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How Do Companies Cook The Books?

Financial statements are one of the widely relied upon tool to analyze a business. However, there are many ways in which companies cook their books and create a false impression of the company’s financial health using accounting gimmicks and financial shenanigans. In this post, we are going to look at how companies cook books and how you can identify such financial shenanigans using accounting red flags.

If you look into the past, you will find that cooking books is not a recent phenomenon, but has existed for a long time. We all know one or the other company which has resorted to accounting gimmicks to dupe investors into believing that the company is doing well. Each market has its own share of such “gutsy” companies which, instead of genuinely improving the business, resorts to cooking books to show improved performance.

Why Companies Cook Books?

The question is, why do companies need to cook books? Why does the management resort to such gimmicks instead of being honest with their investors? Well, cooking books is not just about looking great on paper, some of the common reasons why companies do so are explained below:

1. To meet or exceed market expectations:

Let’s honestly admit one thing, the world is a fiercely competitive place and everyone wants to be on the top of their game. Miss the mark by a few points, and the company’s stock price gets hammered badly by the market.

With ever intensifying competition and “Go big or go home” thinking, the management of every company is pressed to either beat or at least meet the growth expected by the market.

With such mounting pressure to perform, companies that fail to deliver as per expectations, often get involved in cooking books and create a false image of healthy growth.

2. Vested Interests of the Management:

The second reason why companies cook books is because the management has its own vested interest behind it. Nowadays, many companies offer share price linked incentives to their managers.

Such schemes are offered to align the interests of the shareholders to that of management so that both can benefit from the good performance of the business.

Incentives linked to the share price motivates the managers of the company to work harder and deliver a good performance.

When the times are tough, and business struggles to perform, top managers, driven by greed of incentives and fear of being penalized for poor performance start window dressing the accounts to paint a rosy picture of company’s performance.

3. To show a consistent growth rate by under-reporting current spurt of growth:

This is something that does not happen pretty often, but there are times when companies do under-report their financial performance. Why? Let me explain.

Investors love companies with strong consistent performance and growth, and company managers know this very well. There are some companies that have a seasonal business, where they perform well when times are favorable and do poorly otherwise.

Such companies during good times minimize the current earnings by under-reporting the revenues or by inflating current period expenses by postponing good financial information for the future period when the company is more likely to underperform.

This again creates an illusion for investors that the company has performed well compared to its peers even during tough times.

As a result, such companies command higher valuations which they do not actually deserve.

How Companies cook books?

Management of the companies may have different reasons behind cooking books, but the way it is achieved has hardly ever changed.

The only way management of the companies can manipulate books is by concealing information, in other words, by hiding it in places where it is difficult to detect easily.

So how do companies cook books? Well, as I said earlier, it’s all about hiding crucial information about the company within the financial statements so that they are not easily traceable.

There are only three ways a company can manipulate earnings, by manipulating earnings, profit, and cash flow.

1. Earnings Manipulation:

Earnings manipulation occurs when companies try to inflate (or in some cases, hide) their earnings such as revenue. There are two ways companies manipulate their earnings.

— Recording Revenue prematurely: Booking revenues in advance is one of the most commonly used financial shenanigan by the companies. It includes booking revenues even before the goods are sold or a project is completed.

An example of such premature recording of revenue was seen in Sobha Developers in 2008-09. In Q1 of 2008-09, Sobha Developers decided to recognize the revenue earlier during a project cycle. This led to a 20% jump in the company’s profits before tax.

— Recording income from investment as revenue: The second most common way to manipulating earnings is by recording revenue from other sources as operating revenue.

If proceeds from the sale of an asset (such as land, building, plant, and machinery) or income from an investment (such as maturity of a bond or proceeds from the sale of shares) is recorded as revenue, it will boost the total revenue of the company.

Since these are a one-time phenomenon, and cannot be repeated in the future, recording such one-time sources of revenue gives a false impression of improved financial performance.

2. Profit Manipulation:

Profit is considered to be the blood of a business, something which is necessary for the survival and prosperity of a business. Just like revenue, even profits can be manipulated in many ways.

From hiding expenses to making a simple change in the way in which depreciation is calculated, there are numerous ways a company can manipulate its profits numbers. Some of the most common ways companies cook books in terms of profit are as follows:

— Making expenses look like earnings: A simple change in accounting policy can have a significant impact on the way profits are presented. Many companies use this approach to manipulate Net Profits.

For example, a simple change in the way depreciation is calculated can change the entire picture, helping company management boost profits.

For Example, a small change in depreciation policy in case of Jet Airways created profits out of thin air. In the Q2 of 2008-09, Jet airways changed its depreciation policy from written down value method to straight-line value method, as a result of which, Jet Airways was able to write back ₹920 crores to its Profit and Loss account.

— Hiding Expenses as Capital Expenditure: Another way to boost profits is by treating expenses as capital expenditure; that is instead of treating it as expenses during the current financial year, it is treated as investment made to expand the business.

One such incident can be found in the USA, wherein the years 1990, AOL was found guilty of delaying expense.

AOL was distributing installation CDs as a part of its marketing campaign, but instead of treating it as an advertising expense, AOL decided to view it as capital expenditure. As a result of this, the entire amount was transferred from profit and loss statement to balance sheet of the company where the campaign would be expended over a period of years.

Because of AOL’s treatment of expenses as Capital Expenditure, the entire amount was written off the P&L Statement, which resulted in boosted profits.

3. Cash Flow Manipulation:

Cash flow is considered to be the most reliable source of the true financial health of the company for the simple reason that cash is difficult to manipulate. Investors like Warren Buffett rely heavily on numbers like free cash flow to assess the financial health of the business.

Since companies know this well, they have devised new ways where it is possible to manipulate the cash flow of a company using accounting gimmicks.

Detecting such tricks can be quiet challenging for an amateur investor who does not have a deep understanding of accounting and finance or does not have free time to go through the books of the company.

Some of the most common cash flow related financial shenanigans are explained below:

— Showing financing cash flow as operating cash flow: There are two ways a company can generate cash for itself, first, from its own business, where profits earned by the business get converted to cash, and second by borrowing cash from an external source in the form of loan by issuing bonds or bank loan.

The cash received from business operations is called Cash Flow from Operating Activity, and cash received from an external source is treated as cash flow from financing activity.

Many companies try to boost their operating cash flow by treating financing cash flows as operating one, which leads to a wrongful impression that the company is generating a lot of operating cash flow from its business.

— Using acquisitions as a boost to operating cash flow:

Cash flows can also be manipulated using mergers and acquisitions, especially if the target company is rich in cash.

Management often tries to win support from its shareholders by convincing the shareholders that a particular acquisition will be highly beneficial for the company.

As soon as the merger takes place, all the cash that belonged to the target company, now becomes a part of the parent company, thus boosting overall cash flow statements.

Investors must always be wary of the financial history of the target company and its business and find out if the merger is really going to benefit the business.

If an acquisition is happening just because it will boost the EPS or the cash flows of the parent company, with no meaningful benefit to the business, then such acquisitions must be avoided at all costs.

Some Additional ways companies cook books:

Cooking books is not limited to manipulating earnings or hiding crucial details about the weak performance of the company, management of companies go beyond the books and create their own parameters of measuring the growth and performance of a company.

Such parameters, though necessary in certain industries, are still non-standard as per the accounting standards. Because of such creative parameters, managements get an opportunity to change their definition of performance as per their requirements, allowing them to use creative methods to put encouraging but false performance numbers in front of investors.

Some of the examples of such no-standard parameters are explained below:

— Same Store Sales (Used In Retail Stores and Restaurants):

Same store sales is a parameter to measure the performance of retail stores. It gives information about how much sales revenue a store is generating during a fiscal year or more.

Same store sales also give investors an idea of how much revenue a company is generating from its existing stores and how much is contributed by new stores. If the percentage of sales revenue from new store sales is rising, it’s strong evidence that new stores are performing well, sounds rational, right?

This is where companies get a chance to manipulate with numbers without getting noticed. The management of the company may alter the criteria of eligible stores to be used in the metric.

For example, in one financial year, a company may use only those stores older than 3 years to show the same store sales performance while in the next year, if the performance of the stores older than 3 years deteriorates, the management may change the criteria and use only those stores that are older than 5 years.

Companies may keep changing their eligibility criteria as per their suitability to present the desired picture.

— ARPU (Average Revenue Per User):

ARPU stands for Average Revenue Per User and is a performance metric generally used by Telecom companies or DTH service providers. Just like same store sales, ARPU can also be used for manipulating earnings of a company.

Most telecom companies, especially in this age of smartphones, not only generate revenue from selling data, but also by selling ad space, and this is where the manipulation begins.

The right way to calculate ARPU is by calculating total revenue generated from data services provided divided by the total number of subscribers.

However, some companies, to show encouraging revenue growth add advertising revenue to the revenue from subscription, thereby falsely boosting the total ARPU.

How to detect if a company is cooking books?

So far we have seen why and how companies cook books, but the biggest question is, is it possible to detect these financial shenanigans? How would you know that a company is cooking books?

While detecting some of these financial shenanigans requires a degree in finance, most of them can be traced pretty easily if you just observe carefully.

— Improved Revenue with an absence of Cash Flow:

If the complicated accounting terms are giving you nightmares, and you have no clue what to do, here is something very simple and logical thing you can do. Just Watch out for cash flow.

Increase in revenue of the company should be reflected with an increase in cash flow of the company. If you see operating cash flow declining or stagnant even if the revenue is marching upwards, or if cash flow is much slower than the revenue generated, it usually means that the company is generating revenue but is unable to collect cash, or even worse, the revenue numbers are simply fake and bogus.

— If Q1+Q2+Q3+Q4 is not equal to FY:

In an ideal situation, if the financial results are audited, the annual sales and profits should simply be a sum of all the four quarterly sales and profit numbers, except for minor variations.

If there is a significant variation between annual sales and profit numbers and sum of all quarterly numbers, you can say that the books have been manipulated at least to some extent.

— If a company is on an acquisition spree:

Companies make acquisitions as it helps the acquirers grow inorganically while making an acquisition, companies make sure that the interests of both the companies are aligned and that the resources that an acquiring company needs are available with the company that is being acquired, at a bargain price.

In simple words, any acquisition should add value to the company more than what is being paid for it. There are many instances when companies are on an acquisition spree. Firms that make numerous acquisitions can get into trouble, their financials get restated and complicated to understand.

Aside from complicating things, acquisitions usually increase the risk of cooking books and bury the evidence under many layers of financial statements. So if a company is a serial acquirer, but does not show significant improvement in its financial performance, there is a good chance that the acquisitions were made simply to manipulate the numbers.

— If the company has bulging Trade Payables:

Many companies, especially in a competitive, customer-centric market loosen their credit terms, attracting more customers to buy goods and services now and pay later. While this is a great move that helps boost sales revenue, it may create a liquidity crisis in a company.

Longer credit duration means that company has to wait longer for the revenue to be converted into cash, but since a company has to meet its daily expenses in cash form, longer credit means company may run out of cash and may have to either borrow to meet its operational expenses or shut down its operations completely.

The best way to cross-check if the company’s revenue is simply because of loose credit terms is to check if there is a change in days receivables in the past few financial years.

If a company has increased the receivable days, it shows that all the revenue is just on paper and the cash is yet to be realized. Such practice is pretty common in infrastructure companies.

— If the CFO and auditors resign or get fired:

This is by far one of the most vital signs that a company is cooking books. There is an old saying in Latin “Who Watches the Watchmen?” when it comes to financial reporting, the watchmen are the Chief Financial Officer (CFO), and the corporate auditor.

If you find a company that is involved in some of the suspicious accounting activities as mentioned above, and you see the CFO of the company quitting abruptly for no valid or logical reasons, its time to stand guard and find out if there is something going on within the company that has not met your eyes yet.

The same rule applies to corporate auditors. IF a company frequently changes its auditors or fires them after some accounting issues come to light, be watchful and look for warning signs.

There have been many recent examples of auditors resigning after altercation from the company owners, which later revealed that company was involved in dressing up numbers to make things look good on the surface while it was really bad inside.

In the month of May 2018, Deloitte, corporate auditor of Manpasand beverages quit a few days before the declaration of annual result as the company was unable to share crucial data regarding capital expenditure and revenue. As a result, the stock price of Manpasand beverages tanked 20% within a day. You can read the news by clicking here

Another such incident happened recently where PWC (Price Waterhouse Coopers LLP) statutory auditor of Reliance Capital and Reliance Home Finance, quit just before the declaration of FY19 results.

In its resignation letter, PWC stated that as part of the ongoing audit for FY19, it noted certain observations and transactions, which, in its assessment, if not resolved satisfactorily, might be significant or material to the financial statements. You can read the new by clicking here

Conclusion:

If you are looking for a great investment, look for great businesses. The best way to understand if a business id great or not is by analyzing the financial statements of the company.

Since every investor relies on financial statements for his analysis, it’s important that companies remain honest and transparent and give only authentic information.

However, with the ever-mounting competition, and a race to perform better than peers puts a lot of pressure on the management to perform, because of which they often resort to unethical ways to manipulate the number so that the business “appears” healthy.

There is an Old Russian Proverb which means “Trust, but Verify”, taking things at face value can be dangerous and thus it is important that investors, even if they trust the management with the numbers, should always be vigilant and keep checking the authenticity before making an investment decision, after all, it’s your hard-earned money at risk, don’t take anyone else’s word for it.

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About the Author:

This article is a guest post by Ankit Shrivastava, a SEBI Registered Research Analyst. Ankit has been investing in stocks since 2004 and writes about fundamental analysis of companies, principles of investing, investment strategies and a lot more on his blog: Infimoney

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Trade Brains

Trade brains is a financial education blog focused to teach stock market investing and personal finance to the DIY (do-it-yourself) investors in order to make, grow & sometimes even spend money. #HappyInvesting

July 4, 2019 Trade Brains Beginner's guide, Guest Post, Valuations 1 comment

Equity Valuation 102: What is Value?

What is the ‘Intrinsic Value’ of a Stock? What are its components? How do they affect the way the company’s Stock is likely to behave? We will attempt to answer these seemingly daunting questions in simple terms and with relevant, real-world examples.

Intrinsic Value – What is it Anyway?

I personally rely exclusively on Discounted Cash Flow / Dividend Discounting sort of models to estimate the intrinsic value of stocks. The world’s foremost authority on Discounted Cash Flows, is in my opinion, none other than Mr. Warren Buffett, the billionaire investor and the Chairman of the half-a-trillion-dollar entity that is Berkshire Hathaway. He’s as good a teacher as he is an investor.

Sure enough, Mr. Buffett has talked about ‘Intrinsic Value’ in a number of places. In one of those interviews, he put in candidly:

“To value something, you simply have to take its free cash flows from now until kingdom come and then discount them back to the present using an appropriate discount rate. If we could see in looking at any business what its future cash flows would be for the next 100 years, and discount that back at an appropriate interest rate, that would give us a number for intrinsic value. It would be like looking at a bond that had a bunch of coupons on it that was due in a hundred years. Businesses have coupons too, the only problem is that they’re not printed on the instrument and it’s up to the investor to try to estimate what those coupons are going to be over time.”

— Warren Buffett.

Think about what he’s trying to say. In a Government Bond, you have pre-determined cash flows (Coupon Payments and Principal Repayment), a time period in which the cash flows will be credited to your bank account (Maturity) and a Risk-free Rate, which allows you to account for the Time Value of Money.

Now consider a Stock. How is it different from a Government Bond? You still have Cash Flows (Dividends and/or Free Cash Flow to Equity), but they’re not pre-determined. Businesses do not produce results in a straight line. You do have a time period, but it’s generally very long. In other words, this will be the entire Business Life Cycle of a company.

You also have a Discounting Rate, which is usually the Risk-free Rate + a Risk Premium you charge to account for the fluctuation in the results (Fluctuation which does not exist in a Government Bond). That’s it. These are the differences. So, if you are in agreement that a Bond should be valued at the Present Value of all its Coupons and Face Value, you should have no qualms in accepting that a Stock should be valued in a similar fashion too — except, it takes more time to value a Stock than it does a Government Bond.

Components of Intrinsic Value

I personally believe that the intrinsic value of a company (And consequently, its Stock) is composed of the following six components:

Without further ado, let’s take a look into each of them and why I think they matter when it comes to Value.

1. Explicit Drivers

Explicit Divers of Value are those factors which are readily considered by amateur investors while investing in a stock. In fact, most Analysts trying to sell their reports highlight the ‘Explicit Drivers’ the most, because they are easily understandable by the common man.

Management Teams also mostly flaunt their Explicit Drivers in order to boost their rapport with the shareholders. It’s made up of two sub-components: Growth and Margins.

Growth

The easiest of all the drivers. We know for a fact that as a company sells more of its products and services, the more it is known and the more revenue it produces. While thinking about how a company can grow, it has to be tied to reality.

For example, a while back I valued D-Mart, the famous Indian retail chain. In it, I had assumed that the company will grow its Revenues at the rate of 35% in the initial years, and dropping to 25% for the farther years. Here is how I attempted to ‘justify’ my assumptions.

I took the Invested Capital of D-Mart from 2009-2018 and used it to calculate Capital Required per Store, based on the CEO’s comment that D-Mart had been growing at a pace of 10 stores per year. I also calculated the Growth in the Cost of Acquisition per store for the period.

This allowed me to project the Capital Invested per store from 2019-2028. Then, working backwards with this information and my own assumptions of Invested Capital, I calculated that from 2019-2028, D-Mart will grow at an average of 19 stores per year. This coincides with the CEO’s vision of boosting D-Mart growth from 10-ish to 15-20-ish in the next decade or so. Hence, my set of assumptions for Sales Growth stood justified.

Dmart Income Statement (Source: Screener)

However, not all growth is good. Sustainable Growth Rate is the rate at which a company can grow its Revenue without resorting to raising additional capital, which is detrimental to Shareholders. Therefore while valuing a company, it is advisable to restrict oneself to the SGR, unless there’s a very good reason that the company’s products will suddenly become more desirable.

Margins

This refers to the Net Margins of a company. Prof. Sanjay Bakshi often quips that the best kind of value creation happens with a ‘Margin Expansion’ i.e. when a company is able to charge more from the customer for the same kind of products or services they have been selling for so long.

Warren Buffet also claims that the best measure of a Durable Competitive Advantage is to ask whether the company will be able to raise prices tomorrow without affecting sales. Of course, it is also not hard to imagine how a company can save more on its Margins by simply being cost-efficient.

Clearly, a steady or increasing Net Margins is a favorable feature in a company. As Prof. Bakshi was so apt to note, indeed Margins contribute a whole lot to Value creation. One only needs to look at some of the biggest Multi-baggers to realize this truth (Say, Symphony, Eicher Motors etc).

But this means that the opposite is also true. Take the case of Lupin, for instance. In the last five years, Lupin’s Sales has grown by 10.38%, but its Profits have decreased by 26% and change. This is because their Net Margins have fallen from 18% to 1% in the same period. In fact, Lupin has created very little value for someone who bought its stock 5 years back. It’s currently trading at almost the same level as it was half a decade back.

Lupin Income Statement (Source: Screener)

So while attempting to value a company, one has to ask the question “Will this company be able to charge more prices for the same kind of product/service in the future?” or “Will this company be able to spend less for producing the same kind of product/service in the future?” and depending on the answer (Based on research and groundwork), the Margin assumptions can be made.

2. Implicit Drivers

Implicit Drivers are those factors which are considered in line with the Explicit Drivers by good investors. They know for a fact that the Explicit Drivers are superficial if the Implicit Drivers are not up to the mark. Reinvestment and Risk are the two Implicit Drivers of a Stock’s Value.

Reinvestment

Remember earlier when I said ‘All growth is not good’? While a part of it has to do with the concept of the SGR, a bigger part of it lies with the concept of ‘Reinvestment’ or the amount of Assets a company has to reinvest to a certain level of growth.

Let me provide you with two investment opportunities. Company A, which may produce Rs. 100 in Profit, but has to reinvest Rs. 50 in order to end up with that profit. Company B, which may produce Rs. 10 in Profit, but has to reinvest Rs. 3 in order to end up with that profit. If you are a smart investor, you will choose Company B, because they are more productive, that is to say, they only require 30% of their profits to be ‘reinvested’, while Company A requires 50% of their profits.

The efficiency is Reinvestment is usually measured via the Return Ratios (Return on Capital Employed, Return on Invested Capital, Return on Equity).

Charlie Munger, Warren Buffet’s investing partner, loves companies with massive Returns on Invested Capital. It is almost guaranteed that for a stock to grow multi-fold, the company has to temporarily or permanently boost their productivity.

On the other hand, look at any company in a flailing industry (Say, Telecom) and you will realize that they haven’t created any value in the last decade because they found it more and more difficult to retain customers without investing in advertising or some sort of new technology.

Bharti Airtel has grown its Sales by 10% over the last decade, yet it has destroyed value for its shareholders over the same time (Imagine having to hold a stock for 10 years, only to end up with a loss). In fact, it took a massive disruption in Jio to make the entire industry re-think how they can invest better to create value.

Risk

Risk is very personal and it’s not quite easy to explain. In fact, I wrote an entire blog post attempting to explain the fact, but I am pretty sure I didn’t even scratch the surface with understanding Risk. Without getting into complex monsters such as the Capital Asset Pricing Model or the Fama-French Five-Factor Model, the most logical definition of ‘Risk’ is an opportunity foregone.

In Finance, ‘Risk’ is usually measured as an interest rate (Termed the ‘Discounting Rate’), because the Time Value of Money demands that we do. So when it comes to investing in stocks, one needs to ask “If I do not invest in this stock, what is my next best investing option and how much am I likely to earn from investing in that option over the long term?”

I personally use a Discounting Rate of 15% for most of my valuations, because that is the median long term returns on Mutual Funds investments in India (The actual figure is 14.88% if you are curious). So my ‘next best option’ to investing in any stock is investing in a Mutual Fund scheme.

This is where it gets ‘personal’. Some people may not consider investing in a Mutual Fund as their next best option. For a Hedge Fund specializing in Start-ups, 15% may be chump change, so they may demand anywhere between 50–60% on their investments.

At the same time, for a retired pensioner, even an 8% return from a Post Office scheme would look amazing. However, even a retired pensioner can invest in an index fund and earn close to 12–13% over the long term (In India). So it’s not wise for anyone to demand anything lesser than the long term index returns in their country (For instance, in the US, it is about 8–9%). But some academics consider the Risk-free Rate (Usually the 10-year local Government Bond yield) as the true Discounting Rate for any valuation.

3. Hidden Drivers

These are Value Drivers which can be ascertained only by master investors. They aren’t found in Management Commentary, Financial Statements or Analyst Reports. They require additional research to be uncovered.

Redundant Assets

These are mostly Real Estate or some sort of Patent/Right held by the company, which has been long since written off from the books. However, if they were actually sold in the market, they might fetch a fortune for the shareholders of the company.

In the Indian context, Wonderla would be a good example. The company is currently trading at about Rs. 1550 Crores, but the company has unused land parcels of around Rs. 1000 Crores. Of course, this doesn’t mean that the company automatically demands supreme valuation. It simply means that if an investor finds the company’s intrinsic value to be Rs. 600 Crores only, he can go ahead and purchase the stock, because the intrinsic value is actually Rs. 1600 Crores, thanks to the ‘Redundant Asset’ in unused land.

But finding this bare fact isn’t really useful all the time. Take the case of Binny Mills.

Binny Limited, the listed entity which holds Binny Mills, also holds several land parcels and real estate (Mills) in Chennai. But they hold these properties in North Chennai, which is crowded and used to be a trading hub decades back (When ‘street shopping’ was famous). Nobody wants these properties, because of them being located in an archaic trading community. If it was possible to sell these off, some rich investor would have bought out Binny Mills and sold it for parts. thereby netting himself a cool profit via a Special Dividend. The fact that this hasn’t happened tells us the follies of betting on companies simply because the company has a hidden “land bank”.

Competitive Advantage Period

I saved the best for the last. This relates to the most sought-after four-letter magic word in investing: Moat. Before giving my views on this, you should check out Michael Mauboussin’s paper on this topic. It’s bloody brilliant.

It is economic truth that if a specific kind of business is profitable, competitors will emerge to get their own piece of the pie. ‘CAP’ measures how long a company can fend off the competitors, while keeping most of the pie for themselves. This is often too difficult to measure or even see, because the beauty of a good moat is realized over very long time periods. Left unattended, some competitors will breach the moat and run off with a piece of the pie. Let unattended for a long time, the moat will dry up and the survival of the company itself will become a concern.

Once again in the Indian context, I think Eveready Industries would be a great example. Post its initial success as a battery-maker, Eveready’s profits started to dwindle from 2007–2012. But the company still had an amazing ‘Moat’—the brand name, which is known to almost every Indian who’s ever used battery-run appliances. Post 2012, the new management levered the brand name into several new divisions, especially the consumer electronics space, where their products have picked up with little to no investment, thanks to the company’s brand name. The profits in the last 5 years have ballooned at an amazing pace of 56% and more. One could argue that Eveready Industries’ CAP has been lengthened dramatically, which led to the sudden spike in their stock price.

I usually use a 10–20 year projection period, based on a company having no moat, having a thin moat or having a massive moat. The truth stands that very good moats can make companies have CAPs in excess of 20 years (Think Coca-Cola).

However, the Time Value of Money will make sure that profits earned 100 years from now aren’t as important as the ones earned, say, 15 years from now. I still adjust for this by demanding a lesser Margin of Safety for companies that have a proven operating model and a Moat.

In the end, this is just the theory behind why I do what I do when I Value a company. To put it lightly, Value is a marriage of numbers and stories. One cannot do without the other. Only when these ‘stories’ are grounded in reality using ‘numbers’, does the Valuation get complete?

Dinesh Sairam

I’m the quintessential geek and a strong INTP-A. Saying ‘I am passionate about investing’ would be an understatement. I have been investing my own and my family’s money in the Indian markets since 2016. I’m also a voracious reader and listener of topics ranging from cattle rearing to particle physics. When I am not busy investing or reading, I blog about Valuations and Markets at Valuation in Motion. I believe that finance is as simple as knowing where your last dime went. And I hope to show you how.

valuationinmotion.blogspot.com/

March 19, 2019 Dinesh Sairam Guest Post, Investment Basics, Valuations 1 comment

Equity Valuation 101: Why Value?

A prominent question many people have about investing in stocks is, “Does the purchase price matter?” or “Should I value a stock before purchasing it”?

A lot of financial theory argues that you shouldn’t. They say, markets are always efficient in pricing securities and you should rather worry about decreasing frictional costs like brokerage charges, transaction charges, churn costs and so on.

But Mr. Charlie Munger, the business partner of the world’s richest investor Mr. Warren Buffett, has a different answer:

“It was always clear to me that the stock market couldn’t be perfectly efficient, because, as a teenager, I’d been to the racetrack in Omaha where they had the pari-mutuel system. And it was quite obvious to me that if the ‘house take’, the croupier’s take, was seventeen percent, some people consistently lost a lot less than seventeen percent of all their bets, and other people consistently lost more than seventeen percent of all their bets.

So the pari-mutuel system in Omaha had no perfect efficiency. And so I didn’t accept the argument that the stock market was always perfectly efficient in creating rational prices. The stock market is the same way – except that the house handle is so much lower.

If you take transaction costs – the spread between the bid and the ask plus the commissions – and if you don’t trade too actively, you’re talking about fairly low transaction costs. So that, with enough fanaticism and enough discipline, some of the shrewd people are going to get way better results than average in the nature of things.

It is not a bit easy…But some people will have an advantage. And in a fairly low transaction cost operation, they will get better than average results in stock picking. To us, investing is the equivalent of going out and betting against the pari-mutuel system. We look for a horse with one chance in two of winning and which pays you three to one. You’re looking for a mispriced gamble. That’s what investing is. And you have to know enough to know whether the gamble is mispriced. That’s value investing.”

—Charlie Munger (USCB, 2003).

Interesting. So, what’s ‘Parimutuel Betting‘?

Let’s say that you are about to bet $100 on a Horse Race. A total of ten horses are participating in the race and you are given the following statistics:

You are told that 100 people have laid down their bets (Let’s call them the ‘Horse Market’) and the total pool of bets is $4,050. Indirectly, you can assess how these 100 people have determined the probability of winning, or ‘Odds’ of winning, for each of these horses. In fact, Horse #6 seems to be an overwhelming favorite, with $1,700 bet for the horse.

But before blindly betting on Horse #6, you need to understand the most important thing about Parimutuel Betting. If Horse #6 indeed wins, everyone who bet on Horse #6 will get $4,050 i.e. Everyone will make roughly 2 times of their bet amount (For convenience, let’s just say the remaining 0.38 times is participation fee). Is that good?

Hold your horses (Pun intended)!

If you bet on Horse #5 or Horse #9 instead, you can make 81 times the money, instead of the paltry 2 times. Well, well, now is this a better bet? Logically speaking, these horses have had a very little bet on them because they may be poor to begin with. The 100 gamblers already know this. That’s why only 1-2 of them have placed bets for these horses.

Wait, this is confusing. Which horse should I bet on now? Let’s recount the statement made by Mr. Charlie Munger:

“We look for a horse with one chance in two of winning and which pays you three to one. You’re looking for a mispriced gamble.”

A mispriced gamble. That’s where the trick lies. To summarize Mr. Munger’s thought process:

You shouldn’t bet blindly on Horse #6, because you will only make only 2 times the money, the lowest reward of the lot. Even when Horse #6 can be deemed the healthiest horse with the most skilled jockey, the payout is simply too low.
You shouldn’t bet blindly on Horses #5 or #9, even though they have an astronomical payout of 81 times. It is more likely that Horses #5 or #9 could be sick/weak or their jockeys inexperienced.
The sweet spot, therefore, is in a bet where you think there’s mispricing i.e. A bet where the ‘Odds’ have been miscalculated by the Horse Market people. Take Horse #1 for instance. The Odds here are 8:1 i.e. The Horse Market people think there’s only a 12.50% (1/8) Probability of this horse winning. If you believe that these Odds are somehow way wrong i.e. If you believe that this horse actually has a 25% (1/4) Probability of winning, then you should consider betting on this one. Of course, you should repeat this exercise for all the horses and figure out which one has the most mispriced Odds and bet on that one.

Sounds simple enough? Horse Betting is decidedly more complex than this. However, it proves to be an interesting lesson in investing. This system of Parimutuel Betting, Mr. Munger argues, also applies to the Stock Market. I would personally visualize it like this:

To put it in a words, then:

You shouldn’t invest blindly in the well-known, excellent company. Although these type of companies have the lowest probability of making a Capital Loss (i.e. Chance of not achieving the Average Returns) over the long term, they also have a low, 15% returns over the long term. Put together, they have an Expected Returns of 12%, which is neither too high, nor too low.
You shouldn’t invest blindly in the unknown, terrible company. Although these type of companies can become potential ‘multi-baggers’ over the long term, clocking a CAGR of 23%, they also come with a high 50% risk of a potential Capital Loss. Put together, they have an Expected Returns of 11.50%, the lowest of the lot.
The sweet spot, therefore, could be in the lesser-known, mediocre companies. These type of companies offer a decent 18% CAGR over the long term and also come with a moderate, 30% Capital Loss probability. Put together, they have an Expected Returns of 12.60%, the highest of the lot.

Of course, this is just an example. There are thousands of Stocks listed around the world and there might very well be numerous permutations and combinations of this in action at any given time. Instead of the 100 people from our horse betting example, the Stock Market consists of millions of people. They are pricing the odds for a stock every moment a trade is executed. It is an investor’s job to figure out the most mispriced bet and pick it up.

Just remember. You don’t make the most money-per-risk-taken by betting on the most favorite gamble. And you don’t make the most money-per-risk-taken by betting on the least favorite gamble, either. You make the most money-per-risk-taken by betting on the gamble where the odds are highly mispriced.

Also read: Why Warren Buffet Suggests- ‘Price Is What You Pay, Value Is What You Get’?

That’s it for today! I’ve used the word ‘Intrinsic Value’ several times in this post, without really letting on much what it is supposed to be. Think about what it means. Let’s explore this more in ‘Equity Valuation 102’, the next post.

Dinesh Sairam

valuationinmotion.blogspot.com/

March 11, 2019 Dinesh Sairam Guest Post, Investment Basics, Market, Stocks, Valuations 2 comments

Choose the Right Option.

Can you build a long-term portfolio successfully with the help of short-term trading plans? Are you hedging it right?

Everyone knows that India, currently, is one of the finest markets to invest in. The major reasons being the current as well as forecasted economic developments, high returns on investment, increasing consumption pattern, growth prospects, political scenario and outlook, budget deficit and proposed infrastructural plans/projects. The long-term journey of India Inc. looks healthy, rewarding, and in good shape.

However, there are a couple of questions which come in the mind of every investor:

How long is long term?
What is the right time to enter the market?

The first question is correctly valid considering the changing business models, dynamic technological progressions etc. There are many business models which may become obsolete in a few years. Only a handful of companies, which can adapt to the dynamic environment, will survive.

Not to forget, As of 2018, only 7 companies are still part of the original Sensex 30 which was formed in the year 1987.

This entire critique revolves around the discussion for the second question. There are various macro factors affecting the overall market sentiment including market cycles of different time frames, economic cycles, political outlook and last but not the least, company’s stage of growth and development and its responses to the dynamic environment that needs to be considered while entering the capital market for a longer period of time. The most important thing to remember is one should invest in a business as against investing in a company.

Are investors capable of avoiding the short-term movements in the prices of the company’s stock? How does the investor’s mindset change in the bearish market? How can one capitalize such market scenario as well? How to maintain the balance between greed and fear? Can any investor actually time the market? What are the alternatives to be actively present in the market but not getting affected by the market dynamism?

Since the Indian equity markets made the record highs in the calendar year 2017 and 2018, each and every investor must have been waiting for the right entry point. Be it either by way of fresh investments (first entry in the capital markets) or by adding up to their existing portfolio. No one wants to enter the markets when they are just about the consolidate.

With the recent consolidation in the markets and their sideways movement, the fear of a consolidation phase continuing for the rest of the year in the Indian equity markets might be just around the corner for all investors. Although most of the Marquee investors, foreign financial institutions as well as the domestic Institutional Investors are very bullish on the Indian economy in the long run, they are contemplating a phase of consolidation in the year 2018.

One of the marquee investors, Rakesh Jhunjhunwala, even said that the incredible gains marked in the Indian capital markets in the year 2017 are bound to be abridged by some level of profit booking that could be seen in the calendar year 2018. After yielding stellar returns in the year 2017, everyone is expecting the markets to consolidate till the time the quarterly earnings increase to a level that could substantiate and corroborate the current price levels and high P/E multiples.

Here are some of the questions that we get to hear a lot from many of the investors;

How to survive a falling / bearish market?
Can investor do anything about their existing exposure to capital markets when the market sentiments are negative, prices in the forex market are volatile and the share prices are all set to nosedive?
Will the recent default by the IF&FS group lead to a financial crash in India or is this just another case of a group that is Too Big to fail?
How can an investor with an ‘All long equity’ mindset survive in the midst of rising capital market chaos, unveiling flaws with company’s management, high level of volatility and rising political turmoil?
What should the investors do to their existing investment strategy and asset allocation? Should the investors look for a short-term shift from capital markets?
With the likes of Yes Bank, DHFL and other NBFCs plummeting down to unexpected levels, is there something more to come?
The auto sector companies are offering huge discounts to increase the volumes but still failing to meet the street expectations with the quarterly results and the monthly auto numbers. What should be the investor’s bet for this festive season?
With the dollar appreciating against rupee and the rise in the oil prices, what can be expected from India Inc.?

Innumerable questions are on top of the mind of every investor succinct to one broad question –

What are the change/adjustments required in the trading / investing strategy of every investor in order to capitalize opportunities in the bearish market?

To summarize this, each investor is worried about their existing exposure to the capital markets fearing what can come up next to their stocks.

The alternatives available to all the ‘All Long Equity Investors’ are;

The investor will have to sit on cash i.e. exit the existing portfolio; or
Be in the market, earn negative returns on the stock portfolio and wait for the right time to average the holdings until the market has bottomed out.

More than 9 months have passed in the year 2018 and we have seen a steep correction of up to 55 percent in small and mid-cap shares and up to 30-35 percent in some of the large-cap stocks as well. In fact, the broad market index – Nifty has also corrected in a double-digit percentage from the record high made in the year 2018 itself.

After all these discussions as well, there are institutions that are still making money. In a falling market, an investor can make money only by short selling i.e. sell at a higher value first and cover the position by buying the equivalent quantity at a lower price. However, equity markets (cash segment) do not allow the investors/traders to carry forward such a trade to the next day. i.e. the investor will have to square off (buy it again) the open sold position on the same day i.e. Intraday trade only. This is also known as entering a bearish trade. An alternative is to trade in options.

In a scenario where there are no clear opportunities/ideas for investing in specific stocks and earn money from equity markets (cash segment) as well as there are constraints of capital for investing into equities to average the cost of stocks, the investor should look to move to option trading.

The next question that comes to the minds of the investors is that with the constraint of capital, time and resources, how can an individual investor go on to take the additional risks of trading in option.

Options trading, if done with proper analysis and the right approach, are the safest bets that could yield the highest returns. Options trading is just perceived to be risky. Options are very powerful to enhance an investor’s portfolio returns. Option, if used wisely, can prove to be a perfect hedge to the existing exposure to the capital markets.

A popular example would be using options as an effective hedge against a declining stock market to limit downside losses. Options can also be used to generate recurring income (option writing, explained later in this article).

In the Indian derivatives segment, there are two main types of options – Call and Put. In case of strong bullish view on any stock, the trader may go for long-call option i.e. Buy call option. As against this, in case of strong bearish opinion for any stock, the trader may go for a long-put option i.e. Buy put option. Selling call options and put options trades are executed in case of week bearish or bullish interpretation respectively, on the movement of the stocks and it is primarily dealt to earn the share of premium and capitalize time value of money (Option writing, explained later in this article).

As explained, there are four coordinates to option trading – Long call, Short call, Long put and Short put.

Buying a stock gives you a long position. Buying a call option gives you a potential long position in the underlying stock. Short-selling a stock gives you a short position. Selling a naked or uncovered call gives you a potential short position in the underlying stock

People who buy options are called holders and those who sell options are called writers of options.

Call option

A basic call option, in its meekest explanation, can be thought of as a down payment / token money paid for purchasing a house property in future.

For example: Whenever an investor decides to purchase a house property, he sees a new development going up. That person may want the right to purchase the house property in the future but will only want to exercise that right once those prophesied developments (let’s say, upcoming infrastructure road development project has been substantially finalized or a school has been built) around that area are built. These circumstances would affect the investor’s decision to purchase the house property. The potential investor would benefit from the option of buying or not (basis such developments). Imagine they can buy a call option from the developer to buy the home at say INR 10 lakhs at any point in the next three years. Naturally, the developer wouldn’t grant such an option for free. Such a payment is a non-refundable deposit. The total cost of purchase of the house property is INR 200 lakhs.

The investor needs to make that down-payment to lock in the right to purchase the house property at a future date within a stipulated time of three years.

Connecting the above example with the derivative markets, the down-payment no refundable deposit cost is known as the Premium. It is the price of the option contract paid by the investor to acquire the right to purchase at a future date. The investor is said to have gone long the call option. The total cost of the house property fixed between the investor and developer of INR 200 lakhs is the contract price of the option contract. It means that irrespective of the market conditions, the investor has the right to purchase the house property within a period of 3 years at a fixed price of INR 200 lakhs.

Let’s say, two years have passed, and now the developments are in line with the proposed plans of the area and zoning has been approved. There is no garbage dump that is coming nearby; School and road projects, as forecasted, are up and running. The investor exercises the option and buys the home for INR 200 lakhs, as agreed earlier. The market value of that home may have increased multi-fold times to, let’s say, INR 600 lakhs because of all the developments in that area. Nonetheless, the investor has the right to purchase the house property a pre-determined price locked in at INR 200 lakhs only.

Since the value of the underlying asset increased, the call option buyer benefited from the transaction.

Now, in an alternate scenario, say the zoning approval doesn’t come through until year four or the school which was proposed to be constructed, did not come through, and the market price of the house property falls to INR 100 lakhs. The investor will not want to exercise his right to purchase the house property since he is getting it at a much discounted price from the market. The down payment paid shall be, obviously, forfeited by the developer.

The main advantage of going long (bullish trade) with a call option is that the maximum loss shall be restricted to the amount of premium paid to enter into the contract keeping the potential upside of the profit open. To simplify, the investor can gain from the up-move of the stock without purchasing the stock. The huge capital required to purchase the stock is no longer required because the upfront cost is limited to the amount of premium.

Selling a call option (Short call)

The above example was the case when the investor purchases options i.e. get the right but no obligation to purchase the underlying asset. Let’s look on the other side of the coin. What happens when the individual sells options instead of buying? What are the rights and obligation of the other party to the contract?

This phenomenon is called option writing (option selling). In such a case, the option writer will have the obligation to deliver the underlying asset on the date of expiry of the contract, if the option buyer exercises the right in the option contract.

Continuing the above example of making payment of the token money/down payment to purchase the house property on a future date at a predetermined contract price. The developer who receives the token money is known as the option writer. He is obligated to sell the house property at a predetermined fixed rate of INR 200 lakhs (as per the contractual terms), irrespective of the actual market price of the house property at the time of exercising (after 3 years).

To summarize, if the home buyer does not exercise his right, the down payment (known as the premium) received shall be the income of the developer.

Put options

A put option can be thought of as an insurance policy against any asset. It is to protect the downside risk of the asset owned (securities). For example, the investor foresees a fall in the prices of the broad equity index of close to twenty percent in next six months because of the best reasons known to him. However, the investor does not want to liquidate its exposure in the equity markets because of the long-term positive outlook. To avoid the short-term losses because of the increased volatility, the investor can hedge its existing exposure to the equity markets by entering into a put options contract. A long-put option contract is a bearish trade which works like an insurance policy against the underlying asset. A long-put option gives the investor the right to sell the underlying asset at a predetermined price for a specific period as per the options contract.

Even if the value of his shares become zero, the investor can exercise his right to sell at a fixed price determined at the time of entering the options contract.

Needless to say, purchasing such a right to hedge the downside risk of the underlying asset has to come with a cost. This cost is known as the premium of the option. Similar to the long call option, the maximum loss on the long-put option contract is limited to the amount of premium paid to acquire the right to sell the underlying shares.

If there are investor hedging the downside risk of the underlying asset, there has to be someone who ensures such downside risk. With that, we come to the last co-ordinate of option trading i.e. writing put options. Continuing the above example of insurance contracts, the insurance companies which are receiving the amount of premium are known as put option writers. The put option writers are obligated to purchase the underlying asset in case the put option buyer exercises his right to sell the underlying asset.

This works exactly similar to call options where the maximum loss for the put option buyer is limited to the amount of premium paid as against the maximum loss for the option writers is limited to the total value of the underlying asset (the price of a stock can fall maximum till zero).

Now the real question which most of you might have;

Why would anyone opt for writing options as against buying options? Option writing has more risk and limited profits (limited to the amount of the premium received). As against this, option buying has a limited risk (limited to the amount of premium paid) and unlimited profits (the upside of the stock is unlimited)

The answer to this question is also very simple. How often do you see exercising an insurance policy within the stipulated time period? How are insurance companies surviving since their entire business revolves around offering safeguards against losses?

That’s correct, the major revenue stream for any insurance company is by way of the premium received. Most of the policyholders do not exercise the insurance contracts within the stipulated time frame and forgo the amount of premium.

The maximum liability of the insurance company is unlimited to the extent of the amount of loss. The maximum profit shall be the amount of premium. However, no one talks of the probability of winning as an option buyer. Option seller, on the other hand, is operating with a very high probability of winning (discussed later in the article).

To summarize, call holders and put holders (buyers) are not obligated to buy or sell. They have the choice to exercise their rights. This limits the risk of buyers of options to only the premium spent.

Call writers and put writers (sellers), however, are obligated to buy or sell if the option expires in-the-money. This means that a seller may be required to make good on a promise to buy or sell. It also implies that option sellers have exposure to more and in some cases unlimited, risks (theoretically). This means writers can lose much more than the price of the options premium (again, theoretically).

How is the derivatives segment in the Indian capital markets different from the above examples, practically? Does the Indian capital markets offer a physical settlement of the underlying asset? Can the contracts be settled before the stipulated time period in the contract?

Theoretically, this is exactly how any option derivative would function in a hypothetical scenario. However, practically, the Indian capital markets do not offer a physical settlement of the underlying stocks. Instead, the contract is always cash settled i.e. the amount of benefit to the option buyers or option sellers derived from the underlying asset is reflected in the price fluctuations of the premium of that option contract.

Continuing the above example of the right to purchase the house property within three years, with every passing year and the development of that area, the cost of purchase of the house property will increase. Such benefit from the increase in the purchase cost of the house property will be reflected in the amount of premium to be paid to acquire the right to purchase after the stipulated number of years. Initially, the investor paid INR 10 lakhs to acquire the right in year 0. Post the developments, the premium might have increased to INR 30 lakhs in year 2 apprehending the increase in the total cost of purchase of the house property.

Practically, in the derivatives capital market, the investor can sell the premium at the end of year 2 at the market price and the difference will be the profit. This is known as Cash settlement of option contracts. Although the contracts are settled only on the expiry of the contracts, the parties to contract can square off their existing exposure to the option trades with other market players. The difference between the buying and selling price of the premium amounts will be the payoffs for the investor from that trade.

Now the next question that comes to every trader’s mind is that which strategy should be opted?

There are four co-ordinates to option trading having two possible views – bullish or bearish. For example; most of the option traders are confused between ‘selling a call option’ and ‘buying a put option’. Broadly both are bearish strategies. Buying a put option is preferred when the trader expects a weakness (steep fall within the stipulated contract period) in the stock. As against this, selling a call option is preferred when the trader expects no further upside for that stock. In a scenario when the stock is stable through the period of contract, the option seller still earns the amount of premium because of the element of time value in the option. Most option writers capitalize this time value premium in every option price. Option writing should be used as a hedging total as well as to reduce the total cost of buying the option.

In my opinion, option writers tend to earn more than option buying. Selling options, whether calls or puts is a popular trading technique to enhance the returns to the entire portfolio.

If the trades are executed with precision, proper analysis and patience, the trader definitely earns anywhere between 5 (on the minimum) to 25 percent month on month.

To support this view, reliance is placed on a study paper by Dr. John F. Summa which was published in 2003 in Futures Magazine. In his study, Dr. Summa finds that, regardless of the market direction and market sentiments, option sellers have an advantage over option buyers. Based on his study of expiring and exercising options covering a period of three years, an average of 76.5 percent of all the options held till expiration expired worthless (out of the money). The same has been tabulated as under;

On this general level of information about option trading, we can conclude that for every option exercised in the money, there were three options expired out of the money and thus worthless. Therefore, option sellers had better odds than option buyers for positions held till expiration. Even though the study paper was submitted 15 years ago, not much has changed in the context of capital markets except the price of the stocks.

In addition to these, the option buyer is said to operate with limited risk and an opportunity to gain unlimited reward. But no one talks of the probability of winning as an option buyer. Option seller, on the other hand, is operating with a very high probability of winning.

Further, in such a market where investors are fearful of investing more money to the markets and increase the exposure, an option seller can use collateral and need not bring in funds. Further, the seller has the flexibility of hedge his position using the same collateral. As against this, an option buyer has to bring in capital to buy the option.

Even though the statistics and probability backs option writing over option buying, it requires immense precision, diligent thinking, and meticulous monitoring.

To conclude, I would just like to quote PR Sundar’s words in one of his interviews, ‘Option selling is like sitting in front of a bonfire. If you are too close, you can get burnt. If you are sitting too far, then you will not enjoy the warmth. You need to sit at the right distance from the fire’.

Applying the analogy in option trading, If you are trading close to the market price, then the risks will be higher i.e. risk of the strike price so traded, being in the money at the time of expiration). If you are trading a strike price which is too far away from the current market price of the underlying asset, the reward (the amount of premium) will be low as will be the risk of that trade. It is the flexibility, hedging advantage and the probability of success that option trading offers that makes it a very attractive tool to indulge into.

Have a good day! Happy Investing! Happy Trading!

Note: This article is written by guest-author ‘Pranav Thakkar’ and also posted here.

Pranav Thakkar

I am a pursuing Chartered Accountancy and currently working in a Mumbai based firm – KNAV & Co Chartered Accountants. I have been deeply fascinated and inspired by the Indian equities and Indian economy. I am a constant learner of the stock market. In my free time, I read books and play cricket.

October 29, 2018 Pranav Thakkar Guest Post, Trading 1 comment

The Inexperienced Investor.

Don’t you think that people these days are professionally qualified but financially illiterate?

It is very important to invest in ‘Financial Securities’ since this is one of the best investment opportunities available in India considering the high percentage returns from such investments. Especially at this juncture in time, where the Indian Economy is developing at an incredibly fast pace, everyone should be a part of the whole process and reap the fruits of the development.

At this stage, it is vital for people to understand the importance of investing in the accelerating markets, rather than only “saving” a big portion of their income as part of their financial planning for their secured future. As Mr. Robert Kiyosaki rightly says in his renowned book ‘Rich Dad Poor Dad’:

“Don’t work for money, let money work for you.”

A lot of the people today understand the importance of such investment and since they have the resources (like money, time etc), they tend to participate in paper investments (shares, bonds and the like). Be it college graduates, professionals or any other person from any other arena, they might have become financially sound but however, they still lack some amount of financial literacy. Because of a lack of knowledge, they end up losing a chunk of their capital in the volatilities of the stock markets. This is mainly caused by committing some very common but crucial mistakes.

The topic of the article might sound a little harsh in the beginning, but there are some common mistakes committed by most of the investors in their initial years of investing. The small investors (often with less and limited capital), more often than not begin with investing in well-thought-of goodwill backed blue-chip companies (let’s say, Infosys or TCS or Reliance etc.) which have given good profits consistently.

These companies, more often than not, do not disappoint the investors and consistently produce good returns on investment (‘ROI’). Now, these investors are carrying heaps of confidence along with a good rate of return on their investments in the blue-chips. The next step they take, in these series of events, is to try and understand the market (covering more stocks, information-based trading etc.), its movement and the respective stocks better by reading about the same on online self-help articles. However, what people don’t understand is that a ‘risk-adjusted average return’ earned from their investments in any blue-chip company is not because of their expertise in the equity markets. Any person with moderate knowledge about the current economic environment would have most likely invested in one of the blue-chip company to safeguard their initial capital and earn a normal rate of return. With this superficial confidence booster, a common mistake that comes up next is the “change in the investor’s mindset for earning more, all at once”. Investors start thinking from a trader mindset rather than an investor’s perspective.

The aim of this write up is to identify and put forward the common mistakes done by any rational investor in their investing career and to have an opportunity to avoid them and create wealth.

1. Lack of Patience

Investors need to understand that the entire journey of investing is a long and continuous process.

Along with money, time is an important resource that is required to be invested in the stock market. The longer you are invested, the better are the returns (provided you are sailing in the right ship).

Illustration: Let us assume that average returns from equity markets range from 20 percent to 30 percent per annum. A small investment of INR 2 lakhs today can earn you more than INR 16 crores for a period of 30 years as against a return of INR 6 lakhs in 5 years timeframe (considering an average rate of return of 25 percent).

Once a good company is selected, the company will help your money grow. You just have to ‘Buy Right and Sit Tight’.

The prime goal to invest in equity markets should be to satisfy the long-term objectives. For example, one should utilize the money earned from the equity markets to accomplish long-term goals like buying a house, children’s education, marriage, world tour or any other specific capital outflow.

The greed to earn quickly is the biggest problem of all investors who have not prospered in the Indian Stock Market.

2. Investment in penny stocks / small caps stocks

One of the most consistent mistakes that a majority of inexperienced investors tend to make is being drawn to a type of common stock known as penny stocks / small caps. The reason for this (ultimately dangerous) attraction always comes down to the fact that penny stocks appear to fluctuate tremendously in price, which, they convince themselves, should lead to an opportunity to generate a very high return and that too, very quickly. The reason most people seem to be drawn to investing in penny stocks is that these companies fluctuate wildly in very short periods of time. In a single week, shares might go from INR 5 to INR 30.

The naive investor thinks, “Wow! If I had put INR 10,000 in that, I would have been able to turn it into INR 60,000 almost instantly!” Well, here goes to bursting their little bubble. It’s an illusion, make no mistake about it. Not all small-cap stocks give such returns. It often turns out to be precisely the opposite as penny stocks can wipe out your savings in the blink of an eye.

However, there are some penny stocks which have turned into multi-baggers, giving a return of up to 43,000% in a span of approximately 10 years, you just need to know how to pick them.

If you pick the right stock, the returns can be exceedingly huge. As against this, pick the wrong stock, and your entire capital can get eroded.

Also read: What are Penny stocks? And should you buy it?

3. Timing the Market

Another important factor is the timing of investment i.e. entry and exit in the stock market. Wrong timing is one of the most common mistakes that the retail investors tend to make. The decision to buy and sell stocks should not be dependent on acquaintances. Do not invest in stocks because people around are also investing in it. Avoid such practices as they do not yield well in long-term and often end up incurring heavy losses. Retail investors tend to enter into the stock based on some news (often called as ‘tip’) or they tend to follow an ace investor. However, one important thing that they don’t often understand is that stock market prices discount the forthcoming news/events/results well in advance. Therefore, never follow any investment event which is already public.

It all originates with investing in any stock at a wrong time with the intention to hold it for the long term. However, if the wrong timing of entry leads to unfavorable returns in the near term then the stock price declines, along with the investor’s confidence in the stock. However, they tend to hold it just because they cannot afford to lose money i.e. book the loss. They hold it for a medium-term (forgetting all about their long-term targets) and wait for the stock to breach their break-even buy price. After months of holding the stock, they sell the stock at break-even.

What return did these investors get from holding the stock? NEGLIGIBLE. People tend to hold the stock at the time of downside and exit on their up-move at their break-even.

Also read: How To Select A Stock To Invest In Indian Stock Market For Consistent Returns?

4. Lack of discipline

Another beginner’s mistake is the utter lack of discipline in the stock market. The prices of all the shares in the market move several times, to a large extent, because of multiple investors booking their individual profits/losses. The price fluctuations are only an outcome of two emotions – “greed and fear”. The greed to earn more and the fear to lose money.

One should follow strict disciplined risk-reward ratio based on the idea at the time of buying the stock i.e. intraday or positional or delivery-based trading. For example, before even the purchasing the stock, the investor has to decide the expected return and the maximum capacity to bear the loss.

The risk-reward ratio may differ based on the stock selection, investor’s mindset and price volatility of the stock. Ideally and preferably, trading ideas should have a strict ratio of 1:2 i.e. against an expected 10 percent return, there should be a strict 5 percent stop loss below the purchase price.

The volatility in the market has often led to losses even in a bullish trend. Therefore, it is always advised to invest systematically, in the right shares with patience for good returns. Being patient and having a disciplined approach always helps in picking the right stocks for accomplishing long-term goals.

5. Use of Margin to create leverage

This is the last and most important mistake to be avoided, but however, done by most of the investors in the beginning of their careers. First, let us understand the meaning of Margin money. The margin is a loan extended by the broker that allows you to leverage the funds and securities in your account to enter larger trades. The loan is collateralized by the securities and cash in your margin account. The borrowed money doesn’t come free; however, it has to be paid back with interest. Leverage in any business (also, stock market) means the use of debt to finance the assets. Short term traders use Margin from their brokers to create leverage. Essentially, leverage allows you to pay less than the full price for a trade, giving you the ability to enter larger positions even with a small amount of capital.

How can use of leverage be unfavorable to the trader?

Let’s say, you get a margin of 5 times of the portfolio value from your trader i.e. the trader can purchase stocks of INR 500 against a portfolio value of INR 100. Suppose, you used the entire margin to purchase 5 shares of security A at a price of INR 100 per share (as against purchasing one share without margin funding). If the price of security A falls to INR 95 on the next trading day, then the trader suffers a loss of INR 5 per share. Since the margin is available to the trader for a pre-decided number of days, let’s say for 5 trading days in our example, the trader holds this position in anticipation of a price hike (an illustration of lack of discipline too). At the end of the 5th trading day, the trader has to either deposit the funds or sell the shares in order to clear the debit balance in the margin account. Most likely, the broker will sell the shares because the trader is in the shortage of funds (the primary reason to use margin). Suppose, the share price on the 5th trading day is INR 90 per share. Here, the trader has incurred a loss of INR 10 per share i.e. total loss of INR 50 (INR 10 multiplied by 5 shares).

A 10 percent (INR 100 to INR 90) decline in the security has resulted in a loss of 50 percent in the portfolio value (INR 100 to INR 50 i.e. total loss of INR 50).

Here, let us understand the math behind this calculation. The percentage return of the portfolio is directly proportional to the margin funding ratio. Since the broker provided a 5 times margin on the portfolio, a normal 10 percent resulted in a total loss of 50 percent in value.

Leverage can give the same multiplying effect to the profits as well, in fact, that is the motive of most of the traders – to earn quick money using leverage/margin funding. It turns out that no one has ever earned consistently in this fashion.

Also read: 7 Types of Risk Involved in Stocks that You Should Know.

To summarize, it is important to understand that to become a successful stock investor, you must invest your own serious money based on your capacity. Sometimes, it is better to sit on cash rather invest and lose money. “Do not invest just for the sake of investing” – Warren Buffet in his recent annual letter to the shareholders of his company. Form a methodology of stock picking, believe in your ideas of investing and back them by having a longer-term mind frame.

The beauty of investing is that there would be a million investors sailing the same boat but still, their earnings from the stock can be materially different. Finding a great company is not even half the battle. Price matters. Time frame matters. Temperament matters.

Have a good day. #HappyInvesting.

This article is written by guest-author ‘Pranav Thakkar’ and was also posted here.