Stock

Investment
Basics
for Beginners

If you want your

money to grow, there
are hardly any better
options than investing
in stocks.

Connect with Moneylife Advisory Services MONEYLIFE

ADVISORY
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 Stock
Investment
Basics MONEYLIFE
ADVISORY
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Stock
Investment
Basics
I
f you want your money to grow,
there are hardly any better
options than investing in stocks.
For equity investors, certain stocks,
properly selected and discarded, can
become the road to unimaginable
riches. When banks pay you 9% per
annum, every few years a handful
of stocks fetch anything between
100%-200%. If stock investing is
that rewarding, why are most people
averse to investing in stocks?

The reason is that making profits by stock investing isnt easy.

This e-book makes it easier for you to understand what stock
investment is. It is for those investors who have never bought
stocks before and want to understand what the world of stocks
is all about and for those who depend on others advice and
predictions. Treat this as a stepping stone in your journey to make
the best out of stocks.

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Investment
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What are
stocks and
shares?
Y our share of Reliance, Infosys or
any other company represents
a share of your ownership in the
company. You own a slice of every
rupee of profit that the company
makes and have a claim on its assets,
proportional to your stake. As your
share of ownership, you get one
vote per share of stock to elect the
directors and to express opinion
on some decisions. The real point
of owning shares is to share in the
growth, innovation and wealth that the
enterprise economy creates.

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Investment
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What are the advantages

of investing in stocks?
There are two powerful reasons why you should invest in stocks
and they will work for you in the future, especially in a fast-growing
country like India.

Demographic Advantage: Tax Advantage

G iven that most savers are still young

and India is a growing economy, at
least 65% of your money should be in
stocks either directly or through mutual
funds and 25% in post office and 10%
in cash and gold. Select companies will
grow consistently over the long term with
the overall growth in economy. Create a
diversified basket of such stocks from
different sectors.
S hort-term capital gains on stocks
attract only a 10% tax and long-
term gains attract zero tax. It is quite
perverse that speculative holding of
just a few days attract 10% tax and
passively earning money on money by
holding for a year attracts no tax while
business enterprises that create value
in the first place have to suffer a million
kind of taxes. This is an unthinkably huge
positive for stock investors. But that is

10% the wisdom of our tax-planners and so

go out and take full advantage of it by
Stocks buying stocks as long as low taxation
25%
Post office lasts on the risky speculative asset called
65%
stocks.
Gold

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Investment
Basics MONEYLIFE
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Kinds of stocks
Companies can be classified by their market value, which is their
number of shares multiplied by market price. As defined by their
size, Moneylife divides stocks as mega, large, mid, small and micro

Moneylife mega-cap stocks:

Stocks of those companies whose market capitalization is higher than Rs10,000 crore
are classified as mega-cap stocks. These would include stocks of most well-known
companies like Hindustan Unilever, Reliance Industries, Infosys etc. All companies in
the two main market indices, Sensex of BSE and Nifty of NSE have mega-cap stocks.
These are also called blue-chip stocks.

Moneylife large-cap stocks:

Stocks of those companies whose market capitalization falls between Rs 10,000 to Rs
2000 crore are large-cap stocks, as per Moneylife classification.

Moneylife mid-cap stocks:

Stocks of companies whose market capitalization falls between Rs 2,000 to Rs 500
crore are classified as mid cap stocks

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Moneylife small-cap stocks:

Stocks of companies whose market capitalization falls between Rs 500 to Rs 100 crore
are small cap stocks. The mid-cap and small-cap stocks are where the excitement as
well as the disappointment is. These companies grow fast and the best of them always
look pricey for their size and growth. Over time, however, some of them do justify their
high prices.

Moneylife micro-cap stocks:

Stocks of companies whose market capitalization is below Rs100 crore are classified as
micro-cap stocks by Moneylife.

Others such as business newspapers, exchanges and mutual funds may follow a
different classification.

Value stocks:
Stocks of companies that have excellent assets and potential for growth but may be
down in the dumps temporarily are called value stocks. Their prices would be lower
than what seems fair. There is a powerful investment approach that only invests in value
stocks because these are seen to be bargains.

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How to measure
corporate
performance
One of the first tenets of long-term investing is to find a way to value
stocks based on the corporate performance. How do you measure
corporate performance? To invest in stocks or stay away from them,
you have to understand the following set of basic financial numbers
that signify a companys health and its earnings growth:

Operating Profit:
This measures the profitability of the core business operation and is expressed as sales
minus all costs except interest, depreciation and taxes.

Profit after Tax (PAT):

Also called net profit, PAT captures absolute profit, but should not be studied
independently, without looking at the sales-cost structure.

Earning per Share:

EPS is expressed as net profit (profit after tax) divided by the number of shares. A
company with Rs 50 crore in earnings and a capital of 5 crore shares would have an
EPS of Rs 10. A continuously rising EPS is one of the most reliable predictors of future
price rise.

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Cash Flow:
Reported PAT and EPS can be traps since PAT is an accounting number arrived at after
lots of adjustments. A company can show healthy PAT but may have a poor or negative
cash flow. A negative cash flow also indicates that there is a fundamental problem with
the companys operations: either the profitability is too low or money is stuck in high
inventories and receivables.

Profit Margins:
While profits are important, equally important is profitability expressed as a
percentage of sales. Expressed this way, margins allow us to compare companies
across sectors and within a sector indicating how profitable the operations are.

Return on Capital Employed:

RoCE is calculated by dividing profit before tax and interest cost by capital employed.
Capital employed is the total of all equity and preference capital, reserves and all debt.
RoCE measures how the entire money invested in business is doing. RoCE is best
compared to the cost of borrowing. If the interest on fixed deposits is 12% whereas
a company is earning about 14% as RoCE, clearly it is not a great business for
shareholders.

Dividends:
A key measure is regular dividends to shareholders that give them confidence that the
company is in sound financial health. When dividends are increased, the message is
that the company is prospering. When dividends are cut, investors receive the opposite
message and conclude that the companys future prospects have dimmed.

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How to select the

right stocks

T he best stocks are those that have excellent financial performance and are not
valued correctly. If the price is in an upward trend, it helps. This would combine
value with price action an essential combination to win in the game of stock picking.
The three most important measures of performance are sales growth, growth in net
profit or Profit After Tax (PAT) and return on equity (RoE). PAT indicates the absolute
profitability of operations. EPS indicates the profit per share and RoE indicates overall
profitability on owners (shareholders) funds invested. Once you have decided to
identify good stocks based on these parameters, you will have to estimate whether they
are overvalued or not. You must at all times avoid buying stocks with poor financials.

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How to
invest in
stocks
Primary market

T he shares of a company are made

available to the investing public for
the first time through what is called an
Secondary markets
Initial Public Offering. This is the first time
a company issues stock. This segment
of the market is called primary market. A fter an IPO is over, shares are
traded or bought and sold in stock
exchanges among investors in what is
You can buy these stocks from the stock
exchange once they get listed. called a secondary market.

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How shares are valued

Price and value should determine
what to buy, when to buy and when
to sell. There are several approaches
to valuation. All of them are partially
true. You can use them only when you
know the context in which they are
useful as also their limitations. Shares
have an intrinsic value and a market
value and usually there is a huge
divergence between the two. Either the market value is too high or
too low. And therein lies the opportunity. The intrinsic value is the
underlying value of the business.

Fundamental analysis:
Theoretically, when you buy a share, you are buying a proportional share in a business.
So, to figure out how much the stock is worth, you should determine how much the
business is worth. To do this you have to make a detailed analysis of the financial
condition of the company. This is known as fundamental analysis. Some believe that
this is the only rational approach to valuing stocks.

Quantitative approach:
There is another approach to investing. It is using computers and mathematics to
detect patterns, capture the pattern in models/formula and teach computers to provide

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buys and sells based on these models. This is the quantitative approach to investing.
Applying quantitative tools is also called data mining. Quants or data miners develop
a hypothesis defining a relationship among various past data (prices, seasons/months,
streaks of winning or losing days etc.), then look for how statistically significant that
relationship is. This includes testing the relationship within data in different time periods,
market environments, etc., in order to test the robustness of theory. Finally, they would
take investment/trading positions by presuming that those past relationships would
continue to hold in future. It is as close finance can come to a scientific approach.

Technical analysis:
Technical analysis is the study of market action, using price charts, to forecast future
price direction. The central belief in technical analysis is that all factors that influence
market prices (fundamentals, political events, natural disasters, and psychological
factors) are quickly discounted by the market and prices reveal everything. Investors
who focus on chart readings call themselves technical analysts or chartists

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Risks involved in stock

investment
W hile blue-chip stocks do rise steadily over time, stocks are market-linked
products and so their returns are not guaranteed. Bonds return your money
at the end of the tenure plus interest. Stocks may go up and down and while all good
stocks pay dividends, it is not mandatory. Companies can go bankrupt and your
investment can disappear. How can you emerge as a successful investor? Consider
the following rules

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Count-down to
successful stock picking
10 Ignore Extremes: The central belief in technical analysis is that all
factors that influence market prices (fundamentals, political events, natural
disasters, and psychological factors) are quickly discounted by the market and prices
reveal everything. Investors who focus on chart readings call themselves technical
analysts or chartists.

09 Avoid Big Losses: If a stock falls 90%, it has to rise by 900% to get
you back to where you were and that will not happen. So you can never allow
yourself a catastrophic loss. Put predetermined stop losses to avoid being wiped out.
Do whatever it takes to keep your downside limited and your upside unlimited.

08 Keep it Simple: It is not necessary to have complicated models for

success. For instance, the simple idea of buying blue-chips on large declines
works fine.

07 Ego & Emotions: Holding on to a stock thinking you are right or

because the company is good is a sure way to lose money.

06 Patience: Unlike mutual funds you do not need to be always fully

invested. When the market is overheated by your valuation parameters and
there are hardly any picks with attractive risk-reward ratio, it is perfectly fine to wait.

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05 Risk Control: Stocks are risky. Your returns depend as much on

controlling risk as much as fetching rewards.

04 Develop a method: If you dont have a consistent method of buying

and selling, your returns will be pretty low.

03 Learning from Experience: Deep experience is an essential

ingredient. Unless you are born with exceptional personality traits, losses
will be a major part of life. It is even alright for traders to have a majority of losing
trades, provided the losses are small and the winners are big. Winners learn from their
experience of losses and take responsibility for it..

02 Start Small & Stay Informed: It takes years to learn what

drives stock prices, the value of method and discipline and emotional control.
Until then start in a small way, especially if you feel very confident. Prudent investing
rests on keeping up with the flow of basic information. Smart investors seek intelligent
and consistent opinions and track some key investment parameters to ensure that
their investments are on track. They avidly read market history which helps clear our
minds about a lot of contemporary issues and trends. Besides, crunching numbers are
an important part of the stock picking process and successful investors do their own
number-crunching.

01 Commitment: Winning stock pickers have a strong commitment to their

job of finding a winning edge, developing a method and sticking to it through
the rough and smooth.

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16 Timeless
Tips for
profitable
stock
investment
Here is some timeless advice on stock investing
culled from experts:

01 An attempt at
making quick
money leads to losses
02 If stocks dont
seem cheap by
historical standards, stand
03 Buy and hold does
not work always
Never average down a losing
far higher than the initial aside or invest in very small investment unless it is part of a
investment. amounts. well-thought out method.

04
a hot tip.
The best tip: there
is no such thing as 05 Dont fall in love
with your stock; it
will never fall in love with you.
06 Valuations dont
matter in the short
run and short run can last
It will fall with the market. for months and even beyond a
year.

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07 Calculate first how

much you can
lose, not how much you can
08 Experts care about
risk, novices
dream about returns.
09 Forecasts,
especially by
market experts are usually
gain. useless.

10
patience.
Develop a method,
stick to it and have 11 Lots of humility
helps. A rising tide
raises all ships and so you may
12 Stocks fall more
than you think
and rise higher than you can
have been just lucky. possibly imagine.

13 Investing in what
popular stocks, fad
industries and new ventures
14 Bear markets start
in good times. Bull
markets start in bad times.
15 Neglected sectors
often turn out to
offer good values.
are riskier than they seem.

16 Dont assume
either the media
or fund managers know more
than you. Their record shows
they dont.

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6 Stupidest Things
People Say about stock
investments
How much lower can it go?
After the bust of 2000, the four hottest stocks met with the following fate. Pentamedia
fell from Rs 2109 to Rs 4, DSQ Software fell from Rs 2820 to Rs 6. DSQ Software has
been now delisted from the exchanges and the promotor of the company is absconding.
Himachal Futuristic fell from Rs 2552 to Rs 7 and SSI with which the famous US stock
exchange Nasdaq even had a joint venture, fell from Rs 7200 to Rs 40.

How high can it possibly go?

As the saying goes, if you want to make 10 times your money, you cant sell before the
stock goes up 10 times. But nearly all investors sell too early thinking how high can it
possibly go. The only way you make big money in stocks is letting them go higher - by
not taking a profit early. As another saying goes, let your profits ride...

It is only Rs 20 a share, what can I lose?

You can lose the entire Rs 20, a 100% loss Whether a stock is Rs 5 or Rs 50 if it falls to
zero, its a 100% loss. Resist that bargain.

They always come back

Oh yeah? SSI, DSQ Software, Pentafour... It is a silly and dangerous idea to assume
they come back. Besides, while you are waiting for them to come back, what about the
stocks that have doubled?

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When it rebounds, I will sell

We can hear it again and again. When it rebounds, you decide there was nothing wrong
with after all and decide to keep it. If it does not rebound... well, they all come back!

What me worry? I am a long-term investor

In a bear market everything goes down. the best of stocks can lose up 60% of their
value as happened with Wipro between 2000 and 2003. Long term is often short term
goes sour and belief in the long term is simply a justification for people to not pay close
attention to your investments.

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Investment
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