April 16, 2010

Guest post : Investing sensibly in the stock market

I recently wrote a guest post on Jagoinvestor.com, a personal finance blog by Manish Chauhan. A few disclaimers : I am not related to Manish, he is not my evil twin and vice versa :). Just two guys with the same last name writing on investing and personal finance (what are the chances of that !!).

Jokes aside, manish writes well on personal finance and has written quite a few detailed posts on various topics such on mutual funds, fixed deposits, insurance etc.

If you are new to my blog, here are some of the salient posts you may want to read
My personal investment journey –
part 1 and part 2
Index investing – SIP or opportunistic approach
Should you invest in the index funds or buy stocks directly? – here and here
Floating rate mutual funds
Fixed income investing
Planning for retirement – here, here and here
Why ULIPs are a bad idea
Analysing real estate
My experience with equity mutual funds
How I analyse stocks

If you have liked what you have read, you may want to subscribe to the blog.If you are a regular reader, the post is re-published below.

Investing sensibly in the stock market

The common view of the stock market is that it is a place for gamblers and risk takers. If you have the capital and the nerve to take the risk, only then should one put money in the stock market. Otherwise one is better off keeping away from the stock market and putting money in safe fixed deposits.

The truth is far removed from the myth, if one looks at the stock market with a different perspective and avoids the hype and hysteria associated with it.

Let start with the basics – What is the stock market?
The stock market is a place where buyers and sellers meet to buy and sell companies or rather small pieces of it. That’s all! It is nothing more, nothing less.
The small pieces of companies are called shares and they represent a very small ownership of the company. In exchange of owning a small piece of the company, the investor is entitled to his or her share of the profits which is given to the investor as a dividend. Of course the management does not give out all the profits to the investor, as they retain some portion of the profits to re-invest and grow the business.

So how should one invest?
If you agree with the above definition of the stock market, the idea of investing in the stock market boils down to investing your money in a selected group of companies.
If the purpose of an investor is to make a decent return on the money invested by him or her, then the investor should choose companies or businesses which are sound, consistently profitable for a long time and run by shareholder friendly management.

Finding a good company
Let’s explore the above statement a bit further. The long term return for a shareholder, where long term is 5 years or more, will be equal the underlying returns generated by the company.

The returns for a shareholder can fluctuate from year to year based on the market moods and sentiment, but over the long run the returns always track the returns of the company.
If the company can earn 20% on its capital, then the investor will make around the same returns over the long term. Thus we now arrive at the first criteria for successful long term investing, namely that to make above average returns one should invest in above average companies.

The above criteria is not a revelation to most of the people. However very few people want to follow the obvious as they think that there is some hidden magic in the stock market.

So how does one find the above average companies?
Look around you. Do you see products which have been around for quite some time and are used by a lot of people? find out the companies behind them and that would be a good place to start. I never said investing in the stock market does not require work.

Analyzing the company
Once you have identified a few names, the next step would be to get the annual report of the company and browse through it. The mention of reading an annual report either sounds boring or daunting to most people. However if you can bring yourself to it, it will place you ahead of 90% of the people in the stock market.

The idea of browsing through the annual report is not to become an expert at it, but to get a sense of the nature of the company. One can focus on some of the following sections to see if the company is worth putting your money in

Management discussion and analysis – This is the section where the management describes the business and lays out the plan for the company.

Profit and loss and balance sheet – This is the section which tells you if the company is making a profit or not, how much debt is held by the company, amount of dividend etc. If you come across a term you do not understand, search for it on the internet or talk to a friend or someone with a background in finance.

A few important factors should be checked when analyzing the annual report. A short list of these factors can be
- Is the company profitable and has it made profits consistently in the last 10 years?
- Has the company paid dividends consistently in the last 10 years and has the dividend increased over the same period?
- Has the company kept the debt equity ratio constant or better yet reduced the debt?
- Has the company been able to introduce new successful products in the market?

An example
Let’s look at an example – asian paints. This is one of most well known companies in India. This company has been the number one paint company for the last 20+ years. The company’s products like tractor distemper and emulsion, apcolite enamel, Apex exterior etc are well know and are widely available.

The company has been in business for over 30 years and hence we can be confident that the company has done something right consistently to be the no.1 paint company in India.
The annual report shows good performance over a long period of time. The ‘ten year review’ in the annual reports shows an increasing profits and dividend over the years. The company has used these profits to reduce the debt, pay out an increasing amount of dividend and re-invested the balance in the business to grow it over the years.

The above performance has been reflected in the share price too. An investment of Rs 1000 in 1998-1999 would now be worth around 19000 which translates to an annual return of around 31% !!! and this is without counting the annual dividend.

When to buy?
The immediate question which comes to mind is when should one buy the stock ? There is an army of people out there whose job is to advice investors the exact time to get in and out of stocks. I would personally say an investor would be far better off if he or she switched off the TV and ignored the advice of these so called experts.

If one is able to find a stock like the one above, the best approach is to invest in the company on a regular basis. If one can save Rs 2000 per month, then go ahead and invest 6000 Rs every quarter. A regular program of investing in good companies on a regular basis, while ignoring the noise and chatter of the stock market pundits, will give you very good returns and also good sleep at night.

Conclusion
So where is the catch ? The catch is within us. A lot of investors like to get excitement and thrill when investing in the market. They want to chase the hottest stock, so that they boast about it to their friends. At the same time they ignore the gems lying in front on them.
Investing is simple, but not easy. If one can find a few good and high quality companies and invest in them on a regular basis while ignoring the noise and chatter in the media, then that individual is likely to do well and have a good amount of money secured for his or her retirement.

6 comments:

Vic said...

Hey Rohit,

I recall you were tracking Amrutanjan, the price has really come down..any opportunity here?

Thanks,

vikas

Vic said...

Hey Rohit,

I recall you were tracking Amrutanjan, the price has really come down..any opportunity here?

Thanks,

vikas

Anonymous said...

Thanks... you rock :)

Avadhut said...

Rohit,
One crucial point. How to shortlist companies? on which parameters. There are 4500+ listed companies in India. If we get a short list of 10-15 companies by any shortlisting method, the steps you mentioned here are possible to follow.
Looking forward to your reply.

Thanks

Rohit Chauhan said...

Hi vic
yes still tracking. but not cheap enough for me

rgds
rohit

Rohit Chauhan said...

Hi avadhut
i have written on how i filter the initial list in a separate post. let me search and find it for you

rgds
rohit