a key driver of the Indian economy, accounting for around 4% of India’s GDP and over 200,000 jobs. The sector is especially of interest after it has emerged stronger from the recent global downturn, and sales across all segments have seen record breaking numbers in the recent past. Thus, for a sector of prime importance to the economic growth of our country, understanding it and the associated companies is a must for every investor.
So, how exactly does the Indian Auto sector work? And what are the factors that drive it’s growth?
The Consumer Durables industry consists of durable goods and appliances for domestic use such as televisions, refrigerators, air conditioners and washing machines. Instruments such as kitchen appliances (microwave ovens, grinders etc) are also included in this category. This industry includes all those goods which are durable i.e. products whose life expectancy is at least 3 years. These products are hard goods that cannot be used up at once. According to recent industry reports, the steadily growing market for consumer durables is estimated at Rs. 300 billion.
Segmentation of the Consumer Durables Industry: The consumer durables industry can be broadly classified into 2 segments: Consumer Electronics and Consumer Appliances. Consumer Appliances can be further categorized into Brown Goods and White Goods. The key product lines under each segment are as follows:
What does the Past Say?Here’s the review..
In the last two decades, the global face of India has undergone a significant transition. The Indian economy has witnessed an impressive growth during this period. And the sector that has largely driven this transition is the IT sector. Its contribution to the GDP in the last decade has increased tenfold from 0.6% to 6% currently and is still growing; its role in generating employment has also been remarkable. Thus, the IT sector has changed the lifestyle of many Indians, leading to increased income and comfort level.
With such hype surrounding this sector, it becomes imperative that investors have a good understanding of this sector. More so, when companies like Infosys and TCS , which have proven gold mines to investors, form a part of this sector.
So how does the IT sector work? What are the future prospects of the sector? Also get a glimpse of the top players in this sector and whether they are worth investing in.
Defensive sectors are those that are known to fall less than the market as well as show less appreciation This is because earnings of companies from these sectors are relatively stable and predictable both in good times as well as bad.
But, a ‘defensive sector’ which has proven different is the Pharma Sector. While Sensex crashed by close to 55% (in the period Dec-2007 to Jan-09), the BSE Healthcare index dropped by around 34%. However, what has been surprising is that the BSE Healthcare Index has outperformed Sensex over the last 2 years registering a growth of 52% CAGR as compared to the 42% clocked by Sensex. Few companies that led this growth were Cadilla Healthcare, Dr. Reddy’s Laboratories, Ranbaxy etc.
So, how does the Pharma sector actually work? And what are the factors that will drive its growth? Also get a glimpse of the top players in this sector and whether they are worth investing in.
Stock Shastra #48: Indian Power Sector (Generation & Supply) – Powering the growth of the Indian Economy
One sector on which all sectors/industries are dependent on is the Power sector. No other sector/industry would be able to function without the power sector which fulfils their energy requirements. The power sector plays a critical role in the economic progress of our country. Due to the fast-paced growth of India’s economy, the country’s energy demand has been growing continuously. To boost economic growth and human development, one of the Government of India’s top priorities is to provide all its citizens with reliable access to electricity by 2012.
With a mixed portfolio of sources for generation, the power sector comprises of companies like NTPC (the largest company in thermal power generation), NHPC (leader in Hydro power) etc. More so, the FDI inflow in this sector has been on the rise in the last 5 years.
So, how does the Indian Power sector actually work? What lies ahead for this sector? Also get a glimpse of the top players in this sector and whether they are worth investing in.
The Indian Tyre Industry is an integral part of the automobile industry and its fortunes are interdependent on those of the Automobile players. Popular brands like MRF, Apollo, CEAT form an integral part of this industry. Over the last 9 years, this industry has grown by a good 15%.
After suffering a slowdown in FY09, the industry witnessed a significant recovery in FY10 backed by robust auto demand. However, in FY 11, high raw material (rubber) prices affected the margins and depressed the profits of the tyre companies.
So, going forward, should you invest in the tyre industry?
With memorable jingles and advertising slogans like ‘Har Rang kuch kehta hain’, Paint companies have for years brought colour to our lives. From a business perspective as well, the Indian Paint industry has grown at a rate of above 15% for the past few years. The last year proved to be even better with the industry recording a growth of more than 20%.
This industry comprises of strong companies like Asian Paints, Kansai Nerolac, Berger Paints etc. Asian Paints, the most well-known paint brand, thrives on a strong moat (sustainable competitive advantage) that it has managed to build for itself over the years. Also, it has proven to be a gold-mine for investors.
So, how does the Indian Paint industry work? Also, which are the investment-worthy companies in this industry?