Module 3 Fundamental Analysis

Chapter 2

Mindset of an Investor

69

2.1– Speculator Vs Trader Vs Investor

Depending on how you would like to participate in the market, you can choose to speculate, trade or invest. All the three types of participation are different from one another. One has to take a stance on the type of market participant he would like to be. Having clarity on this can have a huge impact on his Profit & Loss account.

M3-Ch2-title

To help you get this clarity, let us consider a market scenario and identify how each one of the market participants (speculator, trader, and investor) would react to it.

SCENARIO

RBI in the next two days is expected to convene to announce their latest stance on the monetary policy. Owing to the high and sticky inflation, RBI has hiked the interest rates during the previous 4 monetary policy reviews.  Increase in interest rates, as we know means tougher growth prospects for Corporate India – hence corporate earnings would take a hit.

Assume there are three market participants – Sunil, Tarun, and Girish. Each of them view the above scenario differently, and hence would take different actions in the market. Let us go through their thought process.

(Please note: I will briefly speak about option contracts here, this is only for illustration purpose. We will understand more about derivatives in the subsequent modules)

speculator

Sunil: He thinks through the situation and his thought process is as follows:

  • He feels the interest rate are at an unsustainably high level
  • High interest rates hampers the growth of corporate India
  • He also believes that RBI has hiked the interest rates to a record high level and it would be really tough for RBI to hike the rate again
  • He looks at what the popular analysts on TV are opinionating about the situation, and he is happy to note that his thoughts and the analyst thoughts are similar
  • He concludes that RBI is likely to cut the rates if not for keeping the interest rates flat
  • As an outcome, he expects the market to go up

To put his thoughts into action, he buys call options of State Bank of India.

trader

Tarun: He has a slightly different opinion about the situation. His thought process is as below:

  • He feels expecting RBI to cut the rates is wishful thinking. In fact he is of the opinion that nobody can clearly predict what RBI is likely to do
  • He also identifies that the volatility in the markets is high, hence he believes that option contracts are trading at very high premiums
  • He knows from his previous experience (via back testing) that the volatility is likely to drop drastically just after RBI makes its announcement

To put his thoughts into action, he sells 5 lots of Nifty Call options and expects to square off the position just around the announcement time.

investor

Girish: He has a portfolio of 12 stocks which he has been holding for over 2 years. Though he is a keen observer of the economy, he has no view on what RBI is likely to do. He is also not worried about the outcome of the policy as he anyway plans to hold on to his shares for a long period of time. Hence with this perspective he feels the monetary policy is yet another short term passing tide in the market and will not have a major impact on his portfolio. Even if it does, he has both the time and patience to hold on to his shares.

However, Girish plans to buy more of his portfolio shares if the market overreacts to the RBI news and his portfolio stocks falls steeply after the announcement is made.

Now, what RBI will eventually decide and who makes money is not our concern. The point is to identify who is a speculator, a trader, and an investor based on their thought process. All the three men seem to have logic based on which they have taken a market action. Please note, Girish’s decision to do nothing itself is a market action.

Sunil seems to be highly certain on what RBI is likely to do and therefore his market actions are oriented towards a rate cut. In reality it is quite impossible to call a shot on what RBI (or for that matter any regulator) will do. These are complex matters and not straightforward to analyze. Betting on blind faith, without a rational reasoning backing ones decision is speculation. Sunil seems to have done just that.

Tarun has arrived at what needs to be done based on a plan. If you are familiar with options, he is simply setting up a trade to take advantage of the high options premium. He is clearly not speculating on what RBI is likely to do as it does not matter to him. His view is simple – volatility is high; hence the premiums are attractive for an options seller. He is expecting the volatility to drop just prior to RBI decision.

Is he speculating on the fact that the volatility will drop? Not really, because he seems to have back tested his strategy for similar scenarios in the past. A trader designs all his trades and not just speculates on an outcome.

Girish, the investor on the other hand seems to be least bit worked up on what RBI is expected to do. He sees this as a short term market noise which may not have any major impact on his portfolio. Even if it did have an impact, he is of the opinion that his portfolio will eventually recover from it. Time is the only luxury markets offer, and Girish is keen on leveraging this luxury to the maximum. In fact he is even prepared to buy more of his portfolio stocks in case the market overreacts. His idea is to hold on to his positions for a long period of time and not get swayed by short term market movements.

All the three of them have different mindsets which leads them to react differently to the same situation. The focus of this chapter is to understand why Girish, the investor has a long term perspective and not really bothered about short term movements in the market.

2.2 – The compounding effect

To appreciate why Girish decided to stay invested and not really react to short term market movement, one has to understand how money compounds. Compounding in simple terms is the ability of money to grow when the gains of year 1 is reinvested for year 2.

For example consider you invest Rs.100 which is expected to grow at 20% year on year (recall this is also called the CAGR). At the end of the first year the money is expected to grow to Rs.120. At the end of year 1 you have two options:

  1. Let Rs.20 in profits remain invested along with the original principal of Rs.100 or
  2. Withdraw the profits of Rs.20.

You decide not withdraw Rs.20 profit; instead you decide to reinvest the money for the 2nd year. At the end of 2nd year, Rs.120 grows to Rs.144. At the end of 3rd year Rs.144 grows to Rs.173. So on and so forth.

Compare this with withdrawing Rs.20 profits every year. Had you opted to withdraw Rs.20 every year then at the end of 3rd year the profits would have been just Rs. 60.

However since you decided to stay invested, the profits at the end of 3 years is Rs.173. A good Rs.13 or 21.7% over Rs.60 is generated just because you opted to do nothing and decided to stay invested.  This is called the compounding effect.  Let us take this analysis a little further, have a look at the chart below:

M3-Ch2-Chart1

The chart above shows how Rs.100 invested at 20% grows over a 10 year period. If you notice, it took almost 6 years for the money to grow from Rs.100 to Rs.300. However the next Rs.300 was generated in only 4 years i.e from the 6th to 10th year.

This is in fact the most interesting property of the compounding effect.  The longer you stay invested, the harder (and faster) the money works for you. This is exactly why Girish decided to stay invested – to exploit the luxury of time that the market offers.

All investments made based on fundamental analysis require the investors to stay committed for the long term. The investor has to develop this mindset while he chooses to invest.

2.3 – Does investing work?

Think about a sapling – if you give it the right amount of water, manure, and care would it not grow? Of course it will. Likewise, think about a good business with healthy sales, great margins, innovative products, and an ethical management. Is it not obvious that the share price of such companies would appreciate? In some situations the price appreciation may delay (recall the Eicher Motors chart from previous chapter), but it certainly will always appreciate. This has happened over and over again across markets in the world, including India.

An investment in a good company defined by investable grade attributes will always yield results. However, one has to develop the appetite to digest short term market volatility.

2.4 – Investible grade attributes? What does that mean?

Like we discussed briefly in the previous chapter, an investible grade company has a few distinguishable characteristics. These characteristics can be classified under two heads namely the ‘Qualitative aspect’ and the ‘Quantitative aspects’. The process of evaluating a fundamentally strong company includes a study of both these aspects. In fact in my personal investment practice, I give the qualitative aspects a little more importance over the quantitative aspects.

The Qualitative aspect mainly involves understanding the non numeric aspects of the business. This includes many factors such as:

  1. Management’s background – Who are they, their background, experience, education,  do they have the merit to run the business, any criminal cases against the promoters etc
  2. Business ethics – is the management involved in scams, bribery, unfair business practices
  3. Corporate governance – Appointment of directors, organization structure, transparency etc
  4. Minority shareholders – How does the management treat minority shareholders, do they consider their interest while taking corporate actions
  5. Share transactions – Is the management buying/selling shares of the company through clandestine promoter groups
  6. Related party transactions – Is the company tendering financial favors to known entities such as promoter’s relatives, friends, vendors etc at the cost of the shareholders funds?
  7. Salaries paid to promoters – Is the management paying themselves a hefty salary, usually a percentage of profits
  8. Operator activity in stocks – Does the stock price display unusual price behavior especially at a time when the promoter is transacting in the shares
  9. Shareholders – Who are the significant shareholders in the firm, who are the people with above 1% of the outstanding shares of the company
  10. Political affiliation – Is the company or its promoters too close to a political party? Does the business require constant political support?
  11. Promoter lifestyle – Are the promoters too flamboyant and loud about their lifestyle? Do they like to display their wealth?

A red flag is raised when any of the factors mentioned above do not fall in the right place. For example, if a company undertakes too many related party transactions then it would send a signal of favoritism and malpractice by the company. This is not good in the long run. So even if the company has great profit margins, malpractice is not acceptable. It would only be a matter of time before the market discovers matters pertaining to ‘related party transactions’ and punishes the company by bringing the stock price lower. Hence an investor would be better off not investing in companies with great margins if such a company scores low on corporate governance.

Qualitative aspects are not easy to uncover because these are very subtle matters. However a diligent investor can easily figure this out by paying attention to annual report, management interviews, news reports etc. As we proceed through this module we will highlight various qualitative aspects.

The quantitative aspects are matters related to financial numbers. Some of the quantitative aspects are straightforward while some of them are not. For example cash held in inventory is straight forward however ‘inventory number of days’ is not. This is a metric that needs to be calculated. The stock markets pay a lot of attention to quantitative aspects. Quantitative aspects include many things, to name few:

  1. Profitability and its growth
  2. Margins and its growth
  3. Earnings and its growth
  4. Matters related to expenses
  5. Operating efficiency
  6. Pricing power
  7. Matters related to taxes
  8. Dividends payout
  9. Cash flow from various activities
  10. Debt – both short term and long term
  11. Working capital management
  12. Asset growth
  13. Investments
  14. Financial Ratios

The list is virtually endless. In fact, each sector has different metrics. For example:

For a retail Industry: For an Oil and Gas Industry:
  1. Total number of stores
  2. Average sales per store
  3. Total sales per square foot
  4. Merchandise margins
  5. Owned store to franchisee ratio
  1. Oil to Natural Gas revenue ratio
  2. Exploration costs
  3. Opening oil balance (inventory)
  4. Developed reserves
  5. Total production growth

Over the next few chapters we will understand how to read the basic financial statements, as published in the annual report. As you may know, the financial statement is the source for all the number crunching as required in the analysis of quantitative aspects.


Key takeaways from this chapter:

  1. The mindset of a trader and an investor is different
  2. The investor has to develop an investment mindset if he is serious about investing
  3. The investor should stay invested for a long period of time for the returns to compound
  4. The speed at which the money doubles increases drastically the more time you stay invested. This is one of the properties of compounding
  5. Every investment has to be evaluated on two aspects – qualitative & quantitative
  6. Qualitative aspects revolve around the non numeric information related to the company
  7. The quantitative aspects involve analyzing numeric data. The financial statements are the important source of finding the quantitative data.

69 comments

  1. Aditya says:

    Hi Karthik/ZeroDha Team,
    Thank you for explaining the way one should approach towards wealth creation. Really helpful.
    I have a question. As I’m completely new, I’ve gone through all the chapters (and modules) till this part. So, I tried to look at Zerodha margin claculator for Equity and Equity Futures and here are my doubts/quesries:
    1) One can hold Equity Futures as NRML till its expiry date while the same stock could very well be bought for investement as an Equity under CNC order and it gets into ones DEMAT account
    2) Zerodha margin caculator comes pre-populated with the stock price for Equity Futures but not for Equity. Which means, If I opt for Eicher in Equity Futures margin caculator, I get the price as “18499.2”. Now, if I want to check how many shares I can actually buy for long term investment for Eicher, I got to Equity margin calculator, bring up Eicher, enter the cash available and the price “18499.2” obtained from Future margin caculator and click Go to see the number of shares I can buy. The Equity margin caculator comes pre-populated with “100” as price for all equities it seems
    3) NIFTY and BANKNIFTY are available under Equity Futures but not under Equity. Does it mean the indexes can be traded only in futures and if one wants to really buy equities as an investment specifically from the index like Nifty/BankNifty, one can buy that for individual companies listed in Nifty/BankNifty (I mean indexes)
    Please bear with me as I’m completely new and got confused at this point of time. Really thanks in advance for reading through my questions.

    • Karthik Rangappa says:

      Glad to know you are liking the Varsity’s material. Here are the answers –

      1) Yes you can buy futures under NRML and hold till expiry or buy spot CNC and hold as investments in your DEMAT
      2) Yes, you can modify the quantity and price. In fact I would suggest you look at nseindia website for live prices and you can feed the margin calculator with that price for more accurate results
      3) Yes, you can trade NIFTY and Bank Nifty under the derivatives segment. However if you want to buy and hold, then you can buy the ETF. A nifty ETF called Niftybees is like a stock which you can buy and hold for long term…and the value of Niftybees varies as per the daily index value. Check this link for more details – http://www.nseindia.com/products/content/equities/etfs/etf.htm

      Also, please feel free to ask us how many ever question you want. After all the purpose of Varsity is to share knowledge and help each other to become informed market participants.

  2. Navin M.vaidya says:

    How can I actively connect with Zerodha. I am a swing trader.,especially ther services & pricing/charges part. Thank you.

  3. Durjoy says:

    Sir,what is your profession?What courses do i need to study to enter the investment business?

  4. Suresh.ks says:

    Hi, sir
    You have mentioned 11 Qualitative aspects in this model
    But how can we get all these information about Related party transaction,operator activity in stock,political affiliation and all

    • Karthik Rangappa says:

      Its all in the Annual Report, you need to read between lines 🙂

      • Himanshu Pant says:

        Annual reports as the name implies are only generated once a year.. Between the remaining 364 days, isn’t this too a big a period where everything can happen ?

        Secondly given the qualitative parameters you have indicated , will there be any company which will be satisfying all of them ? For e.g. even Infosys has been mired in ethics case w.r.t US visa misuse

        • Karthik Rangappa says:

          Well, you can keep track of the company and the developments from its quarterly results. P&L is additive, so you get a good sense of how the sales and expense are trending. Any major debt the company raises is also reported.

          No, its highly unlikely to find a company that scores well on all criteria.

  5. Suresh.ks says:

    Hi, sir
    How can we find red flag is raised pls explain about this once again

    • Karthik Rangappa says:

      Like I said, its all in the Annual Reports. Reading it end to end helps. Additionally read and watch as many management interviews as possible. This will help as well.

  6. RD3032 says:

    Hi Karthik,
    Do we have to manually do fundamental analysis by our own? It will be helpful if you mention some websites where those information is readily available.
    Thanks,
    Deepak

  7. MADHUSUDAN says:

    HI Karthik,
    Little out of context and personal question but i am sure you can help me.
    I am a b.tech graduated from nit kurukshetra and this may i left my job because i want to make my carrier in finance as this is the field i love to learn and i am trading now as a perspective of learning only,But i think i must have to join a good corporate industry so that i can learn fast.So i am here for your guidance,What i do for a head start in this industry? i don’t have a financial background but i am following market from last 4 month actively and i think i have a sound knowledge of market and its working.Had a interview with future first but i didn’t make it.Need your guidance and i think you got my point.I want to work either as a trader or as a analyst.
    I am reading continuously zerodha-varsity and i can say it is the best platform for everyone and specially for a non financial background.Thanks for your valuable work and this remind me the people who work hard for humans for a better knowledge and life,thanks for the valuable time,efforts and dedication.

    • Karthik Rangappa says:

      Thanks for the kind words, feels satisfying when people benefit from our efforts 🙂

      I think the best way forward for you would be to take up a globally recognized certification in Finance. I’d highly recommend these three –

      1) Get a CFA for a career in Asset Management – https://www.cfainstitute.org/pages/index.aspx

      2) Get a FRM for a career in Risk Management or say a Business Analyst at large BFSI companies – https://www.garp.org/#!/frm

      3) Get a CQF for a career in Quantitative trading – https://www.garp.org/#!/frm

      Good luck.

      • MADHUSUDAN says:

        Hi karthik,
        Thanks for your prompt reply to my query,really appreciated your answer.
        Still i satisfied with your answer but i have no plan to study further for a year or two because i want to get full market knowledge and experience and after that i will take a course in finance either through MBA in finance or the courses you recommended so here again i want you to suggest me further on my approach,i can do anything for my dreams.I hope you understand my concern.
        Thanks for your kind support.

        • Karthik Rangappa says:

          I understand, but a formal certification early in your career will take you a long long way later on, so do think about it.

  8. sammandar khan says:

    Hi dear, Does the registration have free of cost on the Zerodha Varsity?

  9. sammandar khan says:

    Dear, why did you repeat the same thing (Profitability and its growth
    Margins and its growth) The quantitative aspects. Is there any difference?
    Thanks

  10. sammandar khan says:

    Hi Karthik
    Where I can get easily about the qualitative aspects details from?
    Thanks

  11. Chandrashekhar says:

    Is there any website where we can check the any updates of the company
    like announcement made by company regarding opening new unit,

    • Karthik Rangappa says:

      None that I know off. However, I use google alerts to keep track of all the companies I’ve invested in.

  12. nadeem says:

    Kathik bhai! You have become my guru because of the amazing work you did with Zerodha Varsity. I’m a budding trader and i’ve started my stock markets journey with zerodha only. Hope you grow to great heights, the market needs hardworking and committed people like you. Keep rocking. Luv from Hyderabad

  13. Tapovan Vashisht says:

    Hi karthik, i have a question for you. While using charts on Pi, we see option to place a buy or sell order instantly through “Quick limit order”, so is there anyway this can be made “quick market orders” by changing the settings?

  14. rohan029 says:

    1, How to check shareholding pattern of a company. For example for Eicher Mototrs in moneycontrol.com I am just able to see Individuals / Hindu Undivided Family are holding 3.4% shares. But I am not able to see their names, so how to check their background? I even checked bse official website.

    2. Also I checked corporate action in bse(for eicher motors). There it was mentioned that independent directors were appointed in march,june. So what deductions cn be made from these.

    • Karthik Rangappa says:

      1) Use the annual report for this
      2) Appointing independent directors is mandatory, nothing unusual about it.

  15. AkshayB says:

    Hello Kartik,
    How can we find Operator activity in stocks.

  16. sansriti says:

    Hi Karthik
    When you write “However since you decided to stay invested, the profits at the end of 3 years is Rs.173.” Do you mean the value will be 173 and the profit will be 73 only?

  17. Sansriti says:

    Also you mentioned about Suzlon being a wealth destructor. Do you see it as a turnaround company capable of generating long term wealth? Any specific checks that I can do?

    • Shyam says:

      Yes I too have same question about Suzlon..May be due to some bad decisions it was struggling..But some how feel it would grow as growth of Renewable energy and back up from Govts.

      Hi Karthik
      Comments please on how to analyze..

      • Karthik Rangappa says:

        As I mentioned, I’ve not been tracking this stock. So I’m afraid I cannot comment. However, you need to see how the cash flow, P&L is performing. Also check if the debt has been reducing (or restrucured).

        • sansriti says:

          I had seen the balance sheet few months back, they are reducing their debt significantly. And they started making profits also I think last year. But I will go through the full Fundamental Analysis module, and then do my own analysis and then get back to you. (might take some time, please don’t vanish).
          And I wanted to thank you soooo much for developing Zerodha Varsity. Past couple of months, before coming across Zerodha, I was just reading randomly on Google, or watching some videos on Youtube. They were okay, I was getting to know what things are, but it was only when I started reading here, that I started to understand things fundamentally which is making my base strong. Zerodha Varsity is the Holy Book for me. And even more thanks for being there, answering to each and every question, no matter what it pertains to. Its a very good feeling to know that someone is out there to guide when we stumble across something. You are way more than wonderful with what you are doing. A big thank you from all of us, the budding trader and investors, for making us learn the words of wisdom 🙂

    • Karthik Rangappa says:

      Not sure, I’ve not checked that stock in a while now.

  18. PRAVESH KUMAR says:

    how to check Company fundamental

  19. amit k says:

    sir, what is cash flow
    and what kind of information this gives us?

  20. Manoj K says:

    Sir,
    I have my trading account with broker Motilal Oswal and zerodha, I want to quit from Motilal Oswal and continue to trade on Zerodha.I hold some stocks with MO, can I transfer in zerodha to keep in the account are sell from here, charges or brokerages etc will be applicable? what is the procedure please help me out.

  21. Deepak says:

    What is the importance of pledge percentage? Can we buy the shares if the company has pledged its shares?

    • Karthik Rangappa says:

      It indicates the % of shares the promoter has pledged. I’d be concerned if this % is very high.

      • Deepak says:

        I analysed one company in IT sector “8K Miles Software”. Its growth is good. But its pledged percentage is 7.90. Should I analyse this further? The industry leader TCS also has pledged percentage of 2.98. So please mention how much % is ideal. Also please explain more about this factor in this chapter.

        • Karthik Rangappa says:

          I’m not sure if 7.9% is high or low. What you need to be doing is to investigate why so many shares are pledged and what are the promoters doing with the amount received.

  22. shahofblah says:

    Hi
    In your qualitative criteria I think ethics should be segregated into breaches of ethics that hurts shareholders and those that help the company. I think the difference is significant for the purposes of an amoral shareholder.

    So I do not see why no. 10 in your criteria is a negative. In fact the two questions you ask here are quite different; being close to a political party is a boon while ‘requiring’ political support implies a competitive defect which is a bane.
    There exist several examples of Indian corporations that have close political connections and have grown in value over the long term(*cough, cough* RIL, Adani Group *cough, cough*) and I am sure every entity of a certain size has political connections in this country.

    Also, are these criteria India specific? While some ethical criteria do apply weakly to India, they would apply even less in, say, banana republics where having ties to a despot is a competitive advantage.

    • Karthik Rangappa says:

      These are sort my own checklist, developed over the years. Nothing is set in stone. There are not two ways about ethics and certainly no classifications. Yes, I do agree with you on the political connections – the question really is, how much of that connection is being leveraged for running the business.

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