Fundamental Analysis

2.1 Speculator or Trader or Investor (Speculator Vs Trader Vs Investor) – Poonit Rathore

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2.1 Speculator or Trader or Investor (Speculator Vs Trader Vs Investor) - Poonit Rathore
2.1 Speculator or Trader or Investor (Speculator Vs Trader Vs Investor) – Poonit Rathore

You can invest, trade, or speculate in the stock market. _ _ _ _ _ It depends on you which of these three routes you want to take. _ _ _ This decision will depend on how much profit or loss you will make in the market.

(Image Credit: Zerodha)

Let us see an example to understand this properly. _

RBI i.e. Reserve Bank of India is going to announce its monetary policy in the next 2 days. Due to the high rate of inflation, RBI has increased the interest rates in monetary policy for the last four times. interest rates as we know _ _ _ Rising creates difficulties for companies and affects their earnings.

Now suppose that 3 people want to participate in the market Sunil, Tarun, and Girish. All three see this happening in different ways, which is why all three take different steps. _ _ _ _ Let us understand his thinking.

Here I will also talk about option contracts but to make you understand it will be discussed in detail in the next module. _ _

Sunil has his own opinion on the whole environment. He believes that :

  • Interest rates are already very high and they cannot go any higher. 
  • Higher interest rates can reduce the growth rate of Corporate India.
  • Sunil feels that the Reserve Bank of India has already increased the interest rates so much that now it will be difficult for the RBI to increase the interest rates further.
  • He listens intently to the other analysts on TV and is happy to know that they share his views.
  • He assumes that RBI will now reduce interest rates.
  • And because of this, the market will go up.

Based on these views, he buys the call option of the State Bank of India.

Tarun‘s thought process is slightly different, Tarun believes that :

  • It is not right to expect a rate cut from RBI. He also feels that it is a difficult task to tell what  RBI will do.
  • Tarun also observes that there is a lot of volatility in the market and in his opinion the option contracts are being sold at a very high premium in the market. 
  • Based on his past experience he knows that the market volatility will come down as soon as RBI announces its interest rates.

Based on these views, he buys five lots of Nifty call options and intends to sell these lots as soon as RBI makes an announcement.

Girish: Girish has a portfolio of 12 stocks which he has held for 2 years. Though he closely monitors the economy, he has no view on what the RBI will do. He is not worried about what comes out of the policy as he knows that he intends to hold his stocks for a long time. He feels that monetary policy is a short-term event, it will have no impact on the market in the long run and even if there is an impact on his portfolio, he has time and patience. He will hold his share. 

In such a situation, Girish decides that if the market gives a big reaction after the RBI decision and the stocks in his portfolio fall, then he will buy more of those stocks. 

Here we are not paying attention to what is the decision of RBI and who makes money in all three. Here we are trying to identify who is a trader, who is an investor, and who is speculating. All three have their own logic and based on that they make their decisions in the market. Note that Girish’s decision to do nothing is also a market-linked decision. 

Sunil is almost sure what the RBI will do and he takes his decision based on the rate cut. But the truth is that what any regulator will do and especially what RBI will do in this case is a difficult task to tell. It is not so easy to analyze the work of RBI. In such a situation, to decide without any logic that there will be a rate cut is just speculation. This is what Sunil is doing.

Tarun is working on a plan. He is seeing that a trade can be entered by taking advantage of the high option premium available in the options market. He is not betting on what the RBI will do and it does not matter to him. His intention is clear that the volatility in the market is high and the option seller is getting good premiums. He expects volatility to come down after RBI’s decision.

Isn’t he betting on the volatility going down?? No, not at all. Based on his past experience, he is assuming that this will happen. A trader executes his trades in a planned manner and does not speculate.

On the other hand, Girish is an investor. He is not affected at all by what RBI will do. For him, this is a short-term noise event in the market, which will not have any major impact on his portfolio and even if it does, he believes that his portfolio will recover from this shock in the coming times. There is only one thing that gives profit in the market and that is – time and Girish is preparing to take full advantage of it. In fact, if the market falls, he is inclined to buy more of his portfolio shares. He intends to remain in the market for a long period of time and is not affected by short-term fluctuations.

All three have their own different ideologies which influence them to take different decisions. In this chapter, we will understand why Girish who is a long-term investor is not affected by short-term fluctuations.

2.2 – The compounding effect

Why did Girish decide to stick with his investments and not act despite short-term market volatility? To understand this, we have to understand how money is compounded. In simple language, compounding means that if the earnings of the first year are reinvested in the second year, the money grows faster.

For example, suppose you have invested ₹100 which is going to grow at the rate of 20% every year. (Remember it is also called CAGR ). At the end of the first year, you will have Rs 120. Now you have two options :

  1. Keep your profit of ₹20 invested and let it grow along with your initial investment of ₹100 
  2. Withdraw the profit of ₹20

If you keep your ₹20 profit with that investment, your ₹120 will grow to ₹144 by the end of the second year and ₹144 to ₹173 by the end of the third year and so on. Now compare this with the position of taking a profit of ₹20. If you had withdrawn a profit of ₹ 20 and kept withdrawing it every year, you would have got ₹ 60 by the third year, whereas at the end of the third year as an investor, you would have had ₹ 173, which means you would have made a total profit of ₹ 13. Which would have been 21.7% more than in 60. This would have happened simply because you had left your money there to invest. This is called the effect of compounding. Now let us see the chart below to understand it a bit more.

(Image Credit: Zerodha)

This chart shows how much an investment of ₹100 grows at 20% in 10 years. You will see that ₹100 becomes ₹300 in 6 years whereas it took only 4 years to go from 300 to 600. This is the most important thing about compounding, the more time you invest, the faster your money will grow. Girish, therefore, decided to remain an investor and tried to take advantage of this time. Every investment made on the basis of fundamental analysis should be left for the long term. An investor should adopt this ideology.

2.3 Does the investment make a profit? (Does investing work ?)

Think of a plant. Will it grow if you give it water, fertilizer, and time? Will definitely grow! In this way, a good business should be thought of. If its sales are getting good, profits are getting good, new products are coming and the management is good, then the share of that company will definitely increase. This growth may be delayed in some cases (remember the Eicher Motors chart we showed in the previous chapter) but it will grow nonetheless. Not only in India, but this thing has also happened again and again in markets around the world.

Investing in a good company that has investing qualities is always a win-win proposition. Just keep in mind that you don’t have to worry about this temporary upheaval over minor upheavals.

2.4 What are the qualities of a company worth investing in? (Investible grade attributes? What does that mean)

As we also said in the previous chapter that every company worth investing in has some qualities, which are visible. These properties can be divided into two parts. According to the quality of the company and according to the data. Both of these are studied in fundamental analysis. However, I trust the quality of the company more than the numbers for my investments.

The quality or quality-related attributes are those parts of the business that do not have data such as :

  1. Management background –  who are the people running the company? What is his background, what is his experience, what has he studied, whether he knows how to run a business or not, whether he has any criminal case against him or not? Etcetera
  2.  How are the business ethics – What is the business policy of the company? Whether the management has been involved in any form of scam, bribery, or business practices that are ethically wrong.
  3. Corporate Governance – Things like the appointment of directors, company structure, and transparency.
  4. Minority Share Holders – How does the company treat its minority shareholders? Does the company take care of its interests? 
  5. Buying and selling of own shares –  Are the promoters of the company secretly engaged in buying and selling their own shares? 
  6. Related party transactions – whether the company is working to provide financial benefit to its near and dear ones such as promoter’s relatives, friends, or other people who are close to the company, at the expense of its investors. 
  7. Salaries of Promoters – Is the management paying itself a hefty salary along with a huge share of the profits? 
  8. Operator’s presence in the stock – Does the company’s stock move abnormally, especially when the management itself is trading in the stock market? 
  9. Shareholders –  Who are the major shareholders of the company? Who owns more than 1% of the company’s shares?
  10. Political affiliations –  Are the company and its promoters close to any particular political party? Is this business running because of political help? 
  11. The lifestyle of the promoters –  Are the promoters living a very ostentatious life? Does he show off his wealth everywhere?

If any of the above things are not true then it is a danger sign. For example, if a company is repeatedly doing related party transactions, then it clearly shows that the company is doing favoritism and adopting bad policies. This is not good for the future of the company. Even though the company is making good big profits, the day the market comes to know about these activities of the company, that day people will sell the shares and the share price of the company may come down significantly. Therefore, it is important that investors do not just look at the profits, but also see how the company’s corporate governance or other things are.

Although it is not easy to know the things related to quality, a good investor can find out about these things by reading the annual report of the company, watching the interview of the management, and knowing the news. We will discuss these things in detail later in this module.

Data issues show up in the company’s financial results. Some figures are in front of you and some you have to find. For example, you will know how much cash is in the inventory, but you will not see the “Inventory Number of Days”. But it is necessary to calculate it. The stock market gives a lot of importance to the data, the important things in these data are : 

  1. profits and growth 
  2. Margin and its growth 
  3. earnings and growth 
  4. expenses 
  5. work efficiency 
  6. pricing freedom 
  7. tax matters 
  8. dividend 
  9. cash flow  
  10. Short-term and long-term loans 
  11. working capital 
  12. asset growth 
  13. new investment 
  14. financial ratios 

This list is even longer. In fact, each sector has its own separate list. For example

For the Retail Industry:For Oil & Gas Industry:
total number of stores average sales per store sales per square foot merchandise margin company store-to-franchisee ratioOil and Natural Gas Revenue Ratio exploration costs oil inventory developed Reserveincrease in total product 

In the next few chapters, we will try to read and understand the figures given in the annual report, from the financial statement. You must be aware that the financial statement is the main source of all the data and the data derived from here is analyzed.

Main points of this chapter 

  1. A trader and an investor have different ideologies.
  2. An investor has to make his ideology that of an investor only then he can invest well.
  3. An investor should stay invested in the market for a long time only then he can take advantage of compounding.
  4. The rate of doubling of money increases more rapidly with the length of stay invested. The longer you stay invested, the more you reap the benefits of compounding.
  5. Every investment should be judged against the quality and statistics of the company.
  6. The investigation of quality issues does not require data, but information about the company.
  7. To collect information related to the data, the available data of the company has to be examined. Financial statements i.e. financial statements are its most important source.

Poonit Rathore

My name is Poonit Rathore. I am a Blogger, Content-writer, and Freelancer. Currently, I am pursuing my CMA final from ICAI. I live in India.

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