Finale Stocks

Stocks To Riches -- An Insights on Investor Behaviour

BASICS

CHAPTER I

1.1 INTRODUCTION

Have you ever wondered how the rich got their wealth and then kept it growing? Do you dream of retiring early (or of being able to retire at all)? Do you know that you should invest, but don't know where to start? If you answered "yes" to any of the above questions, you've come to the right place. The world of finance can be extremely intimidating, but it is firmly believe that the stock market and greater financial world won't seem so complicated once you learn learn some some of the lingo lingo and and major major conce concepts pts.. It is empha emphasiz size, e, howe however ver,, that that investing isn't a get-rich-quick scheme. Taking control of your personal finances will take work, and, yes, there will be a learning curve. But the rewards will far outweigh the required effort.

Contrary to popular belief, investors don’t have to allow banks, bosses or investment professionals to push your money in directions that you don't understand. After all, no one is in a better position than you are to know what what is best best for you you and and your your mone money. y. Rega Regardl rdless ess of your your perso persona nalit lity y type, type, lifestyle or interests, this will help you to understand what investing is, what it means means and how time earns money through through compoundin compounding. g. But it doesn't doesn't stop there. This will also teach you about the building blocks of the investing world and the markets give you some insight into techniques and strategies and help you think about which investing strategies suit you best.

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RICHES 1.2 What Rich Means

Rich, what this means in today’s business world, whether it is person with huge wealth or a person who is able to maximise his wealth day by day, year by year. There are two things needed in these days; first, for rich men to find out how poor men live; and second, for poor men to know how rich men work . A grea greatt amou amount nt of accu accumu mula late ted d mone moneyy and and prec precio ious us possessions: affluence, fortune, pelf, treasure, wealth. Riches are not an end of life, but an instrument of life

Have you never been moved by poor men's fidelity, the image of you they form in their simple minds? Why should you always talk of their envy, without understanding that what they ask of you is not so much your worldly goods, as something very hard to define, which they themselves can put put no name name to; to; yet yet at time timess it cons consol oles es thei theirr lone loneli line ness ss;; a drea dream m of splendor, of magnificence, a tawdry dream, a poor man's dream --and yet God blesses it!

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INVESTMENT OPTIONS

INVESTMET INVESTMET OPTIONS OPTIONS MUTUAL MUTUAL FUNDS FUNDS

COMMODITY COMMODITY

BOND BOND

BANKS BANKS

POST POST OFFICE OFFICE

EQUITY EQUITY Primary Primary Market Market

Secondary Secondary Market Market

IPO’s IPO’s

STOCKS STOCKS

NSCKVP KVP NSC

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GOISAVING SAVING GOI BONDS BONDS


WHO CAN INVEST???

WHOCAN CAN WHO INVEST? INVEST?

RETAIL RETAIL INVESTOR INVESTOR

MUTUALFUND FUND MUTUAL COMPANIES COMPANIES

FOREIGN FOREIGN INSTITUTIONAL INSTITUTIONAL INVESTOR(FII’s) (FII’s) INVESTOR

HUF HUF

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INSURANCE INSURANCE COMPANIES COMPANIES

INVESTMENT INVESTMENT COMPANY COMPANY

BANKS BANKS

POST POST OFFICES OFFICES

Retail investor An individual who purchases small amounts of securities for

him/herself, as opposed to an institutional investor. Also known as individual investor or small investor. A private investor who buys shares through a stockbroker for his/her private portfolio.

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Mutual Funds A mutual fund is a company that pools money from many investors

and invests the money in stocks, bonds, short-term money-market instruments, or other securities. Legally known as an "open-end company," a mutual fund is one of three basic types of Investment Company. The two other basic types are closed-end funds and Unit Investment Trusts (UITs).

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Foreign Institutional Investor (FII’s) FII means an entity established or incorporated outside India which

proposes to make investment in India. An investor or investment fund that is from or registered in a country outside of the one in which it is currently investing. Institutional investors include hedge funds, insurance companies, pension funds and mutual funds. The term is used most commonly in India to refer to outside companies investing in the financial markets of India. International institutional investors must register with the Securities and Exchange Board of India to participate in the market. One of the major market regulations pertaining to FIIs involves placing limits on FII ownership in Indian companies.

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Investment Company Firm that invests the pooled funds of retail investors for a fee. By

aggregating the funds of a large number of small investors into a specific investments (in line with the objectives of the investors), an investment company gives individual investors access to a wider range of securities than the investors themselves would have been able to access. Also, individual investors should be able to save on trading costs since the investment company is able to gain economies of scale in operations. There are two types of investment companies: open-end (mutual funds) and closed-end (investment trusts).

END OF CHAPTER I “Never invest in a business you cannot understand”

STOCKS

CHAPTER II 5


2.1 The Stock Market: The Biggest Auction in the World

Think of the stock market as a huge auction or swap meet (some might call it a flea market) where people buy and sell pieces of paper called stock. On one side, you have the owners of corporations who are looking for a convenient way to raise money so that they can hire more employees, build more factories or offices, and upgrade their equipment. The way they raise money is by issuing shares of stock in their corporation. On the other side, you have people like you and me who buy shares of stock in these corporations. The place where we all meet, the buyers and sellers, is the stock market.

2.2 The Psychology of Stock Market Participants

Understanding the psychology of the participants is the key to knowing how they will behave when they are gripped by fear and greed. He who understands this psychology is able to manipulate the markets by using the different participants at different times. Now let’s see what each one wants from the markets.

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Government At this point when the world has become a global village and each

country wants to attract foreign capital, governments need booming markets. Stock markets are the barometer of an economy. They send positive signals to foreign investors when they are in a bull phase. Booming stock markets create confidence and spur the governments to go ahead with their economic policies. No government likes depressed stock markets.

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Regulator 6


Appointed by the government, the regulator also like booming stock markets. A rising market is evidence of good governance. It also results in additional revenue in the form of higher transaction and service charges due to the increase in turnover.

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Stock Exchanges They facilitate stock transactions. During boom periods, incomes

skyrocket by way of transaction charges from brokers, listing fees, etc.

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Brokers In a bull markets the clientele increases and so do business

opportunities. This results in higher incomes for the brokers.

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Banks Their

business

increases

with

soaring

stock

markets

as

opportunities open up in lending against stocks, margin trading, depository and custodial business, etc. The feel good factor drives investors to banks for various financial services.

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Companies Rising markets lead to higher stock prices. The net worth of owners increase and companies can mop up more capital for expansions. Financially healthy companies are able to attract and retain good talent, and keep their shareholders happy.

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Mutual Funds 7


Higher Stock price means increased net asset values. Rising markets attract more investors which mean more money under management, and higher asset management fees. They are also able to come out with different kinds of funds to satisfy every requirement.

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Media The media plays a pivotal role in spreading information. An increase in investors means increased viewers/readers, which translates into increased advertisement revenue.

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Investors The lure of quick money draws investors in a bull market. Day traders become very active as they are rewarded with easy gains.

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Operators He is the smartest and shrewdest of all. He is aware that the Bull Run psychology creates the Bull Run. He knows the system, he understands the psychology of the participants, and he has the ability to exploit that for his own benefit. He is the king-maker who uses his knowledge to win over investors, brokers and company management.

2.3

Understand the Term - STOCK 8


In financial markets, stock is the capital raised by an organisation through the issuance and distribution of shares.

A person or organization which holds shares of stocks is called a shareholder. The aggregate value of a company’s issued shares is its market capitalization.

Stock is simply a portion of a company. By owning stock, you are a shareholder. Stocks are bought and sold on stock exchanges, such as the BSE & NSE.

Usually stock is issued to raise money for a variety of reasons: expansion, developing new products, to pay off debt and acquiring other companies. When a company issues stock for the first time, it is called an initial public offering or IPO. An IPO is underwritten by an investment banker that decides what the stock is worth and when it is best to issue it.

Volatility is when a stock price goes up or down. Usually, stock prices rise and fall with supply and demand. Nonetheless, there are other reasons for stock prices to fluctuate. The price will rise when everyone wants the stock and is buying it, however mass sales will also drive a price in the negative direction. Prices will drop when a particular industry takes a fall, when the economy has a general downturn, when the company management is failing, or when there is too much debt. Professional analysts and investment bankers who issue buy/sell/hold ratings also affect the price.

2.4 Classifying Stocks: Income, Value, & Growth

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Income Stocks

The first category of stocks is income stocks, which include share of corporations that give money back to shareholders in the form of dividends (some people call these stocks dividend stocks). Some investors, usually older individuals who are near retirement, are attracted to income stocks because they live off the income in the form of dividends and interest on the stocks and bonds they own. In addition, stocks that pay a regular dividend are less volatile. They may not rise or fall as quickly as other stocks, which is fine with the conservative investors who tend to buy income stocks. Another advantage of stocks that pay dividends is that the dividends reduce the loss if the stock price goes down. There are also a number of disadvantages of buying income stocks. First, dividends are considered taxable income, so you have to report the money you receive to the IRS. Second, if the company doesn’t raise its dividend each year and many don’t—inflation can cut into your profits. Finally, income stocks can fall just as quickly as other stocks. Just because you own stock in a so-called conservative company doesn’t mean you will be protected if the stock market falls.

Value Stocks

Value stocks are stocks of profitable companies that are selling at a reasonable price compared with their true worth, or value. The trick, of course, is determining what a company is really worth—what investors call its intrinsic value. Some low-priced stocks that seem like bargains are low-priced for a reason. Value stocks are often those of old-fashioned companies, such as insurance companies and banks that are likely to increase in price in the future, even if not as quickly as other stocks. It takes a lot of research to find a company whose price is a bargain compared to its value. Investors who are attracted to value stocks have a number of fundamental tools (e.g., P/E ratios) that they use to find these bargain stocks.

Growth Stocks 10


Growth stocks are the stocks of companies that consistently earn a lot of money (usually 15 percent or more per year) and are expected to grow faster than the competition. They are often in high-tech industries. The price of growth stocks can be very high even if the company’s earnings aren’t spectacular. This is because growth investors believe that the corporation will earn money in the future and are willing to take the risk. Most of the time, growth stocks won’t pay a dividend, as the corporation wants to use every cent it earns to improve or grow the business. Because growth stocks are so volatile, they can make sudden price moves in either direction. This is ideal for short-term traders but unnerving for many investors.

Penny Stocks

Just as their name suggests, penny stocks are stocks that usually sell for less than a rupee a share (although some people define a penny stock as one selling for less than Rs.5 a share). They are also called pink sheet stocks because at one time the names and prices of these stocks were printed on pink paper. The advantage of trading penny stocks is that the share price is so low that almost everyone can afford to buy shares. For example, with only Rs.1000 you can buy 2000 shares of an Rs 0.50 penny stock. If the stock ever makes it to a rupee, you made a 100 percent profit. That is the beauty of penny stocks. On the other hand, you could put your order in at Rs 0.75 a share, and a couple of days later the stock could fall to Rs.0.50. It happens all the time. A number of traders specialize in these stocks, although this is not easy. After all, penny stocks are so cheap for a reason. That reason could be poor management, no earnings, or too much debt, but whatever it is, there usually aren’t enough buyers to make the stock go higher. Even with their low price, the trading volume on penny stocks is exceptionally low.

2.5 What Makes Stocks Go Up or Down

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When you invest in the market, you should pay attention to anything that may affect your stocks. Some events seem to come out of nowhere —perhaps a terrorist attack, a war, or a recession will cause havoc with the stock market. If there is anything the market hates, it is uncertainty. One of the reasons the most recent bear market lasted so long was that no one knew when the recession would end, whether we would win the war on terrorism, and whether the United States was going to war. Any one of these events can send the market lower as investors seek protection in cash, gold, or real estate. As an investor or trader, you must be aware of outside events. Sometimes it helps to step back and see the bigger economic picture. If you can anticipate how an event could affect the stock market, you can shift your money into more profitable investments. Some pros believe that having a thorough understanding of the investment environment is more important than picking the right stock.

You Buy Stocks for Only One Reason: To Make

2.6

Money

The stock market is all about making money. Quite simply, if you buy stock in a company that is doing well and making profits, then the stock you own should go up in price. You make money in the stock market by buying a stock at one price and selling it at a higher price. It’s that simple. There is no guarantee, of course, that you’ll make money. Even the stocks of good companies can sometimes go down. If you buy stocks in companies that do well, you should be rewarded with a higher stock price. It doesn’t always work out that way, but that is the risk you take when you participate in the market.

END OF CHAPTER II “Never Love or Marry your Stock, Just have a Short Term Affair”

INVESTORS

CHAPTER III 12


“A person who makes investments ”

“A person whose principal purpose is to invest money prudently and productively over the longer term with the investment objectives being

achievement

of a

reasonable

return and capital

appreciation to preserve purchasing power. ”

Many people find investing risky because they are not in control of one or more of these ten investor controls. However, investor may gain some insights on how he can gain greater control as an investor—especially control number 7, the control over entity, timing, and characteristics. This is where many investors lack control, need more control, or simply lack any basic understanding about investing.

3.1 The Ten Investor Controls 1. The control over yourself 2. The control over income/expense asset/liability ratios 3. The control over the management of the investment 4. The control over taxes 5. The control over when you buy and when you sell 6. The control over brokerage transactions 7. The control over the ETC (entity, timing, and characteristics) 8. The control over the terms and conditions of the agreements 9. The control over access to information 10.The control over giving it back, philanthropy, redistribution of wealth.

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3.2

Types of Investors

The Accredited Investor The accredited investor is someone with high income or high net worth. A long-term investor who has chosen to invest for security and comfort may very well qualify as an accredited investor. If you can qualify as an accredited investor, you will have access to investments that most people do not. To be successful in choosing your investments, however, you still need financial education. If you choose not to invest your time in your financial education, you should turn your money over to competent financial advisors who can assist you with your investment decisions.

The Qualified Investor The qualified investor understands how to analyze publicly traded stock. This investor would be considered an “outside” investor as opposed to an “inside” investor. Generally, qualified investors include stock traders and analysts. Here, we define qualified investor as a person who has money as well as some knowledge about investing. A qualified investor is usually an accredited investor who has also invested in financial education. As it relates to the stock market, for example, he said qualified investors would include most professional stock traders. Through their education, they have learned and understand the difference between fundamental investing and technical investing.

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The Investor Controls Possessed by the Qualified

Investor

1. The control over yourself 2. The control over income/expense asset/liability ratios 5. The control over when you buy and when you sell 14


The Sophisticated Investor The sophisticated investor typically has all “three Es.” In addition, the sophisticated investor understands the world of investing. He or she utilizes the tax, corporate, and securities laws to maximize both earnings and to protect the underlying capital. If you want to become a successful investor but do not wish to build your own business to do so, your goal should be to become a sophisticated investor. From the sophisticated investor on, these investors know that there are two sides of the coin. They know that on one side of the coin, the world is a world of black and white and they also know that the other side of the coin is a world of different shades of gray. It is a world where you definitely do not want to do things on your own. On the black and white side of the coin, some investors can invest on their own. On the gray side of the coin, an investor must enter with their team.

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The Investor Controls Possessed by the Sophisticated

Investor

1. The control over yourself 2. The control over income/expense and asset/liability ratios 3. The control over taxes 4. The control over when you buy and when you sell 5. The control over brokerage transactions 6. The control over the E-T-C (entity, timing, characteristic)

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END OF CHAPTER III

CHAPTER IV

INVESTING

Investing is not risky; not being in control is risky.” 4.1 What Is Investing?

The act of committing money or capital to an endeavor with the expectation of obtaining an additional income or profit. It's actually pretty simple: investing means putting your money to work for you. Essentially, it's a different way to think about how to make money. Growing up, most of us were taught that you can earn an income only by getting a job and working. And that's exactly what most of us do. There's one big problem with this: if you want more money, you have to work more hours. However, there is a limit to how many hours a day we can work, not to mention the fact that having a bunch of money is no fun if we don't have the leisure time to enjoy it You can't create a duplicate of yourself to increase your working time, so instead, you need to send an extension of yourself - your money - to work. That way, while you are putting in hours for your employer, or even mowing your lawn, sleeping, reading the paper or socializing with friends, you can also be earning money elsewhere. Quite simply, making your money work for you maximizes your earning potential whether or not you receive a raise, decide to work overtime or look for a higher-paying job. There are many different ways you can go about making an investment. This includes putting money into stocks, bonds, mutual funds, or real estate (among many other things), or starting your own business. Sometimes people refer to these options as "investment vehicles," which is just another way of saying "a way to invest." Each of these vehicles has positives and negatives, which we'll discuss in a later section of this tutorial. The point is that it doesn't matter which method you choose for investing your money, the goal is always to put your money to 16


work so it earns you an additional profit. Even though this is a simple idea, it's the most important concept for you to understand.

4.2 What Investing Is Not Investing is not gambling?

Gambling is putting money at risk by betting on an uncertain outcome with the hope that you might win money. Part of the confusion between investing and gambling, however, may come from the way some people use investment vehicles. For example, it could be argued that buying a stock based on a "hot tip" you heard at the water cooler is essentially the same as placing a bet at a casino. True investing doesn't happen without some action on your part. A "real" investor does not simply throw his or her money at any random investment; he or she performs thorough analysis and commits capital only when there is a reasonable expectation of profit. Yes, there still is risk, and there are no guarantees, but investing is more than simply hoping Lady Luck is on your side.

4.3 Why Investing so Difficult

The most difficult part of investing, understands the behaviour of the stock markets. Market fluctuations are based on the varied opinions expressed by its participants, which in turn are subject to change commensurate with the changing sentiments of people. It’s the crowd behaviour that dominates the decision-making and is responsible for the sudden changes in the sentiments. Take for instance the black Monday in May 2004. The market lost around 700 points when the elections brought the Congress to power. What precipitated this huge fall? Had anything gone drastically wrong with the performance of the companies whose stock prices crashed? Definitely not. But the sentiment changed. The BJP being voted out of power was a big change and normally we do not like changes. Hence there was gloom all around and people dumped stocks as though there was no future. The herd mentality was at work and the markets crashed as each one wanted to get out faster than his neighbour. If you were emotionally strong and you have ended making a huge 17


fortune. But this seems easy only in hindsight. At the point of time to go against crowd is the most difficult but the most sensible thing to do.

Understanding behavioral science is the key to success in the financial markets. Its application not only helps you control your emotions but also helps you to understand other’s emotions and benefit from their mistakes.

4.4 The Law of the Farm

Stock Market investing is all about managing the rewards associated with the risks undertaken. Without risk there is no return. Invest you must but before that you must bear in mind the law of the farm. You reap what you sow but the crop is also subjected to changing seasons. The seed has to endure summer, rain, winter and spring before it turns into a full-blown tree. Stock market investments also work that way. There are no short cuts. If we invest in the right stocks with the right business model and fundamentals, over the long run we are assured of optimum returns. However, to do this requires patience and we have to go through the ups and downs but it is important to stay the course. Getting carried away by the greed of quick returns ultimately destroys wealth, as it does not conform to the law of nature. Many of us forget that nature and society are one.

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4.5 Three Ways of Investing”

There are three ways by which an investor can invest to achieve superior results. One is Intellectually Difficult, the second is Physically Difficult and the third is Emotionally Difficult Path.

1. The Intellectually Difficult Path

Investors like Warren Buffet, Charlie Munger, John Templeton, and a few others have taken the intellectually difficult path of beating the markets. This path is pursued by those who have a profound understanding of investing, can see future trends clearly, and can comprehend business and the environment. They know that patience is a virtue and therefore take long-term positions. We admire them but usually in retrospect. Initially, we may see them as being misguided, but that is only because of our inability to grasp their point of view. This method is all about the cash flow approach. It is the most difficult path as it requires a keen mind of study the different concepts of investing – how different businesses work, and how economic policies and market forces affect the business environment. A good grasp of the various fields of management is required to understand organisations and their ability to capitalize on various business opportunities. A good knowledge of the field of liberal arts is basic to the development of various investment concepts. Here the name of the game is patience. Such investors are always on the lookout for good opportunities and bargain prices. As long-term investors, they are willing to wait for them. They are not perturbed by events, news, rumours and gossip that create short-term volatilities. They have a strong belief in their abilities and, since their goal is investing long-term for cash flows as against capital gains, they are in no hurry to invest. They strongly believe that opportunities are always there but that when the biggest of them come, one must have the money to invest. They are therefore, very careful about allocating resources. They never buy on impulse. They can be out of the market for months, even years.

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They have the patience to wait till the right moment. Brokers usually do not like such investors as they do not churn their portfolios regularly. Intellectual investors as they do not churn their portfolios regularly. Intellectual investors are also emotionally strong. That is the reason they are able to exercise such restraint. We all want to be such investors but we cannot, as we believe that we are not all as intellectually blessed as they are. This is a wrong notion. The reason they are intellectually capable is because they work hard and make the effort to reach that stage. They constantly explore opportunities by talking with managements, examining different viewpoints on business, trying to understand economic policies and its effect on business environment, etc. Their intellectual capability is derived from their hard work and their strong belief in the long-term approach to investments. Moreover, they use common sense in their judgements and are not swayed by rumours.

2. The Physically Difficult Path

Most people are deeply involved in the physically difficult way of beating the markets. They come early to the office and stay late. They do not know what their children are doing as they don’t have time for them. They choose work over the family. They carry with them all the newspapers to read whenever time permits. They are always busy with the breakfast meetings, more luncheon meetings and even more dinner meetings. Their talk revolves round finding the next best investment opportunity to make money. They visit companies and plants and talk with the management. They keep in touch with a number of brokers as they believe it will increase their efficiency in the stock markets. They are overloaded with information. They are constantly on the telephone making calls and receiving more calls though most of the time the answering machine takes the calls. They continuously monitor stock price movements. At the office they scan their terminals and the CNBC news for market movements and at home they keep tabs on the BSE and NSE. They carry home huge reports to read before the next day. 21


When they are on the move, they are busy on their mobile phones. Market gossip excites them and they make decisions based on rumours. News regarding political developments, monsoon forecasts, inflation figures, change in a minister’s portfolio, and GDP growth figures play an important role in their lives. They tend to time the markets on such news. In every way they expend tremendous physical energy and effort to beat the market by outmanoeuvring the competition. But they don’t realise that others are also doing the same.

My experience in the stock market dealing with fund managers has been really amusing. They sincerely believe that keeping themselves busy this way makes them look important and increases their ability to pick up the winners. Once I was at the office of a fund manager and we were chatting informally. The telephone rang but he did not answer it. After a couple of rings, the call went to the answering machine. This is how most of them behave. Show the world they are busy.

The day traders also take the physically difficult path of investing. They spend the entire day collecting information and make decisions based on that information. So, with all the fund managers and the day traders treading the same path, how can any one of them achieve better results???

Good opportunities come once in a while and you spot them only when you are cool and have the time to think. The physically difficult path is based on the assumption that there are a lot of opportunities out there and you have to keep digging hard to be successful at investing. The current volatility in the markets is the result of too many people trying to invest by this method. Life is simple. We make it complicated.

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3. The Emotionally Difficult Path

Most of us may find the intellectually and the physically difficult path too daunting. In that case we could opt for what is called the emotionally difficult path. Actually, this path is very straightforward. Simply work out a longterm investment policy that is right for you and be committed to it. This how you do it. When your friends or your broker tell you about a great investment opportunity and they say it is a great time to buy, don’t buy. When the newspapers report big investment opportunities, be wary of such news. When your neighbours tell of how the stock markets have made them rich in the last couple of months, don’t be tempted. When you banker offers credit facility against your shares to buy more shares, stay calm and unconcerned.

When analysts on TV tell you that the market is going to crash and the stock prices will nose dive, don’t sell. When newspapers report a bear phase and tell you to liquidate portfolio, don’t sell. When your neighbours exit the stock markets, don’t follow them. When you broker tells you to sell as he sees bad times ahead do not listen to his advice and sell. Emotional discipline is the most difficult. It is not easy to control your emotions and go against the herd. But you need to believe in yourself and the investment policy to which you are committed. It often pays to go against popular opinion. The emotionally difficult path like the intellectually difficult pay lays stress on the virtue of patience. Both are based on the view that the long-term approach to investments is the only strategy that can enrich investors and increase their wealth. The stress is on the cash flow approach. Patience focuses an investor’s attention on the goal of compounding money over a long period. It can be magic even when the rate is modest. To give an example: If one were to compound money at a modest rate of seven percent the money would double at the end of 10 years and it would be 16 times at the end of 40 years. Patience also helps you to control transaction costs.

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The more you churn your portfolio the more you pay the broker in terms of taxes of brokerage and off course the government in terms of taxes on your capital gains. All these costs could be avoided if one has patience. The emotionally difficult path requires an understanding of how our emotions guide our decision-making especially when we deal with money. Our emotions directly affect our decisions on investments and expenditure. We have to learn to think with our emotions rather than have our emotions do the thinking. Understanding our own anomalies as also that of others will help us become better investors.

4.6 Investing: Diversification or concentration?

The basic logic for diversifying one's portfolio is, "Do not put all your eggs in one basket." This theory has a solid foundation behind it. For example, if an investor decides to invest only in steel stocks, he or she is putting himself/herself at risk at times when the steel cycle starts to turn down. Now, keeping track of such trends is no easy task, and even the most seasoned of industry veterans have got it wrong occasionally. Thus, there is a case to invest in stocks across sectors, so that in case of a downturn in any one sector, the performance of stocks from other sectors would make up for the losses suffered in that sector.

Let us understand the basic rationale for diversification. It is to reduce risk. Now, there are 2 types of risks - systemic and unsystemic. Systemic risk is that which impacts all sectors and companies, and, thus, cannot be diversified. Examples of such risks include events such as 9/11, an attack on an important crude pipeline, changes in political leadership, geopolitical risks and government policies. On the other hand, unsystemic risk is a risk that is specific to a particular company, such as a strike by factory workers for Hero Honda, or a fire at Bombay High for ONGC.

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Therefore, diversification of a stock portfolio serves the purpose of reducing the unsystemic risk of that portfolio. As a result, a major purpose of diversification is 'optimising' returns (as opposed to maximizing returns, which might involve a higher level of risk). One must understand that returns can never be de-linked from risk - they are never mutually exclusive and always co-exist. ...and against! On the other hand, by not diversifying the stock portfolio, rather concentrating it towards a few stocks, an investor can (still) get higher returns. Of course, as mentioned above, such a strategy would more likely than not involve a higher degree of risk. For example, an investor decides to tilt his or her stock portfolio towards software stocks. Now, while the software sector undoubtedly has strong growth prospects, taking a call on which stock to invest in to outperform the benchmark index is a none-too-easy task for a retail investor, who might not have the time to study the stocks, their business models, management teams and future prospects. Therefore, in order to execute such a focused investment strategy, an investor must have the ability to spot trends in his or her sector of interest, and time it accordingly .

END OF CHAPTER IV

Investing is risking and should be approached

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CHAPTER V

Guide to Stock-Picking Strategies Introduction

When it comes to personal finance and the accumulation of wealth, few subjects are more talked about than stocks. It's easy to understand why: the stock market is thrilling. But on this financial rollercoaster ride, everyone wants to experience the ups without the downs.

Here, Here, investor investor will find some of the most popular popular strategies strategies for finding good stocks (or at least avoiding bad ones). In other words, investor will see the art of stock picking – selecting stocks based on a certain set of criteria, with the aim of achieving a rate of return that is greater than the market's overall average.

Before exploring the vast world of stock-picking methodologies, investor should address a few misconceptions. Many investors new to the stockpicking scene believe that there is some infallible strategy that, once followed, will guarantee success. There is no foolproof system for picking stocks!

This doesn't mean investor can't expand his wealth through the stock market. It's just better to think of stock-picking as an art rather than a science. There are a few reasons for this:

1. So many many factors factors affect a company company's 's health health that it is nearly nearly impossible impossible to construct a formula that will predict success. It is one thing to assemble data that invest investor or can work work with, with, but quite quite anothe anotherr to determ determine ine which which number numbers s are relevant.

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2. A lot lot of info inforrmatio ation n is inta intang ngib ible le and cann cannot ot be measu easure red d. The The quantifiable aspects of a company, such as profits, are easy enough to find. But how do investors measure the qualitative factors, such as the company's staff, its competitive advantages, and its reputation and so on? This combination of tangible and intangible aspects makes picking stocks a highly subjective, even intuitive process.

3. Because Because of the human human (often (often irrational) irrational) element element inheren inherentt in the forces forces that move the stock market, stocks do not always do what you anticipate they'll do. Emotio Emotions ns can chan change ge quick quickly ly and unpred unpredict ictabl ably. y. And And unfort unfortuna unatel tely, y, when when confidence turns into fear, the stock market can be a dangerous place.

The bottom line is that there is no one way to pick stocks. Better to think of every stock strategy as nothing more than an application of a theory - a "best guess" of how to invest. And sometimes two seemingly opposed theories can be successful at the same time. Perhaps just as important as considering theory, is determining how well an investment strategy fits investor personal outlook, time frame, risk tolerance and the amount of time investor want to devote to investing and picking stocks.

At this this poin point, t, inve invest stor or may may be aski asking ng why why stoc stockk-pi pick ckin ing g is so important. Why worry so much about it? Why spend hours doing it? The answer is simple: wealth. If investor becomes a good stock-picker, he can increase his personal wealth exponentially.

Without further ado, let's start by delving into one of the most basic and crucial aspects of stock-picking: fundamental analysis, whose theory underlies all of the strategies explore here. Although there are many differences between each strategy, they all come down to finding the worth of a company.

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5.1 Fundamental Analysis

Ever hear someone say that a company has "strong fundame fundamental ntals"? s"? The phrase phrase is so overuse overused d that it's become become somewhat somewhat of a clich cliché. é. Any analy analyst st can can refer refer to a compa company' ny's s fundam fundament entals als witho without ut actua actually lly saying anything meaningful. So here we define exactly what fundamentals are, how and why they are analyzed, and why fundamental analysis is often a great starting point to picking good companies.

√ The Theory Doing basic fundamental valuation is quite straightforward; all it takes is a little time and energy. The goal of analyzing a company's fundamentals is to find a stock's intrinsic value; a fancy term for what investor believes a stock is really worth - as opposed to the value at which it is being traded in the marketplace. marketplace. If the intrinsic value is more than the current share price, investor’s analysis is showing that the stock is worth more than its price and that it makes sense to buy the stock.

Although there are many different methods of finding the intrinsic value, the premise behind all the strategies is the same: a company is worth the sum of its discounted cash flows. In plain English, this means that a company is worth all of its future profits added together. And this which the Rs.1 investor receives in a year’s time is worth less than Rs.1 you receive today.

The idea behind intrinsic value equaling future profits makes sense if investor thinks about how a business provides value for its owner(s). If investor has a small business, its worth is the money he can take from the company year after year (not the growth of the stock). And he can take something out of the compa company ny only only if he have have some someth thing ing left over over after after he pay pay for for suppl supplies ies and salaries, reinvest in new equipment, and so on. A business is all about profits, plain old revenue minus expenses - the basis of intrinsic value.

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5.2 Qualitative Analysis

Fundamental analysis has a very wide scope. Valuing a company involves not only crunching numbers and predicting cash flows but also looking at the general, more subjective qualities of a company. Here investor will look at how the analysis of qualitative factors is used for picking a stock.

√ Management The backbone of any successful company is strong management. The people at the top ultimately make the strategic decisions and therefore serve as a crucial factor determining the fate of the company. To assess the strength of management, investors can simply ask the standard five Ws: who, where, what, when and why?

√ Who? Do some research, and find out who is running the company. Among other things, you should know who its CEO, CFO, COO and CIO (chief information officer) are. Then you can move onto the next question.

√ Where? Investor need to find out where these people come from, specifically, their educational and employment backgrounds. Investor should ask himself if these backgrounds make the people suitable for directing the company in its industry. A management team consisting of people who come from completely unrelated industries should raise questions. If the CEO of a newly-formed mining company previously worked in the industry, again investor should ask himself whether he or she has the necessary qualities to lead a mining company to success.

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√ What and When? What is the management philosophy? In other words, in what style do these people intend to manage the company? Some managers are more personable, promoting an open, transparent and flexible way of running the business. Other management philosophies are more rigid and less adaptable, valuing policy and established logic above all in the decision-making process. Investor can discern the style of management by looking at its past actions or by reading the annual reports MD&A section. Investor should ask himself if he agrees with this philosophy, and if it works for the company, given its size and the nature of its business.

Once investor knows the style of the managers, find out when this team took over the company. Jack Welch, for example, was CEO of General Electric for over 20 years. His long tenure is a good indication that he was a successful and profitable manager; otherwise, the shareholders and the board of directors wouldn't have kept him around. If a company is doing poorly, one of the first actions taken is management restructuring, which is a nice way of saying "a change in management due to poor results". If investor sees a company continually changing managers, it may be a sign to invest elsewhere.

√ Why? A final factor to investigate is why these people have become managers. Look at the manager's employment history, and try to see if these reasons are clear. Does this person have the qualities investor believe are needed to make someone a good manager for this company? Has s/he been hired because of past successes and achievements, or has s/he acquired the position through questionable means, such as self-appointment after inheriting the company?

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

Know What a Company Does and How It Makes Money A second important factor to consider when analyzing a company's

qualitative factors is its product(s) or service(s). How does this company make money? In fancy MBA parlance, the question would be, "What is the company's business model?"

√ Industry/Competition Aside from having a general understanding of what a company does, investor should analyze the characteristics of its industry, such as its growth potential. A mediocre company in a great industry can provide a solid return, while a mediocre company in a poor industry will likely take a bite out of your portfolio. Of course, discerning a company's stage of growth will involve approximation, but common sense can go a long way: it's not hard to see that the growth prospects of a high-tech industry are greater than those of the railway industry. It's just a matter of asking, if the demand for the industry is growing.

√ Brand Name A valuable brand reflects years of product development and marketing. Take for example the most popular brand name in India: Reliance. Many estimate that the intangible value of Reliance brand name is in the billions of rupees! Massive corporations such as HLL rely on hundreds of popular brand names. Having a portfolio of brands diversifies risk because the good performance of one brand can compensate for the underperformers.

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5.3 Value Investing

Value investing is one of the best known stock-picking methods. In the 1930s, Benjamin Graham and David Dodd, finance professors at Columbia University, laid out what many consider to be the framework for value investing. The concept is actually very simple: find companies trading below their inherent worth. The value investor looks for stocks with strong fundamentals including earnings, dividends, book value, and cash flow - that are selling at a bargain price, given their quality. The value investors seek companies that seem to be incorrectly valued (undervalued) by the market and therefore have the potential to increase in share price when the market corrects its error in valuation.

√ Value, Not Junk! Value investing doesn't mean just buying any stock that declines and therefore seems "cheap" in price.

Value investors have to do their

homework and be confident that they are picking a company that is cheap given its high quality.

√ Buying a Business, Not a Stock Investor should emphasize that the value investing mentality sees a stock as the vehicle by which a person becomes an owner of a company - to a value investor profits are made by investing in quality companies, not by trading. Because their method is about determining the worth of the underlying asset, value investors pay no mind to the external factors affecting a company, such as market volatility or day-to-day price fluctuations. These factors are not inherent to the company, and therefore are not seen to have any effect on the value of the business in the long run.

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√ The Margin of Safety A discussion of value investing would not be complete without mentioning the use of a margin of safety, a technique which is simple yet very effective. Consider a real-life example of a margin of safety. Say you're planning a pyrotechnics show, which will include flames and explosions. You have concluded with a high degree of certainty that it's perfectly safe to stand 100 feet from the center of the explosions. But to be absolutely sure no one gets hurt, you implement a margin of safety by setting up barriers 125 feet from the explosions. Value investing is not as sexy as some other styles of investing; it relies on a strict screening process. But just remember, there's nothing boring about outperforming the S&P by 13% over a 40-year span!

5.4 Growth Investing

In the late 1990s, when technology companies were flourishing, growth investing techniques yielded unprecedented returns for investors. But before any investor jumps onto the growth investing bandwagon, s/he should realize that this strategy comes with substantial risks and is not for everyone.

√ Value versus Growth The best way to define growth investing is to contrast it to value investing. Value investors are strictly concerned with the here and now; they look for stocks that, at this moment, are trading for less than their apparent worth. Growth investors, on the other hand, focus on the future potential of a company, with much less emphasis on its present price. Unlike value investors, growth investors buy companies that are trading higher than their current intrinsic worth - but this is done with the belief that the companies' intrinsic worth will grow and therefore exceed their current valuations.

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As the name suggests, growth stocks are companies that grow substantially faster than others. Growth investors are therefore primarily concerned with young companies. The theory is that growth in earnings and/or revenues will directly translate into an increase in the stock price. Typically a growth investor looks for investments in rapidly expanding industries especially those related to new technology. Profits are realized through capital gains and not dividends as nearly all growth companies reinvest their earnings and do not pay a dividend.

√ No Automatic Formula Growth investors are concerned with a company's future growth potential, but there is no absolute formula for evaluating this potential. Every method of picking growth stocks (or any other type of stock) requires some individual interpretation and judgment. Growth investors use certain methods - or sets of guidelines or criteria - as a framework for their analysis, but these methods must be applied with a company's particular situation in mind. More specifically, the investor must consider the company in relation to its past performance and its industry's performance. The application of any one guideline or criterion may therefore change from company to company and from industry to industry.

5.5 GARP Investing

Do you feel that you now have a firm grasp of the principles of both value and growth investing? If you're comfortable with these two stockpicking methodologies, then you're ready to learn about a newer, hybrid system of stock selection. Here we take a look at growth at a reasonable price, or GARP.

√ What Is GARP?

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The GARP strategy is a combination of both value and growth investing: it looks for companies that are somewhat undervalued and have solid sustainable growth potential. The criteria which GARPers look for in a company fall right in between those sought by the value and growth investors.

Below is a diagram illustrating how the GARP-preferred levels of price and growth compare to the levels sought by value and growth investors?

√ What GARP Is NOT Because GARP borrows principles from both value and growth investing, some misconceptions about the style persist. Critics of GARP claim it is a wishy-washy, fence-sitting method that fails to establish meaningful standards for distinguishing good stock picks. However, GARP doesn't deem just any stock a worthy investment. Like most respectable methodologies, it aims to identify companies that display very specific characteristics. Another misconception is that GARP investors simply hold a portfolio with equal amounts of both value and growth stocks. Again, this is not the case: because each of their stock picks must meet a set of strict criteria, GARPers identify stocks on an individual basis, selecting stocks that have neither purely value nor purely growth characteristics, but a combination of the two.

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5.6 Income Investing

Income investing, which aims to pick companies that provide a steady stream of income, is perhaps one of the most straightforward stockpicking strategies. When investors think of steady income they commonly think of fixed-income securities such as bonds. However, stocks can also provide a steady income by paying a solid dividend. Here we look at the strategy that focuses on finding these kinds of stocks.

√

Who Pays Dividends?

Income investors usually end up focusing on older, more established firms, which have reached a certain size and are no longer able to sustain higher levels of growth. These companies generally no longer are in rapidly expanding industries and so instead of reinvesting retained earnings into themselves (as many high-flying growth companies do), mature firms tend to pay out retained earnings as dividends as a way to provide a return to their shareholders.

Thus, dividends are more prominent in certain industries. Utility companies, for example, have historically paid a fairly decent dividend, and this trend should continue in the future.

Dividend Yield

Income investing is not simply about investing in companies with the highest dividends (in dollar figures). The more important gauge is the dividend yield, calculated by dividing the annual dividend per share by share price. This measures the actual return that a dividend gives the owner of the stock. For example, a company with a share price of Rs.100 and a dividend of 37


Rs.6 per share has a 6% dividend yield, or 6% return from dividends. The average dividend yield for companies in the S&P 500 is 2-3%.

Dividends Are Not Everything

You should never invest solely on the basis of dividends. Keep in mind that high dividends don't automatically indicate a good company. Because they are paid out of a company's net income, higher dividends will result in lower retained earnings. Problems arise when the income that would have been better re-invested into the company goes to high dividends instead.

Stock Picking, Not Fixed Income

Something to remember is that dividends do not equal lower risk. The risk associated with any equity security still applies to those with high dividend yields, although the risk can be minimized by picking solid companies.

5.7

CANSLIM

CANSLIM is a philosophy of screening, purchasing, and selling common stock. Developed by William O'Neil, the co-founder of Investor's Business Daily, it is described in his highly recommended book "How to Make Money in Stocks".

The name may suggest some boring government agency, but this acronym actually stands for a very successful investment strategy. What makes CANSLIM different is its attention to tangibles such as earnings, as well as intangibles like a company's overall strength and ideas. The best thing about this strategy is that there's evidence that it works: there are countless examples of companies that, over the last half of the 20th century, met CANSLIM criteria before increasing enormously in price. In this section we explore each of the seven components of the CANSLIM system.

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√

C = Current Earnings

O’Neil emphasizes the importance of choosing stocks whose earnings per share (EPS) in the most recent quarter have grown on a yearly basis. For example, a company’s EPS figures reported in this year’s April-June quarter should have grown relative to the EPS figures for that same three-month period one year ago. (If you're unfamiliar with EPS, see Types of EPS.)

√

A = Annual Earnings

CANSLIM also acknowledges the importance of annual earnings growth. The system indicates that a company should have shown good annual growth (annual EPS) in each of the last five years.

√

N = New

O’Neil’s third criterion for a good company is that it has recently undergone a change, which is often necessary for a company to become successful. Whether it is a new management team, a new product, a new market, or a new high in stock price, O’Neil found that 95% of the companies he studied had experienced something new.

S = Supply and Demand

The S in CANSLIM stands for supply and demand, which refers to the laws that govern all market activities.

√

L = Leader or Laggard

In this part of CANSLIM analysis, distinguishing between market leaders and market laggards is of key importance. In each industry, there are always those that lead, providing great gains to shareholders, and those that lag 39


behind, providing returns that are mediocre at best. The idea is to separate the contenders from the pretenders.

I = Institutional Sponsorship

CANSLIM recognizes the importance of companies having some institutional sponsorship. Basically, this criterion is based on the idea that if a company has no institutional sponsorship, all of the thousands of institutional money managers have passed over the company. CANSLIM suggests that a stock worth investing in has at least three to 10 institutional owners.

M = Market Direction

The final CANSLIM criterion is market direction. When picking stocks, it is important to recognize what kind of a market you are in, whether it is a bear or a bull. Although O’Neil is not a market timer, he argues that if investors don’t understand market direction, they may end up investing a trend and thus compromise gains or even lose significantly.

Against the Daily Prices and

Volumes

CANSLIM maintains that the best way to keep track of market conditions is to watch the daily volumes and movements of the markets. This component of CANSLIM may require the use of some technical analysis tools, which are designed to help investors/traders discern trends.

CANSLIM is great because it provides solid guidelines, keeping subjectivity to a minimum. Best of all, it incorporates tactics from virtually all major investment strategies. Think of it as a combination of value, growth, fundamental, and even a little technical analysis.

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5.8 Technical Analysis

Technical analysis is the polar opposite of fundamental analysis, Which is the basis of every method. Technical analysts, or technicians, select stocks by analyzing statistics generated by past market activity, prices and volumes. Sometimes also known as chartists, technical analysts look at the past charts of prices and different indicators to make inferences about the future movement of a stock's price.

Is Technical Analysis a Long-Term Strategy?

The answer to the question above is no. Definitely not. Technical analysts are usually very active in their trades, holding positions for short periods in order to capitalize on fluctuations in price, whether up or down. A technical analyst may go short or long on a stock, depending on what direction the data is saying the price will move. If a stock does not perform the way a technician thought it would, he or she wastes little time deciding whether to exit his or her position, using stop-loss orders to mitigate losses. Whereas a value investor must exercise a lot of patience and wait for the market to correct its undervaluation of a company, the technician must possess a great deal of trading agility and know how to get in and out of positions with speed.

Picking Stocks with Technical Analysis

Technicians have a very full toolbox. They literally have hundreds of indicators and chart patterns to use for picking stocks. However, it is important to note that no one indicator or chart pattern is infallible or absolute; the

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technician must interpret indicators and patterns, and this process is more subjective than formulaic.

5.9

Bird’s Eye on the above Strategies Let's run through a quick recap of the foundational concepts that

are already covered in the above well-known stock-picking strategies and techniques:

√ Most of the strategies discussed in this tutorial use the tools and techniques of fundamental analysis, whose main objective is to find the worth of a company, or its intrinsic value.

√ In quantitative analysis, a company is worth the sum of its discounted cash flows. In other words, it is worth all of its future profits added together.

√ Some qualitative factors affecting the value of a company are its management, business model, industry and brand name.

√ Value investors, concerned with the present, look for stocks selling at a price that is lower than the estimated worth of the company, as reflected by its fundamentals. Growth investors are concerned with the future, buying companies that may be trading higher than their intrinsic worth but show the potential to grow and one day exceed their current valuations.

√ The GARP strategy is a combination of both growth and value: investors concerned with 'growth at a reasonable price' look for companies that are somewhat undervalued given their growth potential.

√ Income investors, seeking a steady stream of income from their stocks, look for solid companies that pay a high but sustainable dividend yield. 42


√ CANSLIM analyzes these factors of companies: current earnings, annual earnings, new changes, supply and demand, and leadership in industry, institutional sponsorship, and market direction.

√ Technical analysis, the polar opposite of fundamental analysis, is not concerned with a stock's intrinsic value, but instead looks at past market activity to determine future price movements.

END OF CHAPTER V “Be fearful when others are greedy, Be greedy when others fear” 43


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BEHAVIOURAL FINANCE

CHAPTER VI

6.1Conversation with STOCK INESTOR

If u ask a simple question to a stock investor, ‘what is your objective of stock investment?’ who showed interest in knowing the stock market. Quick came the reply, ‘I want to make money as soon as possible’. Firstly, making money has never been so simple and secondly when we talk of ‘Stock Investment’, many people stick to ‘stock’ and forget the word ‘investment’. Stocks or equity is one of the asset classes like savings instruments, funds, commodities and real estate for investment.

Now turning focus back to stocks, this is a question to a group of people with common interest that ‘is stock investment is an art or a science?’ and got varied answers. “It involves ratios, numbers, calculations, so it is a science”. “Picking the right time to sell and buy is an art” . But in a nutshell, it is a combination of both science and art. At a micro level, details of the company finance, balance-sheet, and cash flow, ratios is science. At the macro level, to understand the global scenarios, market sentiments and trends, supply/demand, interest rates and possess enough knowledge to join all the points to get the right picture and build the conviction to make up mind to buy or sell or to have patience not to buy or sell is an art.

When a common person builds interest in stock markets, the first question asked is ‘How much investment investor should start with to realize good returns?’ The first thing to remember is that return is relative to many factors. It is relative to the duration that you’ve held the stock and relative to the risk you have taken. So the most important thing before entering is a proper homework and build confidence, it does not matter how much you invest.

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The next common comment is ‘Investor got only Rs 50 return for the Rs1000, investor invested, and investor was expecting more’. To start with one should understand that rate of return is not relative the amount you invest. If a stock yields a return of 5% for Rs 1,000 will also yield the same 5 per cent for Rs10, 000. So never measure the return in absolute terms but in Percentages.

6.2Emotions Change Paradigms

This is a true story of a person who ran a coaching class with one of his colleagues. They started off well and within a couple of months they were full to capacity. After six months a few students complained to person about his colleague’s rude behaviour. The allegation was that he was very short-tempered and arrogant. They wanted him removed or else they would discontinue the classes. That person was worried. His colleague was his partner and he could not be removed. Moreover he was a brilliant professional and an able tutor. After a couple of weeks the colleague fell ill and was absent for some time. The students were very happy. They thought that they had been successful in removing him. One day that person learned that the colleague had brain tumour and needed an operation. This news shocked that person, as now his partner would be out of action for quite some time. He informed the students of this calamity. The students were stunned and this shock changed their attitude. Hatred and resentment gave way to empathy and love. They visited him at the hospital and took him flowers. They repented their stand and prayed for his early recovery so that he could come back to teach. The purpose of this story is to understand that as humans we are emotional beings and our behaviour and decisions are guided by our emotions. Frequently emotions prompt us to make decisions that may not be in our rational financial interest. Indeed, decisions that enrich us emotionally may impoverish us financially. Behavioural finance is the study of how emotions and cognitive errors can cause disasters in our financial affairs.

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6.3 Classical Economic Theory

v/s Behavioural Economic Theory

The Classical Economic Theory talks about efficiency of the markets and people making rational decisions to maximise their profits. It assumes that the markets are efficient and no one can take advantage of its movements. It also assumes that humans are rational beings and will act to maximise their gains. However behavioural economists believe that the markets are inefficient and human beings are not rational beings. Consider this example. If you and I were walking down a busy street in Colaba and you said saw a Rs. 5 coin on the road, I would say it’s impossible. So many people walk this road and the markets being efficient someone would have definitely picked it up. But in reality we do come across such instances. This shows that the markets are not as efficient as they seem to be. Further, if we assume that people make rational decisions to maximise profits then how do we explain people giving to charities or throwing a party to celebrate a birthday or an anniversary? Definitely this is not about maximising profits by rational people. Here’s another example for how irrational we can be. The acronym TIPS stands for: To Insure Prompt Service. If tips ensure good service we should be tipping before the service starts. Yet, we give tips at the end of the meal. We even give tips when the service is substandard. Tipping is more a custom. We do it mechanically, unaware that we are behaving irrationally. Yet, in economic theory we are rational beings always intent on maximising our economic status. This is a common mistake we make without realizing its pure economic implications. Behavioural finance researchers seek to bridge the gap between classical economics and psychology to explain how and why people and markets do what they do. Behavioural finance raises a couple of important issues for investors. The first is whether or not it is possible to systematically exploit

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Irrational market behaviour when it occurs. The second issue is how to avoid making sub-optimal decisions as an investor. The goal is to close the gap between how we actually make decisions and how we should make decisions.

√

In the stock markets, Behavioural finance explains why

Investor:



Hold on stocks that are crashing;



Sell Stocks that are rising;



Ridiculously overvalue and undervalue stocks;



Jump in late and busy stocks that have peaked

in a rally just before the price declines; Take desperate risks and gamble wildly when



our stocks fall; Avoid taking the reasonable risk of buying



promising stocks unless there is an absolutely ‘assured’ profit; 

Never find the right price to buy and sell stock;



Buy when we have to sell and sell when we

should be buying; Buy because others are buying and sell



because others are selling.

Psychology can play a strategic role in the financial markets, a fact that is being increasingly recognised. Students and proponents of behavioural finance create investment strategies that capitalize on irrational investor behaviour. They seek to identify market conditions in which investors are likely to overreact or under react to new information. These mistakes cause under priced or overpriced securities. The goal of behavioural finance strategy is to invest in or disinvest from these securities before most investors recognise their error, and to benefit from the subsequent jump or fall in prices once they do. 48


6.4 Understanding Investor Behavior

When it comes to money and investing, Investor is not always as rational as they think they are - which is why there's a whole field of study that explains investor’s-strange behavior. Let us look Where an investor, fits in? Insight into the theory and findings of behavioral finance.

√

Regret Theory Fear-of-regret, or simply regret, theory deals with the emotional

reaction people experience after realizing they've made an error in judgment. Faced with the prospect of selling a stock, investors become emotionally affected by the price at which they purchased the stock. So, they avoid selling it as a way to avoid the regret of having made a bad investment, as well as the embarrassment of reporting a loss. We all hate to be wrong, don't we? What investors should really ask them when contemplating selling a stock is, "What are the consequences of repeating the same purchase if this security were already liquidated and would I invest in it again?" If the answer is "no", it's time to sell; otherwise, the result is regret of buying a losing stock and the regret of not selling when it became clear that a poor investment decision was made - and a vicious cycle ensues where avoiding regret leads to more regret. Regret theory can also hold true for investors who find a stock they had considered buying but did not went up in value. Some investors avoid the possibility of feeling this regret by following the conventional wisdom and buying only stocks that everyone else is buying, rationalizing their decision with "everyone else is doing it". Oddly enough, many people feel much less 49


embarrassed about losing money on a popular stock that half the world owns like Reliance and Infosys - than about losing on an unknown or unpopular stock.

√

Mental Accounting Humans have a tendency to place particular events into mental

compartments, and the difference between these compartments sometimes impacts our behavior more than the events themselves. Say, for example, you aim to catch a show at the local theater, and tickets are Rs 20 each. When you get there you realize you've lost a Rs 20 bill. Do you buy a Rs 20 ticket for the show anyway? Behavior finance has found that roughly 88% of people in this situation would do so. Now, let's say you paid for the Rs 20 ticket in advance. When you arrive at the door, you realize your ticket is at home. Would you pay Rs 20 to purchase another? Only 40 % of respondents would buy another. Notice, however, that in both scenarios you're out Rs 40: different scenarios, same amount of money, different mental compartments. Pretty silly, huh? An investing example of mental accounting is best illustrated by the hesitation to sell an investment that once had monstrous gains and now has a modest gain. During an economic boom and bull market, people get accustomed to healthy, albeit paper, gains. When the market correction deflates investor's net worth, they're more hesitant to sell at the smaller profit margin. They create mental compartments for the gains they once had, causing them to wait for the return of that gainful period.

√

Anchoring In the absence of better or new information, investors often assume

that the market price is the correct price. People tend to place too much credence in recent market views, opinions and events, and mistakenly extrapolate recent trends that differ from historical, long-term averages and probabilities.

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In bull markets, investment decisions are often influenced by price anchors, prices deemed significant because of their closeness to recent prices. This makes the more distant returns of the past irrelevant in investors' decisions.

Over-/Under-Reacting Investors get optimistic when the market goes up, assuming it will continue to do so. Conversely, investors become extremely pessimistic amid downturns. A consequence of anchoring, placing too much importance on recent events while ignoring historical data, is an over- or under-reaction to market events which results in prices falling too much on bad news and rise too much on good news.

At the peak of optimism, investor greed moves stocks beyond their intrinsic value. When did it become a rational decision to invest in stock with zero earnings and thus an infinite price-to-earnings ratio (think dotcom era, circa year 2000)?!

Extreme cases of over- or under-reaction to market events may lead to market panics and crashes.

√

Overconfidence People generally rate themselves as being above average in their

abilities. They also overestimate the precision of their knowledge and their knowledge relative to others. Many investors believe they can consistently time the market. But in reality there's an overwhelming amount of evidence that proves otherwise. Overconfidence results in excess trades, with trading costs denting profits.

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Bird’s Eye Behavioral finance certainly reflects some of the attitudes embedded in the investment system. Behaviorists will argue that investors often behave irrationally, producing inefficient markets and mispriced securities - opportunities to make money. That may be true for an instant. But, consistently uncovering these inefficiencies is a challenge. Questions remain over whether these behavioral finance theories can be used to manage your money effectively and economically. That said, investors can be their own worst enemies. Trying to outguess the market doesn't pay off over the long term. In fact, it often results in quirky, irrational behavior, not to mention a dent in your wealth. Implementing a strategy that is well thought out and sticking to it may help you avoid many of these common investing mistakes.

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END OF CHAPTER VI “Gaps between perception and realty are where Investment opportunities are born”

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INVESTOR LOSE MONEY

CHAPTER VII 7.1 Why Investors Lose Money

Unfortunately, no matter how many times people try to stop Investor from losing money in the market, they often don’t listen until it’s too late. It is only after losing most of their money that they finally admit that they made mistakes. There is nothing wrong with or unusual about making mistakes.

Actually, the biggest mistake investor can make is not recognizing himself that he had made one. The most obvious clue that something is going wrong with his investments is that losing money. A loss of more than 10 percent on an investment is a signal of a problem. Remember this: Do not invest in the stock market in order to lose money.

Here, some of the mistakes which are done by retail investors are as follows:

Mistake #1: √

Investor Don’t Sell Losing Stocks For a variety of reasons, some investor holds onto their losing

stocks too long. Failure to get out of losing positions early is probably the number one reason why so many investing and trading accounts are destroyed. The reasons investor hold onto losing stocks is primarily psychological. To keep your losses small, investor need a plan before they buy their first stock. One rule is so important that investor should post it in front of their computer or on their desk: If they lose more than 10 percent on an investment, sell. They lost, so they sell the stock. They can put a stop loss order at 10 percent below the purchase price when they buy the stock, or they can make a mental note. The main point is that investor should take action when their stock is losing money.

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Mistake #2:

√

Investor let their Winning Stocks Turn into Losers It seems as if you can’t win no matter when you sell. If you sell a

stock for a gain, you are left with the lingering feeling that if you had held it a little longer, you’d have made more money. In contrast, some people made tons of money in the stock market, then sat back and watched helplessly while all their profits disappeared (what the market gives, the market takes away). Some are still in denial about the fact that many of their favorite stocks will never return to even. Many people lost not only their gains but their original investment as well. For these people, it would have been less painful to have never made money in the market at all than to have won and lost it all.

Mistake #3: Investor Get Too Emotional about their Stock Picks Inability to control their emotions is the main reason why most people should not participate in the stock market. When investing in the market with substantial money at stake, many people are flooded with emotions that compel them to make the wrong decisions. In fact, becoming too emotional about your investments is a clue that you could lose money. Making money should be as boring as waiting in line at the supermarket. A common problem, and one that especially afflicts those who have tasted success in the market, is overconfidence. Although some self-confidence is necessary if you are going to invest in the market, allowing your ego to get in the way of your investing is a dangerous sign. One of the reasons the bull market was destined to end so abruptly was that too many people were making too much money and thought they were geniuses. An old but true saying is, “There are no geniuses in a bull market.” The point is that people thought they were geniuses, but in fact they were just being carried by the strength of a bull market.

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Before the bull market’s abrupt end, many investors got so greedy that they couldn’t think straight. They were convinced that the good times would last forever. The signs of greed were everywhere:

• A 15-year-old boy, Jonathon Lebed, made a million rupees pumping and dumping penny stocks. The SEC allowed him to keep half his profits. • The CEOs of dozens of companies were paid hundreds of millions of rupees in salary and compensation, even though their companies were losing money. (Many made their millions through stock options, which although legal, did not seem fair to shareholders who lost money.) • Thousands of people were quitting their jobs to become day traders. • Stock prices in companies that had no earnings were doubling and tripling each day. • Many mutual funds were going up by over 100 percent a year. • Stock analysts and CEOs were treated like rock stars. “Hope is a dangerous thing.” “People are hopeful when they should be afraid and are afraid when they should be hopeful.”

Mistake #4: √

Investor Bet Money on Only One or Two Stocks One of the problems with investing directly in the stock market is that most people don’t have enough money to maintain a properly diversified portfolio. (In general, no one stock should make up more than 10 percent of your portfolio.) Although diversification limits your upside gains, it also protects you in case one of your investments does badly. If you feel that you must bet all your money on only one or two stocks, then buy stocks in conservative companies with low P/Es (less than 10) that pump up their returns with quarterly dividends. You want stocks in companies that are so good that they will be profitable for years.

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Mistake #5: √

Investors Are Unable to Be both Disciplined and Flexible Almost every professional investor will rightly claim that a lack of discipline is the main reason that most people lose money in the market. If you are disciplined, you have a strategy, a plan, and a set of rules, and no matter what you are feeling, you stick to your strategy, plan, and rules. Discipline means having the knowledge to know what to do (the easy part) and the willpower and courage to actually do it (the hard part). It means that you have to stick to your strategy and obey your rules. This has always worked for successful investors and mutual fund managers. Although the pros are right in claiming that you need discipline if you are to be successful in the market, you also need to balance this with a healthy dose of flexibility. Some investors were so rigidly disciplined about sticking with their stock strategy that they didn’t react when the market and their stocks turned against them. In the name of discipline, many investors went down with the sinking ship. Discipline is essential, but you must be realistic enough to realize that you could be wrong. You have to be flexible enough to change your strategy, your plan, and your rules, especially if you are losing money.

Mistake #6: √

Investors Don’t Learn their Mistakes Most experienced investors and traders know that you learn more from your losers than from your winners. One of the worst things that happened to many investors in the tech boom was that they made money in the market too quickly and easily. When the easy money stopped and the market plunged, many of them had no idea what to do next. Why? They didn’t know how it felt to lose money. Because they had made money the wrong way, they were destined to give it all back.

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If you lose more than 10 percent in the market, there are a few things you can do. Instead of burying your head in the sand, take the time to understand your mistakes. It’s not useful to make excuses and act as if your stock losses are only paper losses that will be made up in the future. In the market, everything doesn’t always work out in the end. Accept the loss and make sure you don’t make the same mistake again.

Mistake #7: √

Investor listens or Get Tips from the Wrong People If an investor eyes glaze over when they read about fundamental or technical analysis, there is a simpler way to find stocks to buy—stock tips. The beauty of tips is that investors can make money without doing any work. If this sounds too good to be true, it is. In fact, one of the easiest ways to lose money in the market is by listening to tips, especially if they come from well-meaning but uninformed relatives or acquaintances. These people often become cheerleaders for a stock, trying to convince you to buy it. Because it’s hard to say no to easy money (especially when the tip comes from a trusted source), there are some steps you can take to limit your risks. Should you get your stock picks from experts? Don’t forget that most of the experts who appeared on television or were quoted in magazines were terrible stock pickers. Analysts lied, economists misjudged the economy, CEOs were overly optimistic, and accounting firms fudged the numbers to make losing companies look like winners. At the same time, greedy and lazy investors must take responsibility for buying stocks based on tips. (“Everyone wanted to be a player but we ended up being played.”) The best advice you should received on the market was also the simplest: “Keep your ears shut”

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Mistake #8: √

Investor’s Follow the Crowd If investor want to lose money? Then do what everyone else is doing. Unfortunately, it is excruciatingly difficult to think differently from everyone else. If you study the lives of some of the greatest traders and investors in the recent past, you will find that they often made their fortunes by doing the opposite of what the crowd was doing. That means buying when other people are selling and selling when other people are buying. If you study the psychology of group behavior, you find many periods and events in history that attest to herd mentality—or the “madness of crowds,” as one author put it. Although the crowds can win, they don’t win for long. As mentioned earlier, the signal that a bull market is ending is that it seems as though everyone is in the market. Conversely, a signal of a bear market’s end is that people are too afraid to invest in the market. When almost everyone is avoiding the stock market, and it seems like perhaps the worst possible time to invest, the bear market will end. Unfortunately, no one rings a bell to announce the end. You have to figure it out for yourself. Keep in mind that perception about the market change very rapidly.

Mistake #9: √

Investor’s Aren’t Prepared for the Worst Before investor get into the market, they should be prepared, not scared. Although you should always hope for the best, you must be prepared for the worst. The biggest mistake many investors make is thinking that their stocks won’t go down. They are not prepared for an extended bear market, a recession, deflation, a market crash, or an unanticipated event that will ruin the market. Even if you don’t expect a financial disaster, create a “crash proof” plan based on logic and common sense, not fear.

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Mistake #10: √

Investor’s Miss Out or Mismanage Money Managing money is a difficult skill for most people, but it’s one of the most important skills to have. Unfortunately, if you can’t manage money, you’re destined to have financial problems. In the end, it’s not how much you make but how much you keep that matters. Do you want to know the secret to making money in the stock market or with any investment? Don’t lose money. If you think about it long enough, you’ll realize that this makes a lot of sense. Obviously, it’s not easy to find investments where you don’t lose money, but that shouldn’t stop you from trying. Just as harmful as mismanaging money is missing out on moneymaking opportunities. A little bit of fear keeps you on your toes, but too much fear can cause you to miss out on profitable investments or trades. It’s the fear of loss that prevents many people from buying at the bottom. It’s the fear of missing out on higher profits that prevents people from selling before it’s too late. Usually, fear results from a lack of information. That is why it’s essential that you do your own research when a financial opportunity comes your way. This gives you an opportunity to make an informed decision based on the facts, not on emotion. Obviously, you aren’t privy to all the information that you need in order to be 100 percent right. You have to make a decision based on the best information you have at the time. Many times you’ll be wrong.

7.2 Things Every Investor Should Know (Investing Basics)

There are a number of issues that investors should know and understand PRIOR to making investing decisions.

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Stocks To Riches -- An Insights on Investor Behaviour 

Investing in a vacuum is never a good idea. This sounds ultra simplistic. Set and establish goals for your future

and determine how those goals are influenced by the results of your investing. It is never wise to invest solely for the sake of "doing well" or "I want to retire comfortably". Goals such as these leave too much ambiguity and room for error. Your portfolio should reflect your goals (to retire at 55 with a specific income), risk tolerance. Think of it this way, you are on a journey. How do you know if you have arrived if you do not know where you are going? 

Investor have an advantage over the pros Professional money managers are usually always tied to beating "the market" month to month and quarter to quarter. They are judged solely by their performance and are therefore influenced to take more inherent risk in order to beat indexes and peers. The professionals also do not have the luxury of holding on (or buying more of) when a specific security starts to tank. You should have no such worries over performance measurement but can simply sit back, focused on the long-term, and wait it out. 

The level of return you seek is tied to a level of risk, or in other words the higher the rate of return the higher the risk you assume. Earning a high level of return requires taking more risk, but taking

more risk does not always equate to a higher return. It is a well-known fact that in order to achieve higher return rates you must assume a higher level of risk which can and typically does equate to losses within a portfolio greater than many investors are comfortable with accepting. However, just because a holding or portfolio is high risk it is not necessarily capable of generating high returns. In some cases something is considered "high risk" because it is unlikely to generate a moderate or high return. In fact as Mark Twain once remarked, "I am more concerned about the return of my money than the return on my money".

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Stocks To Riches -- An Insights on Investor Behaviour 

Asset allocation is THE most important part of investing* Much more so than choosing the right security or being lucky

enough to own the next Infosys, asset allocation determines over 91% of the total portfolio performance according to an Ibbotson study. A good, sound selection of asset classes mixed together will establish the framework of your portfolio performance over the long run. 

The Rule of 72. Many investors I have spoken with over time wonder about how

long it takes to double their money. This is typically presented in a statement that they desire their money to double every 3 or 4 years. The rule of 72 is one of those rules of thumb for quick and basic calculation. Take the rate of return and divide it into 72. This will be the approximate amount of time it takes for the money to double at the specified rate of return. For example, if you assume a 12% rate of return and divide 72 by 12 then your money would double in 6 years. For those of you who wish your money to double every 3 or 4 years this should give you an idea of the level of return (and subsequent level of risk) you must achieve. 

Watch what you watch and read. Turn off the talking heads on TV and put down the latest investment

periodical. These formats are informative if taken lightly and in the proper amount but they are more interested in selling subscriptions and driving ratings than they are about giving quality advice. The movements generated by the advice of those in the television and print media are not always the best for the investor. News only sells when it gets our attention and unfortunately that hardly ever equates to good news.

END OF CHAPTER VII An investor should act as though he had a lifetime decision card with just twenty punches on it. 62


CHAPTER VIII

INVESTMENT STRATEGIES

An investor's plan of attack to guide their investment decisions based on individual goals, risk tolerance and future needs for capital. The components of most investment strategies include asset allocation, buy and sell guidelines, and risk guidelines. Investment strategies can differ greatly from a rapid growth strategy where an investor focuses on capital appreciation to a safety strategy where the focus is on wealth protection. The most important part of an investment strategy is that it aligns with the individual's goals and is closely followed by the investor.

8.1 A Good Strategy

There is nothing wrong in speculation as such. On the contrary it is beneficial in two ways. Firstly, without speculation untested new companies like Infosys, Satyam, and in earlier times companies like Reliance, would never have been able to raise the necessary capital for expansion. The tempting chance of a huge gain is the grease that lubricates the machinery of innovation. Secondly, the risk is exchanged every time the stock is sold and bought, but it is never eliminated. When the buyer buys a stock he takes the primary risk that the stock will go down. However, the seller still retains the residual risk of the chance that the stock he sold may go up.



However, speculating can go wrong, if people:

Do not understand the difference between investing and speculating, Speculate without the right knowledge and skill, Speculate beyond the capacity to take a loss (that is called margin trading).

The greatest problem today is that most investors are acquiring speculative habits believing that they are investing. The attraction of quick money and the advent of the futures market have lured them to margin trading. 63


For a number of people, this has become a full-time occupation due to the advent of the Internet and online trading. This could be bad news especially when they are dealing with their life savings.



Nothing is Right or Wrong This conclusively proves a few points namely:



Long-term investing can be very rewarding if you buy the right company at the right price,



A stock can decline significantly in the short run and yet give a decent longterm return,



Short-term investing (speculation) can also be very rewarding if you are able to time the markets and take advantage of short-term volatility.

8.2 MONEY-MAKING STRATEGIES

A strategy is a plan that helps you determine what stocks to buy Or sell. If you are new to the stock market, it’s best to keep an open mind before choosing a strategy. If a particular strategy seems to make sense to you, take the time to do more research. It can take a long time before you find an investment strategy that not only makes sense but also increases the value of your portfolio. Keep in mind that you aren’t limited to only one strategy. Some investors and traders use a variety of strategies, whereas others are comfortable using only one. No matter what strategy you use, here are a few things you should remember:

1. A strategy is only as good as the person using it. In other words, no matter how brilliant and ingenious the strategy, you can still lose money.

2. Not all strategies work during all market conditions.

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3. Don’t become so devoted to a strategy that you are blind to the fact that you are losing money. Money is the scorecard that determines whether your strategy is working.

You have to take the time to find the strategy or strategies that fit your personality and lifestyle. Unfortunately, there are no magic answers to finding success in the stock market. For most people, the only way to find out what ultimately works on Dalal Street is through trial and error.

√

Buy and Hold: The Most Popular Strategy for Investors The reasoning behind the buy-and-hold strategy is that if you buy a

stock in a fundamentally sound company and holds it for the long term (at least a year), you’ll realize a profit. The beauty of a buy-and-hold strategy is that you can buy a stock and watch it rise in price without having to constantly watch the market. Investors who bought companies like Infosys, TCS, and RELIANCE in the early days made huge sums of money on paper without having to pay much attention to the market. The other advantage of buy and hold is that because you are not constantly buying and selling stocks, you are paying very little in brokers’ commissions. Buy and hold is the easiest investment strategy to use, and, in retrospect, it worked extremely well during the bull market. Perhaps the only time buy-and-hold investors sell is if something fundamentally changes in a company. They don’t sell because of what is happening to the market, the economy, or the stock price. They are focused only on the business, and they intend to hold their reasonably priced stocks as long as possible.

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√

Buy on the Dip: An Offshoot of Buy and Hold In this strategy, when a stock goes down in price, especially if it

believes the decline is only temporary, people buy more shares. The idea is that because the market always goes up over time (or generally has in the past); the shares bought at a lower price will eventually be worth more. People who used this strategy in the past made tons of money as the shares they bought kept going higher.

√

Momentum Investing: Buy High and Sell Higher Momentum investors are growth investors who look for stocks that

are ready to make explosive moves upward. They buy stocks at a high price but plan to sell them at an even higher price. They don’t care too much about the price they paid as long as the stock goes higher. Momentum investing works best during bull markets when there is a lot of liquidity. In the 2000s, it seemed as if no matter which stock you bought— especially if was an Internet stock—the stock would go higher. Some critics call momentum investing the “greater fool theory,” which means that no matter how high the stock price is, you will always be able to find a bigger fool who is willing to buy it from you. Momentum investors tend to use technical analysis to look for stocks that will make sudden and dramatic moves in a short period. In the go-go 2000s, a surprise announcement or positive rumor could send stocks up 20 or 30 points in one day. Although it is still possible to find momentum stocks, it’s not as easy as it was a few years ago. (And it’s unlikely that we’ll see that kind of market environment again for many years to come.) Momentum investing, although exciting and potentially profitable, is a difficult strategy. Many momentum stocks can explode in either direction, often costing lot of money. Although it’s possible to catch some of these stocks on the upside, it is definitely not as easy as it looks.

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√

Day Trading: Buying and Selling in Minutes Unlike investors, who may wait years before selling, day traders

buy and sell within seconds, minutes, or hours. Day trading is an extreme trading strategy that involves constantly moving into and out of stocks. Using technical analysis, professional day traders try to anticipate where a stock will go in the near future and trade accordingly. Usually, day traders sell all their stocks and move to cash by the end of each day.

8.3 Simple Investment Strategy: Invest in IPO’s

With more and more companies coming out with tempting IPO or additional offers, there is greater need to exert caution and pick the best IPO investments. Four critical factors to be studied in an IPO offer document, before making an IPO investment. In such a scenario it is but natural for the euphoria to pass on to the primary market. We have more and more companies coming out with IPO’s or additional offers. And predictably enough, these issues have generated huge interest amongst the investors and raised thousands of crores. Practically all such issues have been hugely oversubscribed. And most of them have given huge listing gains to the investors. One good thing about the IPO market vis-à-vis the earlier times has been that most of them have been from good companies and at reasonable prices. This trend, however, seems to be tapering off and we are increasingly seeing public issues from the relatively not-so-good or known companies and at fairly stretched prices. Therefore, it becomes necessary for the investors to become cautious and be more selective about their investments in IPO’s. The four critical factors which need to studied in an offer document when making an investment decision are Promoter, Performance, Prospects and Price.

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√

Check promoter standing This by far is the most important factor in any investment decision. A good promoter or management team is important for any business success, especially over long periods. While businesses may have their ups and downs, a good management will take all necessary steps to ensure profitable performance. Secondly, they would be constantly looking at new business opportunities, thereby ensuring regular growth in the company. Thirdly, we are reasonably certain that the company money will not be deliberately misused or siphoned off to the detriment of the shareholders. Therefore, look at the promoter’s background, the experience he has in the industry, the performance of the other companies promoted by him, his track record, investor complaints etc. Read the risk factors very carefully especially those pertaining to the promoter/management. Check for any serious litigation against the promoter or the company. See whether the company is a defaulter to the banks/FIs and the reason thereof.

√

Study company performance The share price is the reflection of the operational performance of the company. Poor numbers say the sales, profit; EPS etc. would mean poor performance on the stock exchange. Therefore, it is important that the company has a track record of good operational performance. Look for any window dressing. Are the numbers in line with the similar companies in the industry? Is there any sudden improvement in the numbers just before the issue, without any justifiable reasons? Also look at the performance of the group companies and the intercompany transaction within the group. Ensure that there are no dubious transactions. Look at the loans given to group companies. Are they paying reasonable interest? Is the loan likely to be repaid?

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√

Understand future prospects The future prospects of the Company and the industry would play an important role in the performance of the scrip on the stock exchange. Check the objects. How will they impact the future prospects? How will the funds raised be utilised? Will it additionally benefit the company? Is the money being raised for a new project, which will add to the bottomline of the company? If its’ an offer-for-sale, it means the existing shareholders are selling a part of their stake in the Company. The amounts raised from the issue will not go to the Company. Therefore, the Company will not benefit from an offer for sale. If the purpose of the issue is to list the company on the stock exchange and the 4 Ps are positive, then one can consider investing.

√

Look at the price Finally of course every product/scrip has a right price based on its’

fundamentals and industry prospects. Even if the above 3 Ps were favourable, a high price is likely to reduce the prospects of appreciation at the exchange, thereby defeating your purpose of investing. Look at the average industry PE and the companies EPS and try and estimate the fair price. Compare this with the issue price to see if it is undervalued or overvalued. Buy value nor price. An issue which are overvalued. Such issues tend to quote below issue price over a period of time and it may be prudent to enter then, than at the IPO stage. For follow-on issues the price is more or less known. Therefore, there may not be much listing gain or loss. Again look for fair valued or undervalued scrip. A little time spent in reading the offer document and analysing the IPO on the above factors will help you to make right investment decisions and prevent you from ending-up holding a dud stock.

END OF CHAPTER VIII “Lethargy, bordering on sloth, should remain the cornerstone of an investment style”

CHAPTER IX

RATIOS 69


9.1

Determining share prices

Share prices in a publicly traded company are determined by market supply and demand, and thus depend upon the expectations of buyers and sellers. Among these are:

9.2



The company's future and recent performance.



New product lines.



Prospects for companies of this type, the "market sector"



Prevailing moods & fashions.



Calculate Ratios.

Earnings Per Share - EPS The portion of a company's profit allocated to each outstanding

share of common stock. EPS serves as an indicator of a company's profitability.

Calculated as: EPS In the EPS calculation, it is more accurate to use a weightedaverage number of shares outstanding over the reporting term, because the number of shares outstanding can change over time. However, data sources sometimes simplify the calculation by using the number of shares outstanding at the end of the period. Diluted EPS expands on the basic EPS by including the shares of convertibles or warrants outstanding in the outstanding shares number.

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9.3

Price/Earnings Ratio - P/E Ratio: The Granddaddy of Stock Ratios The P/E of a stock describes the price of a share relative to the

earnings of the underlying asset. The lower the P/E, the less you have to pay for the stock, relative to what you can expect to earn from it. The higher the P/E the more over-valued the stock is.

The main reason to calculate P/Es is for investors to compare the value of stocks, one stock with another. If one stock has a P/E twice that of another stock, it is probably a less attractive investment. But comparisons between industries, between countries, and between time periods are dangerous. To have faith in a comparison of P/E ratios, you should be comparing comparable stocks.

A valuation ratio of a company's current share price compared to its per-share earnings.

Calculated as:

P/E

Also sometimes known as "price multiple".

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Various interpretations of a particular P/E ratio are possible: Either the stock is undervalued or the company's earnings are thought to be in decline.

0-13

14-20 For many companies a P/E ratio in this range may be considered fair value.

21-28

Either the stock is overvalued or the company's earnings have increased since the last earnings figure was published.

28+

A company whose shares have a very high P/E either really does have an exceptionally rosy future or the stock may be the subject of a speculative bubble.

N/A A company with no earnings has an undefined P/E ratio.

9.4

Return on Equity - ROE Measuring the Financial Health of a Company A measure of a corporation's profitability, The ROE is useful for

comparing the profitability of a company to that of other firms in the same industry.

Calculated as: ROE

Essentially,

ROE

reveals

how

much profit

generates with the money shareholders have invested in it. Also known as Return on Net worth (RONW).

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a

company


9.5

Return on Investment - ROI A performance measure used to evaluate the efficiency of

an investment or to compare the efficiency of a number of different investments. To calculate ROI, the benefit (return) of an investment is divided by the cost of the investment; the result is expressed as a percentage or a ratio.

Calculated as: Return on investment is a very popular metric because of its versatility and simplicity. That is, if an investment does not have have a positive ROI, or if there are other opportunities with a higher ROI, then the investment should be not be undertaken.

9.6

Price-To-Book Ratio - P/B Ratio A ratio used to compare a stock's market value to its book value. It is calculated by dividing the current closing price of the stock by the latest quarter's book value per share. Also known as the "price-equity ratio".

Calculated as: A lower P/B ratio could mean that the stock is undervalued. However, it could also mean that something is fundamentally wrong with the company. As with most ratios, be aware this varies by industry.

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This ratio also gives some idea of whether you're paying too much for what would be left if the company went bankrupt immediately.

9.7

Dividend Yield Ratio It is calculated to know what % of cash is earned on investment in

particular scrip.

Calculated as: Dividend yield ratio = DPS / MPS. Publicly traded companies often make periodic quarterly or yearly cash payments to their owners, the shareholders, in direct proportion to the number of shares held. By law such payments can only be made out of current earnings or out of reserves (earnings retained from previous years). The company decides on the total payment and this is divided by the number of shares. The resulting dividend is an amount of cash per share. The dividend yield is the dividend paid in the last accounting year divided by the current share price.

9.8

Dividend Per Share Since the shareholders are the owners of the business, they are

entitled to their share of the profits. This is paid out as a dividend, and is usually expressed as an amount per share. This is because the total amount a shareholder gets is reflected by their shareholdings in the company. The dividend per share shows how much the company has paid out on each individual share, and so is worked out as:-

DIVIDEN PER SHARE

Dividends paid

=

Total number of shares issued

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9.9

Profit Margin Indicates what portion of sales contributes to the income of a

company.

Calculated as: Profit Margin = Net Income/Revenue This ratio is not useful for companies losing money, since they have no profit. A low profit margin can indicate pricing strategy and/or the impact competition has on margins.

END OF CHAPTER IX SMART PEOPLE INVESTS SMARTLY KNOWLEDGABLE PEOPLE INVESTS FOOLISHLY

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INVESTING FUNDAS

CHAPTER X

FUNDAS OF INVESTING

10.1

√

Tips for the Successful Long-Term Investor

Many investing websites have hot stock picks and tips - most of which never pan out? Problem is stock picks aren't what makes you a successful investor . They key to making money in the long run is understands the fundamental principles of investing.

1) Use the Stop Loss order. 2) Sell the losers and let the winners ride! 3) Never invest on tips. 4) Stop worrying about the 1/8 th. 5) Pay little attention to the P/E ratio. 6) Don't try to "time the market". 7) Waiting for the market to correct. 8) Price is irrelevant.

These tips are by no means the only way to make money in the market. They are, however, eight pieces of solid advice that will help you come out on top in the long run.

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10.2

The 7 Ingredients to Market-Beating Stocks:

Ingredient #1: Don’t “Pick Stocks” - Invest in Companies (At The Right Price) • It’s all about the fundamentals. • Think about investments from the perspective of an owner and stop renting stocks. • Look for companies with wide economic moats. • Don’t forget about price! Ingredient #2: Focus on the Important Factors • Once you filter out the noise in the stock market, you can objectively analyze stocks. • Focus on factors such as profit margins, cash flow and general financial health. Ingredient #3: Avoid Big Mistakes (and Losses) • After analyzing your stocks for potential red flags, be sure there is still a built-in margin of safety. Ingredient #4: Don't Lose Sight of the Big Picture • Understand how the bigger picture affects a company before you invest in it. Ingredient #5: Know Thyself • Accurately assess your financial and personal situation and build a portfolio that is well-suited to your financial goals and personality.

Ingredient #6: 77


Avoid Conflicts of Interest • Getting investment ideas from an unbiased source is critical (just ask those who invested in the tech stocks to which analysts had given "buy" ratings while privately calling them "junk"). Ingredient #7: Remain Confidently Contrarian • When everyone is talking about something, it’s probably too late.

Do’s & Don’ts for Investors Do’s 1) Always deal with the intermediaries registered with SEBI. 2) Always keep copies of all investment documentation (e.g. application forms, acknowledgment slips, contract notes). 3) Ensure that you have money before you buy. 4) Ensure that you are holding securities before you sell. 5) Give clear and unambiguous instructions to your broker/agent. 6) IF facing a problem act promptly. Talk to broker and find a solution. 7) If your broker can't help you to resolve your problem, then talk to the stock exchange where transacted. 8) If the problem is still not resolved, write to the appropriate authorities. Explain your problem clearly and in brief.

Don'ts 78


9) Don’t deal with unregistered brokers/sub-brokers, intermediaries. 10)

Don’t forgot taking due documents of transactions, in

good faith even from people whom you know. 11)

Don’t fall prey to promises of unrealistic returns.

12)

Don’t

get

approvals/registrations

misled from

by

companies

Government

agencies

showing as

the

approvals could be for certain other purposes and not for the securities you are buying. 13)

Don’t transact based on rumors generally called ‘tips’.

14)

Don’t forget to take note of risks involved in the

investment. 15)

Don’t get misled by guarantees of repayment of your

investments through post-dated cheques. 16)

Don’t panic when facing a problem.

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The Risk Capacity Game Answer these questions to find out if you should even think of direct stock picking. This quiz will throw up an answer that will roughly tell you if you have the risk-taking ability. You may like to take more risk, but you may not have the profile to do so, if you get a low score on this test. Tick the one most applicable to you. 1. How old are you: •

a. 55 or over

•

b. Between 36 and 55

•

c. Under 35

2. Over the next ten years your annual family income is likely to: •

a. Go down substantially

•

b. Grow at slightly above inflation rate

•

c. Grow at more than 15 per cent a year

3. You are financially responsible for: •

a. Yourself and three or more people

•

b. Yourself and one more person

•

c. Only yourself

4. Your income source is: •

a. Risky

•

b. Secure

•

c. Very secure

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5. How far away are your major financial goals? •

a. Less than one year or retired

•

b. 2 to 7 years

•

c. More than 8-10 years

6. Your savings, including retirement plans, are: •

a. You are in debt (excluding the home loan)

•

b. Equal to six months salary or less

•

c. Equal to two years salary or more

7. You live in: •

a. On rent, don't own any real estate

•

b. Your own home on loan

•

c. Your own home that is fully paid for

8. How many years until you expect to retire? •

a. You are retired

•

b. You won't retire for at least another 10 years

•

c. You won't retire for at least another 20-30 years

Score in the following manner: Choice a: 1 point Choice b: 2 points Choice c: 3 points

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Final Scores: 8-13 -- Very low risk capacity. Stay away from direct stock market investing. This adventure sport is not for you. All equity exposure should come through mutual funds. 14-19 -- Medium risk capacity. You could look at allocating a small part of your equity asset allocation to direct stocks. Build a core portfolio with funds and then selectively use direct stocks to take more risk. 20-24 -- High risk capacity. You certainly have the ability to go white water rafting. Use the five tools we discuss to stay dry. Happy stock picking!

END OF CHAPTER X “The human proclivity - it gets feared of losses and Gets induced to greed’s. Every investor - wants to maximize his profit, And minimize losses to least.”

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CHAPTER XI

INVESTMENT Guru’s

Mr. RAAMDEO AGRAWAL JMD MOSt & Portfolio Manager -MOSt PMS Profile of Raamdeo Agrawal –

Date of Birth: 5th April 1957 Educational Qualification: Chartered Accountant Achievements:

Co-Author of the book "CORPORATE NUMBERS GAME" in 1986 Joint Managing Director of Motilal Oswal Securities Ltd Author of annual "Wealth Creation Study *.

Raamdeo Agrawal is the co-promoter of Motilal Oswal Securities Ltd (MOSL) since 1987. Mr. Agrawal is an Associate of Institute of Chartered Accountant of India. An equity research stalwart, he is respected by all in the research and broking industry of his valuable insights on issues related to equity research. His firm belief in “Value Investing” forms the core of MOSL investment philosophy. In 1986, Mr. Agrawal authored the book Corporate Numbers Game, along with co-author Mr. Ram K Piparia. He was awarded the Rashtriya Samman Patra by Central Board of Direct Taxes for a consistent track record of highest integrity in tax payments for a period of 5 years from FY95-FY99.

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CIO: Could we start off by asking you what your overall investment philosophy is? RAAMDEO AGRAWAL:

Investment philosophy evolves as one learns and grows The kind of ocean there is term of knowledge is amazing. One grows by learning and every day I’m learning new things. However, to be honest, I don’t think I have learnt even one percent of what there is to be learnt. There is nobody who can talk about a perfect philosophy of investing . I believe that one’s investment philosophy evolves as one learns and grows through such learning.

When I began my travails with the stock market, there was a strong desire to make big money. But I did not know how to go about thing so. Even to make a modest beginning, you needed some capital. Now, where does one get the first few thousand rupees to start with? I needed an idea that would enable me to begin without the comfort of adequate seed capital.

Broking is a great business I first began investing in 1980 on behalf of my brother who had about a lakh of rupees. I used to go my broker’s office and there I saw some possibility of making money without actually investing in the stock market to start with. The idea was to start as a stockbroker, earn brokerage income and then invest the surpluses in the stock market.

The entire process was very exciting. I started reading balance sheets in 1980. I used to sleep reading them in my apartment. I must have read over 500 balance sheets in the following three-four years. I began to think that I knew a lot about the stock market – much more than most of the guys on the street. I had a good grip on numbers and I wrote a book called The Numbers Game.

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Then I came across Warren Buffett’s principles Then there was the first breakthrough – a ray of knowledge. I came across a book on Warren Buffett, The Warren Buffett Way. Buffett was, I think, famous much before that. A lot of people who followed the stock markets – investors in the United States – had known of him and were regularly reading what he had to say. The Money Masters and some other book had interviewed him but I was not aware of that. This book was my first introduction to his views.

Focus on Return on Net Worth I also happened to change on some of his letters and I found them extremely interesting. I complied the letters right from 1977 and went through all of them in 3-4 months. In one of his letters he said, “Don’t focus on EPS, and focus on return on net worth.” As a chartered accountant, I had a rough idea of what it takes to make money. But it was then that I realised that the real foundation on which good investment is based is the return on net worth. Though I had a little feel for this sort of thing – the return on my money – I had never focused much on that. I used to think that if a company was big, it got a high discounting. I had never really tired to figure out what drove P/E. Buffett’s letter put things into perspective and I decided that I would never buy a stock that was not likely to earn 20-25 percent on its net worth going forward. Companies that earn a 30-35 percent ROE are no doubt great, but the problem is that the whole market knows about such companies. The biggest opportunities can be found in a company that currently has low ROE but because of some inherent strength, it is likely to go up substantially. A company that has identified its biggest competence and its confident of driving up its ROE substantially because of this is surely going to become rich.

Follow a focused approach to investing

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Patience is an invaluable virtue I found that it is better to invest within your own stocks provided of course that you have chosen them with care. Good businesses with sound management generally have a long life and their falling out of favour is normally a temporary phenomenon. In fact, such instances often give you a good investment opportunity. All the stocks in your portfolio will never remain at the peak. There will be some stocks that are undervalued and some stocks that are fairly valued. You actually make money by sitting rather than by thinking. You have to allow a good company to run its own course before your investment begins to pay off. It takes time for a young tree to flower and bear fruit. You need to have patience.

Always be vigilant 

CIO: You say buy and hold but don’t buy and neglect. RAAMDEO AGRAWAL: Yes, you have to be constantly watching. In India, the economy as a whole is changing. Even in the larger economies, things are not stable. The whole environment is dynamic and as circumstances change, the prospects of the stocks you hold also change. Say for instance you hold shares of a company that manufactures pens. If the customs duty on raw material increases or if the import duty on finished pens falls, it could have an adverse impact on the company’s profitability. If you do not keep a constant vigil on the businesses you have invested in, you could be caught on the wrong foot.

Focus on generating positive returns

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CIO: But right now we are witnessing tremendous volatility in the market. In such a scenario, wouldn’t diversification help?

RAAMDEO AGRAWAL: I have always focused more on generating positive returns from my investments rather than on what the market index does. My basic philosophy has been very simple. Initially I used to think that we should double our money in two years. But now I am comfortable if we double our money in three years. If I genuinely feel I have found a stock that will double in three years, I have no hesitation in picking it up. I consider buying a stock with the intention to sell it within a year as speculation, which I don’t want to indulge in. Not that six months or three months is a short period but it doesn’t give me that tax break. So, anything with a holding period of less than a year is not of great interest to me. After one year, the decision to hold the stock is driven by whether or not I think that it meets my basic criterion – the possibility of doubling in three years.

Pick high quality companies I generally invest in big companies. I somehow don’t value very small cap companies as much as the large cap ones, unless a particular small cap company is really uniquely placed and has interesting ideas. I am not saying that I consider only those companies that have market caps of at least Rs 5, 000 crores or Rs 10, 000 crores. No, that’s not the issue. The issue is that if it is not already large cap, the company should have the potential to become large cap. I am basically concerned with picking very high quality companies for my portfolio. So long as I am confident of the quality of the businesses that I have invested in, market volatility is never an issue. If all my 20-22 stocks were

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affected by market volatility in the same manner and they all fell in line with or faster than the market indices, I would be deeply concerned. However, I have never encountered such a position. It is always the poor quality stocks that are most affected by market volatility and you need to be extremely worried if your portfolio is made up of such stocks. Risk arising out of market volatility cannot be eliminated unless you go into cash. So I’m not particularly concerned about market volatility so long as my portfolio is colorful.

Follow a strategy that suits temperament CIO: Have you ever made money going short on any shares? RAAMDEO AGRAWAL: No, I have never made money by going short. I did try once or twice and when I look back, I realise that those were very good decisions. I would have made a good fortune had I stuck to my positions. But I don’t have the temperament to sit with a short position. I am not comfortable even if my total short position is just one percent of my portfolio value. If you have the right temperament, however, going short could be a much better way of making money. Of course, I am assuming that the laws are conductive to short selling.

Identifying a good business in not enough Examine whether good performance has been sustained CIO: In terms of quantitative measures would you say that high returns on equity, low gearing are some of the………… RAAMDEO AGRAWAL: It is possible that in a particular year a company might show extremely attractive financials. Profit & loss statements and balance sheet numbers can be suitably doctored to show a high return on equity. However, it is not possible to keep doing so in a sustained manner. If a company has been able to achieve high ROE and ROCE for the last five-six years in a sustainable fashion, it is very unlikely that the management is not 88


credible. A sustained high ROE, low gearing and a growing stream of profit is always associated with some unique business philosophy that has been guiding the company.

CIO: There is very little literature on what should determine one’s exit from a company: How do you decide when to exit? RAAMDEO AGRAWAL: If you get into a stock because it is undervalued, by the same logic, you should get out when it is overvalued. Typically, however, you fall in love with a stock when it gets overvalued. Not so much for the profit it has made for you, but because there is so much of consensus that it is such a great stock. If it is widely agreed upon that Infosys is a great company and it occupies the front pages of not only the national business dailies but also the global headlines, then it becomes difficult to take a contrary stand and sell the stock. It is not easy to follow a disciplined approach to investing. I have also been guilty of breaking my own rules in the recent times. I am not a good enough artist.

If you make a mistake, admit it and get out 

CIO: Are there any other factors that could influence you to exit a stock? RAAMDEO AGRAWAL: If a company is not behaving the way you thought it would, if your predictions about its performance go wrong, you should consider exiting. Say you thought that steel prices are going to be up but global recession sets in and they actually fall. Then you need to sell the steel companies you had bought on the premise that prices would rise. Normally, this is how one’s thought process would be: If one had

bought at Rs 108 and the stock had run up to Rs 120, one would comfortably get out. But if the stock had fallen to Rs 88, one would say, “Let me wait for the stock to go up to at least Rs 100.” But the stock might never again see a price

89


of Rs 100. So, wisdom is in getting rid of the stock at any price once you realize that your story has gone wrong.

Never count on making a good sale I believe that if you identify about ten fast growing large companies and even if you go wrong on three-four of these, you could still get desirable returns on your portfolio. It has been my experience that the successful ones normally yield disproportionately high returns, which more than make up or the losses resulting from the failures. Besides, I always love to keep that margin of safety when I buy a stock because I can never count on making a good sale. As long as I am sufficiently prudent in deciding my purchase price, even a mediocre sale gives me a good return on investment or at least helps me to conserve my capital. I strongly believe in Buffett’s following two principles,

“Rule 1: Never lose money.” “Rule 2: Never forget rule one.”

As somebody once said, “I walk very slowly but I never walk backwards.” Even a slow and painful progress over time leads us forward. We never borrow – neither for our business not for our portfolio. So long as we make good money we are not particularly concerned about the pace at which we do so.



CIO: You had recently talked about a slightly different or a new valuation tool, which you call the payback ratio. Could you discuss what this payback ratio is and how it works? RAAMDEO AGRAWAL: Yes, as part of our study on “Wealth Creation,” we had talked about the payback ratio or the purchase price recovery ratio . The current P/E should reflect the figure growth scenario for a company. But we find that one can’t 90


really figure out clearly how much growth is assumed. If the P/E is 5, does it mean that the company can grow at 5 percent? I don’t think it is so. So, the P/E per se is not a very good indicator of growth. The problem with PEG is that it takes into account the last two or three years that we include. It assumes a static condition for G going forward, which is not true. I mean it is coming to everybody’s notice in the last three month that whatever we had assumed in December is no longer true. So, the stocks that we had found to be suitably price based on PEG calculations then, appear expensive now. This is because G has fallen. So we said let’s take a more relevant measure. I think if you bought a company at a price that is less than the present value of its future cash flows, you’d have made a good investment.

The issue here is how far into the future should one go? We assumed a five-year time frame and experimented with past data of recent multibaggers to see if the theory worked. We took their market capitalization as they stood in 1995 and added their profits for the next five years to see whether they ‘paid back’ their market prices during that period. Infosys’ payback ratio in 1995 was less than one. It could recover more than what it took to buy it in 1995 in the next five years. Today I have the benefit of saying this because I am looking back. In 1995, you would have paid a price of Rs 380 crores for Infosys and in the next five years it would have earned Rs 500 crores. But had you bought it then, your wealth might have had multiplied by as much as 220 times. The rewards of identifying such companies at the right time can be truly great. In our last two studies we found that the overwhelming majority of the companies that do well on the stock markets show an earnings growth of at least 25 percent over the last three-four years. This may not be a sufficient condition. There are companies that grow at 25 percent but even then they do not make money. However, companies that are not growing at 25 percent

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definitely don’t make money. So, the condition that a company should be growing at 25 percent is a good starting point. Unless I believe that a company’s earnings will double in the next five years, I do not consider an investment in it. Zeroing in on a low payback ratio is basically about trying to see whether the company can grow its earnings by 25 percent on a consistent basis. If you are saying that 25 percent should be the earnings growth rate, 25 percent should be the ROE then you PEG ratio should be 1/2. So, if you pay 11-12 times current earnings of this kind of company and if your projections are right, it is unlikely that you will not make money. How much money you finally make will depend on the euphoria that the company generates. Five years back, Hero Honda had done better than many of the software companies on several parameters – whether it was free cash flow or earnings growth rate. But there had been no euphoria about the auto company. Thus, we saw that while Hero Honda’s P/E fell from 35 to 8 during the period, it went up from 8 to over 250 for IT companies.

Valuation should come last in your evaluation process 

CIO: So, is there a rule of thumb? If an investor is looking for a multibagger , what payback ratio should he look at? If he is looking for a steady 20-25 percent kind of return, then what payback ratio should he look at? RAAMDEO AGRAWAL: I would be very comfortable with a payback ratio of less than one for a potential multi-bagger. When I say I expect my investments to double in three years, I don’t mean that it is my starting point. That is my last point. I will always prefer investing in established large cap companies with good management. Valuations would come after I am satisfied with the business and its management. That sequence is very important. If

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you start with the valuation first, you could land yourself in serious trouble. 

CIO: Given that there are 10,000 listed companies, what really determines your population of companies or your circle of competence? How do you go about determining what companies you would consider investing in? How many companies from the universe you would select from? RAAMDEO AGRAWAL: You can afford to completely ignore most companies. There are just about 100-150 listed companies that are really worth even looking at.

CIO: How important is liquidity in your investment decision making? RAAMDEO AGRAWAL: I give

liquidity

a

lot

of

importance. In fact, I have let go of a number of good opportunities in the past because

the

stocks

concerned were not listed. I am stuck with one of my largest

investment

because it is not listed. So I hate to invest in company which is not listed. But I am not averse to investing in stocks that are out of favor

I

just

keep

my

tension levels low. I’m not looking should

for

stocks

have

that

trading

volumes of one or two million.

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CIO:



Having

invested in a stock, how frequently do you update yourself? RAAMDEO AGRAWAL: In fact, I spend lot of time doing that. It’s good you asked me that because I need to put it in perspective. I have my own research department and I kind of eat what I cook most of the time – 99 percent of the time. There is constant monitoring with the help of the respective squadron leaders. There is a practice of getting a valuation sheet organized value wise and business wise every day although I don’t really look at it on a daily basis. But the records are maintained so that I am able to go through them whenever I feel that there is a need to do so. It is, nevertheless, a continuous process.

CIO: And between these border thoughts of bottom-up investing and top-down investing have you by and large always been a bottom-up investor or you think that top-down investing has relevance an overall investment philosophy? RAAMDEO AGRAWAL: I have largely been a bottom-up investor , but in terms of risk management, top-down investing also has its own relevance. Say for instance, you get out of one overvalued IT stock and invest into another IT stock that you consider as undervalued at that point of time, you are actually not reducing your risk. Particularly the risk associated with that business. When the IT sector peaked, I did reduce holdings in some IT stocks but I went back searching for alternative stocks within the sector. Hence the stock that I replaced my earlier investment with also depreciated almost as much as the one that I sold. When you feel that a business has peaked out because of some bubble factor, it might be wise to go into cash. In such circumstances, even if you were investing in some other sector, you may not be very much better off. 94


CIO:

Are

you

suggesting

than

an

investor can actually time the market as well? RAAMDEO AGRAWAL: No, I am not suggesting that. Actually, I firmly believe that you should remain

100

percent

invested

both in good and bad times.

But if you don’t see a suitable investment opportunity, it is better sit on cash. It is like asking should you go to the river for taking a bath. There is no problem about it but if it is actually swollen or extraordinary torrential, you’d better avoid going there. Situations like the 1992 boom or the recent tech boom are akin to the extraordinarily torrential river. In such times, you’d fare better if you remained out of the market.

When greed is pervasive, move out 

CIO: Unfortunately, small investors typically enter the market at the wrong time. Could you tell us about the obvious indications that one could read into and hence avoid doing so? RAAMDEO AGRAWAL: I think the most obvious indication that the market is ripe for a fall is the entry of a large number of lay investors. When people who do not know anything about the markets and who are not normally interested in them begin to invest passionately, the seasoned investor must start contemplating an exit. During such times you’d see that the pensioner, instead of trying to get half a percent more on his old-age provisions, starts speculating in highly volatile stocks. Trading volumes witness a massive increase and the market index shows no signs of falling. When you see that greed is pervasive, it is time to move out.

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

CIO: Who is your ideal in the investment world? RAAMDEO AGRAWAL: I have read several investment gurus and have benefited from them. However, the ones that stand out particularly are Graham, Fisher and Buffett. As I told you earlier, I think I have been most fortunate to read Warren Buffett. I have particularly benefited from the concept of ‘margin of safety.” When I buy a stock, I look at it as buying a part of the company in question and not just as buying a share. I am conservative and I look for value.

Buffett has

covered

most

of what

Graham

propounds

–

conservatism, margin of safety, focusing on value and the like. Fisher talks more about growth companies and is closer to technology. I like more of growth investing than looking for some kind of dead value. I find it difficult to absorb things like asset stripping in special situations. I have been most influenced by Buffett and partly by Fisher. Although I have books on investing by several authors, I strongly feel that you must have only one guru. I consciously avoid getting deeper into investment techniques that I feel I do not have the temperament to follow. I think I don’t have the capability to become a super doctor after meeting 10 doctors. But I am talkative and I like reading. So, I am listening to all these people.

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Warren Buffet -- Ace stock picker, of course and now, an empire-builder

Background: A follower of Benjamin Graham, Buffet used a modified valueinvesting approach after he made a mistake by buying Berkshire Hathaway, then a textile firm.

Investment philosophy: Investors should bet on companies that not only fit the Value Investing criteria, but their business should have solid economics behind it. They should ask questions about the earnings growth and consistency in margins return on equity and whether they retain earnings for future growth.

The Buffett Way Step 1.

Turn off the Stock Market. 97


Step 2.

Don’t worry about the Economy.

Step 3.

Buy a Business, not a stock.

Step 4.

Manage a Portfolio of Businesses. The Warren Buffett Way is deceptively simple. There are no

computer programs to learn or two-inch thick investment banking manuals to decipher. There is nothing scientific about valuing a business and then paying a price that is below this business value. “What we do is not beyond anybody else’s competence,” says Buffett. “It is just not necessary to do extraordinary things to get extraordinary results.”

Whenever people try something new, there is initial apprehension. Adopting a new and different investment strategy will naturally evoke some uneasiness. In “The Warren Buffett Way,” the first step is the most challenging. If you can master this first step, the rest of the way is easy.

Step One: Turn off the Stock Market Remember that the stock market is manic-depressive. Sometimes it is wildly excited about future prospects and at other times it is unreasonably depressed. Of course, this behaviour creates opportunities, particularly when shares of outstanding businesses are available at irrationally low prices. But just as you would not take direction from an advisor who exhibited manic-depressive tendencies, neither should you allow the market to dictate your actions. The stock market is not a preceptor; it exists merely to assist you with the mechanics of buying or selling shares of stock. If you believe that the stock market is smarter than you are, give it your money by investing in index funds. But if you have done your homework and understand your business and are confidence that you know more about your business than the stock market does, turn off the market. Buffett does not have a stock quote machine in his office, and he seems to get by just fine without it. If you plan on owning shares in an 98


outstanding business for a number of years, what happens in the market on a day-to-day basis is inconsequential. You will be surprised that your portfolio weathers nicely without you constantly looking at the market. If you don’t believe so, give yourself a test. Try not to look at the market for forty-eight hours. Don’t look at a machine, don’t check the newspaper, don’t listen to a stock market summary, don’t read a market dairy. If after two days you companies are well, try turning off the markets for three days, and then for a whole week. Pretty soon you will be convinced that your investment health has survived and that your companies are still operational, despite your inattention to their stock quotes.

“After we buy a stock, consequently, we would not be disturbed if markets closed for a year or two, “says Buffett, “We don’t need a daily quote on our 100 percent position in See’s or H.H. Brown to validate our well being. Why, then, should we need a quote on our 7 percent interest in Coke?” The same holds true for individual investors. You know you have approached Buffett’s level when your mind is: “Has anybody done anything foolish lately that will allow me an opportunity to buy a good business at a great price?”

Step Two: Don’t Worry About the Economy Just as people spend fruitless hours worrying about the stock market, so too do they worry needlessly about the economy. If you find yourself discussing and debating whether the economy is poised for growth or tilting toward a recession, whether interest rates or moving up or down, or whether there is inflation or disinflation, STOP! Give yourself a break. Except for his preconceived notions that the economy inherently has an inflation bias, Buffett dedicates no time or energy analysing the economy. Often investors begin with an economic assumption and then go about selecting stocks that fit nearly within this grand design. Buffett considers this thinking foolish. First, no one has economic predictive powers any more than they have stock market predictive powers. Second, if you select stocks that will benefit by a particular economic environment, you inevitably invite turnover and 99


speculation. Whether you correctly predict the economy or not, your portfolio is continuously adjusted to benefit in the next economic scenario. Buffett prefers to buy a business that has the opportunity to profit regardless of the economy. Of course, macroeconomic forces may affect returns on the margin, but overall, Buffett’s businesses are able to profit nicely despite vagaries in the economy. Time is more wisely spent locating and owning a business that has the ability to profit in all economic environments than by renting a group of stocks that do well only if a guess about the economy happens to be correct.

Step Three: Buy a Business, Not a Stock Let’s pretend that you have to make a very important decision. Tomorrow you will be given an opportunity to pick one business in which to invest. To make it interesting, let us also pretend that once you have made your decision, it cannot be changed and, furthermore, you have to hold the investment for ten years. Ultimately, the wealth generated from this business ownership will support you in your retirement. Now, what are you going to think about? Probably many questions will run through your mind, initially causing a great deal of confusion. But if Buffett were given the same test, he would methodically begin with:

Business Tenet: Is the business simple and understandable? You cannot make an intelligent guess about the future of your business unless you understand how it makes money. Too often individuals invest in stocks without a due as to how a company generate sales, incurs expenses, and produces profits. If you can understand this economic process, you have the ability to intelligently proceed further in your investigation.

Business Tenet: Does the business have a consistent operating history?

Step Four: Manage a Portfolio of Businesses

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Now that you are a business owner as opposed to a renter of stocks, the competition of your portfolio will change. Because you are no longer measuring your success solely by price change or comparing annual price change to a common stock benchmark, you have the liberty to select the best businesses available. There is no law that says you must include every major industry within your portfolio, nor do you have to include twenty, thirty, forty, or fifty stocks in your portfolio to achieve adequate diversification. If a businesses, why should it be any different for the owner of common stocks? Buffett believes that wide diversification is only required when investors do not understand what they are doing.

If these “know-nothing” investors want to own common stocks, they should own a large number of equities and space out their purchases over time, other words,

The “know-nothing” investors should use an index and dollar cost average purchases. There is nothing shameful about becoming an “index investor.” In fact, Buffett points out; the index investor will actually outperform the majority of investment professionals. “Paradoxically,” he notes, “when dumb money acknowledges its limitations, it ceases to be dumb. “On the other hand, “Buffett says, “if you are a know-something investor, able to understand business economics and to find five to an sensibly-priced companies that possess important long-term competitive advantages, conventional diversification makes no sense to you. “Buffett asks you to consider: Investors can measure the economic progress of their business portfolio by calculating their look-through earnings, just as Buffett does. Multiply the earnings per share by the number of shares you own to calculate the total earnings power of your companies. The goal of the business owner, Buffett explains, is to create a portfolio of companies that, in ten years, will produce the highest level of look-through earnings.

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Because growth of look-through earnings, not price changes, now becomes the highest priority in your portfolio, many things begin to change. First, you are less likely to sell your best businesses just because you have profit. Ironically, corporate management understand this when they focus on their won business operation. “A parent company,” Buffett explains, “that owns a subsidiary with superb long-term economics is not likely to sell that equity regardless of price.” A CEO wanting to increase the value of his business will not sell the company’s “crown jewel.” Yet this seems CEO will impulsively sell stocks in his personal portfolio with more logic than “you can’t go broke taking a profit.”

END OF CHAPTER XI “An investor needs to do very few things right as long as he or she avoids big mistakes”

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TOP PICKS Sector

Analysis\ Reasons 1.

Companies

Diwali

Festival. 2. Auto Sector

Sales will

1. BAJAJ

increase. 3.

High

2. HERO HERO HOND HONDA A

spending Power, because of bonus,

3. MARU MARUTI TI

salary increment, 4.

Low Interest

rates 5.

Easy

Availability of Loans. High Credit Demand Low Interest Rates Banking Sector

1. SBI

Low Inflation Bond Prices are high.

2. PNB

1 year Laggards 1. High Demand despite of Monsoon Cement Sector

2.

Now

Monsoon Over, Prices will be high 3.

1. ULTR ULTRAT ATEC ECH H

As per the

current situation, Demand is high and supply is low.

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2. JP ASSO ASSOCI CIAT ATES ES


Retail Sector

1.

More

PANTALOONS

Spending power

INOX

2.

PVR

Diwali

Festival 3.

Increase in

Sales.

My Investment Strategy After completing Workshop on Capital Market, I took decision of investing in shares. I started buying and selling shares in the month of August, 2005, when the bull market was just started, I opened my demat account in India bulls, because 2 of my friends suggested me to do so. Account was opened, now I have have to depo deposi sitt mone money y into into the the acco accoun untt for for buyi buying ng shar shares es.. I star starte ted d my investment with Rs. 5000, which I borrowed from my father. After completing all the formalities, I start looking which to company to buy, why to buy, what will be my investment strategy and these types of questions was coming in my mind. I starte started d buying buying share shares s with with the trad trading ing strat strateg egy, y, beca becaus use e the amount which I was having was too small, I can’t buy shares and hold, so my goal was to maximise wealth by hook or by crook. You must be thinking with only Rs 5000 how can I trade, because because of India bulls, they have a facility called as 4x (times) margin available on ur deposit. So, I can trade unto Rs 20, 000. My investment strategy while buying shares. Is to call the broker, ask him intraday or short selling scrips, and ask him whether it will give profit or not, then too decide how many shares to buy for intraday or for short selling. At the end of the day either profit or loss. This type of investment strategy is because of lack of money.

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But then I decided to buy shares for delivery, for that I started investing in IPO’s, which I believe is the easiest path of earning good profits in equities. But after completing this project, I came to a decision, to change my beha behavio viour, ur, and and my invest investme ment nt strate strategy. gy. Want Want to becom become e a Long Long Term Term Investor, or a Value Investor. My aim while purchasing a stock I will its balance sheet and several ratios, which are required while analysing the correct price.

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Conclusion

Before you attempt to buy your first stock, be aware that you are entering a battlefield populated by sharks that want your money. If you are going to invest in the market, you must fight them with knowledge (a very effective shark repellant). If you aren’t willing to do your own homework (independently do research on companies and stocks) and must depend on a stockbroker or a stranger on television to tell you what stocks to buy or sell, you are destined to lose money. You have no one to blame but yourself when you do.

If you lose money, the government won’t help you, nor will your broker. Remember that making money in the stock market is serious business. It is as serious as raising children or working at a fulltime job. In the end, you must take responsibility for your own investments. You’re completely on your own.

Now that you are aware of the risks as well as the rewards, you have choice. If you are willing to take the time to learn what works on Dalal Street, you can survive and prosper as a twenty-first-century investor.

To win, you have to be faster, more knowledgeable, and more flexible than investors in the past. Don’t stop until you have created a successful portfolio.

On the other hand, if you decide that stocks are not for you, at least you have a better understanding of how the stock market works. This misinformation that should help you no matter what you decide to do in the future. Always be on the lookout for profitable money-making opportunities while remaining cautious. When in doubt, however, don’t do it.

“It’s been a pleasure sharing my knowledge with you. I wish all of you the best of luck and hope that all your financial dreams come true.”

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BIBLIOGRAPHY

WEBSITES www.bse.com www.investopedia.com www.investmentu.com www.esnips.com

BOOKS India’s Money Monarch. Investing Secrets. The Warren Buffet Way. How to build wealth like Warren Buffet.

NEWSPAPERS Economic times

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Finale Stocks

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