Investing in share market

Investing in share market

I assume everyone has heard about stocks and the share market. For those who may not be aware, here is quick overview:

Let’s take the example of Reliance Industries. When it was formed, Dhirubhai Ambani and his family privately owned 100% of the company. They sold a certain percentage to the public to raise funds, which they used to grow the company.

A stock or a share is a fractional ownership of the company. Let’s assume the Ambani’s had 100 shares of the company. Now they sold 10 shares at Rs 100 each to raise Rs 1000 in the form of new capital.

If you bought 5 shares, you owned 5% of the company. With Rs 1000 that the Ambani’s raised, they grew the revenues and increased the profits of the company.

As a 5% shareholder, you are entitled to 5% of the profits of the company. Some companies pay a part of the profit to shareholders in the form of dividends.

Some companies retain the profits and invest them back in the business to grow it even further.

As an investor, you are primarily concerned with two things – the price of the stock. You would prefer to see going up year on year and the dividends declared by the company.

So how is the stock price of a company calculated and why does it go up and down.

The share price of a company is affected by three primary factors:

1.) Return on investment.

2.) Cost of capital.

3.) Growth prospects of the company in the future.

The basic idea is that stock prices go up year on year as the company grows and makes more profits.

The stock of Eicher Motors represents one such example – In the year 2004, the stock price of one share of Eicher Motors was Rs 22. After 13 years, the price of one share has reached ~Rs 25,000+. Eicher Motors is able to deliver this phenomenal performance due to superior return on its investments, low debt levels and extraordinary revenue growth.

Investing in quality stocks is one of the best ways to grow your money over a period of time.

So why are some people afraid of investing in stocks?

You must have heard some folks in your social circle say stuff like, “Oh, stocks are very risky, don’t invest in them” or “Investing in stocks is like gambling, put your money in safe assets” or “There are no guarantees in the stock market. Invest in real estate – their prices will only rise.

Yes, stocks are a risky asset class and you can lose almost all your money if you don’t invest your money carefully.

The chances of you losing money arise from 2 scenarios:

1.) You buy a stock of an unknown company based on a tip thinking the stock price will rise. However, the stock price falls and if you need money, you will need to sell it at a loss.

2.) You invest in quality stocks for a short-term period – and due to a temporary fluctuation in the indices, your stock prices may be down – but since you need the money, you may be forced to sell at a loss.

Remember, when you buy stocks, you are actually buying a very small piece of the company – and if the company does well, your stock price will go up.

Now companies don’t grow in one day. They take years to grow. And the same logic applies to shares.

Think about it – do the revenues or profits of a company rise every day or even every month?

Not really right – and since a stock price is supposed to be a function of future growth, but since revenues cannot double every day, why do you expect the stock price to rise and continue rising every day?

Yet, this is what day traders in the stock market hope to achieve – because the prices of stock fluctuate on a daily basis – which they aim to beat.

As a long-term value investor, you should be investing in fundamentals and long-term potential of value stocks instead of short-term movements or forecasts by experts on TV.

If you are a first-time investor and are interested in buying stocks directly, I recommend you first wait, learn more about the process and then take baby steps.

If you wish to pursue this as a hobby or out of interest, I recommend you allocate no more than 5 to 10% of your total liquid net worth to buying stocks directly.

Four pillars of stock investing

Four pillars of stock investing

“Is it the right time to gain equity exposure ?” The answer depends upon the investment portfolio you want to structure.

For a diversified portfolio (mutual funds and ETFs), you need to wait till the euphoric sentiments cool down. For a concentrated pool of equity, there is no right or wrong time to invest in equity market.

Investing and making a return in direct stock investing is an exercise that combines finance and behavioural skill.

The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. You only find out who is swimming naked when the tide goes out – Warren Buffet.

With respect to direct equity investment, there are four pillars of value creation:

  1. The core-of-value principle establishes that value creation is a function of returns on capital and growth.

  2. The conservation-of-value principle says that it doesn’t matter how you slice the financial pie with financial engineering, share repurchases, or acquisitions; only improving cash flows will create value.

  3. The expectations treadmill principle explains how movements in a company’s share price reflect changes in the stock market’s expectations about performance, not just the company’s actual performance (in terms of growth and returns on invested capital). The higher those expectations, the better that company must perform just to keep up.

  4. The best-owner principle states that no business has an inherent value in and of itself. It has a different value to different owners or potential owners. A value based on how they manage it and what strategy they pursue.

Ignoring these cornerstones can lead to poor decisions that erode the value of companies.

An intelligent investor will do his analysis, find out the true value of the business and then decide whether the asking price is justified. Anyone who does not follow this process is just speculating in the stock market.

Do not get caught up in the euphoria of a rising or declining stock market. Do your own due diligence or consult an investment firm that can perform the analysis on your behalf. 

Do not try to answer “is it the right time to invest in the stock market” but rather “is it right for me to invest in the stock market”.