Lesson #1: Why Invest in Stock

Markets?
Value Investing for Smart People is a course that will teach you the simple and sensible
strategies to invest in the stock markets to grow your wealth over the long term.
But since this is the very first lesson, let us answer this question to start off with
Why invest at all?
All of us have a long list of financial goals, starting with things like paying the EM of our
house, putting food on the table, and paying all other bills so that we live comfortable
lives.
!hen you work your way down the list, you get to things like replacing the old car, buying
a second house, putting the kids through college, and retiring.
"ou see, most of our wants # and you might associate with this # will e$ceed our
e$pected lifetime earnings. %his is even before you include a lu$ury car and a foreign
holiday that you&ve promised your wife.
'ow to you plan to meet all these e$penses( )emember, we&ve already said that most of
these e$penses will e$ceed your e$pected lifetime earnings.
*o how do plan to meet at least the critical financial needs that will arise in the future #
like putting the kids through college, and your own retirement(
"ou already work so hard to earn money to meet your e$penses and save for the future.
"ou toil hard, you sacrifice your personal life, and sometimes your health in the race to
earn more and more money.
But amidst all this, how much thought do you give to that fact that you can take help from
+someone else& as well to earn us more money to help you meet all your financial goals in
the future.
,et me cut it short here. %hat +someone else& is none other than your own money # what
you are earning and saving today.
"es, your own money can earn money for youand lots of it- .eople who are rich know
this for a fact. But most of us in the middle class don&t.
After all, our school and college education has never taught us this way to earn money.
And neither have our parents.
!hat we have always learnt is to study well, get a good /ob, earn money, and save for
the future. 0obody has really told us that there&s one more aspect to our working and
earning life # investing for the future.
%his is the reason most ndian middle1class households +save& money # in safe deposits
of banks and post offices, or in the form of gold and silver # and rarely +invest&. "ou might
be one of them too.
But do you know how much our money grows when kept in these +safe& places(
A bank account can give you a ma$imum of 2134 interest per year. A bank fi$ed deposit
or a post office saving will give you somewhat better, but only 5164. 7old and silver
won&t earn you anything till the time you don&t sell them. And as far as property is
concerned, in a normal year, it can rise at an 819:4 rate as well.
;Aren&t these good returns(< you might ask. 0ot really, let me say-
!hile calculating your +real& return from all these or any other avenue, we must also take
into account the +inflation& factor.
n simple terms, inflation is nothing but a rise in prices of things that we consume. *o, if
we are paying )s =: a kg for onions today while these were costing )s 9: a kg one year
back, the rate of inflation is a whopping 3::4. But this is an e$ception.
nflation is ndia has generally been in the =164 range over the past many years. And it is
e$pected to remain in this range in the future as well, notwithstanding sharp spikes and
falls in between.
*o, when you calculate the +real& return on your investment, you must reduce the inflation
rate from your total return. ,ike, if your bank account gives you an annual interest of 34
while inflation is at =4, your real return equals a negative 94 >194?. And if a fi$ed
deposit gives you 84, your real return will stand at 24 >84 minus =4?.
0ow do you think that this kind of return is fine, especially when inflation rate is only
going to rise in the future >given the rising shortage of everything we consume?(
t isn&t. mean this is not what we can call +growth of our money&. nflation actually eats
into our money. And how(
,et&s assume that you have )s 9:: with you are looking to buy onions. At a rate of )s 9:
per kg, you will end up buying 9: kg of it. But what is the price rises to )s =: a kg after
one year while you still have only )s 9:: to spend(
n that case, you will be able to buy only @ kg of onions. %hat&s the negative effect of
inflation # the value of every rupee you will have in the future will be lesser than the value
of that one rupee today. And that&s the where the concept of investing and inflation
comes into play. %o grow your money fast at a time when inflation is eating into it is very
important.
Aorget onions. ,ook at the total cost of living that is rising at such a fast pace these days
that that we need to prepare ourselves well to meet our future financial obligations. And
these can include our children&s high education and marriage, our parents& healthcare
needs, and our own retirement. All these are big e$pense items and as such we need to
save and invest a lot to collect their kind of money over the ne$t =, 9:, 9=, or @: years.
,et us now look at how many years you will take to accumulate )s 9: lac for your new
born daughter&s higher education 98 years down the line, if we start with )s @ lac today.
!e will assume real returns >total return minus inflation of =4? of different avenues to
arrive at this number.
'ere&s the chart that shows it all.
Note: Real returns (shown inside brackets) are calculated assuming inflation rate of !
As the above chart shows, the only way to meet you target of reaching )s 9: lac >if you
start with )s @ lac today? in 98 years is to invest in stocks. !hile your bank AB will not
get you anywhere, the property route will take a much longer time that what your
requirement >of 98 years? permits.
%hese calculations are not based on some random numbers. %hese are e$actly what
these investment avenues have earned over the long term in the past.
%hus we arrive at the fascinating >though risky? world of stock markets # one of the most
critical investment avenues that can help you achieve your long term financial goals.
/ust said that stock market is a risky place, but so are our lives. %here is always a risk in
anything we do. But then, with the right education and research, we can minimiCe that
risk. And as we get more education, we can better decide how much risk we want to take
and conversely how much return we can make safely.
Dnderstanding the risks is the first step toward minimiCing them. n fact, it is possible to
make 9:19=4 annual return on your stock market investment with almost no risk. But
only if you know what you are doing.
%here are many paths you can go down when you get into investing in the stock market.
But there&s one thing you can be sure of. !ith education and research you will make
money.
Lesson #2: Hey, You Call This
Investin?
"I am reall# shocked to hear #our stor#$ Ravi% &ut how did #ou manage to do this'( I said
in a tone of s#mpath# mi)ed with sarcasm*
"I don+t know Vishal* I had been so careful all this while with m# investments* &ut despite
that$ I have lost ever#thing in the crash* ,# stock portfolio is down in the dumps%( Ravi
sounded utterl# depressive*
"-ou call that investing' &u#ing stocks without a hint of what #ou were getting into' It+s
like flirting with someone and then sa#ing that #ou were serious all this while%(
still remember this small conversation with a friend sometime in Ectober @::8. %his
gentleman, my classmate from school, had been a bright student in the past. 'e was a
practicing doctor, but had no clue about investing in the stock markets.
But one fine day, on advice from some of his patients >yes, even patients can give
doctors some +painful& advice?, took his first step into the stock markets only to see his
savings burn in the crash that followed.
*ometimes wonder how even intelligent people >like my doctor friend? fall into the trap
of playing with their hard1earned money without knowing what they are getting into.
%hey work so hard for many years to become successful students, professionals, and
businessmen. And then, in a small phase of mindlessness, lose their entire savings /ust
because +someone& advised them a way to become rich fast.
Most of such people have had the luck to meet call what they are doing as +investing&.
f the father of investing # or let me say +sensible investing& # Ben/amin 7raham were to
hear that, he&d turned over in his grave-
7raham was the first to clearly define what +investing& actually is, and how it differs from
what most people do in the stock markets >like my friend did? i.e., speculate.
n what is known as the best book on investing ever written # %he ntelligent nvestor #
7raham differentiated investment and speculation asF
!"n invest#ent o$eration %investin& is one 'hich, u$on
thorouh analysis, $ro#ises sa(ety o( $rinci$al an) an a)e*uate
return+ ,$erations not #eetin these re*uire#ents are
s$eculative+-
%his definition of investing isn&t difficult to understand.
n fact, it can easily be understood if we break it down to its three key elements.
9. Airst, 7raham says that you as an investor must thoroughly analyse a company,
and the soundness of its underlying business operations. !hat he means alternatively
is that an investment in a stock without understanding its underlying company is
purely speculation.
@. %he second important task for you is to identify all the potential risks associated
with the investment so that you can protect yourself against chances of serious
losses.
2. %he third key element of 7raham&s definition is that an investor must aspire for
only an +adequate& return on his stock market investments # any rate if return,
however low, which the investor is willing to accept, provided he acts with reasonable
intelligence. 'e must not go after +e$traordinary& performance, which is what the stock
market e$perts usually promise to dupe gullible investors.
%he combined practice of these key elements is what investing is all about.
Invest, to #eet your li(e.s oals
"ou must have some dreams and goals in life. "ou also realise that most of these
dreams and goals require money.
*o whether it is the dream of spending your @=th wedding anniversary traveling around
the world, or the goal of saving enough money for your child&s higher education, you
need to have enough money at your disposal whenever you need it.
%he good part here is that you usually need this kind of money 9:19=, or sometime even
@: years from the time you first start investing your savings.
*o you have ample time to see your investments grow and build into a huge corpus that
you can use to meet your dreams and goals.
But /ust because someone advises you a +sure1shot& way to get rich fast by speculating in
the stock markets, you spend your entire life&s savings in speculation only to lose
everything when the markets take a bad turn.
!/ut, is s$eculation a sin?-
%his is what most of my friends whom warn against speculating in the stock markets ask
me. And &m glad you also want to know this.
*ee, there is no doubt that speculation is bad. *peculators are always obsessed with
predicting the future of stock prices, which is in fact a near impossibility.
*peculators thus depend not only on their own forecasting skills, but they also go by the
baseless and biased predictions of brokers or stock market e$perts appearing on
business channels. %hey try to guess the future, which is ne$t to impossible-
But for better or worse, the speculative or gambling instinct is a core part of every
human&s nature.
"ou and both want to speculate at some points in our lives. And stock markets are no
different.
*o what 7raham has also said is that even if an investor wants to speculate, it
>speculation? must be a restrained activity. t must be controlled by the amount of money
you use in speculation.
"ou can call it +sin money&, and it must be not more than =4 of the total funds you have
for investment.
0ever increase this level of sin money i.e., money you use to speculate in stocks. %his
way you won&t go overboard with your speculation.
The Invest#ent0S$eculation 1yra#i)
But this requires a lot of discipline. And the discipline says that you must never equate
speculation with serious investing. %his is because as soon as speculation becomes a
serious activity, it gets e$tremely dangerous for you.
'ere, remember what the famous American author Mark %wain once saidF
!There are t'o ti#es in a #an.s li(e 'hen he shoul) not
s$eculate: 'hen he can.t a((or) it, an) 'hen he can+-
Anyways, stay tuned for the ne$t lesson, because here&s where things start to get
interesting. &m going to give you some specifics about the kinds of strategies that work
well to make money from stock markets, and in a sensible and easy1going way.
Lesson #2: There.s " /usiness /ehin)
3very Stock
f were to ask you to bet your money on the future success of one of your classmates or
colleagues, whom would you choose(
!ould you bet on your best friend amongst these people(
Er would you bet on the most capable person >assuming that you friend is not the most
capable out there?(
f can trust your G, betting on the most capable person would make greater sense for
you than betting on your best friend.
%he same philosophy holds true while investing in stocks. "ou must not put your money
on a stock whose name you like the most or whose chairman is your best friend.
nstead, you must invest in the stock of a business you believe has the ma$imum
potential.
But this is one reality that most investors forget # that
!4 a stock is not 5ust a $iece o( $a$er that has a na#e, 6ut a
share o( a 6usiness that has real assets an) $ro(its+-
!hile buying a stock, you should take the same approach as you would if you were
buying an entire business. %he only difference is that instead of buying the whole of the
business, or a partnership in the business, you are only buying a tiny share.
Investin.s nine #ost i#$ortant 'or)s
;nvesting is most intelligent when it is most businesslike,< said Ben 7raham.
As per 7raham&s best student !arren Buffett, these are the nine most important words
ever written about investing. And rightly so-
%he biggest differentiating trait of Buffett&s own investing philosophy is the clear
understanding that stocks are representative of businesses, and not /ust pieces of paper.
%he idea of buying a stock without understanding the company&s operating functions # its
products and services, management quality, employee relations, raw material sources
and e$penses, plant and equipment, capital reinvestment requirements, and needs for
working capital # is unacceptable.
%his mentality reflects the attitude of a business owner as opposed to a stock owner, and
is the only mentality an investor should have.
Ewners of stocks who perceive that they merely own a piece of paper are far removed
from the company&s financial statements.
%hey behave as if the stock market&s ever1changing price is a more accurate reflection of
their stock&s value than the business&s balance sheet, income statement, and cash flows.
Aor Buffett and all other successful investors , the activities of a stock owner and a
business owner are closely connected. Both should look at ownership of a business in
the same way.
As Buffett saysF
!I a# a 6etter investor 6ecause I a# a 6usiness#an an) a 6etter
6usiness#an 6ecause I a# an investor+-
As e$plained in +%he !arren Buffett !ay& by )obert 'agstrom, these are some of the key
questions that you must answer to understand the business of a company.
7uestions you #ust ans'er to un)erstan) a co#$any.s
6usiness
,et&s discuss them in some detail here.
Guestions on the core business
1+ Is the 6usiness si#$le an) un)erstan)a6le?
0ever invest in a business you do not understand, for you can&t see the future
opportunities and challenges before they arise.
2+ 8oes the 6usiness have a consistent o$eratin history?
.ast performance is no guarantee for future success, but it shows if a business can
operate under varying business conditions.
2+ 8oes the 6usiness have (avoura6le lon ter# $ros$ects?
+*ustainable business& is the key word here. *tay away from companies that operate on
trends and fads that can go out1dated in the future. ,ook for business that can sustain in
the long term.
Guestions on management quality
9+ Is #anae#ent rational?
0ow this is a very important part of an investor&s business analysis. %he rationality of the
management and its ability to deploy cash in a profitable manner is what separates a
good business from a bad one.
:+ Is #anae#ent can)i) %(rank& 'ith its sharehol)ers?
"ou don&t want to get into a future *atyam, right( ,ook for managers that admit mistakes
and take complete responsibility of their actions.
;+ 8oes #anae#ent resist the institutional i#$erative?
nstitutional imperative is the need for managers to act like their peers, no matter how
irrational their actions may seem. Avoid managers who have the tendency to give in to
peer pressure.
Guestions on financial position
<+ What is the return on e*uity?
As we will understand later, return on equity is one of the most important metric for
evaluating the profitability of companies. Earnings can be manipulated, but return on
equity will show how worthy a business is.
=+ What are the $ro(it #arins?
A company that can convert its sales into profits is a successful business. %he key is to
keep costs at the minimum, and go for higher profits instead of higher market share.
Avoid companies with low margins.
!e will discuss all these above1mentioned points in the subsequent lessons of +Halue
nvesting for *mart .eople&. %ill then, /ust remember what Buffett saidF
!I( a 6usiness )oes 'ell, the stock eventually (ollo's+-
Lesson #9: >no' Your Circle o( Co#$etence,
an) Stay Well Within It
".hat did #ou stud# in #our college$ Ravi'( I asked m# friend*
"-ou know Vishal that I am a doctor% .h# are #ou asking this unintelligent /uestion'( Ravi looked at me
with disgust* 0e was alread# disappointed seeing his stocks crash and savings wiped out* 1nd now he
had to face such /uestions from me*
"2h oka#$ so #ou studied how medicines work on a human bod#$ right' &ut what made #ou invest in a
banking compan# then' 3o #ou know how a bank works'(
"No Vishal% &ut are #ou telling me that a doctor can+t invest in a banking stock'(
"No$ I am not sa#ing that% .hat I am sa#ing is that #ou must not invest in a banking stock if #ou don+t
understand how a bank works*(
Ravi looked with confusion at me as I continued$ "If #ou don+t know wh# rising interest rates suggest and
how it is different from what rising blood pressure indicates$ #ou have no right investing in a banking
stock*(
"ou see, we generally do not know the answers to questions from sub/ects we have not studied in the
past. And we are humble in accepting our ignorance on such sub/ects.
But things get different when it comes to investing in the stock markets. !e have no qualms in going
beyond the boundaries of what we know.
!e have no doubts before treading beyond our +circle of competence&.
Aor most investors, investing outside their +circle of competence& is what creates the ma$imum losses.
What.s your ?circle o( co#$etence.?
n simple terms, your circle of competence with respect to investing defines your understanding about
certain businesses.
%he businesses that you understand fall within the circle, and the ones you don&t understand fall outside
it.
As !arren Buffett, the world&s most successful investor ever, has said so oftenF
!You )on.t have to 6e an e@$ert on every co#$any, or even
#any+ You only have to 6e a6le to evaluate co#$anies 'ithin
your circle o( co#$etence+ The siAe o( that circle is not very
i#$ortantB kno'in its 6oun)aries, ho'ever, is vital+-
%his means that you as an investor need to restrict yourself to the businesses you know # businesses
you can understand.
Dnderstanding one&s circle of competence is a very necessary discipline in investing. %hose who do not
do this are left to suffer.
8ra' your o'n circle as /u((ett )i) his4
Buffett&s investing process involved creating three lists of companies # n, Eut, and %oo 'ard.
/u((ett.s List o( Co#$anies
%his was his way of sticking to his circle of competence, however small it was.
As he said, ;!e have a ton of doubts on all kinds of things, and we /ust forget about those.<
nteresting, isn&t it(
But then
The key i)ea 6ehin) the circle o( co#$etence is not its siAe C the
nu#6er o( 6usinesses you can un)erstan) C 6ut your
a'areness a6out its siAe C the nu#6er o( 6usinesses ?you kno'.
you can un)erstan)+
%his means that a simple and understandable business is one within your +circle of competence&.
t isn&t important how big that circle is. t is important how well you have defined its perimeter.
A business will be +within& your circle of competence if you fully understand the underlying economics of
itF
'ow it works(
!hat drives its growth(
!hat makes it profitable(
'ow does it stand against its competitors(
'ow does it manage its raw material costs(
"ou need to have the answers to such questions, and others like these to make sure that you
understand the business. %o invest in something you do not understand can have disastrous
consequences.
Ask your doctor friend who invested in dotcom companies in @::: without understating what the
underlying businesses were.
Er ask your software engineer cousin who invested in real estate companies in late @::6, without
understating the huge risks that lied on the balance sheets of these companies.
f you can&t find businesses within your circle of competence, don&t /ust e$pand the circleor at least
spend some time studying industries outside your circle before crossing the boundaries.
,esson I=F Jnow %he ,anguage of Business
It isn.t rocket scienceD
;!hen in )ome, do as the )omans do,< goes the famous saying. !hat this saying suggests is that you
need to know the language and customs of people when you visit an unknown society. Boing so is
polite, and also advantageous.
%he same holds true when you enter the +investing society&. Before you enter, your gate pass must show
that you understand the language of business.
And what&s the language of business( 0umbers.
0umbers speak the language of business.
f you don&t understand the numbers that businesses use to communicate with you, the investor, the
investing society can be like a maCe. "ou won&t know where you are, and you won&t know how to come
out in case of a fire.
But believe me, if you can read a nutrition label on your bo$ of corn flakes, or you know how to read
your home loan statement, you can learn to read basic financial statements.
%he basics aren&t difficult and they aren&t rocket science.
!e all remember Kuba 7ooding Lr.&s immortal line from the movie Lerry Maguire, ;*how me the
money-<
%hat&s what financial statements do.
%hese statements appear in the company&s annual report, and are broadly classified into three
categoriesF
1+ /alance Sheet
t is also known as the *tatement of Ainancial .osition and reports on a company&s assets, liabilities,
and equity >also known as shareholders& funds? at a given point in time.
%he assets side of a balance sheet shows what a business +owns& # the factory, building, car, machines,
computers, etc. %he liabilities side represents what a business +owes&.
Assume you bought a house using a housing loan, and also put in some money from your own pocket.
n this case, your house will fall on the asset side of your personal balance sheet. %he housing loan will
be a liability. %he money you infused from your own pocket will be your equity.
%here are several others assets and liabilities that are included in a balance sheet, as you can see in
the following image of an actual balance sheet. .ick up a high school accounting book, and you can
learn it all from there.
Sa#$le /alance Sheet
n simple terms, a balance sheet shows how a company stands at a given moment. %here is no such
thing as a balance sheet covering the year @:9:. t can only be for a single date, for e$ample, March 29,
@:9:.
2+ 1ro(it E Loss State#ent
Also known as the *tatement of Komprehensive ncome, the .rofit and ,oss statement >or a .M,?
reports on a company&s income, e$penses, and profits over a period of time.
*o if you start a business manufacturing televisions, all the money you spend on buying raw materials
for manufacturing television sets, and all money you earn selling them in a year will come in the .M,.
Sa#$le 1EL State#ent
2+ Cash Flo' State#ent
%he cash flow statement is the most important of all statements, because it shows the movement >inflow
and outflow? of all cash during a year. And cash, as you must know, is the most precious resource for a
business.
Sa#$le Cash Flo' State#ent
Ho' these state#ents hel$?
*o these were the three key financial statements through which businesses talk to investors. %hese
statements help businesses showcaseF
9. .erformance during the year gone by # !hether the year was a good one of bad one for the
company.
@. 'ow strong the business is # %he stronger a business, the more capable it is to face slowdown
and competition.
2. %he level of profitability # a highly profitable business gets the ma$imum investor attention.
3. !hether the business is guCCling cash or releasing a lot of it # %he former type of business is
hated by intelligent investors, and the latter loved.
%he ability to read financial statements and understand what they convey will open up several areas for
you to analyse stocks, buy the good ones, and ignore the bad ones.
By knowing how to read and analyse financial statements, you will be able toF
9. Dnderstand how a specific company has performed in the past.
@. Dnderstand whether the company is doing a profitable business or is running loss1making
operations.
2. *eparate well1performing companies from the bad ones that are losing money for
shareholders.
3. Jnow if a company is using faulty accounting to inflate its sales andNor profits.
=. )ealise that some stocks you already own in your portfolio, are actually dud businesses that
are doomed to fail.
"es, this fifth realisation is the most striking aspect of your understanding of the financial statements.
have met several investors over the past few years # some from within my e$tended family, some from
among my previous company&s clients, and some /ust by the way.
!hat has amaCed me is that a ma/ority of these investors # and several have been old timers in the
stock markets # know little or nothing about identifying a good balance sheet from a bad one. And it&s
not by chance that almost all these investors have a large proportion of their portfolios invested in bad
stocksNweak companies.
But don&t blame them for their ignorance, which they have misunderstood for bliss all these years.
%heir source of stock ideas have been brokers, friends and relatives # people whom you can consider
least likely to tell you how a goodNbad balance sheet looks like.
.robably you might have been one of their types. And if that&s the case, don&t worry.
!e have /ust studied the key financial statements that you need to read in a company&s annual report to
make out how it is doing.
0ow, let us move a bit deeper, and understand some key financial terms and ratios that you must know
in order to make a /udgement on a good business versus a bad business.
%his is going to be a pretty long lesson, so you can read it over the ne$t few days before you get the
ne$t lesson. !hile the sub/ect is boring by nature, &ve tried to make it as easy and interesting as
possible.
*o let&s get started.
1+ SalesGHevenue
*ales is what a company earns by selling its products or services. Aor e$ample, if Kompany A sells 9::
units of a product at )s =: per unit, its sales will be )s =,::: >or 9:: multiplied by =:?.
!hile the sales figure is /ust the entry point to your understanding of a company&s financials, it is
important to know how the company is doing on this front. Aor, without sales, there won&t be any
business.
%racking a company&s sales growth over a number of years >at least 9: years? gives a good indication of
its siCe and stability. A company with a stable growth in sales over a 9:1year period is generally
considered better as compared to a company that has a rapid yet volatile sales growth history.
2+ Iet 1ro(it
%his is +the& figure most investors look out for in a company&s .M, account. 0et profit represents the
money left over with a company after reducing all kinds of e$penses from its sales. 0et profit is akin to
your monthly savings after paying for all household e$penses from your monthly income. ,ike sales,
looking at the long term performance of net profits gives a good indication of a company&s financial
health and stability.
2+ ,$eratin #arin, or 1ro(ita6ility
.rofit >like net profit, as we discussed above? is what a business earns after it reduces all e$penses from
its sales. But profit is a number and does not e$plain much on an as1is basis. !hat is more important for
you as an investor is the +profitability +, which is equal to the money a business makes for every rupee of
its sales.
Assume Kompany A sells toys worth )s 9:: in a year and earns a profit of )s 3:. Kompany B sells toys
worth )s =: in the same year and earns a profit of )s 2:. 'ere, the profit of company A is higher than
profit of company B >3: O 2:?.
But when to comes to profitability, that of company B is better than that of company A >2: divided by =:
is greater than 3: divided by 9::?. Always remember, profitability is more important than profit in
understanding how a business is doing.
n highly competitive industries, a more profitable business has a greater fle$ibility to reduce prices to
fight competition. A more profitable business also generates more cash to spend on its e$pansion and
pay dividends to its shareholders.
9+ 8e$reciation
All the fi$ed assets, e$cept land, that a company owns >like plant, machinery, computers, automobiles,
etc.? are sub/ect to a gradual loss of value through age and use. %he allowance made for this loss of
value is known as depreciation >or obsolescence, depletion, and amortiCation?.
%he amount of depreciation to be charged each year is based on the value of the property >usually
taken at the cost it was bought at?, its e$pected life, and the salvage or scrap value when it is retired.
,et&s understand with an e$ample. "ou buy a car for your personal use at a cost of )s =::,:::. %he
e$pected life of this car is = years, and your e$pected scrap value is )s =:,::: >at which it can be sold
off after = years?. n this case, the annual depreciation charge will be 9N=th of )s 3=:,::: >)s =::,:::
minus )s =:,:::?. %his gives )s P:,::: as the annual depreciation charge. A company will reduce such
an amount from its operating profits every year.
'owever, note one important thing here. Bepreciation is a non1cash charge i.e., a company does not
have to +pay& depreciation to anyone. t only needs to reduce the depreciation amount from its operating
profits.
0ow, since it reduces this amount from its operating profits, the ta$ it has to pay to the government also
gets reduced >as net profit before ta$ comes down due to reduction of depreciation e$penses from the
operating profit. Money so saved can be used by the company to replace the depreciated asset after the
end of its useful life.
%his is the core reason behind the concept of depreciation # it enables companies to save ta$es every
year so that it can accumulate money so saved to buy replace its old assets after cross their useful
lives.
Note: In case #ou have an# doubts4problems understanding the financial concepts as e)plained in this
lesson$ please fee free to send me a message using the 5ontact page$ and I+ll be able to e)plain #ou
further*
:+ 3*uity
Also known as shareholders& funds or book value, equity is the money shareholders >like you? put in the
business. Equity is a very important concept in financial analysis because a very rough relationship
tends to e$ist between the amount invested in a business and its earnings.
t is true that in many individual cases we find companies with small book values earning large profits,
while others with large book values earn little or nothing. "et, as Ben/amin 7raham suggests in his 6he
Interpretation of 7inancial Statements >one book you must read to understand financial statements?, in
these cases some attention must be given to the book value situation, for there is always a possibility
that large earnings on book valueNinvested capital may attract competition and thus prove temporary.
;+ 8e6t
Equity is what belongs to the owners of the business >shareholders like you?, debt is what is borrowed
>from banks and others? by the owners of the business. !hile the owners of equity >shareholders? have
a claim on the company&s earnings >by way of dividends?, those that e$tend debt to companies >like
banks? receive interest payments every year.
!hile debt isn&t a dangerous figure on the balance sheet, too much debt can be a cause of concern.
%his is especially when this debt is not backed by almost equal or higher amount of equity.
*o, as a thumb rule, a debt to equity ratio >BNE? of higher than one, and consistently for several years, is
a cause for concern. 'owever, a reducing level of BNE, or one that is already less than :.=$ >or =:4?, is
a comfortable situation.
<+ Workin Ca$ital
As you can see in the sample balance sheet as shown above, there are two items named +current
assets& and current liabilities&.
Kurrent assets are those that are immediately convertible into cash or which, in due course of business,
tend to be converted into cash within a reasonably short time >ma$imum one year?. *uch assets includeF
9. Kash and equivalents
@. )eceivables >money that a company has to receive from its customers for the goods or
services that have already been sold?
2. nventories >goods that the company has produced but are waiting to be sold, or raw materials
and semi1finished goods that the company holds in its stock?
*ince these assets can be converted into cash in a short time, they are collectively known as +current
assets&.
En the other side, i.e., on the liability side of the balance sheet lie +current liabilities& that represent the
amount a company owes to its vendors who have supplied it with raw materials to semi1finished goods,
and are waiting to be paid. *uch vendors are known as creditors of the company. Apart from creditors,
all the debts of the company that will be repaid within one year are classified under current liabilities.
0ow, coming to +working capital&, it is the figure arrived at by reducing current liabilities from current
assets. *o,
.orking capital 8 5urrent 1ssets 9 5urrent :iabilities
!orking capital is a consideration of ma/or importance in determining the financial strength of a
manufacturing company. %his is because the study of working capital results in knowing whether the
company is in a position to carry on its normal day1to1day business comfortably without any financial
constraints.
*hortage of working capital >when current assets that can be converted to cash and not enough to cover
current liabilities that must be paid out soon? results in slow payment of bills.
%his results in poor credit rating of the company, which subsequently means that the company not /ust
needs to borrow short term funds to meet its day1to1day e$penses, it also has to pay higher interest in
the money so raised.
An important ratio you can work out here is the amount of working capital per rupee of sales. ,ower the
ratio, lower is the working capital requirement of the company, and the more financially strong it is.
Note: In case #ou have an# doubts4problems understanding the financial concepts as e)plained in this
lesson$ please fee free to send me a message using the 5ontact page$ and I+ll be able to e)plain #ou
further*
=+ Free Cash Flo'
Kash >as you can see in the balance sheet above? is what a business holds in banks and other
investments. But the concept of free cash flow >AKA? is entirely different.
AKA is what a business is left with at the end of every year after it takes care of its capital e$pansion
and working capital needs. *o if you look at the cash flow statement in the previous slide, the AKA will
be calculated asF
AKA Q Kash flow from operations # Kapital e$penditures
Q )s 2:==.6P lac # )s 6@@.92 lac
Q )s @222.55 lac
n simple terms, AKA tracks the money a business has generated by the end of each year. t&s the cash
that is left over with the company at the end of the year, after it pays all its bills and pays for any new
capital e$penditures. t is what it has left over to pay investors. And that is why AKA is one of the most
important numbers you must track as a shareholder in a company.
J+ Heturn on e*uity
)eturn on equity, or )EE, is one of the most useful tools to determine how well management creates
value for shareholders. %he formula isF
R2; 8 Net profit 4 ;/uit#
!e&ve already discussed both +net profit& and +equity& in this lesson, so you must not have any problem
calculating the )EE.
%he legendary investor, !arren Buffett believes that the return that a company gets on its equity is one
of the most important factors in making successful stock investments.
As such, the higher the )EE, the better it is for shareholders, as it indicates that the management has
allocated capital >equity? in a profitable way.
A higher )EE also means that surplus funds can be invested to improve business operations without
the owners of the business >shareholders? having to invest more capital.
t also means that there is less need to borrow, which is a positive sign for the business >we read above
the perils of borrowing more?.
1K+ 8ivi)en)
Ene of the most loved words in a shareholder&s dictionary, +dividend& is a payment made to the
shareholders >owners? of a company, out of the company&s profits. Most ndian companies usually pay
dividends on a yearly basis while some also do it quarterly.
*o why is dividend important( *imply because it comes out of a company&s profits. Er, more
specifically, its free cash flow. A consistent, rising dividend payment is usually a hallmark of a solid, well1
run business that generates substantial, consistent cash flow.
All things equal, that equates to a relatively stable business and a stock that might be a little less volatile
than the market at1large. n other words, companies that pay consistent and rising dividends are usually
lower risk than companies that don&t pay dividends.
*ee, these are some of the basic yet among the more important concepts that you must know as an
investor. "ou will get data for all these terms and ratios in a company&s annual report.
"our /ust need to pull out the relevant data, make necessary calculations, and check for yourself the
financial health of the company.
Anyways, won&t go further into the sub/ect here, as that would require the space of a book.
!hat you can do is pick up a high school accounting book or basic book on finance and that will teach
you everything you&ll need to know about understanding financial statements.
"ou might ask # s there a way can invest without understanding financial statements(
Ef course, there&s a way. But it&s very much like climbing Mount Everest without knowing
mountaineering.
"ou might still reach the peak, but the chances are miniscule.
"ou know that, don&t you(
Lesson #;: It.s "ll "6out The Intrinsic Lalue
Kan you compare the price of a Mercedes *1Klass and that of a Maruti18::(
Ef course, one costs )s 5: lac while the other costs less than )s 2 lac. And you can compare )s 5: lac
with )s 2 lac.
But then, is that the right comparison( mean, isn&t this the same as comparing apples to oranges(
%he two cars have different values in terms of lu$ury, safety, quality, and brand value. *o comparing
them /ust on their prices won&t be the right idea. "ou need to see the difference in their values.
After all
!1rice is 'hat you $ay+ Lalue is 'hat you et+-
%he same goes for stocks. A )s =: stock might be considered cheaper than a )s =:: stock. But that&s
an incorrect way of looking at it, /ust like comparing the price of a Mercedes with a Maruti18::.
As we learnt in the third lesson, a stock is not a piece of paper but a share in a business. *o it is
important to compare a stock&s price with the company&s business value >and not with anything else,
ever-? to ascertain whether it is cheap or e$pensive as compared to another stock, and also in isolation.
%he )s =: stock might be backed by a business whose value is )s @= # thus a price1to1value of @ times
>=: divided by @=?. En the other hand, the )s =:: stock might be backed by a business whose value is
)s 9,::: # thus a price1to1value of /ust :.= times >=:: divided by 9,:::?.
!hat this means is that the first stock is priced at @ times the business value, while the second stock is
priced at thus :.= times >or =:4? the business value.
0ow, which is cheaper( %he )s =: stock, or the )s =:: stock( Based on this short analysis, the )s =::
stock definitely looks cheaper. sn&t it(
Anyways, the idea of this discussion is to bring to light the key investing concept of +intrinsic value&. n
simpler terms, you can also call it the +core business value&.
*o, why you should calculate intrinsic value(
!To calculate intrinsic value is vital+ It is one secret to
success(ul investin that you can.t a((or) to inore+ You nee) to
calculate the intrinsic value 6ecause you #ust not 6uy any
stock at any $rice+-
%he price you are paying is the ultimate determinant for the rate of return that you&ll be earning from a
stock. %he higher the price you pay for it, the lower will be your return. As simple as that-
And that is why you need to know how much a stock is really worth. Ence you know its intrinsic value,
you can identify if the stock is trading cheap or e$pensive. A very high stock price as compared to the
business& intrinsic value means that the stock is e$pensive >like our first stock above?. And a low price
as compared to the intrinsic value means that the stock is cheap >like the second stock as discussed
above?.
%hese are general rules of thumb. !e will understand the specifics of how much price to intrinsic value
makes a stock cheap or e$pensive in the ne$t two lessons. And we will also study the different ways you
can calculate the intrinsic value of a stock.
But for starters, remember that intrinsic value is an estimate rather than a precise figure. And it is an
estimate that must be changed with changes in the variables that are used to calculate it >don&t worry,
we will study all that in the ne$t two lessons-?
Lesson #7: Calculating Intrinsic Value-
Part I
Moving ahead from the previous lesson on the basics and purpose of intrinsic value,
lets now move a bit further into this very important subject for value investors.
Lets learn something about the different ways you can calculate the intrinsic value of
a stock.
But first, heres the easiest and the most important definition of intrinsic value that
youll come across anywhere. This is what arren Buffett wrote to his companys
shareholders in !""#$
%e define intrinsic value as the discounted value of the cash that can be taken out
of a business during its remaining life.&
'n simpler terms, intrinsic value of an asset is the discounted value of the e(pected
cash flows that that asset can earn over its life.
Cash I know, ut whats the discounted value!
'n his definition of intrinsic value, Buffett mentions that the intrinsic value is nothing
but the )discounted value of cash that can be taken out of a business.
Lets understand these two key terms *
!. +ash
,. -iscounted value
Most investors believe that understanding the term )cash is akin to understanding the
.nglish alphabets.
But your see, cash isnt as simple as +/0/1/2.
+ash is not what a company earns when it sells its products or services. 0nd it is
neither the profits a company makes during the year after paying its operating
e(penses 3like raw material costs, employee salaries, sales 4 marketing costs,
administrative costs5, interest, depreciation and ta(es.
+ash is beyond these * sales and profits.
Cash is what re"ains with a usiness at the end of a #ear and after $a#ing for
the cost of an#thing and ever#thing a usiness u#s and $a#s for during the #ear%
1o it is a much/refined form of profits. But it is what remains with a company after
also paying off the dividends, cost of new plant 4 machinery and buildings 3or capital
cost5, and working capital changes 3and adding back depreciation which is a non/cash
charge5.
This cash is also known as )free cash flow, and it is the ultimate measure of a
companys profitability.
By looking at free cash flow, you can see whether a company is actually making any
money and you can get a sense of what its spending its money on.
Lets now turn our attention to the second critical element of Buffetts definition * the
)discounted value.
-iscounted value is used to define the present value of future cash flows. 1o it is also
known as the )present value.
Let us understand this concept using a simple e(ample.
'f ' offer you 6s !77,777 and you could receive it now or in !7 years, when would
you take it8 Most likely you would say, %9ow.&
This is because you already know that money received now is more valuable to you
than money received in the future, simply because you can invest this money 36s
!77,7775 to earn interest on it for the ne(t !7 years.
9ow assume that the interest rate that a bank is willing to offer you for 6s !77,777
that you deposit it there now is !7:. 1o your cash flow for the ne(t !7 years will look
like this$
PV when cash flows are constant &as in ank de$osits'
; 0ssuming interest rate of !7:, which will also be the discount rate
hat this table shows is that if you deposit 6s !77,777 in a bank at !7: interest rate,
you will earn 6s !7,777 as interest 3cash flow5 for the ne(t !7 years, plus your capital
36s !77,7775 at the end of the tenth year.
9ow, when you calculate the present value of each of these cash flows 3as shown in
column +5, and total it, the sum comes to 6s !77,777, which is the present value of all
these cash flows 3that total to 6s ,77,777 over this !7 year period5.
1o, as you can see from the e(ample, while you receive a total of 6s ,77,777 over
these !7 years, when you calculate the present value, the number comes to 6s !77,777
or e(actly what you had deposited in the bank.
9ow, the <uestion is, if the present value of 6s !77,777 deposited for !7 years at !7:
per year is 6s !77,777, why would someone deposit or invest money at all8
9ice <uestion, ' must say.
But please know that this is a very simplified e(planation of present value. 'n reality,
what it means is that when ' offer you 6s !77,777 and you want it now, you have the
fle(ibility to invest in a business where you e(pect cash flows to grow by !7: per
annum, instead of depositing in a bank where the cash flows remain at !7,777 each
year for the ne(t !7 years.
PV when cash flows are growing &as in a usiness'
; 0ssuming annual growth in csh flow of !7:, and discount rate of !7:
0s you can see from the table above, 6s !77,777 invested in a business earned you a
cash flow of 6s !7,777 in the first year, which is e(actly same as the bank deposit
earned you in the first year. But from second year onwards, this cash flow grew by
!7: every year.
1o at the end of !7 years, your total cash inflow totalled 6s ,=",>?#, and the present
value of this cash flow stood at 6s !,",#@>.
1o, while you invest 6s !77,777 today, the present value of your total cash flows
stands higher by 6s ,",#@>, which makes it a profitable investment.
This calculation of 6s !,",#@> minus 6s !77,777 is called as )net present value or
9AB and is at the heart if all business decisions.
0 company takes up a project or enters a new business only when the 9AB is a
positive number, as in the second e(ample above. 'f the 9AB is Cero, like in the first
e(ample where you deposited 6s !77,777 and the present value of all cash flows for
!7 years was 6s !77,777, it is a neutral case.
0s an investor, you must invest in stocks of businesses where you e(pect to earn a
positive 9AB over your investment horiCon.
0nd you can calculate the 9AB using the free cash flows a business is estimated to
earn over the ne(t !7 years.
Dnow that the 6s !,",#@> that we calculated as the present value of future cash flows,
is the )intrinsic value of this business. 0nd since this is higher than the original
investment of 6s !77,777, it makes for a good investment opportunity if the business
were to be listed on the stock e(changes.
2ere is the formula for calculation of discounted cash flow 3-+E5 or present value
3AB5 of future cash flows$
PV ( C)* + &*,k' , C)- + &*,k'- , . /0C) + &k - g'1 + &*,k'n-*
here$
PV = present value
CFi = cash flow in year i
k = discount rate
g = growth rate assumption in perpetuity beyond terminal year
TCF = the terminal year cash flow
n = the number of periods in the valuation model including the terminal year
'f you were to go through the -+E calculation e(cel, there are three key variables you
need to calculate the -+E value of a company$
!. 2sti"ates of growth in future free cash flows &)C)': Frowth in E+E over
say the ne(t !7 years, using last > years average E+E as the starting point.
3+lick here to see the calculation of E+E from a companys cash flow
statement5
,. 0er"inal growth rate: 6ate of growth in E+E after the !7th year and till
infinity.
>. 3iscount rate: 6ate at which the future cash flows must be discounted to
bring them to present value.
9ow there are three key issues that arise with these variables$
!. hat growth rate to assume for future E+E estimates8
,. hat discount rate to assume8
>. hat terminal growth rate to assume8
Let me help you with how do ' answer these <uestions for calculating -+E valuations
myself.
*% 4ow do I $redict future )C)!
0s an analyst, ' always found it difficult to predict growth rate in volumes, sales and
profits. But ' still tried to do that * after all, ' was paid to predict the futureG
2owever, as 've realised over the years, trying to find a perfect answer to the
<uestion %hat growth rate to assume8& is like trying to find a %perfect couple&. 9one
e(istG
Fiven this limitation of trying to predict the future, 've changed my way of analysis
to value stocks based on the present data rather than what will happen in the future.
Thats why ' now dont try be accurate with my E+E growth estimates. ' just try to be
reasonable and use common sense.
Eor most stocks, ' generally perform a !7/year ,/stage -+E analysis. hat this means
is that ' assume a particular growth rate for the first five years of my E+E calculations
3as you can see in my -+E e(cel5, and then another number for the ne(t five years.
' rarely go above !7/!,: annual growth rate for the first five years, and @/H: for the
ne(t five.
The best practice is to keep growth rates as low as possible.
'f the company looks undervalued with just =: annual growth in E+E over the ne(t
!7 years, you have more upside than downside.
The higher you set the growth rate, the higher you set up the downside potential.
To repeat, while assuming E+E growth rate for the future, just be reasonable and use
common sense.
0 caveat * dont take cues from the past as the past performance is rarely repeated in
the future.
-% 4ow "uch discount rate do I assu"e!
'n simple words, discount rate is the rate at which you must discount the future cash
flows 3as estimated using above growth assumptions5 to the present value.
hy present value8 Because we are trying to compare the companys intrinsic value
with its stock price %now&I.in the present.
Just to help with an e(ample, what price would you pay for an investment today if
company 0B+s future cash flow is worth 6s !,777 after ! year8
'f the discount rate is =:, you must pay 6s "=, now 3!777K!.7=5.
'f the discount rate is !7:, you must pay 6s "7" now 3!777K!.!5.
'f the discount rate is !=:, you must pay 6s H?7 now 3!777K!.!=5.
'n other words, the higher the discount rate you assume, the lower you must pay for
the stock as of now.
Einance te(tbooks and e(perts would tell you to use +apital 0sset Aricing Model
3+0AM5 to calculate discount rate. ' used +0AM myself to arrive at discount rates in
the past.
2owever, if you are worried what +0AM is, dont be because you can avoid knowing
about it and still live happily ever afterI.like ' am living.
Look at discount rate as the %annual rate of return& you want to earn from the stock.
'n other words, if you are looking to invest in a business that has comparatively higher
3business5 risk than other businesses 3like in case of most mid and small cap stocks5,
you may want to earn a !=: annual return from it.
Eor valuing such businesses, take !=: as the discount rate.
'n case of relatively safer businesses 3think 'nfosys, 2LL, +olgate5, earning around
!7/!,: annual return over the long term is a good e(pectation 3because these
businesses will also provide some stability to your portfolio during bad times5.
Eor valuing such businesses, take !7/!,: as the discount rate.
Better still, assume a constant discount rate for all companies. ' am gradually turning
to this model * of taking a constant !=: discount rate for all kind of businesses 3safe
or risky5.
%But this way, how would you adjust for the risk in each business8& you may ask.
1imple * adjust the risk in E+E growth estimates. That is where the real risk lies,
right8
5% 4ow "uch ter"inal growth rate do I assu"e!
0s ' mentioned above, ' do a !7/year E+E calculation for arriving at a stocks -+E
valuation.
But the companies 'm valuing wont cease to e(ist after !7 year. 1ome will survive
for !7 more years, some for ,7 years, and very few for =7 years.
That is where the concept of %terminal value& 3or the value after !7th year and till
eternity5 comes into picture.
The terminal value ' generally assume lies between 7: and ,:. 0ssuming higher
terminal value 3M>/#:5 is like assuming the company to grow bigger than the world
economy in the infinity, which isnt possible.
1o the idea is to keep it as low as possible. Best to keep it at 7:.
Lesson #6: Calculating Intrinsic Value-
Part II
'f you are a reader of financial newspapers, or watch business channels, you must
have come across stock market e(perts and analysts blabbering terms like )AK. or
)AKBB.
Nou must have even cursed the speaker for using such difficult terms that bounced
above your head. 'f thats the case, you are not alone.
' have come across many investors who have been in the market for years, but who
still do not understand the basic difference between )price and )value 3the intrinsic
value as we discussed earlier5, forget understanding terms like AK. or AKBB.
But like investing isnt difficult 3its just made out to be difficult5, understanding these
terms and their relevance isnt hard as well.
1o lets start with the superstar of them all * the AK. ratio or price to earnings ratio.
hy superstar8 This is because AK. is by far the most popular valuation metric used
by investors and analysts to assign an intrinsic value to a stock.
The AK. ratio of a stock is a simple tool for measuring the markets temperature. 't is
calculated by dividing a stocks price by the companys earnings per share or .A1.
P/E atio = Price per share / !nnual earnings per share
1o if a companys latest years earnings 3or profits5 per share stand at 6s !7, and its
stock is trading at 6s !,7, the AK. of this stock is !, times. 'f the same stock moves
up to 6s !=7 while the earnings of the company remain at 6s !7, the AK. moves up to
!= times. 1o both the change in a stocks price and the companys earnings define
how a AK. ratio moves.
0s a general rule of thumb, higher a AK., more e(pensive is a stock as investors are
paying more for each rupee of a companys earnings.
P+2 7 8hats the right nu"er!
The <uestion is * what is the right AK. ratio that an investor must pay for a stock8
The answer * it depends. 't depends on the companys past track record, its business
strength, its financial performance, its management <uality, its competitive position,
and its past AK..
0 safe company with slow yet steady growing earnings 3like one from the consumer
goods sector5 can easily command a AK. of ,7/,= times across several years.
On the other hand, a fast growing company can sometimes trade at a AK. of >7/#7
times.
1o the point is that the AK. of a stock depends on the companys <uality as also the
overall market sentiment towards that stock.
0nd given this * that market sentiment also has a role to play in the determination of
the AK. * it isnt a perfect way to calculate intrinsic value despite the importance it
gets.
'n fact, when you calculate a companys intrinsic value using the AK., dont forget to
cross/check with the value you get using the -+E calculation 3which we discussed in
the previous lesson5.
P+2 close cousin 7 P+9V
Book value gets a lot of attention like earnings. This is simply because this number is
widely available and is very easy to calculate.
Book value of a company is simply its net worth or e<uity. Book value per share is the
net worth divided by the number of shares outstanding.
Arice to book value is thus$
Price to book value "P/#V$ = Price per share divided by #ook value per share
Before we move further, lets simplify the calculation of book value.
2ere is the table showing the latest balance sheet of 1waraj .ngines.
Look at the top of this Balance 1heet. The formula to calculate book value is$
Book Balue P .<uity capital 305 Q 6eserves 4 1urplus 3B5
P 6s !,#!."H crore Q 6s !>"?". "# crore
P 6s !=,,!.", crore
Lets now understand what book value e(actly means.
'n most cases, book value is an artificial value that appears on the liability side of a
balance sheet 3as shown above5.
0lso known as shareholders e<uity, book value represents what investors have put
into a business, including the companys undistributed earnings 3part of profits that is
not paid out as dividends5.
't is assumed that if the company were to li<uidate 3close down its business and sell
its assets5, it would receive in cash the value which is at least e<ual to its book value *
the value at which its tangible assets are carried on the books.
2owever, as a matter of fact, if the company were actually li<uidated, the value of the
assets would most probably be much less than their book value as shown on the
balance sheet 3and thus the book value as shown on the balance sheet is an artificial
value5.
The sale of inventory would most likely be at some loss. 0nd the fi(ed assets will also
be sold at a substantially lower price than what these are shown in the book 3balance
sheet5.
'n general terms, book value is considered a measure of what shareholders can take
out from a company when it is li<uidated.
'n reality, book value is the money that shareholders have )put into the business.
0nd what they get in a business li<uidation is mostly less than what they have put in.
The book value is of some importance in analysis because a very rough relationship
tends to e(ist between the amount invested in a business and its average earnings
3calculated as return on e<uity5.
't is true that in many individual cases, we find companies with small book values
earning large profits, while others with large book values earn little or nothing.
Net in these cases, some attention must be given to the book value situation, for there
is always a possibility that large earnings on the invested capital may attract
competition and thus prove temporary.
't is also possible that companies with large book values, not earning meaningful
profits now, may later be made more productive.
Overall, AKBB is often used to gauge a stocks relative value.
0 company trading at a low AKBB, particularly when compared to other companies in
its industry, is thought to be undervalued relative to its share price.
2owever, a low AKBB could also be an indication of negative investor confidence
towards the company, most likely for the reason when the company is not earning
good returns on book value.
0s such, when used in calculating the intrinsic value of a stock, AKBB must be
coupled with metrics such as AK. and 6eturn on .<uity to get a better snapshot of the
company as a whole.
Lesson #:: Insure ;our Invest"ents
8ith a <argin of safet#
Before we move ahead into this ninth lesson, just answer NesK9o to these five simple
<uestions$
!. -o you own an insurance policy8
,. -o you save money8
>. -o you keep e(tra cash 3more than you will need5 with you when you travel8
#. -o you reach the railway station an hour before the scheduled departure of
your train8
=. -o you believe that prevention is better than cure8
'f you answer )Nes to all or most of the above <uestions, you are a practitioner of
)margin of safety.
Nou keep some e(tra time and money on your hand in case things do not go as
planned * like if you run out of cash during your travel, or you get stuck in a traffic
jam while going to the catch a train.
The same )margin of safety applies even to stock market investing.
'n fact, these are often considered the three most important words in investing.
The principle of margin of safety in investing was first introduced by the )father of
value investing Benjamin Fraham.
'n simple terms, for stocksI
=<argin of safet# if the difference etween the intrinsic value of a stock
and its "arket $rice%>
This principle suggests that you must buy a stock only when it is worth more than its
price in the market.
1o if a stock is trading at 6s !77 in the market, and you calculate the companys
intrinsic value as 6s !=7, you have a margin of safety of 6s =7 3!=7 minus !775. 'n
other terms, the stock is trading at a >>: discount to the companys intrinsic value.
'f the said stock is of a high <uality company, it is advisable to buy it at any price that
is H7: or lower than the companys intrinsic value 3any price lower than 6s !,75.
0nd if the said stock is of a company that is not an e(ceptional one 3but worthy
enough for investment5, you must not buy it for more than =7: of the intrinsic value
3only if the price is lower than 6s ?=5.
=8hat "argin of safet# does is that it $rotects #ou fro" $oor decisions
and downturns in the "arket%>
1o if you pay just 6s !77 for a stock that you believe is worth 6s !=7, even if your
analysis goes wrong and the stock is actually worth less than 6s !=7, your investment
will still be safe.
Fiven that the calculation of intrinsic value 3of 6s !=7 in this e(ample5 is subjective
in nature, it is always better to have a good margin of safety while buying a stock. 0
>7/#7: margin of safety is what Fraham recommends.
This disciplined pursuit of bargains 3stocks that are available for >7/#7: less than
their intrinsic values5 makes value investing very much a risk/averse approach.
But the greatest challenge for you as an investor is to maintain that re<uired
discipline.
0he tra$ of a rate race
Most of us generally fall in the trap of following the herd. 1o we buy stocks when the
prices are rising, just because we do not want to miss out on the paper profits that our
friends, colleagues, or relatives are making by betting on rising stocks.
But then, being a value investor means standing apart from the crowd, and
challenging conventional wisdom.
't can be very lonely being a value investor practising a concept like margin of safety.
But if you can do it with utmost discipline, you can earn great returns from the stock
markets over the long run.
ith respect to margin of safety, here is what arren Buffett, whom Fraham
considered his best student, has to say$
=8e insist on a "argin of safet# in our $urchase $rice% If we calculate
the value of a co""on stock to e onl# slightl# higher than its $rice,
were not interested in u#ing% 8e elieve this "argin-of-safet#
$rinci$le, so strongl# e"$hasi?ed # 9en @raha", to e the
cornerstone of invest"ent success%>
Buffett describes margin of safety concept using this e(ample * %hen you build a
bridge, you insist it can carry >7,777 pounds, but you only drive !7,777/pound trucks
across it. 0nd that same principle works in investing.&
4ow "uch "argin is good "argin!
+oming again to the <uestion of what is an ade<uate margin of safety, the answer
varies from one investor to the ne(t. But it chiefly depends on *
!. 2ow much bad luck are you willing and able to tolerate8
,. 2ow much volatility in business values can you absorb8
>. hat is your tolerance for error8
'n short, it all boils down to how much you can afford to lose.
Losing some money is an inevitable part of investing. 'n fact, there is nothing you can
do to prevent it.
But to be a sensible and intelligent investor, you must take responsibility for ensuring
that you never lose most or all of your money.
Lsing the margin of safety concept, and by refusing to pay too much for an
investment, you minimise the chances that your wealth will ever disappear or
suddenly be destroyed.
To conclude, as Fraham reminds us, the intelligent investor must focus not just on
getting the analysis right. 2e must also insure against loss if his analysis turns out to
be wrong * as even the best analyses will be at least some of the time.
1o that was about margin of safety. Nou now know its relevance, right8
'n the ne(t 3tenth5 lesson, we will talk about a weird creature called Mr. Market, who
with his ever/changing moods, lures investors to make big investing mistakes.
But there is a way you as an investor can protect yourself from the whims of Mr.
Market. ell find )how in the ne(t lesson. 1o stay tuned.
Lesson #*A: 0he curious case of <r%
<arket
'magine yourself as a businessman, working in partnership with your friend. This
friend of yours is a strange fellow, but you have him as a partner just because of some
old family ties.
2is behaviour gets so worse that every day he appears in the office asking you to
either sell the entire business to him. Or buy the entire business from him. On both
such occasions, he also <uotes a price at which hell buy or sell the business.
0nother strange habit of your friend is that the prices he <uotes for buying or selling
the business change each day.
The day he is very optimistic about the future of this business, he will <uote a very
high price to buy or sell the business. On such days, he is ready to buy your share at a
very high price because he sees very bright prospects for the business. 0lternatively,
he is ready to sell his share of the business only at a high price.
Then there are days when he feels very depressed. On such days, he sees nothing but
trouble ahead for both business and the world. These are the occasions when he would
name a very low price, as he is terrified that if he does not do so, you would burden
him 3sell him5 with your share in the business.
'n both such cases, what would you do assuming that you arent as strange as your
friend8
'f you were a sensible businessman, you would not let his daily moods and prices
determine your view of the value of your interest in the business. Nou may be happy
to sell out to him when he <uotes you a ridiculously high price, and e<ually happy to
buy from him when his price is low.
But at the rest of the time, you would be wise enough to form your own ideas of the
value of your share in the business.
9ow replace your share in your own business with your share in someone elses
business that you own through stocks. 0nd replace your neurotic partner with the
)stock markets that offers you a different price daily for your stocks.
+all this friend as Mr. Market.
2ow much influence will Mr. Market have on your own independent view of the
stock you own8
Lsing the above e(ample, Mr. Markets ever/changing moods and ever/changing
prices must not force you into changing your view of the business. 0nd this must be
true of your stocks as well.
The above story is created using the parable of Mr. Market that was first told by
Benjamin Fraham in !"># in his )The 'ntelligent 'nvestor. .ven after almost eight
decades of being first introduced, Mr. Market remains a manic figure.
0nd just like when he was introduced, the prices <uoted by Mr. Market seem
reasonable, but often they are ridiculous.
0s an investor, you are free to either agree with his <uoted price and trade with him,
or to ignore him completely. Mr. Market wont mind this. 'nstead, he will be back the
following day to <uote another price.
The point is that you should not regard the whims of Mr. Market as determining the
value of the shares that you own. 'nstead, as Fraham suggests, you should profit from
market folly rather than participate in it.
Nou will be better off concentrating on the real life performance of the companies
whose stocks you own, rather than being too concerned with Mr. Markets often
irrational behaviour.
Lesson #**: 4e#, "ind #our ehaviourB
ere you ever punished in school for not behaving properly in the class8
'f you are like me, you must have e(perienced the happiness 3mi(ed with some
embarrassment5 of being )out/standing on a regular basisG But then, you must have
behaved well after that punishment.
1ometimes ' wonder if we as adults were always guided and punished by our teachers
for all our mistakes and mindless behaviour. Frowing up and moving out of school
gives us a lot of freedom to behave the way we want to. But then, for some of us, it
becomes a license to behave any which wayIeven at the cost of our own peace, and
money.
Talking about stock markets, the pundits will tell you that to learn to invest, you need
to read the theory books. Nou need to understand comple( accounting. Nou need to
know the jargons, the AK., the .BK.B-'T0, the 1OTA.
hat these pundits however fail to tell you is that before you get to all that investing
theory, you need to work on the practical. Nou need to study )yourselfIyour
behaviour.
8e are who we are.
Ibut our behaviour shapes us. 0nd as human research suggests, ?7: of our
behaviour is shaped by our e(periences 3the remaining >7: by our genes5.
This implies that whatever we have learnt about saving and investing from our parents
doesnt matter that much. hat matters is what we have e(perienced ourselves in our
lives and professions.
0he rain is a leaking oat
e call ourselves rational beings. The truth is that we arent rational but rationalising
beings.
The brain that sits on the top of our head isnt a flawless machine. Nes, it is powerful.
But it has its weaknesses. 'n everyday terms, we call such weaknesses as )biases.
The good part is that while we cannot e(change our brains with other people nor can
we upgrade it at a hardware shop, we can avoid mistakes that our biases cause by just
taking notice of them.
'ts just like getting into a boat. Before getting in, you would want to know about any
holes in it before you start paddling. 6ight8
Biases are such holes in our brains reasoning abilities. 0nd these biases can damage
our decision making.
2ere are five most common biases that we carry with us, and which can really have a
negative impact on our decision making capabilities, including the way we invest in
stocks.
*% Cverconfidence
0nswer this simple <uestion * %hich is the worlds only officially 2indu country8&
'ndia8 1ure8 +onfident8 Over/confident8 1orry, but you are wrongG 'ts 9epal.
9ow tell me * %0re you sure the stock you just bought will go up8& 1ee, you are
again getting over/confidentG
-% Confir"ation ias
Nou can call it )wishful thinking. +onfirmation bias appears when you see what you
want to see. 'ts a bias that makes you notice and look for information that confirms
your e(isting beliefs, whilst ignoring anything that contradicts those beliefs.
5% Dvailailit# ias
More people are killed every year from attacks by donkeys and by drowning in
swimming pools than those who die in car accidents or plane crashesG But just after a
plane crash, we give more prominence to those killers than anything else. 1o what is
the reason for that8 The answer lies in )availability bias, which is a phenomenon in
which people predict the fre<uency of an event based on how easily an e(ample can
be brought to mind.
2ey, did you hear about that company that is coming out with 'ndias biggest 'AO8
Theyre all around the media. 'm buying their stockG
E% )ra"ing
Nou may think its fine to eat a burger that is "7: fat/free. But when you turn it
around and think of it as a burger thats !7: fat, you may think twice about eating it.
Thats what )framing does to you * how you say and hear things makes a good
impact on how you respond or act. 'n investing, a =7: loss hurts more than the
pleasure from a =7: gain.
F% 4erding
hen in doubt, followG This is what the herding bias tells us. e are programmed to
feel that the consensus view must be the correct one. This mistaken belief that )not
everyone can be wrong has led to many a disastrous decision. The Freat -epression
of !",7/>7s, the dotcom boom of !"""/,777, and the more recent financial crisis are
the most famous e(amples of how investors have lost big time by doing what
everyone else was doing.
1o, which herd are you following8
Gnow the holes, and fill the"
1imply noticing the holes in a boat wont save you from drowning. 0 boat will fill
with water whether you are aware of a hole or not. But by being aware of the holes
you can devise methods to patch them up.
'n the same way, if you know how your biases can hurt you, you will take
precautionary action to safeguard yourself from them.
1o just be aware of yourselfG
Lesson #*-: Checklists, Checklists,
Checklists
'magine going to a doctor with a stomach pain after you have been operated upon.
The doctor asks you to get an (/ray done. The (/ray report shows a piece of sponge in
your tummy.
Erightening, isnt it8 This could be life threatening.
0s per a study done by the orld 2ealth Organisation, such medical mistakes result
in around ? million getting disabled every year. One reason this number is not higher
is that doctors use what is known as a checklist before and after every operation.
Medical treatments have become so comple( that it is difficult for doctors to keep
personal check on each and every procedure. Mistakes still occur. But then the
number of such mistakes is greatly reduced due to the use of such checklists. 1o,
checklists save lives.
The L1 0ir Eorce introduced the concept of checklists decades ago. These have
enabled pilots to fly aircrafts at mind/boggling sophistication. 'nnovative checklists
are now used in hospitals around the world. These help doctors and nurses respond to
everything from common cold to epidemics. .ven in the comple( world of medical
surgery, a simple "7/second checklist has cut the rate of fatalities by more than a
third.
0 fair amount of research has been done in the past that suggest the immense value of
checklists. +hecklists are valuable as these help short circuit the human brain in a way
that it wants to work against us.
e generally are overconfident of our capabilities. 0 checklist can remind us that we
are not infallible, that we do make mistakes, and not to be too sure about our
decisions.
'nvesting in stocks is not as comple( as doing a medical surgery or flying an airplane.
But checklists play a very important role when it comes to investing in stock markets.
+harlie Munger, arren Buffetts partner at Berkshire 2athaway, can be credited of
first introducing the checklists in investing. Munger talked about these in his book *
Aoor +harlies 0lmanack.
2ere is a checklist ' have prepared from my study of Mungers checklists and that of
other great investors like arren Buffett and Ahilip Eisher.
0he Investing Checklist
Hte$ *: 3o the initial groundwork
!. 6ead about the company * +ompany website, Foogle search, B1.
announcements, 9ewspaper clippings
,. 6ead about the competitors * 1ame sources as above
Hte$ -: Iead $ast F-*A #ears annual re$orts of the co"$an#
!. 6ead the financial statements * 'ncome statement, Balance 1heet, +ash Elow
1tatement
,. 9otes and 1chedules at the end of financial statements
>. Management discussion 4 analysis
#. Managements compensation * 1ee for red flags like higher compensation as
compared to industry, e(cessive bonus or commissions
=. Aromoter stake * +heck shareholding over the past few years
@. 6ead annual reports of the closest competitors and see for differences in tone
and industry outlook
Hte$ 5: Iatio anal#sis 7 Calculate the following ratios and the trend in
the $ast
!. 9et/net working capital
,. Eree cash flow to .A1 growth
>. Eree cash flow to sales
#. 6eturn on e<uity
=. 6eturn on invested capital 36O'+5
@. .arnings yield 3inverse of Arice to earnings ratio5
?. 'nventory turnover and 6eceivables turnover
H. -ebt to e<uity
". E+E to debt
!7. Baluations * -+E, .AB
Hte$ E: 2"otional Check
!. rite down how you are feeling
,. rite down the biggest reason you want to buy the stock
>. Beware of wanting to just buy and study later
#. 1ee if you are being overconfident in your analysis
=. 0re you buying just due to amount of research youve put into the stock8
@. 0re you reluctant to accept differing opinions8
?. Beware of buying just because others are buying the same stock
H. Fet away from the e(citement and noise. 'f necessary, take a break and clear
your mind.
Hte$ F: )inal 2valuation
!. hat can go wrong8
,. hat will be you reaction if things really go wrong8
>. hat are the risks8 2ow likely are the risks8 2ow big are the risks8
#. 2ow attractive is this idea compared to the other holdings8 's that stock you
already hold, better than this stock8
=. hat is your e(pected holding time frame8
@. hat price will you sell8
3oneB
1o here was the checklist that you must run through before making any investment
decisions. 0nd if you do your homework on this properly, you can rest assured that
the stocks that pass this checklist will give you great return in the long run.
But theres a caveat here * even if a stock passes this checklist and you go ahead and
buy it, it is important that you run this checklist on that stock ever year to see if things
have changed. That will keep you on your toes in case any adversity was to hit your
stocks.
Lesson #*5: Gnow when to sell
Most value investing discussions revolve around when to buy a stock. %hich stock
should ' buy8& is the first <uestion that comes to your mind when you think about
your investment. But e<ually important is the <uestion * %hich of my stocks should
' sell8& ell, the answer to this <uestion is often as difficult and individual as
deciding when to buy a stock.
Ahilip Eisher, in his seminal book )+ommon 1tocks and Lncommon Arofits writes,
%'f the job has been correctly done when a common stock is purchased, the time to
sell it is * almost never.&
But then, there are times when the job is not done correctly and we realise later that
the stock purchase was a mistake. 't is then that a stock must be sold.
0nyways, Eisher suggests three reasons a stock must be sold. Lets discuss them now.
# * Ieason to Hell D Htock 7 8hen D <istake 4as 9een <ade
This is the most obvious reason to sell a stock * when you realise that it was a mistake
to buy it in the first place. hen you realise that the actual background 3business,
performance5 of the company is less favourable by a significant margin than what you
had thought when you had bought the stock, it makes utmost senses to sell it.
0lso, while an investor must sell his stock if he realise that a mistake has been made,
the losses from that sales must never cause self/disgust. 0nd neither should these
losses be passed over lightly. Nou need to review these losses as that you learn a
lesson out of the same, and do not repeat the same mistake in the future.
# - Ieason to Hell D Htock 7 8hen D Htock 3oes not Jualif# 0o 9e
4eld Dn#"ore
hile this reason might sound similar to the first reason to sell a stock, it isnt.
'nstead, here we are talking about the good stocks in your portfolio. Nou must sell
such stocks when, because of passage of time and due to fundamental changes in the
companies, these stocks no longer <ualify to be held anymore. That is the reason you
must run your investment checklist on your stock portfolio after a certain interval, say
si( months or a year.
'f you realise that a companys business has changed for the worse, like on any of the
following factors, you must sell its stock.
!. The company is facing increased competition and has thus lowered the prices
of its products or servicesR
,. The company is seeing a deterioration in its profit margins andKor cash flowsR
>. The management has made a wrong decision * like entering an unrelated
business * that will could negatively impact the company in the futureR
There could be other reasons to sell a stock, but these are the most common and
obvious ones. 'f you find any of your stocks to be facing any of these situations, it
will always pay to get out of the same.
# 5 Ieason to Hell D Htock 7 8hen D 9etter C$$ortunit# is Identified
'f you have made the right decisions while buying your stocks, this reason for selling
stocks does not arise often. But in case you were to find a better opportunity in
another stock than you find in any of your holdings, and you dont have additional
funds to deploy, it is a good idea to sell some of your e(isting stocks to reinvest in
that better opportunity.
The stocks that you might decide to sell might still be good. But then the newly
identified stock might be even better. 'ts like selling a stock where you e(pect annual
average returns of !=: 3which is good in absolute terms5 to buy a stock where
e(pected returns are around ,7:. But when you are looking to switch to a better
company, return must be just one of your criteria. The new company must also pass
your investment checklist.
Kever sell #our stocks Lust ecause.
Nou think a big stock market correction is round the corner, and that you must
book profits on your stocks before the correction takes place. This is
ridiculous. Like purchase of good <uality stocks must not depend on what the
general markets are going to do ne(t, the decision to sell bad stocks must not
be driven by this reason as well.
The stock has become e(pensive. ell, this seems a logical reason on the face
of it. But wait before you make any hasty conclusions.
Eirst answer, what is )overpriced or )e(pensive8 ont a good stock almost
always sell at higher AK. valuations than a stock that has stable earnings that
are not e(panding8
e hear the talking heads on business channel reciting their predictions for a
companys earnings for two years hence. 0nd the confidence in their voice
suggests that they are sure that their predictions will come true. But this is the
case till the ne(t <uarter comes, and the earnings projections are revised, either
up or down. 0nd the same cycle of predictions begins.
'f the company has the potential to grow strongly that its earnings <uadruple in
another ten or twenty years, is it really of such great concern whether the stock
is currently selling >7/>=: overpriced8
The stock has moved up sharply and that it cannot go up much further up. This
reasoning seems right unless of course you are talking about an 'nfosys.
0nyone who bought 'nfosyss stock in !""> and sold it after it doubled or
tripled, must be ruing now. This is because the stock has multiplied almost
>,=77 times 3yes, thats the right numberG5 since its listing. 1ee, its difficult to
predict which stocks will go up ten/fold or twenty/fold. 1o it is good to stick
with good stocks as long as the story is intact.
To repeat Eishers words, %'f the job has been correctly done when a common stock is
purchased, the time to sell it is * almost never.&
Lesson #*E: <onitor the 9ehaviour of
<anage"ent
'n the original version of The 'ntelligent 'nvestor, Ben Fraham began his discussion
of a chapter on %The 'nvestor as Business Owner& by pointing out that, in theory, %I
the stockholders as a class are king. 0cting as a majority they can hire and fire
managements and bend them completely to their will.&
But he changed this part in the subse<uent editions of the book.
'n practice, says Fraham, %Ithe shareholders are a complete washout. 0s a class they
show neither intelligence nor alertness. They vote in sheeplike fashion for whatever
the management recommends and no matter how poor the managements record of
accomplishment may be.
%The only way to inspire the average 0merican shareholder to take any independently
intelligent action would be by e(ploding a firecracker under him.&
This is a fact that is true for not just 0merican shareholders, but all shareholders.
0sk yourself these two <uestions if you have been an investor in stocks in the past *
!. 2ow many times have ' disliked what the management of a company was
doing8
,. 2ow many times have ' communicated my dislike to the companys
management8
Eor most investors, the answer to the first <uestion will be )never. 0nd that will
automatically make the answer to the second <uestion )never as well.
hatre your answers8
;ouve ought the stock% 9ut do #ou own it!
Nou buy a house, and you own it. 'ts your private property.
The same goes with anything else you buy * car, television, timeshare holidays etc.
Nou buy them, and you own them.
But when it comes to stocks, do you really )own the stocks you hold in your
portfolio8
Ownership means that we dont allow anyone else to do anything with what we own
without our permission.
Ownership means keeping a keen eye on things happening around what we own.
Ownership means if someone is acting smart to play around with what you own, you
have all the right to chide him away.
0nd if that is what ownership of a stock means, you must know thatI
!. The companys managers, all the way up to the +.O, work for you.
,. The companys board of directors must answer to you.
>. The companys cash belongs to you.
#. The companys businesses are your property.
=. 'f you dont like how the company is being managed, you have the right to
demand that the managers be fired, the directors be changed, or the property
be sold.
But for that, you need to know that you )own the company via its stock. 0nd if not,
you should wake up and know your rights as a shareholder.
0s Fraham suggests, %There is just as much reason to e(ercise care and judgment in
being as in becoming a stockholder.& This suggestion is something very basic but
incredibly important.
4ow to own #our stock!
Just be aware of your rights as a shareholder, raise your voice if you find something
fishyIand youll know that you own the stock.
Fraham suggests that there just two basic <uestions to which shareholders should turn
their attention$
!. 's the management reasonably efficient8
,. 0re the interests of the average outside shareholder receiving proper
recognition8
The first <uestion can be answered by the companys past financial performance.
!. 2as the company grown its sales at a steady pace in the past8
,. 2as it earned good profitability in the past8
>. 2as it shared profits with shareholders in the form of dividends8
#. 2as it been able to earn return on capital over and above its cost of capital8
=. 2as it gotten too aggressive in past to make faulty ac<uisitions by taking high
debt and thereby risking the <uality of the balance sheet8
)Nes to the first four <uestions and )9o to the last <uestion would mean that the
management has been reasonably efficient in running the company.
0nd if the answer is )9o to most or all of the first four <uestions andKor )Nes to the
last <uestion, you will know that the management has been inefficient.
1o what can an investor do if the management has been inefficient8
The answer is two pronged$
!. 'f you own a major stake in the company, you can call for a change in the
management.
,. 'f you just own a few shares in the company 3and thus a minority shareholder5,
the best option you have is to sell your stock immediately.
But remember this * you can take either of these decisions only if you know how the
company and its management have done in the past. 0nd you can know that only if
you have read its annual reports.
1o, readG 6ead the annual reports of the company you )own.
6ead its directors report to know his vision.
6ead the management discussion on the annual performance and the risks it
foresees in the future.
6ead to find out of the management is taking the blame of a year of poor
performance. Or whether it is laying the blame of everything else * like a
global crisis, or a domestic crisis.
6ead the financial statements to find out big changes over the previous year.
6ead the schedules and notes after the financial statements to really
understand what the company is up to.
6ead the <ualifications and background of the independent directors * you
dont want mute spectators as people approving all management decisions.
'n short, be open/minded and read diligently about the company you own.
'f you do that, youll be better than "": of shareholders who dont read the annual
report at all.
This will help you become intelligent, cautious, and thereby truly successful as an
investor.
Lesson #1:: Five Ha6its o( Hihly Success(ul
Investors
!e are nearing the end of our value investing course # Halue nvesting for *mart .eople. At this
/uncture, let&s spend some time on understanding the five habits that you as an investor can practice to
become better at investing in the stock markets.
,et&s start right here.
Ha6it #1: Set a oal, an) 'ork to'ar)s it
"ou would vouch for the fact that the core reason you are an investor is because you want to create
wealth for yourself and your family. And you would also agree that there are some reasons you want to
create this wealth.
%he reason might be toF
9. Kreate a nest egg for a post retirement life.
@. .lan for the education and marriage of children.
2. Accumulate money to go on a world tour.
3. Kreate wealth to meet all these wants, wishes, and obligations.
*o, it is important that you have some financial goals in mind for which you are working >investing? to
create that kind of a resource pool. But then, you might be one of those ma/ority investors who do not
have any goal for which they invest. Ask them why they invest in stocks, and the plain answer # ;%o
make money-<
Ef course the idea is to make money. But the bigger idea here is to have a future goal for which to make
money by investing in stocks. *o, if you haven&t yet set yourself such a goal, do it now.
But /ust remember one thing # the goals you set are not static and are very much sub/ect to change. *o,
be realistic and fle$ible. )evisit your goals whenever there has been a ma/or change in your life, such
as marriage, child birth, or the purchase of a home.
Ha6it #2: >no' 6asic accountin
0ot comple$ accounting that companies use to manipulate their earnings- But you need to understand
the basic accounting concepts before you even become an investor. After all, accounting is the
language of business. And /ust like you learned the basic grammar in school to be able to speak and
write now, you need to understand basic accounting to identify good companies from the bad ones
based on their past financial performance.
*incerely, if you cannot tell the difference between something like a current asset and a fi$ed asset, you
have no right to invest in the stock markets.
Ha6it #2: Hea)4rea)4rea)
%hat&s the best habit that to can have as an investor. *uccessful investors will tell you that if you /ust
read a company&s annual report, you will be better read than P:4 of all investors. And if you read the
footnotes >e$planations? after the financial statements in an annual report, you&ll be better than PP4 of
all investors.
!arren Buffett&s business partner Kharlie Munger once said, ;n my whole life, have known no wise
people over a broad sub/ect matter area who didn&t read all the time # none, Cero.<
Buffett and Munger are both well1known for the incredible amount of reading they do. And you can
follow their footsteps by starting with reading a lot.
)ead books on value investing. )ead books on human behaviour. )ead books on the financial history
of the world. "ou never know when you&ll find a brilliant idea to add to your repertoire.
)ead the daily newspapers, read the annual reports, read the biographies of successful businessmen.
Jnowledge is power, and there is no shortcut to success. 0ot even in investing-
Ha6it #9: Min) your 6ehaviour
As you must have read in lesson 92, minding your own behaviour plays a critical role in your acts as an
investor. !e humans are not hard1wired to be rational beings despite the fact that we clam this honour.
%he truth is that we are rationalising beings. !e make emotional decisions and then try to rationalise the
same with logic.
*ensible investing however requires that we notice where our emotions are guiding us to, and then take
preventive measures to fall in emotional traps. %raps likeF
Being overconfident # !e know all the right answers-
!ishful thinking # 'earing from others what we believe to be true.
Availability bias # Believing the news that&s readily available.
Araming # 7oing by how words are framed and not the rationale behind the same.
Aollowing the herd # My truth, your truth, +the& truth-
Ha6it #:: Mn)erstan) risk
%his is the hardest habit to form, simply because most of us investors never count risk as part of the
equation. And those who do, have a fuCCy idea of what +risk& really means.
n general terms, investing risk refers to the uncertainty of the occurrence of a certain event that can
affect future returns. But ask Buffett, and he would go a step further. Buffett defines risk as +permanent
loss of capital&.
As per this definition, risk is to lose whatever you&ve invested and not have any chance to get it back.
*hort term fluctuations in the stock prices, therefore, don&t equate with +risk&, as is generally considered
in the investing circles.
*o the good idea for you to become a smart investor is to understand what risks you are taking while
investing in stocks.
Before buying a stock, try to answer this question # ;Kan this stock cause a permanent loss of capital to
me(<
f your answer is +yes&, or even +maybe&, you better stay away from that stock. Buying it despite knowing
that it would involve risk1taking would be foolish.
Ef course we can never eliminate risks from stock market investing, but we surely can minimise the
chances of the same.
Lesson#1;: Why Your Stocks Will Iever Make
You Hich
Every money1making opportunity comes with its share of myths and fallacies. *tock market investing is
no different. n fact, believe this industry is the biggest game for the myth creators.
%he stock market landscape is dotted with shaky principles. %ime and again, the average investor gets
caught wrong1footed by this shadiness.
%hese myths not only cause heavy losses to investors, they also lead to opportunity losses that block
investors& path towards true riches from stocks.
'ere are what believe the top five stock market myths, which if side1stepped, can lead to big success
and wealth through investing.
Myth #1: Investin is too risky
)eally( f investing is too risky, so is swimming, crossing the road, riding a bike, and driving a car. !ith
proper training and guidance from your parents, you had learnt to do these things fairly early in your life.
But the sad part is that, parents rarely teach their children how to treat the money # how to save and
how to invest. And that is what makes the grown1up children believe that +invest is too risky&-
%he truth is # investing isn&t risky. t&s made out to be risky by the number1crunching, /argon1filled
analysts, fund managers, and other stock markets e$perts. After all, if they do make you think that
investing is risky, how will they ever be able to sell you their wares # stock recommendation tips, mutual
funds, etc.(
am +not& saying that investing is not risky. t is- But only if you are ignorant about the sub/ect and still try
your hands at it. f you do not understand it, or if you aren&t properly educated on the risks involved,
investing can be incredibly dangerous. Lust ask someone who lost a lot of money during the previous
stock market crash what he knew about investing in the stock markets e$cept that he was acting on free
and hyped1up stock tips received from friends, relatives, business channel e$perts, and their brokers.
!arren Buffett once said # ;)isk comes from not knowing what you&re doing.< By educating yourself in
investing, you will know what you&re doing. And that will take away a lot of risk from your investment
decisions.
nvesting in stocks isn&t risky if you know how to do it the right way. nstead, not investing is the biggest
risk of all.
Myth #2: ,nly e@$erts can #ake #oney (ro# stocks
Most large business houses in ndia were started by people who had little or no education. %hey were
not glorified MBAs who used comple$ strategies to growth their businesses. Bespite this handicap >of
less or no formal education?, they made some remarkable investments that have brought them such
grand legacies. "ou as an investor can take a leaf out of their books.
%his myth that you need to be an +e$pert& to make money from stocks follows from the first myth
discussed above. f only you know what the e$perts were prescribing at the start of @::8 >when they
were all bullish? and at the start of @::P >when they were all bearish?, you will know why +being an
e$pert to make money& is a big myth. Ef course, you need to be educated and aware about what you
are investing into >some basic accounting and awareness about your own behaviour are necessary?, but
that&s akin to a high school education, not a .hB-
%he irony is that the entire financial services industry has conspired to make you believe that investing is
tough and it&s better to leave the game to the e$perts. After all, if they do not do so and instead spread
the belief that you can make your own profitable investing decisions, how would they earn their billions
from selling worthless advice, and commissions every time you trade in stocks(
%he reality is that you do not need more than these free >or very cheap? resources to become a
successful investor yourselfF
9. Brain >we rarely use it when it comes to investing, but it&s still the most precious of our
resources?
@. %ime >this is precious, but you do not need to spend more than 2:13: minutes of it each week
towards enhancing your investing knowledge?
2. !illingness >you need to put in some of your own effort for sure-?
3. Annual reports of companies >for studying which companies are doing well, and which aren&t?
=. An internet connection >apart from getting investing ideas, you need this to read everything
else on a company that its annual reports do not provide # like about its competitors?
Myth #2: I( you can.t 6eat it, stay out
,eaving aside the efficient market theory, believe that +beating the markets& is /ust a whim. %he reality
is that your core goal must not be to beat the markets, but to meet your financial goals with comfort. And
for that, whether you earn same as the markets, or 91@4 here or there than the markets, makes no
sense.
t&s true that ma/ority of all mutual fund managers have not been able to beat the market in the last @:
years, but then you are not a fund manager and your investing performance won&t be /udged by whether
you beat the market. nstead, it will be /udged by whether you and your spouse are living comfortably
after your retire from work.
remember a /oke that will make this fallacy about +beating the markets& clearer for you.
Ence upon a time, two guys were hiking through the /ungle when they spotted a seemingly hungry tiger.
Ene of the guys reached into his pack and pulled out a pair of sports shoes.
'is friend looked at him in fear, and asked, ;Bo you really think those shoes are going to make you run
faster than that tiger(<
%he second replied, ; don&t have to run faster than that tiger. /ust have to run faster than you-<
*imilarly, the idea is that your stocks don&t need to earn you more than the markets >or your friend,
relative, or the fund manager?. "our stocks /ust need to earn you enough to live happily in your life in
your golden days. Every other idea is superfluous-
Myth #9: Hih risk0hih returns
Bo you think you were a safe driver when you last drove your car to your office or somewhere else(
mean, safe for others walking and driving around you( f you are like P:4 of the respondents, your
answer will be +yes&.
0ow imagine if your ten year old son or daughter is behind the steering wheel the last time you travel by
your car. !ill your /ourney be still safe( mean, you will still travel in the safety of your car, and you will
possibly take the same route. But still, will your /ourney be safe(
*ee, my point is that when we put someone in the driver&s seat who doesn&t know how to drive, a
relatively safe trip becomes an incredibly risky trip.
E$actly the same thing holds true for investing in the stock markets. f you don&t know what you&re doing,
your /ourney is going to be either very slow or very dangerous. 0ot knowing what you are doing, as we
discussed in the first myth on investing, is what risk is all about. And considering this, if you take a high
risk >you known nothing at all about the stock markets?, you won&t be getting high rewards anyways.
%he concept of high risk1high rewards is possibly true when you get paid a bounty for working in the
middle of the Atlantic Ecean as an oil driller. "ou might never come back from there. But if you do come
back, your family will reap the rewards.
But when it comes to investing in the stock markets, high risk mostly does not equate with a high reward
until and unless you know the insider, or are one of them. And mind you, am talking about +investing&
here, not speculation.
"ou might earn high rewards with high risks when you speculate. But the biggest problem with this is
that you need to repeat this cycle over and over again. %his is because after every period of high
rewards, you will face a period of big losses that will wipe out your previous gains.
n investing, you get high rewards only when you take low risks. nvesting in quality companies selling at
cheap prices is a good way to get there. %he whole idea is to keep a good margin of safety to nullify the
impact of potential losses in the future. And when you do that # buy a good company at cheap
valuations # you aren&t taking a high risk, right( "ou are indeed lowering your risk of going wrong.
*o, when it comes to investing, low risk Q high rewards.
Myth #:: This ti#e it.s )i((erent
;%his time it&s different-<
'ow many times have you heard this from a stock market e$pert or from your friend who has made big
money from stocks in a short time( %hese words are commonly used in the stock markets to e$plain
that stock prices can touch the sky, or touch the earth&s crust depending on if they are rising or falling.
But if you were to listen to the legendary *ir Lohn %empleton, these are four most dangerous words in
investing # ;%his time it&s different.<
'istory repeats, and it repeats itself many times over when it comes to the stock markets. %hat is what
causes booms and busts, after booms and busts.
Lesson #1<: The Fallacy o( "sset "llocation
A time1honored investment rule is that your asset allocation should mirror your age. *o, you should
allocate your money into stocks and bonds in a ratio of 5:F3: at age 3:, 3:F5: at 5: and so on.
Ask any stock market e$pert or financial advisor for a proper allocation of your money, and he will tell
you that you must simply subtract your age from 9:: and invest that must proportion of money into
stocks, and the rest into bonds or other safe instruments.
*o if you are @=, you are advised to invest 6=4 >9::1@=? of your money into stocks. And as you age,
your stock allocation must come down while that of safe investments like bonds must rise.
En the face of it, this logic of increasing an allocation to less1risky, less1volatile bonds as one gets older
seems convincing.
As investors approach and enter retirement, their ability to earn their way out of a stock1market plunge
evaporates. *o does their ability to outlive a market decline.
*o what is wrong with the allocation rule and the advice based on it(
.lenty- ,ike many investment rules, this one strikes me as grossly simplistic at best, and dangerous at
worst.
Why /en5a#in Nraha# #ocke) such an allocation
%he most striking thing about the father of value investing Ben 7raham&s discussion of how to allocate
your assets between stocks and bonds is that he never mentions the word +age&.
%his is what sets his advice firmly against the winds of conventional wisdom # which holds that how
much investing risk you ought to take depends mainly on how old you are.
Dnless you&ve allowed the proponents of this advice to subtract 9:: from your G, you should be able to
tell that something is wrong here.
!hy should your age determine how much risk you can take(
A P:1year1old with )s 9: crore in his bank account, a big enough house, and a gaggle of grandchildren
would be foolish to move most of his money into bonds. 'e already has plenty of income, and his
grandchildren >who will eventually inherit his stocks? have decades of investing ahead of them.
En the other hand, a @=1year1old who is saving for his higher education and a house down payment
would be out of his mind to put all his money in stocks. f the stock market takes a nose dive, he will
have no bond income to cover his downside # or his backside.
!hat&s more, no matter how young you are, you might suddenly need to move your money out of stocks
not 3: years from now, but 3: minutes from now.
!ithout any warning, you could face troubles in your life # like losing your /ob, getting divorced,
becoming disabled, or suffering who knows what other kind of surprise.
%he une$pected can strike anyone, at any age.
As such, everyone must keep some assets in the riskless haven of cash.
Also, as &ve seen over the past many years, many people stop investing /ust because the stock market
goes down.
!hen stocks are going up 2:4 or 3:4 a year, as they did between @::2 and @::8, it&s easy to imagine
that you and your stocks are married for life.
But when you watch every rupee you invested getting crushed, it&s hard to resist moving into the +safety&
of bonds and cash.
Because so few investors have the guts to cling to stocks in a falling market, 7raham insists that
everyone should keep a minimum of @=4 in bonds >or other similar safer instruments?.
'e argues that such a cushion will give you the courage to keep the rest of your money in stocks even
when they are sinking.
Lesson #1=: The "rt o( Forecastin Stock
1rices
is not really an art-
t&s like shooting an arrow in the dark. f you hit the bull&s eye, you&re lucky. And if you don&t, you&re a
ma/ority.
%hose who have read the history of stock markets must have come across this famous prediction that
went horribly wrong # ;*tocks have reached what looks like a permanently high plateau.<
%hese were the words of one of the most respected economists of his time, rving Aisher, in 9P@P. Lust a
week after Aisher made this glamorous statement, the D* stock markets crashed and the D* economy
went into what we now know as the 7reat Bepression.
,ook no further. Before the latest crisis hit home in Lanuary @::8, you must have heard several market
pundits >those who fill the slots in business channels and newspapers? gloating about how they thought
the B*E1*ense$ was on its /ourney to the @=,::: mark.
!hat happened later is not a secret anymore.
'ere&s what !arren Buffett has to say on the futility of forecasting the direction of stock markets and
stock prices.
;!e have long felt that the only value of stock forecasters is to make fortune1tellers look good. Even
now, >Berkshire 'athaway vice chairman? Kharlie >Munger? and continue to believe that short1term
market forecasts are poison and should be kept locked up in a safe place, away from children and also
from grown1ups who behave in the market like children.<
Bespite this, most stock markets investors crave to know the future direction of stock price.
n fact, if there was ever a ranking of the most used statements in ndia, after ;!hat&s the >cricket?
score(< would come ;!here is the *ense$ headed(<
Everyone wants to know the future before it happens. Ef course this is good in terms or positioning your
portfolio to take advantage of what might come, the issue is that future stock market predictions have
seldom been true.
And the irony is that this doesn&t stop brokers, analysts and fund managers to keep crystal gaCing into
the future. And they make their forecasts sound like a gospel truth, as if whatever they are predicting will
definitely happen. Enly that this truth changes at the ne$t market surge or crash.
But the most interesting part is that despite finding that none >or ma/ority? of their predictions come out
to be incorrect, they spout out even newer predictions each passing day.
"ou can validate this fact by switching on to a business channel right away. Ene or the other +stock
market fortune teller& will be therelivemaking some predictions about the future of stock prices.
Er if you are away from the television, pick up any business newspaper and you will find a flurry of such
+free& recommendations everywhere.
%he biggest problem with such +free& and +widely available& predictions is that they cost the small
investors heavy.
f you have been investing in the stock markets for the past @12 years, you already understand what &m
trying to tell you.
Aorecasting earnings, stock prices, or direction of the stock markets with precision is as hopeless as
e$pecting a politician to be honest.
*mart investors don&t believe in such forecasts. %hey do their own homework, and take their own
decisions.
And know you are a smart investor.
Lesson #1J: Three Investin Leen)s an)
Their Three /i I)eas
;f at all have been able to see any further, it is because have stood on the shoulders of giants,< said
*ir saac 0ewton. 'e was spot on given that most of the big things we do in our lives are generally
inspired by someone else # someone we idoliCe, or someone who trains us.
n my career and life of the past eight years, have come across several giants # people who have lent
their helping hands in training me in investing and stock market research.
But my best teachers all these years have been three people, whom have never met personally, but
have seen them through books written byNon them.
%hese teachers are # Ben/amin 7raham, .hilip Aisher, and !arren Buffett # the legends in the field of
value investing. !hile 7raham and Aisher are no longer alive, Buffett continues to amaCe me with his
wit and wisdom on investing and how he handles his investments.
%his lesson is a dedication to these three legends. t also discusses briefly the one big idea >each? that
has come to be the hallmark of their investing philosophies.
/en5a#in Nraha# %1=J901J<;&
The leen): 7raham is also known as the father of value investing. 'is biggest contribution to the
investing world has been his two books that were published almost eight decades ago. %he first #
*ecurity Analysis # was published in 9P23.
As the name suggests, it was meant for people who wanted to understand the quantitative analysis part
of buying an investment, whether a stock or a bond.
7raham&s second book # %he ntelligent nvestor # came out in 9P3P. 0ow this is the most widely
acclaimed book on value investing and has been described by !arren Buffett as +by far the best book
on investing ever written&.
7raham wrote this in e$tremely simple manner, so that the man on the street can understand it, and
incorporate the learning in his investing.
Nraha#.s 6i i)ea: %he investing world sums up in three simple words # margin of safety. %hese are
also the three most important words for an investor. !e studied the concept of margin of safety in
lesson eight of this series on Halue nvesting for *mart nvestors. *o won&t go in much detail again.
But in simple terms, margin of safety is the difference between the intrinsic value of a stock and its
market price. t is like paying )s =: for a stock that is worth )s 9::, so that even if the actual worth is )s
8:, your buying price of )s =: is still much less and won&t lead into trouble if the stock were to fall.
Anyways, margin of safety was not the only big idea that came from 7raham. 'e is inarguably called the
father of vale investing. And /ust like any devoted father, this man has contributed a lot the founding and
development of this field of sensible investing.
And you can grasp all his learning by /ust reading %he ntelligent nvestor, and also by following *afal
0iveshak where we will discuss a lot about the man, and his ideas.
,et&s now turn to another doyen of the value investing field, .hilip Aisher.
1hili$ Fisher %1JK<02KK9&
The leen): %hough not as widely known as 7raham, Aisher has also contributed remarkably towards
the development of value investing. 'e is best known for dispelling his learning through his famous book
# Kommon *tocks and Dncommon .rofits # that is a must1read for all value investors and those who
are trying to learn the art.
!hile 7raham was more of a quantitative investors # deeply analysing the numbers before buying his
stocks # Aisher add the tinge of qualitative aspects to the field. 7raham, for instance won&t buy a stock
trading at a .NE higher than 9= times, no matter what the quality of the company was.
Aisher, on the other hand, was all for paying a higher price >though not very high-? for a quality business.
Fisher.s 6i i)ea: 'e called it +scuttlebutt&. *imply e$plained, it means keeping your mind, eyes, an
ears open while studying a company. %his involves meeting the company&s management, its
competitors, buyers and suppliers to take an all1round view of the company. R"S
Warren /u((ett %1J2K&
The leen): Buffett is inarguably the best practitioner of the value investing ideas laid out by 7raham
and Aisher. 'e in fact calls himself +8=4 7raham and 9=4 Aisher&- !hile not much information is
available regarding the investment returns and wealth of 7raham and Aisher, Buffett&s story is an open
book.
Adhering to the value investing principles that he learnt from these two masters, Buffett has grown his
wealth at an average annual rate of over @:4 during the past 3= years. !hile this number might not
mean much at first, it is enough to grow every )s 9:: invested into )s 2.5 lac over a 3= year period.
%his is unmatched by any other investor, living or dead.
/u((ett.s 6i i)ea: !hile most of Buffett&s ideas are what he learnt from 7raham and Aisher, the
simplicity with which he has passed on these ideas to generations of investors is what is his biggest
idea. Buffett&s annual letter to the shareholders of his company Berkshire 'athaway are considered a
must read for any investor, analyst, or fund manager /ust starting out.
%hese letters that come out at the end of Aebruary each year >here&s the latest letter?, contain a wealth
of investing ideas and how Buffett practices them to invest his company&s money. %hese letters are the
ultimate epitome of selflessness from the man who has been the most generous in passing over his
legacy to the investing world.
!ith this, we come to the end of this educational series on value investing. hope +Halue nvesting for
*mart nvestors& has really made a worthwhile and easy reading for you.
Halue investing is a very vast field and will not claim to have covered all aspects of it through this
series.
But it has been my sincere effort to include all the ma/or ideas from the field that can be part of every
sensible investor&s toolkit.
Lesson #2K: Invest#ent ,'ner.s ,ath
%his investment oath was first published in 7raham&s %he ntelligent nvestor. have modified it to suit
an ndian investor&s requirements.
Aill it, print it, stick it in front of your work desk, and read it every day.
Invest#ent ,'ner.s ,ath
, TTTTTTTTTTTTT TTTTTTTTTTTTTTTTTTT, hereby state that am an investor who is seeking to
accumulate wealth for many years into the future. know that there will be many times when will be
tempted to invest in stocks because they have gone >or ;are going<? up in price, and other times when
will be tempted to sell my stocks because they have gone >or ;are going<? down.
hereby declare my refusal to let a herd of strangers make my financial decisions for me. further make
a solemn commitment never to invest because the stock market has gone up, and never to sell because
it has gone down.
will invest with discipline # month after month # and into businesses that understand and stocks that
find are trading with a good margin of safety as compared to their intrinsic values.
hereby declare that will hold each of these investments continually through at least the following date
>which must be a minimum of 9: years after the date of this contact?F TTTTTTTTTTTTTTTTT TTTTT,
@:TT.
%he only e$ceptions allowed under the terms of this contract are a sudden, pressing need for cash, like
a health1care emergency or the loss of my /ob, or a planned e$penditure like a housing down payment
or my children&s education bill.
am, by signing below, stating my intention not only to abide by the terms of this contract, but to re1read
this document whenever am tempted to sell any of my investments.
%his contract is valid only when signed by at least one witness, and must be kept in a safe place that is
easily accessible for future reference.
*ignedF TTTTTTTTTTTTTTTTTTTTTTTT
BateF TTTTTTTTTT
Witnesses:
9. TTTTTTTTTTTTTTTTTTTTTT
@. TTTTTTTTTTTTTTTTTTTTTT