Value Investing – An Exhaustive study
WARNING: This is a really long post and meant for really serious beginners who actually want to succeed in the share market and are ready to put in the efforts that it really takes to succeed. Casual market participants or people who are reading this in anticipation of some “tip” can immediately stop reading and switch on some business channel.
Before I start, I’d like to lay down the objective of writing this exhaustive post. The objective is to make you aware of some harsh realities that inhabit the world of share market and then draw the basic outline of the ways that one can choose to succeed in this otherwise confusing territory. So, this post will cover everything from what is a share market, why does it exist to what does it take to succeed here. Please also note that though I will touch a variety of subjects in this post for the purpose of conveying the message but I will not go in depth of each individual topic as every topic is a subject of a separate post in it.
Every man who is earning some discretionary money either from a job or a business, sometime in his life, gets attracted to Share Market for sure. Most of the people don’t know a bit about the market and its complex ways but surely want a bite out of it. They feel as if market is a big casino and they are smart enough to take the money home. The reason for such allure and glamour is the desire to make easy money. What stimulates the mind more than the idea to make boundless amount of money and that too just by clicking the mouse and pressing some keys on the laptop? Most of the people enter the markets thinking that it will fulfill all their dreams; that big house, that fancy car, those foreign trips, freedom from boss’s scolding and what not. In their perception, share market breaks all the conservative rules of money that people have grown with. In real world, one has to study hard, get good marks and get a job to make money or to struggle for years to establish a business. That’s how money is made in real world. But share market seems to be a wonderland, a fairy world where all one needs to do is to open an account with a broker and money rain starts. Needless to say, more than 90% of people who enter the market lose their shirts.
The stock market or most commonly known as the Satta Bazaar is the easiest way to lose money and the hardest way to make money. Yes, that’s the truth. So, if you want to be in the share market to make easy money, my sincere advice to you will be that please get out of it immediately and focus on your job or business. That will give you better returns and save you from the heartache later. The blunt truth is that majority of people who participate in the market are not fit to do so.
Most of the people who enter the markets have no idea about what investing means and how it is different from trading and dance on the tunes of their brokers only to fall flat on their faces sooner or later. Everyone has their own assumptions about the market and its ways but they don’t actually know the real thing. So, first thing first, let me tell you the fact that Share Market is a very dangerous place filled with the most sharpest and brilliant minds. And the moment you decide to enter the market, you actually get in competition with those brilliant minds and shockingly, you also expect to win. The market is like a vast ocean with no ends, filled with sharks and other dangerous creatures. And you are like a tiny fish struggling to have your pie from the ocean. In fact, you are so small that you are not even a fish, rather a micro water insect. So, you can understand the kind of odds which are stacked against you.
So, definitely you need some tools and resources to find your way in this financial jungle. This is where once commits three biggest mistakes rather blunders. Firstly, the new entrant assumes that his mentor is his broker and it is the fiduciary responsibility of the broker to fulfill his dreams. He fails to understand that on a very basic level itself, there is a conflict of interest between him and his broker. And that is, that broker’s income does not depend upon his making money. Secondly, he looks around and perceives that most of the people who are in share market, read business newspapers and watch business channels on TV.
So, thinking that this is the way to fulfilling his goals, he also starts indulging in those intellectual activities. He forget one simple thing that if it was really so easy that watch news and follow what they tell you to, then everyone would be raking in money but this is not happening if you see around. And thirdly, new entrants get caught in the grip of endless number of tipsters who offer sure shot money making tips in lieu of some money. In fact, experienced people also fall in this trap. They fall for it without thinking that it was really so sure shot then why is the seller selling his advice and why not he uses his own advice himself and become a millionaire. If you are reading it and visualizing yourself committing all these errors, then my friend, I have written this thing for you.
So, you may ask, what must one do in order to achieve Nirvana in share market?
The one and only answer is, “DEDICATE YOURSELF TO LEARN CONTINUOUSLY & ATTAIN KNOWLEDGE”. Trust me, there is no other way to succeed. Even here, people commit the mistake of confusing information with knowledge. They read business standard, economic times etc., and think it is making them knowledgeable. The fact is, that they are just dumping information inside themselves and no true knowledge is being absorbed. I will come to this point later on. But, before I do that, let me come onto the very important concept and that is the distinction between investing and trading. Those who already know can read it again to cement their existing knowledge and those who don’t know must read it very carefully. I am getting to very basic concepts because there are many who don’t know it but are shy to accept it.
This is something which concerns a lot many people in the market. Majority of people don’t know their orientation whether they are a trader or an investor. But to know that, one must first know the difference between them. And to explain that difference, I’d have to give a basic idea about why share market exists.
Primarily, the share market exists because a business needs money and it does not want to take loan or debt. So, the business (company) decides to take money from people to fund their activities and in return they make the people, owners of the business. To bring more clarity, a company divides itself into shares and each share is worth some money and total value of the shares is the total value of the business. So, the promoters keep a controlling number of shares and distribute the rest among people and take money from them. This happens at the time of IPO (Initial Public Offer). So, if the company decides to break itself into 1000 shares. And the promoters of the company decide that the value of their business is Rs 1 lac. So, theoretically, each share will be priced at Rs 100. The promoters decide to keep 500 shares with themselves and distribute the balance 500 shares among people so as to raise money from them to finance their business. So, they will sell 500 shares in the primary market (IPO) and collect Rs 50000 (500 X Rs 100). Assuming that, each person bought 1 share and a total of 500 people bought shares of the company, 1 share each. So, effectively each person financed Rs 100 to the company. Now, since the company’s total worth is Rs 1 Lac, each person will become 0.1% owner of the company. And since, each of those 500 people own 0.1% of the company, collectively they own 50% of the company (0.1% X 500).
Remember, the shareholder has not given any loan to the company. He has become an owner in the company against the money that he paid so the company as such does not owe him anything. But since the person has become an owner of the business, he is looking forward to make money from the business. And the two ways through which he can make money are capital appreciation and dividend. As the name suggests, capital appreciation is when the capital that a person has invested in the business, appreciates.
Now, how would that happen? If you recall that when you invested Rs 100 in the business, the business was valued at Rs 1 lac and you became 0.1% owner of the business. Now, imagine if the value of the business increases to Rs 10 lacs, then since the total number of shares are 1000, the value of each share will rise to Rs 1000. So, the share which you bought at Rs 100 would now be worth Rs 1000. This is the theoretical concept of capital appreciation. The company may also choose to reward its shareholders through dividends. A dividend is an amount that company pays back to the shareholders from profits. A company may or may not give dividend as it is not mandatory. So, capital appreciation happens when the overall worth of the company increases and thus the value of your share also increase and dividend is an amount that you receive out of the profits of the company if the company chooses to do so.
What you read just above was the basic outline concept of IPO. It is also called primary market. But the share market that we talk about is not primary market. It is secondary market. So, what is it? The moment a company collects money from its first shareholders and allot them ownership, the shares of the company are listed on stock exchanges. By this I mean that now people can trade these shares between themselves without any involvement with the company per se. So, when we talk of buying or selling shares, we buy shares from the people and sell it to the people rather than buying it from the company and selling it back to the company. You may think that why is secondary market required? Imagine that a shareholder, has taken ownership of the company by buying a share of the company.
Now, his money is practically blocked because he has become an owner and he can’t just take money of the business at his own whim. If he is allowed to take money back from the company, how will the business run? So, to bring liquidity to the shareholder without disturbing the finances of the company, the concept of secondary market exists. So when we talk of share market, we generally mean secondary market, where people trade shares between themselves and not with the company. So, if you have bought the shares from the company in primary market and given money to the company, you can sell your shares in the secondary market if you are in need of money.
By selling, you are just transferring the ownership rights (0.1%) of the company to someone else. The company does not come into picture anywhere. So, to summarize, the share market is divided into two parts, primary market and secondary market. A primary market is where the person gives money to the company directly and the company allots him the shares of the company as per his invested capital. This happens at the time of IPO. The secondary market is where the shareholders can trade these shares between themselves. Now, since you understand the overall rough structure of the animal, let’s move onto investing vs trading.
See, practically speaking, there is no difference between investing or trading. Investing and trading both involve buying and selling of shares. But, conceptually and ideologically they are oceans apart. Some people bifurcate trading and investing based on time. They think that if you hold a share for short time, it is trading and if you hold it for long then it is investing. It is completely wrong. In fact there can be very short term investments and there can be very long term trades. So, what is investing and what is trading if holding time is not the decisive factor? The difference lies in approach not the time.
Investing is when you buy shares of the company with the perspective of becoming part owner in the business. So, you think like an owner thinks. You focus on the business. This involves knowing the business model, knowing its products; it’s target customers, product pricing, margins, employee structure, manufacturing process, debt status, promoter’s profile, competition and so on. An investor views a share as a token of part ownership in the actual business whose value will increase based on the growth of the business. So, it aims at ‘knowing’ the business in and out. Investing focuses on the business rather than the market. The study of understanding a business is called ‘Fundamental Analysis’. There can be different types of investing; the main categories can be value investing, growth investing and special situation investing. Though these are subjects of a separate discussion altogether, I will just give a bird’s eye view of all of them.
Value investing is when you aim to buy the share of a company for less than it’s actual value. What does it mean? See, there are two things, price and value and both are two very different things. Price of a share is what a share is being traded at in secondary market and it is decided by the forces of demand and supply. Value of a share is total value of the business divided by total number of shares. There can be huge deviations between price and value and a value investor aims to take advantage of those deviations or irrationality. For example, you analyze a company’s business and everything and come to a conclusion that a business is worth Rs 1 Crore and since there are 1 Lac shares of the business, each share is worth Rs 100/-. But you find that in the share market (secondary market), the share of that company is being traded at Rs 20/-.
You may ask why would it ever happen? See, there can be hundreds of reasons for this gap. As I told you, a share is priced by the forces of demands and supply not by the actual value of the business so sometimes due to people’s sentiments; shares are mispriced in the market. That may happen due to some temporary bad news or a bad quarter result and so on. So, a value investor keeps himself busy in finding out value of as many companies as he can and he buys those shares when the market offers the shares at a discount to the original value of the share.
A value investor does not care much about what market does on daily basis. He is focused on analyzing businesses and finding out their true values and waits for the market to make a mistake. It is a very tough form of investing and you need razor sharp business analysis skills. You need to be able to understand a variety of businesses and then extracting their true values. Valuation is one of the most difficult endeavor in the field of finance because it involves valuing company’s assets, liabilities, future profit/losses, cash and so on. It also involves huge amount of patience because sometimes, market can take a long amount of time to reconcile both price and value.
Also note, that a value investor sometimes sacrifices quality in search of value. So, let’s say a business whose true value is Rs 100/- per share but the share is available at Rs 10/-. The value investor will buy that share even if he knows that it is a pathetic business and going to get bankrupt. He will calculate bankruptcy value of per share and if it is more than Rs 10/-, he will not be apprehensive in buying the share. Few notable value investors are Warren Buffett, Charlie Munger, Howard Marks, Seth Klarman, Mohnish Pabrai, Sanjay Bakshi etc.
Growth investing is when an investor studies all the aspects of the company and its business like a value investor does but he is ready to buy the share for more than what it is worth. He does it because he is thinking that the value of the business will rise in the future due to whatever reason he thinks, be it rising profits, competitive advantage or some government policy. So, though the growth investor indulges himself in fundamental analysis like the value investor but he is not obsessed about buying it cheaper than its worth. An example would be that the actual value of a share is Rs 50/-, based on total value of the business. But in the market, the share is being traded at Rs 80/-. Definitely, a value investor will not buy it but a growth investor might buy it for Rs 80/- if he thinks that the company has a potential of growth and in few months or years, the true value of the share will become Rs 200/-, let’s say. Few notable growth investors across the world are Warren Buffett again, Late Philip Fisher, Peter Lynch, Rakesh Jhunjhunwala, Basant Maheshwari (India) and so on.
Special situation investing is when an investor invests in the shares of a company based on some special change that is going to happen in the company. So for example, if an investor figures out that a company is going to acquire another company or going to get merged with some other company or going to spin-off it’s business in some other company and so on, and that the value (worth) of the business will rise post that change, the investor buys the shares of that company. Please note that here neither he is investing because he is getting the company cheap, not he is investing because he feels that company has huge growth prospects, but he is investing because he feels that the per share value of the company will rise due to some event. Warren Buffett, over his career, has played a number of special situations.
Also, note that all the great investors employ a combination strategy based on value, growth and special situations. They do not hard-wire themselves into either of the category. Sometimes, investors change their style overtime. For example, Warren Buffett started his career as a hardcore value investor but then under influence of Charlie Munger, he became a Value cum growth investor.
So, I hope now you have a fair idea of what is investing. To summarize, investing is buying shares of a company with the vision of its actual business. And to do that, an investor performs fundamental analysis of the business.
Trading on the other hand is not about analyzing the company. It’s about analyzing the price of the share. It’s about analyzing the demand and supply situation of the share of the company. It involves forecasting the future share price by analyzing what market thinks about the share of the company. Now, how do you do that? To do that, traders perform Technical Analysis. Technical analysis involves analyzing the data of people’s buying and selling of a company’s shares. By plotting the data of the company’s share on the chart and using a variety of statistics, one can understand whether there is any demand for company’s share or not. One can also find several price trends, momentum, formations, structures and patterns which help to gauge the sentiment of the market and thereby forecast the price movement. Just as there are different investment strategies based on fundamental analysis, there can be different types of trading as well. But, majorly trading can be of 3 types namely intra-day trading, swing trading and positional trading.
As the name suggests, Intra-day trading involves buying and selling of the shares of the company on the same day. It involves forecasting very small movements in the price of the share based upon study of charts, order flow (demand and supply) and other factors.
Swing-trading involves buying and selling of shares over a small period of time, lets say 1-2 weeks. Positional trading involves forecasting long term trends and then trading based upon them. It can be for duration of 1 month of 6 months or even more.
Also, remember, that one can trade both in shares and other tools such as futures and options. I will cover the basics of futures and options in some other post. But, just remember for now that all three types of trading (intra-day, swing and positional) can happen in shares as well futures and options.
All in all, trading is aimed at buying and selling shares of a company based on the understanding of market’s behavior and demand/supply situation of the share and not based on the business of the company or its value. So, if price of a share is Rs 100/- and a trader feels that there will be demand of the shares of the company due to whatever reasons and people will want to buy the share even above Rs 100/-, he buys the share to sell at a higher price. He does not care what the company makes or what its profits are and so on. Several notable traders are Paul Todor Jones, Marty Schwartz, Ed Seykota, Michael Marcus, Ray Dalio, Richard Dennis, Late Jesse Livermore, Rakesh Jhunjhunwala and so on.
So, as you saw, the only difference between investing and trading is of approach. Both activities involve buying and selling of shares. But the difference lies in the reason of buying and selling those shares. An investor buys or sells based upon the business fundamentals and valuation and trader buys or sells based upon the demand and supply of the share in the market. As I said there can be short term investments and there can be long term trades, here is an example. For example, a company is going to get bankrupt, and an investor calculates that in bankruptcy, when all the assets will be liquidated and all the creditors will be paid, the per share money that will be left in the company will be Rs 100/-. And he sees that the share is being traded at Rs 30/-. He immediately buys the stock. He sells it when his target is achieved even if it happens in 15 days or 1 month. But this is not trading; this is pure investing as it is based upon a business event. Similarly, let’s say the share of a company is at Rs 100/- and looking at the long term demand-supply data, a trader forecasts that the share will rise to Rs 200/- in an years time. Now, let’s say the share reaches Rs 200/- in 1 year, the trader will sell the shares and pocket the profit.
Please notice that even though the selling happened after one year of buying, it is not investing but it is purely trading because the decisions were not taken based upon business fundamentals but on demand and supply of the share. So, most of the people that you see around yourself who call themselves investors are actually traders. Buying shares of a company just because its quarterly result is going to be good is trading and not investing. The reason it is trading is that you are basically theorizing that since the results will be good, the demands of the shares will be more hence you are buying the shares. So, even if no technical analysis is done, it comes in the category of trading because the focus in on demand and supply of shares and not on value of the business.
With this I hope, you have a fair idea of investing as well as trading. Now, let’s talk about the skills it requires to become a successful investor and trader. If I say that investing and trading are world’s most difficult businesses, it will not be an over-statement. The greatest investors and traders are world’s best minds. One of the reasons that it is the most difficult profession is that there is no linear path to become a great investor or a great trader. Just as to become a doctor, there is a defined path; there is not defined path to become a great trader or an investor. Due to absence of a clear path, the whole thing gets immensely confusing and difficult.
Though I will discuss traits of successful investors and traders separately, but first I will talk of a trait which is common to both investing and trading. That one trait is reading. Warren Buffett himself said that he owes all his success to just reading. Now, you would say, of course I read economic times, so I am a reader. No sir, that does not count. Reading involves continuous learning of concepts not information. You must know a variety of concepts in order to extract crux of any information. For example, if you read in a newspaper that US fed decides to do quantitative easing. It will be a complete waste if you don’t know the concepts of quantitative easing, US monetary policy, its history, its effect on India, political and business ties of US and India and so on. So, information will only make sense if you fit it in framework of concepts. And concepts, my friend, are infinite in this field. So, unless one dedicates himself to continuous learning, forget success in this field.
Now, coming on to specific traits for becoming a successful investor. To become successful in investing, one must be fluent in fundamental analysis. That means one must have thorough knowledge of accounting, finance, valuations, business models and so on. Just knowing that a company’s quarterly results are good and investing in that company, is sheer betting and not investing. An investor knows the business as its true owner. He knows in and out of the company and its finances. He must be able to forecast business trends.
To do that, he must be learned in fields of economics, politics, finance, business administration, business law, and government policies and so on. So, being an investor means being a dedicated learner. One cannot just take investing as a hobby. The second trait that is required for successful investing is patience. Since an investor is betting on business fundamentals and business fundamentals do not change overnight. So, an investor must learn to be patient. The bottom-line is that investing is a serious business and it needs immense amount of diverse skills to be able to dissect a business and find its true value. News is not knowledge. News is information. To be able to dissect the news, one needs knowledge and that will come through diverse reading.
Now, coming onto trading. Trading looks very glamorous from outside and majority of people who enter the markets are attracted towards trading. They think that unlike investing, it is quick money. Nothing can be farther from the truth. Since trading involves forecasting demand and supply of shares, one needs immense statistical and mathematical skills. Also, one needs great psychological skills to observe crowd’s behavior. I have been an investor, I have been a trader and trading is an immensely difficult way to make money. Apart from skills of technical analysis, mathematics, statistics, trading involves immense amount of emotional discipline and money management skills. Investing is little forgiving in nature. You can make mistakes as an investor and still survive but even a single mistake in trading can make you bankrupt. Thus, trading requires sharp mind, agile instincts and fast analytical skills. And it becomes all the more difficult when one has to apply all these skills while being detached and unexcited. Technical analysis on the face of it looks very simple to a lay man who has the impression that one can learn just by reading a couple of books and you are ready to trade with its help. That is where all are mistaken.
As I said, there is no formula, there are just perceptions. So, you have to read a concept from 10 different places and then think over it continuously like a maniac so as to develop a theory in your mind. Then you need to practice that so hard that it becomes a second nature. If you ask me, read at least 5 good books on trading. Read, learn, study, live it for a while and after that you may test waters in the stock market as a trader. Technical analysis can be your gateway to freedom, the stairway to success, the road to financial freedom. But, it’s a long winding road filled with a lot of obstacles. In order to be a successful, you need to slug it out, work hard, burn the midnight oil, read, read and read and when you think that you have read enough, you take a pause, recap what you have read and then read some more, seeping in all the knowledge, let the books take control of your mind and let your brain become an encyclopedia.
To put it in short you have to put in HARD-WORK. If you don’t have this quality, then don’t ever think of trying to indulge in trading. Then comes the time to put in action all that you have learnt, jumping in the sea to swim with the sharks. The initial trades will be a sort of test for you to realize how much of whatever you have studied has been retained in your mind and here you will realize the most important aspect of trading. And that aspect is the control of your EMOTIONS. Each book that you have read would have taught you how to enter a trade, put in stop loss, place your targets etc. But no book will train you to control your emotions whilst trading. This process will have to be learnt by YOURSELF. This is the toughest aspect of trading. I have seen even the best of chartists fail miserably here. There are so many technical analysts who fail in real trading. The only reason is that they cannot supply the mental discipline required to make money. All efforts of learning and understanding will come to zilch if you don’t control your feelings.
Being ruthless in cutting short your losses, booking profits at targets or when patterns change unpredictably during an intra-day trade, all emotions have to be kept at bay. The urge to hold on a losing trade leaving it to hope and faith, these are all been there, done that, by successful traders who have overcome failure. Failure should be meant as a stepping stone to success, learning from mistakes, going back to the drawing board to see what went wrong, introspecting, realizing the mistake and coming out wiser from it. Successful traders prepare themselves on a war footing basis, day in and day out. Short listing probable scrips, timing of entry, target, stop loss, putting in trailing profit and so on, these are the preparations that a trader makes each day, and the weapons used by trading warriors are modern day computers and software, high speed internet, because you cannot win a war with outdated arms.
If you are not a master of all these things, you are most likely to succumb to your losses. So to put everything in a nutshell, trading is solely for brave-hearts. If you have the courage to do consistent hard work, learn, study, and affinity to reading books, have the will and determination to overcome failure, wrestle with your emotions, have an open mind, are willing to learn and read books throughout your life, have a consistent thought process, are patient in character, can face untold difficulties, have the fighting spirit, determination to learn new things daily, are consistent in your approach and most important have a good mentor to guide you; hands down you will turn out to be a winner and an expert in trading.
The reason most people fail at trading is not that trading in itself is bad. It is because trading is one of the toughest task that you will ever undertake. Looking at the kind of traits that are required to become a successful trader, you must have understood this fact. But what is it that makes trading more difficult than investing? See, investing is not a zero-sum game. In investing, everyone can win. But in trading for one to win, the other has to lose. So, the competition is fierce in trading. So when you put on a trade, long or short, you don’t know who are you competing against. And as I said, trading field is filled with geeks, nerds, avid and voracious readers and genius people and you don’t stand a chance in front of them if you don’t sharpen yourself day in day out.
I am sure; majority of people would not have chosen to read this long post. Out of those, who dared to read, majority would have stopped reading in between. But those, who made it till here, you have it in you. Trust me, to become a successful trader, you would need to read 10 times more than the length of this post, per day.
So, stop looking for tips because tips are mostly pits. Stop looking for someone who will make you rich. The truth is nobody can. The only person who can help you is the one in the mirror. So, if you really want to become a serious trader or investor, dedicate yourself to continuous learning and thinking. If you do not identify with the traits mentioned above, trust me, you will be better off focusing on your job or business than share market.
And, on your journey, I assure my support and cooperation whenever you require so.
Below are the books which can start you in the field of investing/trading:
- Class XI and XII accounts books
- The Intelligent Investor by Benjamin Graham
- Security Analysis by Benjamin Graham
- One Up On Wall Street by Peter Lynch
- Common Stocks and Uncommon Profits by Philip Fisher Bruce Greenwald
- Accounting For Value by Stephen Penman
- The Most Important Thing by Howard Marks
- Thoughtful Investor by Basant Maheshwari
- Stocks For The Long Run by Jeremy J. Siegel
- Berkshire Hathaway letters to shareholders
- Technical analysis of financial market by John J. Murphy
- Candlesticks by steve nison
- Trading for living by Alexander elder
- The disciplined trader by Mark Douglas
- Reminiscences of a stock operator by Edwin Lefevre
- Market wizard series by Jack Schwagger
- Mind over market by Mark Douglas
- Trading beyond matrix by Van tharp
- Trade like a casino by Richard Weissman
- How to make money in stocks by William o neil
Yes, you have to read so much. I have just stated 10 books in each department, trading and investing. If you ask me, there are hundreds of them out there that would need to be read in order to become an expert. But reading these 20 books will make you free for life. That’s a promise.