You cannot create wealth with an 8% interest rate investment option like Fixed Deposit.
Let’s go back 20 years back.
If you had invested Rs. 1 Lakh in 2020 into a fixed deposit then this would have been the growth at 8%.
Your investment would have become Rs. 4.66 Lakh in 20 years.
But if you had invested back the same Rs. 1 Lakh in shares of Eicher Motors (Royal Enfield Bullet)?
Disclaimer: I am not sharing any tips to buy/sell shares. All the company names are mentioned in this email for educational purposes only.
Eicher Motors was trading around Rs. 3 per share in 2020 and you could have bought 33,000 shares in 1 Lakh.
A single share of Eicher motor is trading at Rs. 2000 today.
The value of those three thousand odd shares at the present date is:
33,000 shares x Rs. 2000 = Rs. 6.6 Crores.
A huge difference in returns and that too after accounting for two big stock market crashes – the subprime crash of 2008 and the recent crash because of COVID-19 in 2020.
Even after huge fluctuation, due to some economical or market conditions just like COVID, you could have built a good enough wealth.
Let us take a look at one more example of Bajaj Finance. In 2000 the stock was priced at hardly Rs. 4 per share. With Rs. 1 Lakh investment amount, you could have purchased 25,000 shares.
Bajaj finance is trading above Rs. 3000 now:
Means value of your 25,000 shares would have been over Rs. 7 Crores.
This is the power of investment in equities that no other asset class can match including real estate which has its own share of problems in terms of returns (10% CAGR), ease of handling, liquidity and huge initial capital.
Difference Between Debt and Equity Asset Class
Debt Class is for lending but Equity Class is for business ownership.
People become rich when they own a business, right?
When you are investing in a debt instrument you are lending money to banks in return you receive the interest. Your returns are fixed.
Whereas, when you invest in equities (shares), you are a part-owner of the business. If the business does well your stock does well too, which means increases in value.
Be a Business Owner
Always think like a business owner and your mind will think in the right direction. Assessing a business is the heart of stock market investing.
You have to understand and know the business you are buying. That effectively means being passionate about knowing everything about the business like a true owner.
When you are familiar with the business and know the in-and-out of the business then only you can know the correct value of a stock. This means while analyzing any stock for value investment, you should think like a business owner who is going to run that business.
Thinking like a business owner helps you understand the factors that will impact your manufacturing process, business operations and market dynamics.
You will understand why there is product appeal, the brand value and the competition and their products. The various strong points give you an edge over your competition.
Value investing helps you to make the right choice of a business that you understand thoroughly.
#1. Scalability of Business
A scalable business is one that can be expanded and grown to capture a larger market share.
For example, you can consider the market for consumer goods in India as a scalable business. As the market grows because of increased consumption, the demand for consumer goods automatically increases.
Take the case of Britannia Industries. It’s a high potential scalable business.
Increased consumption for biscuits, cakes and bread drives more demand for its products, increasing its market share, thereby making the business scalable.
The Britannia stock gave 10X returns in the last 5 years as consumption for its products increased in India.
#2. Brand Power
A strong brand doesn’t require much convincing and has a huge recall value in public memory.
The products of such brands sell easily resulting in huge sales consistently year after year.
Take the case of Maruti Suzuki, one of India’s most trusted brands and the go-to choice in the car segment.
Maruti Suzuki has built its brand power over the years through affordable pricing, wide distribution, and great customer service.
The stock has moved from Rs 125 to Rs 10,000 delivering a staggering 80X returns.
In business terminology, Moat is the competitive advantage that one company has over the other within the same industry.
The wider the moat, the larger the competitive advantage of the company and the more sustainable the company becomes.
It would be difficult for the competitors to displace that company and capture its market share.
Take the case of L&T, one of India’s top infrastructure & construction companies. The company has very strong expertise and capability to execute infrastructure & construction projects that other companies find very difficult to match.
#4. Industry Outlook
Industry outlook helps in understanding the current and future trends in the economic environment.
When you study the industry as a whole, then you will uncover key trends, come to know about the challenges, opportunities, and other insights that influence the business you are interested in.
A company can be really good in its industry but it’s never insulated from the industry-specific problems.
For example, the airline industry in India. The industry is having problems with high capital requirements, high aviation turbine fuel costs, low-profit margins and intense competition.
This means even market leaders like IndiGo airlines are not insulated from the industry-specific problems.
#5. Management Quality
Fraud management is one of the reasons that some people do not trust the stock market for investments.
There have been many cases in the past where management of listed companies did shady deals, committed accounting frauds, misled shareholders thereby causing a lot of monetary loss to investors.
A famous example is Ramalinga Raju of Satyam.
In 2018 there are examples of bad management like Gitanjali Gems (Chairman- Nirav Modi) because of whom shareholders lost a lot of money.
The recent case is of Yes Bank where Rana Kapoor, the founder & former chairman is accused of receiving kickbacks in exchange for loans.
Therefore, it is very important to check that the stock/company in which you plan to invest, is run by an honest, transparent, and competent management.
Companies with competent management sail the company through tough times and are true wealth creators.
Like Avanti Feeds, a frozen seafood exporter company that has delivered 7000% returns in the past 5 years creating huge wealth for its investors.
Beyond qualitative assessment, one way of finding good companies is to ask whether their product/service will undergo any change over the next 10 years.
In the words of Warren Buffett –
“We will never buy anything we don’t think we understand. And our definition of understanding is thinking that we have a reasonable probability of being able to assess where the business will be in 10 years”.
Meaning, you need to be able to understand a company’s business and be able to look out how a company is going to do 5 or 10 years ahead.
Furthering Buffett’s logic, it is better to avoid companies selling products that can one day become obsolete or replaced by technology.
For example, businesses like physical bookstores, fax, CD, DVD players, scanners, digital cameras, travel agents and traditional taxis have all taken a hit because of smartphones and changes in technology.
The above businesses are either extinct or are struggling to survive.
Buy Stock at the Right Price
Buy a business at the time when the stock is available at a price that is lower than its intrinsic value.
If the actual value of a business is Rs. 400 per share then buy when it is trading in the stock market at Rs. 100 per share.
The stock will reach its actual price in the future and you can make actual returns of 4X or higher.
Let’s take Maruti Suzuki’s example. The stock is trading around Rs. 6,500.
What if after the latest analysis you realize that the stock is worth Rs 20,000?
You would definitely buy it since there is a potential of earning more than 3X gains.
But what if your latest analysis says that the stock is worth Rs. 4,000 only. You would stay away from it since the stock could correct in the future leading to a loss in investment.
This is what valuing a business is all about. This is how you identify a good/bad business that makes a great/poor investment.
But, how do you know the true value of a business?
How do you know whether to pay Rs 50, Rs. 110, Rs. 250, or whatever the right price might be for a business?
The answer lies in its “Intrinsic Value”.
Intrinsic value is the fundamental or inherent value of a business. The intrinsic value may or may not be the same as the current market value.
If the current market value of the stock is above the intrinsic value, then you can say that the stock is overvalued i.e you need to pay more than what the stock is for.
If the current market value of the stock is below the intrinsic value, then you can say that the stock is undervalued i.e, you will get the stock for a cheaper price than what the stock is for.
Also sometimes, you come across businesses with attractive/cheap valuations. That doesn’t mean you should buy those stocks because the cheap valuations could be because of the poor fundamentals of the businesses.
Common Mistakes to Avoid
#1. Relying too much on numbers and ratios
Financial numbers and ratios definitely help you gauge the performance of the company. But unfortunately, the qualitative aspects like corporate governance and good management of a company can’t be measured.
Apart from numbers, you need to look into the softer aspects of running the company.
#2. Large businesses and conglomerates
Large businesses or conglomerates with lots of products and services may seem to be stable and diversified. But you do not know the multiple ownership structure and the arrangements.
Look for investing in a simple business that is easier to understand as compared to large complex conglomerates.
#3. A highly profitable company is not always fundamentally strong
We all have a notion that profitable companies are fundamentally strong. But even profitable companies can have bad management or are influenced by industry-wide problems.
#4. Low PE ratio
A common pitfall is buying shares of companies that have a lower PE ratio as compared to the industry PE.
This may not be the correct way of valuing a company. PE can be high or low because of certain reasons. You need to understand the cause of lower PE before you buy the stock.
Start Stock Investment
#1. Open Demat account
You need a “demat & trading” account to invest in stocks. If you love to do your own research then you can open a demat account at a discount stockbroker.
A full-service broker charges huge brokerage whereas a discount broker offers free stock delivery.
If you have a large corpus to invest then you can save decent money with a discount broker.
I would suggest you open a Zerodha account because of
- Cheap brokerage
- Good customer support
- Quick account opening process
#2. Shortlist a few companies that you understand
Look around for some businesses that are simple and which you can understand easily.
You can use online stock screener tools for shortlisting companies based on different parameters like market capitalization, net sales, profits, or total assets.
#3. Use tools to analyze the company performance
After you have selected the companies, next, you need to analyze the company’s performance. Collecting all the data and doing calculations can be a tedious task.
#4. Read the annual reports
To dig deeper into the company’s management, vision, audit reports and breakup of financial performance you need to go through the annual report.
The annual reports for previous years can be found on the company’s website and also on the stock exchange website if the company is a listed entity.
#5. Find the right price to buy the price
Based on your findings and analysis you need to arrive at the intrinsic value of the company. Compare this value with the current trading price of the company on the stock exchange.
If the current market price is higher than the intrinsic value then you should not invest. If the price is lower then you should consider how much lower the price is from the intrinsic value.
If it is lower by 3x or more then you should consider buying the share. Or wait for such time when the price gets lower due to market news or volatility
Now you have to choose 1 industry that you understand and analyze their top 3 shares. Would you share your research with me?
PS– If you don’t have the demat account yet, then open through this quick application link because in the next chapter we are going to share about stock trading.