Equity Guide

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Foreword
Many of you may have heard and read about host of things related to investing in stocks. But have you
practiced the right approach to investing? While equities can help you counter the inflation bug better
by accelerating the pace of wealth creation, you see, it is imperative to have a prudent and disciplined
approach to investing as well.
During exuberant times of stock markets, many find investing in equities tantalising and often make a
mistake of ignoring fundamentals and valuations. And the result is known; they stand to lose money and
blame their luck for not having created wealth through investment in equities. But heres a famous
quote by Ignas Bernstein, he said, If you wait for luck to help you, youll have often an empty stomach.
This is so true and reflects the importance taking responsibility for our actions.
In turbulence times such as those encountered in the past few years in the equity markets, it is vital to
be a responsible investor first, to tread on the path of wealth creation while investing in equities.
PersonalFN primarily would like to thank Equitymaster.com for being knowledge partners, in the
endeavour to educate investors towards investing in equities successfully. Through this guide we have
tried to capture expertise and experience to your benefit and explained the prudent and disciplined way
of investing in stocks; which can help you make money in equities.
We hope it will be an informative reading and wish you a VERY HAPPY & SMART INVESTING!!
Team PersonalFN

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Section II: How to Pick Stocks prudently for your portfolio 13 - 23
Index

Section I: Building a stocks portfolio 4 - 12
Importance of Asset Allocation
Understanding Equities from a Market Capitalisation Perspective
Setting the Foundation for Equity Allocation

Using Price to Earnings Ratio
Using Price to Book Value Ratio
Using Return on Equity Ratio
Using Return on Capital Employed
Identifying opportunities in major corporate events

Section III: Value Investing 24 - 30
What is Value Investing all about?
What is value?
4 simple steps to Value Investing

Section IV: Lesson from Successful Investment Gurus 31 - 45
Warren Buffett - The Legendary Investor
Charlie Munger - The Legendary Investor's Alter Ego
Peter Lynch The Legendary Fund Manager

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becomes an ideal investment option, as it does not strain your monthly finances and plus gives you the benefits
of investing in the equity market.


Section I: Building a stocks portfolio

In our ambition to make money, we often get attracted towards equity markets, and why not? Equities
carry a history of being the most rewarding asset class in the long run. We all vie to invest in stocks and
most often get fascinated with the excitement created with equity investing. We buy stocks based on
calls and tips that come from our brokers, friends, newspapers, news channels etc. Many of these may
work and many may not. In this process many of us end up holding a list of stocks in our portfolio and
we do not know what to do.
The best strategy is to have a systematic and well aligned stocks portfolio. And while you tread on your
path to wealth creation by equity investing, the prudent approach is very vital. So here we explain the
prudent approach to equity investing and how to go about building your stocks portfolio.
Let us start with Asset Allocation.

Importance of Asset Allocation
Over the past few years, the stock market has been on a roller coaster ride. Investors have seen the S&P
BSE Sensex reach dizzying heights and then crash with equally dizzying speed. One moment the surge
was the toast of the town. At the very next moment as the Sensex crashed, so did people's dreams; and
investors were in a state of collective mourning.
Even as the markets today look promising, many investors are still confused. "How and where do I invest
my money," is the question on everyone's mind.
While investors know that equities or stocks should form a key component of their investments, they
still do not know how they should go about deciding which companies to invest in. So, they usually tend
to rely on 'tips' or on their broker's or friends' advice. Then when an unforeseen situation like the Stock
Market crash is witnessed, that is when the proverbial cookie crumbles.
In order to safeguard one's investment, it is essential to follow the principle of "asset allocation" while
investing in equities.
So what exactly do we mean by 'asset allocation' with regards to a stock portfolio?
To simply put, asset allocation in equities is just a practical extension of the age-old adage Do not put
all your eggs in one basket. It advocates the need to have a stock portfolio where your investments are
distributed over not only different companies and sectors, but also cover different types of equity


groups such as large caps, mid caps and small caps. But you see, ideal allocation should be a function of
your investment objective and also your appetite for risk.
When you smartly allocate your 'equity money', the risks you take get distributed.
Suppose, for instance, there is a drought and as a result of which consumer demand in the country is
expected to suffer a setback. Now, companies which are focused on selling their goods and services to
the domestic market are likely to take a hit as their near term prospects no longer look great.

But on the other hand, a company that is selling software services in the global market will be relatively
isolated from these developments. So, having both such companies in a portfolio has the impact of
reducing the volatility in returns over time.
Thus having stocks across sectors is a step towards investing wisely. Holding stocks of companies with
different market capitalization (such as small caps, mid caps and large caps) is a step further in the same
direction.

A small cap software company, with a market cap of say Rs 3.49 billion, may promise greater rate of
returns compared to say a large cap software company which has a market cap of say about Rs 1,700
billion. However, the security of having a blue chip company in your portfolio cannot be matched by
small caps.
This is of course a very simplistic example. We will further discuss the pros and cons of companies with
different market caps even further, but the core idea is to have a mix of companies in a portfolio.

Let's take another very well-known example: During the late 1990s everyone was talking about and
investing in what they called "Tech stocks" as technology was perceived to be a booming sector.
Everyone wanted to position their portfolios and capitalize on what was then called the 'new economy'.
And we know what happened soon after... tech stocks crashed. In fact hundreds of these tech wonders
actually disappeared (mostly the smaller companies) leaving a big hole in investors' portfolios. A smart
investor, who had a well-diversified portfolio, though impacted, far outperformed 'tech' leveraged
investors over the years that followed.
And at the end of the day, that's what matters the most - what you earn from your stock portfolio over
the long-term. After all, stocks are instruments that are best suited for generating long term wealth!

Why should allocation be done?

We need returns on our investment for different reasons. Some invest in equities to secure their life
after retirement. For others, equities are meant to be used for their child's marriage or education. For


some others it may just mean funds for planning a world tour two years down the line while for some it
may be a combination of all these goals.
As our needs differ, so does the time period needed to fulfil them. While planning for a world tour may
be viewed as a short-term (2-5 yrs) objective, investments done for a child's education may be done
keeping in mind a time period of 5 - 15 years. So based on the duration for which you require to keep
your money invested in, you need to accordingly allocate your 'equity money'.

How do you draw the ideal asset allocation plan?

Each individual is different so an asset allocation plan will differ from person to person based on his or
her personality traits, age, risk taking capacity and the ultimate investment objective in mind. One
cannot take a 'one size fits all' approach.
Building a stock portfolio is a complex activity. In this guide we will focus on one very key aspect - how
to allocate your portfolio between large cap, mid cap and small cap stocks, along with other critical
aspects related to investing in equities. The following topic in this guide to investing in equities is aimed
at giving you a deeper understanding of the various parameters influencing asset allocation in order to
benefit the most from your investments.

Understanding Equities from a Market Capitalisation Perspective
You see, before understanding how to allocate funds for investing in equities, it is important to
understand both your expectation of return (which can be a function of your financial goals) and also
your risk appetite. Once you are clear on these, it will be a lot easier for you to allocate money between
the various categories of stocks.
So let us step forward and understand the three categories one has to pick from for one's portfolio.

Understanding 'Market capitalisation'
There are three main classifications when it comes to stocks -
1. Large Cap stocks;
2. Mid Cap stocks; and
3. Small Cap stocks.
Here, the term 'cap' simply refers to the 'market capitalisation' of the stock.


And what is market capitalisation?
It is the value of the stock that you arrive at by multiplying the stock price by the company's outstanding
number of equity shares.
Market Capitalisation = Current Stock Price x Number of Shares outstanding

For a better understanding, let us see an example:

Company XYZ has 1,00,00,000 shares outstanding and its current share price is Rs 8. Based on the above
formula, we can calculate that Company XYZ's market capitalisation is Rs 80 million, or 10,000,000
shares x Rs 8 per share.

Large cap stocks

As we mentioned above, the first category based on market capitalisation is that of 'large cap stocks'.

One can look at the S&P BSE-Sensex or S&P BSE-100 Index as a reference point for large cap stocks.
Market capitalisation for stocks in the S&P BSE-100 Index, for instance, ranges from Rs 200 bn to Rs
3,500 bn.

These are stocks of usually large and well-established companies that have a strong market presence
and are generally considered as relatively safe investments. One important fact about large caps is that
information regarding these companies is readily available in newspapers and magazines. Most of the
large cap companies have good disclosures and therefore there is no dearth of information for an
investor looking into them.

Large companies such as Infosys, TCS, and Wipro are classified as large cap stocks. These companies
have been around in the industry long enough and have firmly established themselves as leading
players. Their stocks are publicly traded and have large market capitalisations.

Mid cap stocks

Mid caps lie between large cap stocks and small cap stocks. Mid cap stocks are those that generally
have a market capitalisation within the range of Rs 50 bn and Rs 200 bn. These represent mid-sized
companies that are relatively more risky than large cap as investment options yet, they are not
considered as risky as small cap companies. They rank between the two extremes on all the important
parameters like size, revenues, employee and client base.


When one invests in mid caps for the long term, he may be investing in companies that could become
tomorrow's runaway success stories. Generally speaking, mid cap stocks as an investment can bring you
higher returns in 3 to 5 years as opposed to their big brother large cap stocks that can bring you
moderate (yet safer) returns during this timeframe.

Small cap stocks

Lying at the lowest end of market capitalisation, small cap stocks are generally viewed under the
misconception of being hazardous or 'quick rich' stocks. However, both these labels are untrue.

Small cap companies have smaller revenue and client bases, and usually include the start-ups or
companies in the early stage of development. Small cap stocks are potentially big gainers as they are yet
to be discovered within the sector and can show growth potential in large numbers once unfurled in the
market. However, as these enterprises are small ventures, these should be researched properly. This is
considering that a lot of small companies do not have the financial strength to survive bad times and
some of them might be mismanaged businesses run by greedy promoters. Hence it is essential,
especially in the case of small caps investments that one does a thorough research regarding the
promoters' credentials, management strength and track record, and long and short term growth
plans of the company before investing.

Small caps are often stated to be a platform to make big returns in a short span of time. However, we
would state that small caps can prove to be a very wise 'long term' investments especially if the chosen
companies are good businesses and are well-managed.

So to conclude
As seen from the above, an investor has three options to choose from as far as allocating money to
stocks is concerned. And as mentioned earlier, the allocation is dependent entirely on an investor's risk
appetite. All these categories consist of some really good long term investment opportunities. As such,
investors must decide the allocation based on the opportunity's merit and not just whether it is a large
cap, mid cap, or small cap.
But purely as a matter of prudence and safety, investors looking to build a portfolio from a 10 to 15
years perspective can have a 60-70% allocation to large caps and 10-15% each to mid and small caps.
Treat this allocation as just a guideline and, we repeat, allocate your equity portion using your
understanding of different kinds of companies across different levels of market capitalisation.


Setting the Foundation for Equity Allocation
Now that you have understood the categorisation of equities in terms of market capitalisation, we can
get into the more specific need of building a stocks portfolio that fits your needs. Along with keeping in
mind your risk appetite, it is firstly important to identify your age factor, earnings, and objectives for
creating wealth. Keeping in mind that we can't have a 'one-size-fits-all' strategy, we have discussed
broadly the different and necessary key assumptions required towards an investor:

Being single
As the old saying goes, what the wise man does in the beginning, fools do in the end. When you're
young and without a care in the world, life seems perfect. If you haven't crossed the 30 mark, and are
still single, planning for your retirement or even your future seems a distant thought. But wise are those
who start planning from the start!
Life as a singleton is often a lot more carefree and individualistic. You tend not to think of additional
responsibilities such as kids, housing, schooling etc. It's all about working hard, partying harder and
living it up. But somewhere reality sets in and that's when you start preparing to plan for your future.
Indicative asset allocation portfolio for a singleton

Single
<30 years 30-45 years 45-55 years >55 years
Carefree Building Wealth Adding To Wealth Carefree Retirement
Large cap 70-80% 60-70% 70-80% 80-90%
Mid cap 5-10% 10-15% 10-15% 0-5%
Small cap 5-10% 10-15% 0-5% 0-5%

As a young and single individual, under the age of 30, you would enjoy a carefree lifestyle. As a single
person you would have lesser earnings due to a single source of income, and would most definitely have
more expenses keeping in mind the way most people enjoy a high profile lifestyle. Then, for a person
like you, the best kind of investments would be those of investing into safer large cap stocks which
would ensure a safe return at the end of a longer tenure.
As you progress through the years and become stable in your career, your income starts to rise and you
can ideally afford to take a slight amount of risk towards wealth creation. It would be advisable at this
juncture to invest in mid and small cap stocks as you cross 30 years of age.


Being in your 30s and early 40s, mid and small caps are usually suggested at this juncture as they bring
higher returns in a shorter span of time or even if you invest in small caps for a long period of time they
will bring you higher returns than that of simply investments in large caps.
As your age advances, the inherent urge to take risks reduces. So, as you approach the 45 to 55 age
bracket, you would want to take lesser risks, and therefore your concentration shifts from simply
building wealth as you may have done earlier. At such a stage, the majority of your portfolio (70-80%)
should be in large caps. This not only ensures safety of the original capital invested, but also ensures
relatively safer returns on the said capital.
Once you cross 55, it's all about looking towards building a safe retirement plan at around 60. This is the
time to start increasing allocation to safer stocks - large caps in the equity portfolio. Allocation to mid
and small caps should reduce, while the same towards large caps should increase to 80-90% of the total
equity portfolio. And ideally while you are around the retirement age, you should not have a dominant
portion allocated towards equities as an asset class, and thus the focus should shift towards wealth
preservation, wherein fixed income instruments could be considered.

Two's company
There are those who enjoy their single status in life, and then there are those for whom life is about
having someone to share it with. Sharing joys and sorrows, sharing health and wealth, it's all about
being a couple for some.
Indicative asset allocation portfolio for a person who is married and has no kids

Married- No kids
Property Top Priority Building Wealth Planning Retirement Carefree Retirement
Large cap 70-80% 60-70% 70-80% 80-90%
Mid cap 5-10% 10-15% 10-15% 5-10%
Small cap 5-10% 10-15% 0-5% 0-5%

There is a famous acronym for working couples in the West - DINK, deciphered as a 'Double Income No
Kids' family. This concept is also now being adopted within the Indian culture amongst the youth, who
work harder to earn and enjoy spending their wealth between the husband and wife only.

However despite the 'double income', as a married person you would still have more expenses
compared to the earnings as there is a second person to fend for as well. The most practical approach to


investing at this point would be to invest a greater portion of your equity investments into safer large
cap stocks.

Similarly as it is with singletons, once you cross the 30 age mark and your income has risen, there is a
sense of having achieved financial stability. You feel more secure in your financial growth and hence find
it easier to allocate a slightly larger amount (10 to 15%) as opposed to earlier towards small and mid cap
stocks, in order to generate wealth.

Once as a couple you reach the circle of 45 to 55 years of age, you usually start thinking and planning
for your retirement as opposed to creating wealth for purposes such as buying a house, holidays,
jewellery etc. Hereon it would be best to allocate a significant portion of your funds (70-80%) towards
large caps and pare down the investments in small caps.

Once the magical number of 55 years hits you, the main focus remains the retirement plan you have
been building. As a couple without children to support them after retirement, this is a very important
corpus. It would be best to further increase allocation to safer large cap stocks while reducing
allocations to mid and small caps, so as to ensure that you have built a safe and secure corpus funding
for your retirement.

Family matters

There is a famous line - 'Small family, happy family', but where exactly is that line drawn today? Would it
end at being a happy couple, or would it end with the proverbial husband-wife and child scenario? If we
were to go by the population of India, it would most definitely be a family inclusive of kids. Yes, there
are the rare exceptions to the norm, but on an average the idea of a happy family consists of a set of
parents with 2 kids.
Indicative asset allocation portfolio for a person who is married with two kids

Married-2 kids
Property Top
Priority
Planning Children's
Future
Property For
Children
Retired/Children On
Own
Large cap 70-80% 50-60% 70-80% 80-90%
Mid cap 5-10% 25-30% 10-15% 0-5%
Small cap 5-10% 5-10% 0-5% 0-5%

Being a married couple is not easy, and especially if you are a married couple with 1-2 kids. Your main


priority at the age of 30 or so would be to ensure you provide your family with housing. A crucial factor
at this point would be that even if there are two incomes, the expenditure would most definitely be
more, given the fact that there are more than two mouths to feed. It would be best for you to allocate a
greater portion of your equity investments into relatively safer large cap stocks.

As you cross the 30 year mark, the main focus would be creating wealth for the future needs of your
children. As kids start growing up the responsibilities that arise along with them need to be addressed
and planned for in advance - such as children's education, marriage and property plans too. At this
juncture since your earnings have increased and your career has gained more stability, you are better
positioned to take more risks towards portfolio management. Hence you can invest a slightly large sum
(10-30%) towards mid and small cap stocks.

As you grow in age, so do your kids and so do their needs and demands. Once the 45 age mark is
crossed, your main concern becomes fulfilling the immediate concerns of your kids lives, such as their
growing needs of higher education and perhaps even marriage plans, within the time span of another 5
years or so. Keeping this time factor in mind, it is best to redirect your equity allocation more towards
large caps (70-80%) which will bring you relatively safe returns, and minimise your sum invested in Small
and midcap (5-15%).

Once you are > 55 years andyour children have been educated and are settled with their own lives, you
tend to be concerned with your own plans of creating sufficient wealth for an easy and relaxed
retirement, which will soon be approaching. At this point it is best to switch most of your equity
allocation into large cap stocks, while reducing investments in small and mid caps stocks, and ensure
that you are not dominantly skewed towards equities.

So to conclude
There's a saying "Boulders we cross, it's the pebbles that we stumble over". That is exactly what
happens as we strive hard to build our wealth. We work hard, scrimp, save, make adjustments and
finally save money - for us, our dreams, our children and their dreams. Somewhere, however, we are so
busy trying to survive in our race against time that the money that we earn so hard is invested quite
quickly, without giving it the much needed thought are our investments are in tandem with our
current and future needs? This is where the mantra of asset allocation comes handy.

Asset allocation ensures that our expectations from our investments, our dreams for our future and the
way we invest money are all in sync with each other.


Section 2: How to pick stocks prudently for your portfolio

Now, while you know how to go about building a stocks portfolio, the next significant step is to pick the
right stocks for your portfolio. Though many of us aim to get the best money making stocks for our
portfolio, selecting the right stocks may not be an easy task. Apart from the required skill sets and
knowledge, it needs understanding of some basic concepts based on which you can measure if the stock
is worth buying for your portfolio.
Here are few important ratios which you can use to compare and prudently choose the right stock for
your portfolio.

Price to Earnings Ratio (P/E Ratio)
The most commonly used valuation metric by investors is the price to earnings ratio or commonly
referred to as the P/E ratio. Though commonly used, it is also misunderstood for various reasons.
In simple terms, P/E Ratio indicates how much an investor is willing to pay to earn every single rupee
from each share he holds. Or to put it the other way, P/E indicates the approx. time (in years) an
investor would take to realize the money invested, provided the company grows at the same pace.
How is P/E Ratio calculated?
P/E Ratio is calculated by dividing market price of a stock by EPS (earnings per share). EPS in turn is
calculated by dividing the net profit of the company by the number of shares outstanding.
Having calculated the P/E, what does it stand for?
Lets assume a stock XYZ is trading at Rs 100 and its EPS is Rs 20. The P/E multiple is 5 (100 upon 20).
Assuming that the company's EPS is likely to be Rs 20 each year, it will take 5 years for the investor to
realize Rs 100. Of course, the assumption here is that the company's EPS is not growing at all.
You may at times find wide difference in P/E multiple of two different companies from different sectors.
Why is it so? It is believed that the stock price of a company tracks its long-term earnings growth
potential. In an economy, some companies (or sectors) are likely to grow at a faster rate; so, the P/E
multiple of companies from these sectors are likely to be higher and vice versa. Depending upon growth
expectations, the P/E multiple could vary.


Determining the right P/E multiple for a stock/sector
Unlike metrics like discounted cash flow method and so on, P/E is relatively a simple and at the same
time, a powerful metric from a retail investor perspective. Though the factors behind determining the
'right' P/E multiple are important, a historical perspective of a stock's P/E could make this exercise less
complex.
A person X may assign a higher P/E multiple to the stock as compared to a person Y depending on the
risk profile and growth expectations. But in the end, it all boils down to how the company is likely to
perform.
To determine the P/E multiple for a stock/sector, it is also important to understand industry
characteristics of the company.
For a stock of a steel manufacturing company, EPS tends to grow at a faster rate when steel prices are
recovering or are at the peak and the EPS is likely to decline at a faster rate during downturns. So, if one
believes that steel demand is likely to trace long-term economic growth and that 15% growth is
unsustainable, the P/E multiple should be ideally much lower than 15 times. Similarly, the long-term
growth prospects for software companies could be much higher than commodities. So, the P/E multiple
for software stocks could be at a premium.
Determining the P/E multiple for a stock/sector also depends on:
1. Historical performance - Why does a stock of a reputed software company trades at a higher P/E
multiple compared to a newly founded software company? By historical performance, we mean,
focus of the management (without unrelated diversifications), ability to outperform competitors in
downturn/upturns and promise vs performance. This can be gauged if one looks at the last three to
five year annual reports of a company.
2. The sector characteristics - Margin profile, whether it is asset intensive and intensity of competition.
Less asset intensive sectors (say, FMCG) are considered defensive and therefore, could trade a
premium to the overall market.
3. And more importantly, expectations. Take the case of textile stocks. Expectations of significant
growth opportunities post the 2005 quote regime phase out has resulted in upgradation of P/E
multiple of the textile sector.


When is P/E not useful?
1. Economic cycles - Businesses operate in cycles. During downturn, EPS will be low but P/E will be
inflated and vice versa. At the same time, during expansionary phase, corporates invest in
capacities. In this case, high depreciation costs suppress earnings. P/E, in this context, may mislead
investors.
2. Not actively tracked - There are number of companies in the Indian stock market that are not
actively tracked by investors, analyst and institutions. For example, Infosys' average price was Rs 2 in
FY94 and the P/E multiple was 17 times. At times, P/E multiple may be lower because some
sectors/stocks are not in the limelight.
3. Expectations - On the downside, some stocks may be trading at a significant premium because
earnings expectations are higher. High P/E also does not mean a good stock to buy. What if the
expectations are unrealistic? One needs to exercise caution to this extent.
4. Means little as a standalone number - P/E, as a standalone number, means little. Besides P/E, it is
also important to look at margins, return on net worth, cash generating ability and consistency in
performance over the years to assign a value to a stock.
5. Market sentiment - During bear phases or when interest in stocks is low, valuations could be
depressed. Since equities are considered less attractive during these periods, valuations are likely to
be below historical average or below earnings growth prospects.

Price to Book Value Ratio (P/BV Ratio)
The price to book value (P/BV) ratio is a widely used valuation parameter used for valuing stocks. P/BV
ratio indicates if we are paying more or less for a stock when compared to its book value. This ratio will
help you determine if you are paying more for the value of what you can recover if the company decides
to dissolve or goes bankrupt immediately. You as an investor should know how to use this parameter to
value your investments.
How is price to book value calculated?
P/BV is arrived at by dividing the market price of a share with the respective company's book value per
share. Book value (BV) is equal to the shareholder's equity (share capital plus reserves and surplus). BV
can also be derived by subtracting current and non-current liabilities from total assets. For the banking
and finance companies, book value is calculated as 'share capital plus reserves minus miscellaneous


assets not written off. This formula then takes care of the bank's NPAs (Non Performing Assets) and
gives a correct picture.
Let us take up a hypothetical example to calculate the book value:
FY13 Balance sheet of company XYZ
Liabilities Rs bn Assets Rs bn
Equity capital 3 Cash 206
Reserves & surplus 310 Other current assets 97
Current liabilities 69 Fixed assets 61
Non-current liabilities 4 Non-current assets 17
Deferred tax assets 5
386 386
(The above examples are hypothetical and used for illustration purpose only)

If one were to take a look at consolidated balance sheet of company XYZ for FY13, as mentioned above,
book value will be arrived at by adding Rs 3 bn (equity capital) and Rs 310 bn (reserves and surplus),
which equals to Rs 313 bn. Conversely, when we deduct current and non-current liabilities from total
assets, we shall arrive at a similar figure. Now, by dividing this book value (Rs 313 bn) by the issued
equity shares of the company (say approx 574 m), we would arrive at the book value per share figure,
which is Rs 545. Say if the current market price of company XYZ is Rs 2,438; taking Rs 545 as
denominator for calculating the P/BV for the stock, the P/BV will stand at about 4.5x.
What does P/BV indicates?
Usually, P/BV figures for companies in the services industries like software and FMCG are high as
compared to those of companies in the sectors like auto, engineering, steel and banking. This is due to
sectors such as software and FMCG have low amount of tangible assets (fixed assets etc.) on their books
and therefore, the P/BV may not be a correct indicator of valuation. On the other hand, capital intensive
businesses such as auto and engineering require large balance sheets, i.e., they have a large amount of
fixed assets and investments. P/BV is a good indicator for measuring value of stocks from such capital
intensive sectors.
If a company is trading at a P/BV of less than 1, this indicates either or both of the two -
Investors believe that the company's assets are overvalued, or
The company is earning a poor return on its assets.


A high P/BV indicates vice versa, i.e., markets believe the company's assets to be undervalued or that
the company is earning and is expected to earn in the future a high return on its assets. Book value also
has a relationship with the Return on Equity of a company. In fact, book value can also be termed as
equity (equity capital plus reserves and surplus). As such, for a company that earns a high return on
equity, investors would be ready to give the stock a high P/BV multiple.
What does P/BV fail to indicate?
P/BV indicates the inherent value of a company and is a measure of the price that investors are ready to
pay for a 'nil' growth of the company. As such, since companies in the services sectors like software and
FMCG have a high growth component attached to them, P/E Ratio would be a better method of gauging
valuations.

Investors would do well to note that P/BV should not be used for valuing companies with high amount
of debt. This is because high debt marginalizes the value of a company's assets and, as such, P/BV can be
misleading.
Though P/BV ratio offers an easy-to-use tool for identifying clearly under or overvalued companies, it
also has its shortcomings that investors need to recognise.

Return on Equity (RoE) Ratio
Return on Equity (RoE) ratio is one of the most important ratios that every investor must understand.
RoE ratio is used to measure the efficiency with which a company utilises the equity capital.
How is RoE calculated?
RoE is calculated by dividing the 'profit after tax' earned in an accounting year with the 'equity capital' as
mentioned in the balance sheet of the company. Let us take a hypothetical example of company XYZ.
The company earned a profit after tax of Rs 59,880 m in FY09. Also, its average equity capital for FY09
was Rs 182,540 m. Thus, RoE of the company XYZ in FY09 was 32.8% i.e. Rs 59,880 m divided by Rs
182,540 m.
Thus, RoE, when used correctly, can easily measure the management's capability on the three fronts
1) Profitability (PAT/Sales),
2) Asset turnover (Sales/Assets), and


3) Financial leverage (Assets/Equity)
This can be made simpler when we break down the calculation of RoE into these three parts. As such,
RoE can also be calculated as -
Return on Equity = (PAT/Sales) * (Sales/Assets) * (Assets/Equity)
OR
Return on Equity = Profit margin * Asset turnover * Leverage
1. RoE and Profit margins
Profit margins are, most importantly, a measure of the company's pricing power. Consequently,
pricing power is a function of
a. Competition: The price a company can charge to its customers depends a lot on the
level of competition that it faces. Higher the competition, higher will be the bargaining
power of customers and thus, lower will be the pricing power.
b. Quality of offerings: When competition increases, a company can still charge higher for its
products if it moves up the value chain.
Another factor that can impact the company's margins is its aggressive investments in building up
physical (infrastructure) and human (manpower) resource base. Spending consistently towards
employees and marketing initiatives may affect companys margins, though at a slower rate. And
will affect the company's RoE.
2. RoE and Asset turnover
Although margins play a crucial role in influencing the RoE of a company, the sales generated for
each rupee of assets also plays a very important role. Generating, more sales on less assets means
tying up of less capital that a business generates on its assets. As such, determining the asset
management capability of a company is the key to gauging the quality of its RoE.
3. RoE and leverage
Leverage (the other name for debt) is a tool finance managers can use to perk up a company's RoE
in the short term. They can simply take on more of debt than equity to finance their expansion
plans. And wow, what investors see is an improved RoE (since debt is deducted from assets to


calculate the value of equity)! However, over the long-term, the fact that the company has to pay
interest on this debt, reduces its profit margins. This acts as a counter to the rise in RoE due to
increased debt levels (if the debt is not productively employed).
Thus, investors need to also study debt levels of a company, as this would make their understanding
of RoE even simpler. In case of companies with high levels of debt (those in capital intensive
industries like steel and automobiles), the leverage ratio will play a very important role in
understanding the RoE
While RoE is important, it is not everything
RoE suffers from one drawback. As mentioned earlier, a company that takes high levels of debt will
show up a high return on equity. As such, 'Return on Invested Capital (RoIC)' and not RoE will be a good
indicator of testing the company's efficiency levels. However, for understanding the value of companies
with nil or marginal amounts of debt, RoE is of great help. We shall explain this with an example:
Company 'A' is a debt-free company with a networth of Rs 100 m. During FY09 it earned a net profit of
Rs 15 m. As such, its RoE would stand at 15% for the year. Now, in another case, company 'B' has a net
worth of Rs 50 m and a debt to equity ratio of 1:1. This means it would have taken up debt to the tune
of Rs 50 m. Capital employed in the business is the same amount as of company 'A' i.e. Rs 100 m.
Now, as the company has taken up some debt, it would have to pay a certain amount of interest on the
debt. For instance, the interest rate on the debt is 10% for the year. As such, the interest cost for the
company will be Rs 5 m (10% * Rs 50 m) for the year. The net profit for the year will stand at Rs 10 m (Rs
15 m Rs 5 m). Now, if we calculate RoE on this basis, it would stand at a high rate of 20% (Rs 10 m / Rs
50 m). This does show the wrong picture.
As such, it helps investors to look at trends in RoE over a number of years and analyse each of its
components (as mentioned above). It will not only help them understand the P&L account, but also to
balance this against the much overlooked left and right sides of the balance sheet.

Return on Capital Employed (RoCE):
RoCE is a measure of how effectively a company is able to deploy its capital base (debt and equity) to
generate returns for the capital providers. A company which can generate higher return from a lower
capital base and continues to improve on the same, should in theory, always be preferred over its peers
which need higher capital to generate the same level of return and which cannot sustain the growth in
RoCE. As a corollary, this superior RoCE performance should get reflected through the growth in share


price.

Lets understand this with a hypothetical example of three companies with increasing RoCE trends:

To test the above hypothesis, we analyze three companies with dissimilar market capitalization and with
increasing RoCE trends for the period FY08 to FY13.
Key parameters of Company A, Company B and Company C (Rs million)
Company A
FY08 FY09 FY10 FY11 FY12 FY13 CAGR(08-13)
Gross Sales 21,369 30,466 38,787 47,069 65,850 89,831 27%
PBIT 1,706 2,100 2,669 3,480 6,378 8,842 32%
Capital Employed 5,807 6,561 7,244 8,049 10,906 15,376 18%
ROCE 32.1% 34.0% 38.7% 45.5% 67.3% 67.3%
PBIT Margin 8.0% 6.9% 6.9% 7.4% 9.7% 9.8%
Company B
Gross Sales 7,948 8,908 10,131 11,133 12,947 15,711 12%
PBIT 471 560 809 1054 1,438 3,628 41%
ROCE(%) 19.5% 21.9% 28.5% 33.7% 37.7% 72.8%
PBIT Margin 5.9% 6.3% 8.0% 9.5% 11.1% 23.1%
Company C
Gross Sales 2,377 3,210 5,304 5,902 7,243 10,317 28%
PBIT 345 652 895 1,039 1,403 1,775 31%
ROCE(%) 15.2% 23.7% 30.6% 31.5% 37.0% 38.9%
PBIT Margin 14.5% 20.3% 16.9% 17.6% 19.4% 17.2%
(The above examples are hypothetical and used for illustration purpose only)

From the above table, it is evident that Gross Sales, Profit before Interest and Tax (PBIT), and Capital
Employed (CE) have grown for all the three companies across the period FY08 to FY13.


The compounded annual sales growth rate (CAGR) was 27% for Company A, 12% for Company B and
28% for Company C. PBIT grew at a CAGR of 32%, 41% and 31% for Company A, B and C respectively,
while Capital Employed (CE) grew at a CAGR of 18%, 15% and 13% respectively for Company A, B and C.

So, for each of these companies, PBIT increased at a higher rate than CE, and as a result RoCE grew
significantly from FY08 to FY13. In fact, as the table shows, RoCE for Company A more than doubled, for
Company B it nearly quadrupled and for Company C it also got more than doubled. These RoCE trends
thus clearly highlight efficient capital management by each of the companies.
RoCE is just one of the parameters
A company with superior and consistent RoCE growth can reward its shareholders handsomely over the
long run. We can also say that 'bottom-up' stock picking with a long term horizon can be more
rewarding for shareholders rather than trying to time the market or investing blindly in an index.

RoCE is just one of the parameters that an investor should keep in mind while picking stocks. Other
parameter like RoEs' can be artificially inflated by taking resort to higher debt levels and often
companies which rely on higher gearing (debt to equity ratio) tend to fare badly in cyclical downturns
Finally, an investor should also keep in mind other valuation metrics like the Price to Earning (P/E) ratio
and the Enterprise Value to Earnings before Interest, Tax and Depreciation (EV/EBITDA) ratio on trailing
and projected bases. While historical data may be readily available, projection of financial metrics is a
combination of art and science and requires pain-staking research.

Identifying opportunities in major corporate events
To understand how you can identify profitable corporate events, lets take a reference from a book 'You
can be a stock market genius'- authored by Joel Greenblatt. Greenblatt runs a private hedge fund called
Gotham Capital. His firm achieved 50% average annual return over a 10 year period which spanned from
mid-1980's to the mid-1990s.
In his book, Greenblatt advises investors to keep their eyes open to opportunities which do not come
out of the ordinary course of business. These could be specific corporate events such as spin-
off, business restructuring, bankruptcies, risk arbitrage and mergers which may result in large profits.
As per Greenblatt, individual investors can have long term investment horizons as their performance is
not being evaluated every quarter unlike money managers. Hence, they can patiently wait for special
corporate events/situations to fold out. Here are some important corporate events, which occur quite
often.


Corporate Spin-off
In spin-off; companies separate a subsidiary, division or a business segment from its parent to create a
new, independent company. The motives behind spin-off can be many. It includes unlocking a business
division's hidden value, separating out a bad business or tax considerations. Moreover, sometimes a
spin-off is a way to get value to existing shareholders for a business division which can't be easily sold.
- As per Greenblatt, insider participation is one of the key areas to identifying a profitable spin-off.
One has to ascertain if the management is being incentivized for the spin-off. If the management is
going to receive a good part of their compensation in form of stock or options; chances are high that
they will be motivated to work hard and perform well which will boost stock returns.
- Spin-offs could also uncover a hidden opportunity in terms of a good business or a cheap stock. Also,
non-core divisions are a usual candidate for spin-offs. Since these divisions have always been
neglected when they are a part of a bigger corporation. Once they are spun off, their management
can focus to improve their business.
Greenblatt says that irrespective of the institutional motive behind a spin-off; it has been proven time
and again that stock of spun off companies and parent companies have significantly outperformed the
market averages. But he also reinstates that there can always be few exceptions and you cannot always
blindly follow this observation. Instead, you should weigh the pros and cons of a spin-off carefully
before jumping the gun too quickly.
Corporate Restructuring
Restructuring is another significant event which if evaluated appropriately can help investors make a
fortune.

Greenblatt states that remarkable value in a stock can be uncovered through corporate restructuring if
one carefully assesses 'big' changes. This means sale or liquidation of an entire division. The most viable
investment opportunities are; where companies sell or close major divisions to stop losses, pay off
debt or rather focus on more promising business.
Many a times, it may be the case that the division being sold out or liquidated has actually hidden the
value inherent in the company's other businesses. E.g. a conglomerate has earnings per share of Rs 20
and its stock trades at Rs 300 per share. Actually, that Rs 20 earnings may combine Rs 30 earnings of two
businesses and loss of Rs 10 of another business. So, if one liquidates the loss making business, the
conglomerate's earnings increase to Rs 30 and P/E multiple declines from 15x to 10x; creating enough
headroom for returns.


Restructuring can reap benefits if timed correctly. Before evaluating any restructuring prospect, it is
important to look at the company size as well as current business environment to assess whether it can
pull off restructuring smoothly. It will also be more fruitful for investors if the company not just aims at
increasing its profitability but also keeps in mind the interest of its minority shareholders.
Corporate Mergers
Corporate mergers can prove to be another significant event for investors if appraised appropriately.

As per Greenblatt, a general rule he follows for merger is to believe that no one wants merger
securities! This means that people generally sell shares in merged entities. This could be because of
complexity of the merged entity or lack of transparency in valuations. Greenblatt says that this is indeed
a chance for you to pick the stocks at dirt cheap prices. However, not before doing your homework! He
advises investors to go through merger filings and look for explanation for the consideration that is
being paid to the target for merging the entities. So in short, thoroughly study the rationale of a merger
as well as compensation being provided for a merger.
Many a times; the complexity and circumstances of the merger makes assessment very difficult.
Corporate event like mergers need to be evaluated very carefully and investors should not make a hasty
decision. Simply following the market may not help all the times. It is essential for investors to do their
own research also about the management, integration process of the merger and value accrued to
minority shareholders before making an investment decision.


Section III: Value Investing

It is most common for investors to get lured into buying the stock of a company that is very popular, is
being talked about by a lot of people, and is said to be certain to do fabulously well in future. Its stock is
on business channels all the time, its prospects are mouthwatering, its profits are set to grow
exponentially, and its products are seeing demand like never before. It seems almost obvious that there
could be no better company to invest in.
However, if that's how you feel, be sure that the guru of value investing - Benjamin Graham would
definitely not agree with you. More specifically, he sees two problems imminent for someone making
investing decision based on such a strategy.
For one, placing all the emphasis on choosing and investing in such a company can often lead one to get
tempted into paying too high a price for such a 'great' stock. The buying price is as important, if not
more, as choosing a company to invest in.
The second problem is that the company itself may be chosen imprudently. It would be instinctive to
choose a company that is large and well managed, has a good record, and is expected to show
increasing earnings in the future. But such expectations are highly vulnerable to subjective
interpretation, and so are putting a price on such qualitative factors. Thus, wherever such factors come
into the picture, prices are frequently overdone.

What is Value Investing all about?
Although investors appear to pay somewhat more attention to growth-oriented strategies, research has
shown that a value approach to portfolio management tends to provide superior returns. It is tempting
to conclude that value is clearly superior to growth as an investment style. However it is important to
note that, although value investing produces higher average returns than growth investing, this does not
occur with much consistency from one investment period to another.
One of the most important developments in equity management during the last decade has been the
creation of portfolio strategies based on "value" or "growth" oriented investment style. It is now
common for money management firms to define themselves as "value stock managers" or "growth
stock managers" when selling their services to clients.


What are the thoughts that come to your mind when you think of value investing? Is it about buying
cheap stocks? Is it buying stocks and holding them for a very long term? Is it to do with buying
companies with fantastic fundamentals that are valued relatively cheap to their peers? Or is it about
following the portfolios of legendary value investors and creating a similar one for yourself? Well, there
is nothing wrong with either of these approaches.
The conceptual difference between the value and growth investing may be reasonably straight forward.
The growth investor focuses on the current and future economic story of a company with less regard to
valuation. The value investor, on the other hand, focuses on the share price in anticipation of a market
correction and possibly improving company fundamentals. However, it could be dangerous to assume
that using any one of these approaches without paying heed to the others could be rewarding.

What is value?
A value lies in something that is available at a discount. We as an investor may find value in buying
something that is available at a price lower than its actual worth. Value investing is, knowing exactly
what you are paying for today rather than speculating over what could you possibly get in future. And in
order to know the correct price to be paid, you need to assess the value of the underlying asset
correctly. Only when the investor understands the moat the business enjoys and the risks it takes, he
can determine the intrinsic value and price he should be paying. There must be adequate margin of
safety.
Now the obvious question that may come to your mind is how should one go about choosing the right
kind of stocks and then eventually calculate its intrinsic value. Its a process and let us now discus how
does this process exactly works?

4 simple steps to Value Investing
Step 1: Identifying your circle of competence
This comprises all the businesses that you are familiar with and thoroughly understand. For a value
investor it is important to invest only in businesses that he understands. A value investor must focus
solely on areas of business where he believes he has an edge over the average investor. Say you're a
doctor. Being an insider to the healthcare industry, you would most likely have a pretty good first-hand
understanding of the sector. You may have knowledge of various drugs by pharma companies. An
analyst, on the other hand, would not have access to this valuable information. This puts you in a


position of advantage. Of course, this does not mean you are already an expert on pharma stocks. But
you are at a great starting position.
Similarly, many products and services that you use in your daily lives are often listed companies. As a
regular consumer and visitor to the mall, you may have a good starting knowledge about product
quality, pricing and competitors. Staying away from what you don't understand is equally important.
Step 2: A 'moat' to protect your castle
If we look at the castles, there is one feature which is pretty much common across all of them. The
feature is a deep trench all around the castle. In the old days this trench was typically filled with water
and crocodiles or other predatory reptiles. The idea was that the trench would keep the enemy away
from the walls of the castle, thereby acting as an important security measure. This trench is called a
moat. Since they provided security, the kings of the time were obviously big fans of moats. In value
investing too, you should look to protect your castle. In simple words, you should look for companies
with a sustainable competitive advantage. Larger the advantage wider is the moat. This moat would
protect the business from competition. And if the company is able to use its competitive advantage to
widen the moat over time, then it is the perfect business to be in.
Companies that have a wide moat are able to earn higher returns for its shareholders. And it is able to
do so consistently year after year, every year. This in turn propels its stock value over years. The best
part about such companies is that they are able to do well even when conditions are bad. Given the
gloomy picture that the current macroeconomic scenario paints, won't such a stock be a good idea? But
how do you identify a stock with a solid moat? For this you need to understand how a company can
build a moat.
How to build a moat
This safety moats can be built by the business in a lot of ways.
1. Brand: A good way for a business to build a competitive advantage is by building a brand. A brand
that has consumer recall. It would take years and lot of investment for another company to
challenge the authority of a good brand. Take the example of Coca cola. It is one of the most well-
known brands in the world. This brand gives it the pricing power. Despite the number of soft drink
manufacturers who have been in existence, none has been able to dethrone Coke as a leading soft
drink brand.
2. Economies of scale: A good way to look at economies of scale is to think of a company that can
increase its operations without increasing its costs at the same pace. Such companies tend to have a
massive size of operations. They have already incurred huge fixed expenses. Additional costs that


are more variable in nature are not very high. So as sales increases, these companies are able to
expand their operating margins. The economies of scale help the company makes a moat because
for any competitor to enter the market, it would need to make a huge investment. Something that is
only possible if it has very deep pockets. And even if it is able to make such an investment, it would
still take time for it to become a low cost producer something that economies of scale can help in.
As a result, the dominant company could cut prices to retain its competitive advantage. Think of
Walmart. The company has been able to reach the size where it is today simply due to the
economies of scale.
3. Switching costs: When you buy a laptop or a computer, more often than not it comes loaded with
the Microsoft operating system. Have you even thought about changing the operating system? The
answer would most probably be no. Why? Because there is a cost involved. This is what is called a
switching cost. High switching costs make it costly for a customer to switch from one product to
another. Or from one company to another if a company is able to create this moat, then it ends up
having a customer following without the threat of competition. Switching costs create a barrier of
entry in a way that it deters competition.
4. Patents: A great way to build a moat is to simply patent the product. If competition has to enter,
then it has to wait till the patent expires. Or will have to buy the patent from the company. Typically
pharma companies have been able to build such moats.
5. Monopoly: Being in a unique or niche business makes for a good way to create a safety moat. Being
the only company in the area means that there is literally no competition. But there is something
important to note here. The company should not be a monopoly in a business that has demand.
However, this advantage is something that needs a lot of work to be sustained. The higher returns
that a monopoly earns can and does end up attracting competition. Therefore the test for the
company is whether it can defend its competitive advantage over long term.
These are just some ways in which a company can create a safety moat. Other ways include creating
network effects, having cheaper access to raw materials, government regulations that favour one
company over another are among others.
The bottom line is that the company should have a competitive advantage. The advantage should help it
generate superior returns over time. And the advantage should ideally be growing over time. If the moat
is too tiny, then competitors can easily cross it over time. So safety moats need to be getting wider
and/or deeper as the years go by. And if you find such a company, then make sure you invest in it when
it is available at cheap valuations. Such a stock can help you earn superior returns in the long term.


Step 3: A word about management
Perhaps among various factors that need to be looked at before investing in a company, the
management is the most important. But that is also where the difficulty lies. After all, how do you assess
management? Unlike company financials, ratios and valuation methods which can we quantified and
expressed in numbers, management quality is more subjective. No number can be assigned to it. And
yet it is one of the most crucial elements in value investing.
There are three main factors in assessing management
1. The results of the company
2. The treatment of the company's shareholders
3. How well it allocates capital
Let us consider these separately.
1. Results: Past performance is highly indicative of how well the management has been able to
steer the growth of the company. This is through both good times and bad. Indeed, a good
management needs to be proactive and should have the ability to respond to changes,
competition, opportunities and threats. Having said that, what needs to be noted is that the
management track record has to be evaluated in context of the sector dynamics in which
companies operate.

2. Treatment of shareholders: Shareholders obviously stand to benefit if the management has been
able to provide healthy returns on capital and dividends on a consistent basis. Return on invested
capital and dividend yield are some of the important parameters to be looked at while determining
whether a shareholder is getting the most of what he has put into the company.

3. Allocation of capital: How effectively the management is able to allocate capital is a very good
indicator of its quality. For instance, one needs to evaluate whether this capital is being invested in
projects or activities in line with the company's overall growth strategy. Moreover, are these
investments generating good returns? If the capital is not being invested, then whether the same is
being distributed to the shareholders.
There have been instances in the past where the management of cash rich companies has made ill-
suited acquisitions which have been a drag on the overall company performance. Instances such as
these are examples of misallocation of capital by the management.


Management strength at the end of the day is a qualitative factor. But investors need to have a grasp on
the people at the helm of affairs before they decide to invest in the stock of a particular company. This
would mean reading annual reports, analyzing company performance and keeping check on the
management's communication with the shareholders. This may not be as concrete as numbers but it
certainly helps in forming a reasonable judgment on what the management's objectives are and what it
intends to do to drive company performance going forward.
Step 4: Valuations
The last step pertains to valuations. It is most important of all the steps since valuations decide the
action points (buy or sell) of investors.
How to estimate intrinsic value?
Determining value is a tough task. That's because it involves forecasting future cash flows which in itself
is a challenge. Discounting those cash flows at an appropriate rate gives us an estimate of value.
However, forecasting cash flows for a business is not easy because of the uncertainty involved with the
future, unlike coupon bonds. Valuing coupon bonds is relatively easier since you know the coupon
payments of future. But that is not the case with businesses.
So, basically the mantra is to look out for businesses that resemble coupon bonds. This would make the
valuation exercise easier. In other words, businesses where forecasting future cash flows is relatively
easier are the ones that should be on the radar. Once you have the estimate of cash flows discount it
with the appropriate interest rate and compare it with your purchase price. The decision then needs to
be taken accordingly.
Predicting cash flows for cyclical businesses
But, say you are looking at a business where forecasting free cash flow is difficult. Say for example a
capital intensive business. How to forecast cash flows then? Also, what kind of discount rate should be
used here considering the riskiness in cash flows?
The legendary investor - Warren Buffett feels that for cyclical business the estimates for cash flows have
to be conservative. Also, since he focuses on long term investing, the discount rate used is constant
across securities. And that figure is arrived at by using the government bond rates. An appropriate
premium over that and you are on the right track. No complicated financial models like risk premiums,
sensitivity analysis, scenario framework and betas, just simple logical mathematics.


Word on relative valuation
You might have known by now that Buffett is not a big fan of relative valuation because of his focus on
cash flows. Nonetheless, if used, appropriate relative multiples need to take into account the return
generating capability of the business like shareholder returns - return on equity, return on capital
employed etc.
How to estimate growth rates?
Forecasting future cash flows involves an estimate of growth rate. The mantra here is to be
conservative. If the growth rates are higher, then the estimate of intrinsic value will increase. And
investment decisions are based on comparing intrinsic value with the market price. Thus, your estimate
of intrinsic value has to be as accurate as possible. High growth rates make intrinsic value more
susceptible to changes. Hence being conservative pays off.
Margin of safety
The concept of margin of safety is the essence of valuation. Since the estimates of intrinsic value involve
subjective judgments there is a possibility of being overly optimistic. Margin of safety provides cushion
by adjusting the optimism from the forecast. Say for example your estimate of intrinsic value is Rs 100.
Taking into consideration a margin of safety of 20% you can adjust the value to Rs 80. This will ensure
that you do not overpay for any asset.


Section IV: Lessons from Successful Investment Gurus

While we may have read or heard about many people who would have made fortunes in investment
world and equity markets; there are very few who are successful and are role model for equity
investors. Let us share with you some important lessons that we have picked from the number of
lessons these Investment Gurus have set for investors.

Warren Buffett - The Legendary Investor
Warren Edward Buffett is an American business magnate, investor, and philanthropist. He is widely
considered the most successful investor of the 20th century. Buffet is the primary shareholder, chairman
and CEO of Berkshire Hathaway and consistently ranked among the world's wealthiest people. He was
ranked as the world's wealthiest person in 2008 and as the third wealthiest person in 2011. In 2012,
American magazine Time named Buffett as one of the most influential people in the world.
Buffett is called the "Wizard of Omaha", "Oracle of Omaha", or the "Sage of Omaha". He is known for his
adherence to the value investing philosophy and for his personal frugality despite his immense wealth.
Buffett is also a notable philanthropist, having pledged to give away 99 percent of his fortune to
philanthropic causes, primarily via the Gates Foundation. On April 11, 2012, he was diagnosed with
prostate cancer, for which he completed treatment in September 2012. - Wikipedia

Mr Buffett says,
"Only follow two rules in investing

Rule#1: Do not lose money, and
Rule#2: Do not forget Rule no. 1"

Warren Buffett's investments have grown a whopping 5,000 times over the last few decades. Well, it
may or may not be possible for you to repeat EXACTLY the same feat. Nonetheless, if one devotes his
investment lifetime to following Mr Buffets disciplined approach and timeless philosophies austerely
embracing the above quote, he is likely to emerge a much successful investor.


1. Quality Over Quantity
Mr Buffett says, "It's far better to buy a wonderful company at a fair price than a fair company at a
wonderful price. Charlie (Buffett's business partner) understood this early; "I was a slow learner. But
now, when buying companies or common stocks, we look for first-class businesses accompanied by
first-class managements. Good jockeys will do well on good horses, but not on broken-down nags.
The same managers employed in a business with good economic characteristics would have
achieved fine records. But they were never going to make any progress while running in quicksand."
It is worth mentioning here that in the early years of his career, Mr Buffett bought into businesses
based on statistical cheapness rather than qualitative cheapness. While he experienced success
using this approach, the difficult time faced by the textile business made him realise the virtue of a
good business i.e., businesses with worthwhile returns and profit margins and run by exceptionally
smart people.
In his letters to the shareholders of his investment vehicle, Berkshire Hathaway in 1978 he said, "The
textile industry illustrates in textbook style how producers of relatively undifferentiated goods in
capital intensive businesses must earn inadequate returns except under conditions of tight supply or
real shortage. As long as excess productive capacity exists, prices tend to reflect in direct operating
costs rather than capital employed. Such a supply-excess condition appears likely to prevail most of
the time in the textile industry, and our expectations are for profits of relatively modest amounts in
relation to capital. We hope we don't get into too many more businesses with such tough economic
characteristics."
The above paragraph once again highlights the fact that no matter how good the management, if
the economic characteristic of the business is tough, then the business will continue to earn
inadequate returns on capital. This can be further gauged from the fact that despite all the capital
allocation skills at his disposal, the master was not able to turnaround the ailing textile business that
he had acquired in the early years of his investing career. He further adds that such businesses have
little product differentiation and in cases where the supply exceeds production, producers are
content recovering their operating costs rather than capital employed.
While the comment is reserved for the textile industry, we believe it can be extended to all
commodities like cement, steel and sugar. Say a sugar industry may face downturn due to supply far
exceeding demand and this in turn may have a great impact on returns on capital employed by
these businesses. The only hope for them is a scenario where demand will exceed supply.
Buffet adds "We get excited enough to commit a big percentage of insurance company net worth to
equities only when we find (1) businesses we can understand, (2) with favorable long-term
prospects, (3) operated by honest and competent people, and (4) priced very attractively. We
usually can identify a small number of potential investments meeting requirements (1), (2) and (3),


but (4) often prevents action. For example, in 1971 our total common stock position at Berkshire's
insurance subsidiaries amounted to only US$ 10.7 m at cost and US$ 11.7 m at market. There were
equities of identifiably excellent companies available - but very few at interesting prices."
Buffett then goes on to make a very important comment on valuations and says that no matter how
good they are, there is a price to pay for businesses and he in his investing career has let many
investing opportunities pass by because the valuations were just not right enough.
Comparison can be drawn to the tech mania in India in the late nineties when good companies with
excellent management like Infosys and Wipro were available at astronomical valuations. While these
companies had excellent growth prospects, investors had become far too optimistic and had bid
them too high. Thus, investors who would have bought into these stocks at those levels would have
had to wait for five long years just to break even! Hence, no matter how good the stock is, please
ensure that you do not pay too high a price for it.
According to him, while one may make decent profits in an ordinary business purchased at very low
prices, lot of time may elapse before such profits can be made. Hence, Buffet feels that it is always
better to stick with a wonderful company at a fair price, as according to him, time is the friend of a
good business and an enemy of a bad business.

2. Circle Of Competence
Focus on what you know and leave aside what you do not. Simple, isn't it? In other words, define
your 'circle of competence'. Your 'circle of competence' would comprise all the businesses that you
are familiar with and thoroughly understand. As Buffett puts it "Everybody's got a different circle of
competence. The important thing is not how big the circle is. The important thing is staying inside
the circle." As simple as it sounds, it is the most difficult principle to follow. And wandering away
from it can cause investors the biggest harm.
A value investor must focus solely on areas of business where he believes he has an edge over the
average investor. As we mentioned this earlier, say you're a doctor. Being an insider to the
healthcare industry, you would most likely have a pretty good first-hand understanding of the
sector. You may have knowledge of various drugs by pharma companies. An analyst, on the other
hand, would not have access to this valuable information. This puts you in a position of advantage.
Of course, this does not mean you are already an expert on pharma stocks. But you are at a great
starting position. Similarly, many products and services that you use in your daily lives are often
from listed companies. As a regular consumer and visitor to the mall, you may have a good starting
knowledge about product quality, pricing and competitors.


Investing in what you know is one thing. But there is another very important aspect which is often
ignored. And this is where the likes of Buffett have a significant edge over others. Great investors
have a very clear understanding of what they do not know. Buffett is known to be quite disciplined
as far as staying within the 'circle of competence' is concerned. He avoids businesses whose
dynamics he does not understand well. But he is also famously known to have shunned technology
stocks in the late 1990s at a time when they were a rage and anyone not owning them was labelled
as stupid. At that time, he had argued that technology stocks fell outside his circle of competence
and hence, he was not comfortable owning them. It turns out that most people who actually
invested in technology stocks, some of who ridiculed Mr Buffett, did not understand them either!
Investors can draw some very big lessons from this incident and develop a discipline that makes
them avoid anything that falls outside their circle of competence. Invest in companies whose
businesses are within your circle of competence and keep it easy and simple. According to Mr
Buffett, human beings have this perverse tendency of making easy things difficult and one must not
fall into such a trap.
This brings us to another very useful insight. Great familiarity may not always result in great
understanding. Buffett has been a long-time friend of Bill Gates, the billionaire founder of
Microsoft. While he donated a significant part of his wealth to Bill & Melinda Gates Foundation, he
never invested in Microsoft. The reason has been simple. He did not know that industry very well.
He could not clearly envision what the business would be like 5 to 10 years later. As such, he was
willing to let go of a seemingly great investment opportunity. It is this discipline that has made him
one of the world's richest investor.

3. Discounted Cash Flow
Mr Buffett quotes, "In The Theory of Investment Value, written over 50 years ago, John Burr
Williams set forth the equation for value, which is condensed here: The value of any stock, bond or
business today is determined by the cash inflows and outflows - discounted at an appropriate
interest rate - that can be expected to occur during the remaining life of the asset. Note that the
formula is the same for stocks as for bonds. Even so, there is an important, and difficult to deal with,
difference between the two: A bond has a coupon and maturity date that define future cash flows;
but in the case of equities, the investment analyst must himself estimate the future 'coupons'.
Furthermore, the quality of management affects the bond coupon only rarely - chiefly when
management is so inept or dishonest that payment of interest is suspended. In contrast, the ability
of management can dramatically affect the equity 'coupons'."
As evident from the above paragraph, Mr Buffett seems to be a firm believer in using the
'Discounted Cash Flow' approach or what is more popularly known as the DCF approach to
valuations.


So, what is DCF and how does it work?
DCF is a valuation technique, the purpose of which is to arrive at future cash flows that the company
is expected to generate over its lifetime and adjust it for time value of money. The resultant value is
nothing but an 'intrinsic value' (since different people will have different assumptions about a
company's future cash flows, intrinsic value might vary from person to person) and which is then
compared to the prevailing stock price to judge the investment worthiness of the stock. If the
intrinsic value is higher than the actual stock price of the company, then the stock offers an
investment opportunity; the greater the discount to the intrinsic value, the more attractive the
investment opportunity. Conversely, if the intrinsic value is lower than the current market price,
then the stock is 'over valued' and should be avoided.
Mr Buffett also goes on to recommend further that an investment that appears to be the cheapest
under the DCF analysis should be bought irrespective of what the other valuation techniques such as
P/E (price to earnings) or P/BV (price to book value) indicate.
Investors who've tried using the DCF would know that cash flows of not all companies can be
predicted with great degree of certainty given their past history of inconsistent performances and
the nature of their businesses. Furthermore, even in cases where cash flows can be predicted with
some degree of certainty, one is not sure whether they will actually fructify. What should be done in
such cases? Mr Buffett has dealt with these two issues as well and this is what he has to say on
them.
Mr Buffett says, "Though the mathematical calculations required to evaluate equities are not
difficult, an analyst - even one who is experienced and intelligent - can easily go wrong in estimating
future "coupons." At Berkshire, we attempt to deal with this problem in two ways. First, we try to
stick to businesses we believe we understand. That means they must be relatively simple and stable
in character. If a business is complex or subject to constant change, we're not smart enough to
predict future cash flows. Incidentally, that shortcoming doesn't bother us. What counts for most
people in investing is not how much they know, but rather how realistically they define what they
don't know. An investor needs to do very few things right as long as he or she avoids big mistakes."
Now that one has performed a DCF on the company that falls under one's circle of competence and
has found out that the value arrived from DCF is greater than the market price, should he go ahead
and invest in the company? Mr Buffett thinks otherwise.


4. Margin of Safety
Mr Buffett has often emphasized the fact that when investing, only two skills are of paramount
importance: One is that of valuing a business, and other of knowing how to think about market
prices.
Through this important concept of Margin of Safety Mr Buffet simply states - Pay as little as
possible for your mistakes!
As the master himself explains the concept in one of his letters to his shareholders, "We insist on a
margin of safety in our purchase price. If we calculate the value of a common stock to be only
slightly higher than its price, we're not interested in buying. We believe this margin-of-safety
principle, so strongly emphasized by Ben Graham, to be the cornerstone of investment success."
Civil engineers, who construct bridges, always insist on using a 'margin of safety' in the maximum
load a bridge can carry at any given time. Thus, if a signpost on a bridge says 'maximum payload
capacity 1,000 tonnes, one can be sure that the engineers have designed the bridge in such a way
that it can carry weight 20% to 30% more than the designated payload capacity. This is done to not
only account for any errors that must have crept in while designing but also for the errors made
while projecting the future traffic needs of the bridge.
Similarly, since doing DCF involves predicting the future, which as we all know is uncertain; errors
are bound to creep into our analysis. Thus, having a margin of safety is important, as in the case of a
bridge construction. Mr Buffett learnt this technique from his mentor Benjamin Graham and widely
believes it to be the cornerstone of investment success. Thus, whenever you do DCF next, consider
buying only if your estimations are at least 50% more than the current market price of the stock, so
that even if you go wrong in your assumptions, capital loss can be minimised.
Warren Buffett has always been a believer of the theory that stock investments should be made after
taking into account an adequate margin of safety. But in euphoric times such as the current one on the
Indian bourses, it is difficult to come across a good quality stock with an adequate margin of safety.
However, when markets tumble and panic sets in, quite a few stocks start trading at an adequate margin
of safety but the same stocks become risky for investors who not so long ago where willing to pay a
hefty premium for them.
The master believes, "The most common cause of low prices is pessimism - sometimes pervasive,
sometimes specific to a company or industry. We want to do business in such an environment, not
because we like pessimism but because we like the prices it produces. It is optimism that is the enemy of
the rational buyer."
However, he cautions that not everything should be bought at low prices and this is what he has to say
on the issue.


"None of this means, however, that a business or stock is an intelligent purchase simply because it is
unpopular; a contrarian approach is just as foolish as a follow-the-crowd strategy. What is required is
thinking rather than polling. Unfortunately, Bertrand Russell's observation about life in general applies
with unusual force in the financial world: "Most men would rather die than think. Many do."
Thus, while low price scenario may be a good time to buy stocks that provide adequate margin of
safety, one should look for good quality businesses that have delivered consistently on a long-term
basis and are being run by shareholder friendly managements. Please bear in mind that long-term
wealth has been made in the market not by investing in the latest overpriced fads but by investing in a
good quality company trading at valuations that have built in a considerable margin of safety.

Charlie Munger - The Legendary Investor's Alter Ego
"When you locate a bargain, you must ask, 'Why me, God? Why am I the only one who could find this
bargain?" - Charlie Munger
Charles Thomas Munger (born January 1, 1924, in Omaha, Nebraska) is an American business magnate,
lawyer, investor, and philanthropist. He is Vice-Chairman of Berkshire Hathaway Corporation, the
diversified investment corporation chaired by Mr Warren Buffett; in that capacity, Buffett describes
Munger as "my partner." Munger served as chairman of Wesco Financial Corporation from 1984
through 2011 (Wesco was approximately 80%-owned by Berkshire-Hathaway during that time). He is
also the chairman of the Daily Journal Corporation, based in Los Angeles, California, and a director of
Costco Wholesale Corporation.
Like Buffett, Munger is a native of Omaha, Nebraska. After studies in mathematics at the University of
Michigan, and service in the U.S. Army Air Corps as a meteorologist, trained at Caltech, he entered
Harvard Law School, where he was a member of the Harvard Legal Aid Bureau, without an
undergraduate degree. - Wikipedia

The Use and Abuse of Incentives
Munger is a generalist for whom investment is only one of a broad range of interests. In many ways, his
personality has traces of his own hero-Benjamin Franklin, who along with being a great scientist and
inventor, was also a leading author, statesman and philanthropist, and played four instruments. On
similar lines, Munger hops around science, architecture, psychology and philanthropy with as much
passion and curiosity as he does with business and investments.


Munger very aptly follows this multidisciplinary approach in all kind of situations. He draws influences
from fields as diverse as physics and psychology to his investment process. For long, he had been
interested in standard thinking errors. Without diving much into academic psychology textbooks, he
developed his own system of psychology more or less in the self-help style of Ben Franklin. Munger once
gave a speech on "24 Standard Causes of Human Misjudgement", which have very powerful
implications for investors.
Of the many causes of Human Misjudgement, Munger finds incentives one of the most difficult to
understand. In other words, Why do we do what we do? Why are we tempted to do certain things while
refraining from others?
Well, all creatures seek their own self-interest. Our innate drive is to maximise pleasure, while at the
same time avoiding or reducing pain. In any given circumstance, we assess the risks and the associated
rewards and respond in a way that seems to best serve us. With this premise, it is imperative to
understand the role of incentives and disincentives in changing cognition and behaviour.

1. The power of incentives
There is this interesting case of the logistics services major FedEx Corporation. The integrity of the
FedEx system required that all packages be shifted rapidly among airplanes in one central airport
each night. And the system had no integrity for the customers if the night work shift couldn't
accomplish its assignment fast. And FedEx had a tough time getting the night shift to do the right
thing. They tried moral persuasion. They tried everything in the world without luck. Finally,
somebody thought it was foolish to pay the night shift by the hour. What the employer wanted was
not maximized billable hours of employee service but fault-free, rapid performance of a particular
task. So maybe if they paid the employees per shift and let all night shift employees go home when
all the planes were loaded, the system would work better. And that solution worked just perfectly.
This is a classical case of the power of incentives and how they can be used to produce desirable
behavioural changes.

2. The abuse of incentives

One of the most important consequences of incentives is what Munger calls "incentive-caused
bias." The following example will explain the same. Early in the history of Xerox, Joseph Wilson, who
was then in the government, had to go back to Xerox because he couldn't understand why its new
machine was selling so poorly in relation to its older and inferior machine. When he got back to
Xerox, he found out that the commission arrangement with the salesmen gave a large and perverse
incentive to push the inferior machine on customers. An incentive-caused bias can tempt people


into immoral behavior, like the salesmen at Xerox who harmed customers in order to maximize their
sales commissions.
The story of mutual funds in India is quite similar to that of the Xerox case. Few years ago mutual
funds that offered the maximum commission to distributors were the best sold funds. Also, consider
your own stockbrokers. There will be seldom one who will not lure you to trade too often. And
seldom will a management consultant's report not end with an advice like this one; "This problem
needs more management consulting services." Such behavioural biases exist in most places and
situations. And human nature, bedevilled by incentive-caused bias, causes a lot of ghastly abuse.
For you investors, we believe it is important to understand the motives and incentives of people and
organisations you're dealing and investing with. Everyone ranging from the company you're investing in,
to your stockbroker, your mutual fund agent and your equity advisor must pass your scrutiny.
Widespread incentive-caused bias requires that one should often distrust, or take with a grain of salt,
the advice of one's professional advisor. The general antidotes here are:
I. Especially fear professional advice when it is especially good for the advisor.
II. Learn and use the basic elements of your advisor's trade as you deal with your advisor.
III. Double check, disbelieve, or replace much of what you're told, to the degree that seems
appropriate after objective thought.

3. Doubt -Avoidance Tendency
The name itself is quite self-explanatory. Doesn't our mind often display a tendency to steer clear of
doubts to quickly reach a decision or conclusion? It surely does, and at times to our own
disadvantage. Charlie Munger presents an evolutionary perspective about how this tendency must
have developed in humans from their non-human ancestors. He asserts that it would be suicidal for
a prey animal threatened by a predator to take a long time to decide what to do. The development
of this tendency has come as a survival tactic in times of stress and confusion.
So the evolutionary justification of this tendency is reasonable. But the problem with any kind of
psychological tendency or mental programming is that it doesn't work well in all situations. Say, a
person who is neither under pressure nor threatened should ideally not be prompted to remove
doubt through rushing to some decision. Yet, more often than not we find ourselves doing exactly
the opposite.


Doubt-avoidance tendency in stock markets
How often do you trade on impulse without asking the right questions? How open are you to hear
negative things about stocks that you are very optimistic about? When a person comes to the stock
markets with a bag full of money to invest, he is usually inclined to fall in love with any stock that
seems promising. The boredom and pain that is usually part of a thorough scrutiny and analysis of a
stock is often avoided. Quick conclusions and quick decisions are often preferred instead of the
burden of doubts and ambiguity.
Without any exaggeration, it is strongly believed that if you learn how to reign over the doubt-
avoidance tendency while you conduct your business in the stock markets, there is little that can
stop you from becoming a successful investor.

4. Liking and Loving Tendency
There is another very common error that most investors do with stocks that they own. Once they
have bought a stock, they automatically start developing a feeling of affection towards it. This is the
liking and loving tendency. Dont we often hear people raving about certain blue chips with an
admiration that borders around reverence? Any negative comment about them will either be
ignored, dismissed or defended. It almost seems like a marriage brimming with loyalty and affection.
Take the so-called "hot" sector stocks. Dont they often cause many a feeble hearts to melt? And
what happens to all thoughts about business and valuation? Well, you know best. We dislike
challenging and reasoning with things and ideas that we love.
Our bottom line is this. Do fall in love, but not with your stocks. Love your capital and do the best
you can to protect it and to help it grow. And what better way of doing that than being a disciplined
value investor!
Inconsistency-avoidance tendency in stock markets
Charlie Munger says, "People tend to accumulate large mental holdings of fixed conclusions and
attitudes that are not often re-examined or changed, even though there is plenty of good evidence
that they are wrong."
Another extremely important human tendency that every serious investor should be well aware of is
the inconsistency-avoidance tendency, which is very rampant amongst human beings. In simple
words, we filter away any piece of information which may be inconsistent to our ideas and beliefs.
You may have read as students how many great scientists and discoverers were often discredited
and ridiculed for their so-called lunacies. Many were acknowledged for their great work only after


their death. Do you see how the inconsistency-avoidance tendency works? Not just history, even our
day-to-day life is filled with such stories.
Our aim is not to profess psychology for its own sake but to attempt to relate it to human behaviour
in the stock markets. Stock markets are largely driven by sentiment. So you must do your best to be
as objective as you can and guard yourself from the lures of greed and fear.
Getting back to inconsistency-avoidance tendency, can you remember instances when you have
used this tendency to your own peril? We'll point out a few for your benefit:
Have you lost money on your favourite stock that had once been an outperformer? The company's
prospects may have changed, it may no longer be worth putting your money into, but you still
couldn't let go of it. Why? Because letting go of it would be inconsistent with your original beliefs
about it. So you did everything to console and convince yourself that nothing was wrong. But your
portfolio losses have a different story to say, don't they?
Each investor will have innumerable such instances to share. Now the more important question,
how exactly do you get rid of this tendency? There are several ways to do that, but more than
anything else, you need to be very disciplined with your investment approach. One great way is to
play the devil's advocate. If you find a prospective company very compelling, first start with rejecting
the hypothesis. In other words, try to gather facts and arguments that will prove that the stock is a
bad investment. After all your analysis, if you arrive at the conclusion that the stock is still good,
then it has passed the bar. You can also take a good lesson from the court of law. Law courts have
processes and procedures in place that tend to minimise hasty and biased decision-making, which
can cost someone's life.
As investors, you must learn not to be hasty. Adjourn your stock purchases till you're not clear in
your mind. Always remember, stock markets will always keep swinging higher and lower. Investing
opportunities will be there. If you can tackle with your inconsistency-avoidance tendency, money
will consistently keep pouring into your bank accounts.


Peter Lynch The Legendary Fund Manager
Peter Lynch is an American businessman and stock investor. He is a research consultant at Fidelity
Investments. Lynch graduated from Boston College in 1965 and earned a Master of Business
Administration from the Wharton School of the University of Pennsylvania in 1968. Wikipedia
In this age of information overload, picking the wheat from the chaff is difficult. And that is so true in the
world of investing. Hot stock tips, recommendations and run of the mill research reports leave a
common man clueless as to where to begin, what to follow and what to ignore.
And here to his rescue is Mr Peter Lynch, the man who believes that 'Everyone has the brainpower to
follow the stock markets. If you made it through fifth-grade math, you can do it'.

1. Invest In What You Know
It is human nature to discount what one already knows, and put a premium to what is unknown and
esoteric. That perhaps is the biggest irony as far as investing is concerned. Because this behavioral
pattern makes one ignore the basic tenet of investing - Invest what you know/understand.
The first step to investing is screening stocks. And the power of common knowledge at this stage can
help you get that 'multibagger'- a term made famous by none other than Mr Lynch. It's all about
keeping eyes open and using a bit of logic. Next time you visit a shopping mall, keep an eye for the
products that are popular and attract mob. The next step would be to check out if the company
making the product is listed. Keep an ear open for what a direct consumer has to say about a
product. For every stock has a company tagged to it, and each company is associated with either the
products or services. So, the starting step to stock analysis can be as simple as product/service
analysis for which one needs not be a financial expert.

2. Your edge over a fund manager
Investing is more of an art combining logic than numbers and statistics. It is the power of common
knowledge that counts. And as far as that is concerned, a common investor is as good as or may be
even better than a fund manager. Even if you can pick up one multibagger, it can make a huge
positive difference to your small portfolio. So much so that you can afford to sleep a bit on the rest
and still outdo the markets and the experts. And that can be your advantage over a mutual fund
manager. This is because while a multibagger can make a huge difference to your 'small' portfolio,
the economies of scale are unlikely to work the same way for your fund manager.


Hence before becoming an investor, step into the shoes of a customer and try to know the potential
of the product. Over a period of time, you will know what's good and what isn't, what sells and what
doesn't.
The common perception is that best investment ideas are a rare commodity that gets exchanged
amongst privileged people surrounded by stock quoting terminals. But the fact is - it is the ground
level knowledge that counts. You just need to be alert and use common sense to make use of this
knowledge.

Using this approach, you will avoid falling for recommendations blindly. And that is likely to pay off
in the long run. It will also keep you shielded from the herd mentality that more often than not leads
to losses, and at times when right, limits the gains.
But there is a caveat. A great service or a popular brand need not always translate into a great
investment for shareholders. So far, the impression that one gets is that what is popular today and
has the potential to remain so could be a good option. However, there is nothing sacrosanct about
it. Take the example of Facebook. Despite being immensely popular (and holding the promise to
remain so) has not been a smart investment
This is a great lesson for all investors. A company like Facebook enjoys great brand equity and a
huge user base. Yet it has no clear plan that will drive revenues and profits. And it's important to
understand that the most vital factor that drives share prices is earnings.
So, though it is a great idea to look at businesses around you, this should only be the starting point.
It is crucial to take into account factors that would drive earnings over the long term. And finally, the
most important aspect is valuations. Investors must always buy stocks at a sufficient margin of
safety.

3. The right approach to invest in the markets
As a beginner in the stock markets, one is likely to start straight with the stock screeners to select
the stock that fulfills qualifying criteria. However, in doing so, a key step in investing that decides
final outcome gets skipped. We are referring to an unbiased self-assessment of investor's
requirements, attitudes, psychology and emotions. Even if two different investors start with the
same portfolio, they are likely to end with different results. This is because markets tend to be
volatile to which every individual will react differently. For e.g., while decline in the price of a stock
may look like a perfect buying opportunity to one investor, it may trigger a panic button reaction
from another and make him sell at a loss.
This is where Behavioral Aspect of Finance comes into play which most of us hardly ever spend any
time to analyse. Our investment choices should be based on our liquidity requirements, horizon


period, and most importantly, the risk appetite. Hence, before doing a stock analysis, a self-analysis
of attitudes and objectives is must.
"There seems to be an unwritten rule on Wall Street: If you don't understand it, then put your life
savings into it. Shun the enterprise around the corner, which can at least be observed, and seek out
the one that manufactures an incomprehensible product." - Peter Lynch

4. Look for Specific Edge
Once as an investor you have done a self-assessment, there is one fact that you are better off
knowing from the start. That there is no good market. Infact, no one can predict good or bad
market. It may sound quite discouraging to some. But the good news is - this is not what you need
to know to make money in the stock markets. Mr Lynch believed that it is a futile exercise to predict
the economy and interest rates. Making money in the stock markets is all about buying
underappreciated companies, irrespective of the markets. In short 'Invest in companies, not in
stock market'.
For picking up underappreciated companies, one needs to have an edge. The specific edge will be
different for different investors. It could be a knowledge or news that can give you significant head
start. For example, if you are employed as a sales person at cosmetic store, you will know which
brands are in fashion and likely to remain in demand. The next step will be to find which company
they belong to.
By virtue of your job, you will have a better idea of the sales trends than an analyst covering the
industry. If the stock satisfies other criteria, you will be able to pick up stock before the premium
starts getting reflected in the stock price.
One of the very simple examples of how to spot an opportunity is using online shopping websites.
For e.g., Flipkart offers the option to sort products under categories 'most viewed' and 'best-selling'.
It also offers users reviews and product comparisons on quality and price. Such websites could be a
good option to begin your research.
Mr Lynch has drawn an interesting comparison between stock markets and game of stud poker. So
while there is no winning formula, the player always has some open cards that can offer you insight
and tilt the odds in your favor. Investing without research is like playing stud poker and never
looking at the cards.
"Although it's easy to forget sometimes, a share is not a lottery ticket. It's a part ownership of a
business." - Peter Lynch


5. Understand the business
Since you are picking up the stock based on the popularity of a product/service, it is important to
find out what is the contribution of that product /service to the company's topline and bottomline
and thus the stock valuation.
Ratios and numbers without the correct interpretation and understanding mean nothing. Mr Lynch
suggests that if you don't understand the industry and the business, don't go further. Otherwise,
you may end up comparing apple with oranges and making some flawed assumptions. For e.g. a
high debt to equity ratio is generally undesirable. However, there are some capital intensive
industries such as construction that have inherently high debt on their balance sheets, purely
because of the nature of the business they are in. Hence, comparing FMCG or service based
company with construction based on this parameter will make little sense.
Similarly, if you are thinking of a pharma based company and have no knowledge about patents,
competition and different market and regional /geographical dynamics, you might end up burning
your hands.

6. Annual report - your best friend
These days, lot of websites are available that give a decent snapshot of financials. As Mr Lynch
suggests, investing in stock markets is a matter of hard work and not gambling. If you want to be
confident and convinced about your story, you cannot ignore the annual report. Infact, it can be
your best friend as far as research and building a story is concerned.
One of the important data that is likely to be found mostly in annual reports only is the data on
contingent liabilities and off balance sheet items. Lot of behemoths have fallen, the symptoms of
the upcoming doom reflected only in off balance sheet items that was unfortunately ignored by the
investors. Further, an annual report gives us an idea of not just the performance in the past year,
but also management's outlook and comments that give valuable insight on where the company is
heading.
Research is an open ended concept. Hence, unless you do it in a systematic way, you can feel totally
lost. While annual report in itself offers a lot of data, you as an investor are better off following a
systematic approach not to get bogged down by the sheer amount of information.

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