Chapter 2: In the second chapter on the commonly asked questions about the stock market, we look at the skills and tools required to get started on the journey to becoming a successful investor.
Q: Is prior knowledge of companies and the stock market essential before investing in equities?
A: An investor buys a stock with only one aim: that it will do better than any of its peers, or even any other stock in the entire market.
Betting on a particular stock vis-à-vis any other means that the investor has a view on why it is likely to do well. Absent this view, any such bet would be akin to gambling, or a coin toss.
It is logical to presume then, that this view can be derived only after having an insight into a company’s operations, the condition of the market it operates in, or at least a reading of its financials.
Can you claim with any degree of certainty that company A in the auto industry is likely to do better than company B, if you don’t know about interests of auto customers, or the amount of debt each company has?
Assuming you do have a basic understanding of a company’s fundamentals and you decided to invest in a stock, you also need to know the very basics of how to go about the investment process. For instance, you need to have a demat account or know how to open and operate one.
If your view is short-term in nature, and you have decided to buy a stock using non-fundamental analyses, such as technical analysis, you will need understanding of those tools, and of areas such as futures and options etc.
Q: I am a beginner in the stock market. What kind of knowledge do I require and where can I pick it up?
A: Quick answer: Follow the MC Learn series
Long answer: You will need to pick up an understanding of a few areas. These include knowing how to interpret financial statements and understanding in some degree of detail how various industries and companies work. Combine the above two points with an understanding of what they mean from an investing standpoint and you will have prepared a framework for fundamental analysis.
Ultimately, it all boils down to developing an understanding of how to think like a businessman.
Let’s evaluate this in the context of a popular restaurant in your neighbourhood. If the owner of the restaurant offers to sell it to you, you will run some quick numbers. What are the restaurant’s sales? How much profit does it make? If it makes a profit of Rs 5 lakh a month, or Rs 60 lakh a year, you will ask yourself what the appropriate price is to acquire ownership of the restaurant. Maybe Rs 2 crore is a good price (or a little over three times its annual profit). Perhaps Rs 5 crore is too much.
A fundamental analysis framework will allow you to evaluate investment opportunities in an objective manner. If a company’s market value (termed market capitalisation in stock market lingo) is Rs 1,000 crore, and it makes an annual profit of Rs 100 crore, is it worth investing at 10 times the profit?
Now think back to your neighbourhood restaurant example. It may serve only traditional cuisine while you think youngsters prefer more of fast food. Would you then assign a lower value to it? Such principles apply when we are talking about an auto or consumer-goods company – the only difference being they operate at a much larger scale and are more complicated to understand than the neighbourhood restaurant.
You can develop this framework by attending shareholder meetings and reading business news articles, books on investing and annual reports.
Q: Where can I look for basic information on a company?
A: Financial information on listed companies is widely available and can be accessed on stock exchange websites or on Moneycontrol.
A good resource on getting a strong understanding of a company’s operations is to read its annual reports. In fact, investing guru Jim Rogers claims that reading an annual report puts you ahead of 98 percent of investors, implying that most investors do not bother to read it. While it is difficult to argue for or against Rogers’ 98 percent estimate, it is clear that reading the annual report of a company you want to invest in is a must.
Q: What are the qualities required to be a good investor?
A: We have dealt with the part about understanding and information in the previous answers. But having sound understanding and information are necessary but not sufficient conditions to become a good investor.
In fact, most successful investors believe that the ability to think logically, critically and to minimise the influence of emotions are critical to doing well.
The emergence of the field of behavioural finance has created awareness on how investors can hone the latter skills.
Q: I have heard that good investors read a lot of books. I don’t like reading books on finance. Can I still be a good investor?
A: So long as you have the basic understanding of investing principles and have the ability to think independently, you should be fine. Having said that, the ability to do the above two things often comes from reading.
Think of it this way: the more you read, the higher you are giving yourself the probability of success.
Q: OK. Give me a list of some books I should be reading.
A: Below is a quick list of books that will get you up to speed on various aspects of investing. This list is by no means exhaustive but is a good start.
Understanding of investing and businesses:
The Essays of Warren Buffett, by Lawrence Cunningham;
Common Stocks and Uncommon Profits, by Philip Fisher;
One Up on Wall Street, by Peter Lynch
You Can Be a Stock Market Genius, by Joel Greenblatt
Stocks for the Long Run, by Jeremy Siegel
The Little Book that Builds Wealth, by Pat Dorsey
The Most Important Thing, by Howard Marks
Honing your investment framework:
Irrational Exuberance, by Robert J Shiller
A Random Walk Down Wall Street, by Burton G Malkiel
Thinking, Fast and Slow, by Daniel Kahnemann
Principles: Life and Work, by Ray Dalio