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You have the option to trade, speculate or invest depending on your preference. Each type of participation is different. It is important to decide what type of market participant you want to be. This can make a big difference in his Profit & loss account.
Let's look at a market scenario to help you understand the implications and how each market participant (trader, investor, speculator) would respond.
THE SCENARIO
In the coming days, the RBI will meet to discuss their latest stance on monetary policy. Due to high and sticky inflation, RBI raised interest rates during each of the 4 previous monetary policy reviews. We all know that an increase in interest rates would mean less growth for Corporate India, which would result in lower earnings.
Let's say there are three market players - Shubham. Rohit and Aakash. Each would have a different view of the above scenario and take different actions in the marketplace. Let's take a look at their thinking process.
(Please Note: Option contracts will not be discussed here. This is just for illustration. In the next modules, we will learn more about derivatives.
Shubham: He analyzes the situation and uses these thoughts to make his decision:
He purchases call options from the State Bank of India to put his ideas into practice.
Rohit has a slightly different view of the situation. Here is his thought process:
He sells five lots of Nifty call options to put his ideas into practice and expects that he will be able to close the position around the announcement time.
Aakash's portfolio of 12 stocks is his, which he has held for more than 2 years. He is an avid observer of the economy but has no opinion on what RBI will do. He doesn't worry about the outcome of the policy as he plans to keep his shares for a long period. He believes that the monetary policy will only have a short-term effect on his portfolio and is merely a passing tide in the market. He has the patience and time to keep his shares even if it does.
Aakash will buy more portfolio shares if the market reacts too strongly to the RBI announcement and portfolio stocks fall sharply.
We are not concerned with the final decision of RBI and who makes the money. Based on their thinking process, it is possible to identify a trader, a speculator and an investor. The logic that they use to take market actions seems to be the same for all three men. Note that Girish's decision not to take any market action is market action.
Shubham seems very certain about what RBI will do. Therefore, his market actions seem to be oriented toward a rate reduction. It is difficult to predict what RBI or any regulator will do. These complex issues are difficult to understand. Speculation is betting on blind faith without any rational reasoning to support one's decision. Sunil appears to have done exactly that.
Rohit has figured out what to do based on a plan. If you're familiar with options, Tarun is just setting up a trade in order to take advantage the high options premium. As it doesn't matter to him, he clearly doesn't speculate about what RBI will do. He believes that volatility is high, so premiums are attractive to options sellers. He expects volatility to fall just before the RBI decision.
Are they speculating about the possibility that volatility will fall? He seems to have tested his strategy in similar situations before. Traders design all their trades, not only speculate on the outcome.
Aakash, the investor on the other side, doesn't seem to be too concerned about what RBI will do. This is a temporary market noise that may not have a significant impact on his portfolio. He believes his portfolio will recover even if the impact was significant. Girish believes that time is the only luxury market and is determined to maximize this luxury. He is willing to purchase more stocks from his portfolio in the event that the market reacts negatively. He wants to keep his positions in place for a long time, and not be influenced by market movements.
They all have different mentalities which can cause them to react differently in the same situation. This chapter focuses on Aakash, an investor who has a long-term view and is not concerned about the market's movements.
Understanding how money compounds are key to understanding why Girish chose to remain invested and not react to market movements. In simple terms, compounding is the ability for money to grow when years 1 and 2 are reinvested.
Consider investing Rs.100 to get a 20% annual growth rate (also known as the CAGR). The money should grow to Rs.120 by the end of the first fiscal year. You have two choices at the end of year 1.
Instead of withdrawing Rs.20 profit, you decide to reinvest your money for the 2 and 3 years. The 2nd years end with Rs.120 growing to Rs.144. At the end of the 3 years, Rs.144 rises to Rs.173. And so on.
This is similar to withdrawing Rs.20 every year. If you had chosen to withdraw Rs.20 each year, the profit at the end 3 years would have been Rs. 60
The profits after 3 years are Rs.173, however, because you chose to remain invested. You chose to invest and did not do anything. This generated a good Rs.13 or 21.7% more than Rs.60. This is known as the compounding effect. Let's take this analysis one step further.
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Above is a chart showing how Rs.100 invested at 20% growth over a 10-year period. It took 6 years for the money from Rs.100 up to Rs.300. The next Rs.300 was however generated in just 4 years. From the 6th to the 10th year.
This is actually the most fascinating property of compounding. The compounding effect works harder and faster if you are invested longer. Girish made the decision to stay invested to take advantage of the market's luxury of time.
Fundamental analysis is a requirement for all investments. Investors must be committed to the long-term. This mindset is essential for any investor who chooses to invest.
Consider a sapling. If you gave it the right amount of water, manure, and care, would it not grow? It will. Think about a business that is profitable, has high margins, innovative products, and employs ethical management. It is not hard to see how the share prices of these companies would rise. While the price appreciation might be delayed in some cases (remember the Eicher Motors chart mentioned earlier), it will always appreciate. This is what has happened in every market around the globe, including India.
A good investment is defined as investable grade attributes you will always get results. But, it is important to be able to digest the volatility of the market in the short term.
As we have already discussed, an investment-grade company is distinguished by a few characteristics. These characteristics can be divided into two categories: the Qualitative aspect' or the Quantitative attributes'. These aspects are both important in evaluating a company's fundamental strength. Actually, I place more emphasis on the qualitative aspects than the quantitative aspects in my personal investment process.
The Qualitative AspectThis mainly involves understanding non-numeric aspects. These factors include:
If any of the above factors are not in the right place, it is a red flag. A company that engages in too many related-party transactions could be a sign of favoritism or malpractice. That's not really a good idea for the long term. Even if the company has high-profit margins it is unacceptable to engage in malpractice. It is only a matter of time until the market finds out about "related party transactions" and penalizes the company with a lower stock price. Investors would be better off staying away from companies that have large margins if they are not satisfied with corporate governance.
Because these are subtle issues, it can be difficult to identify qualitative aspects. An investor who is diligent can find these aspects by looking at the annual report, interviews with management, and news reports. We will be highlighting various qualitative aspects as we go through the module.
Quantitative aspects are financial matters. While some aspects of quantitative analysis are simple, others are more complex. Cash in inventory, for example, is straightforward. However, the inventory number of days is more complicated. This is an important metric to calculate. Quantitative aspects are very important to stock markets. Quantitative aspects can include many things.
There are many other options. Each sector actually has its own metrics. Take, for example:
| For a retail Industry: | For an Oil and Gas Industry: |
|---|---|
1. Total Numbers of stores | 1. Oil to Natural Gas Revenue Ratio |
| 2. Average Sales Per Stores | 2. Exploration Costs |
| 3. Total Sales Per Square Foot | 3. Opening Oil Balance Inventory |
| 4. Merchandise margins | 4. Developed Reserves |
| 5. Owned Stores to Franchisee Ratios | 5. Total Population Growth |
In the following chapters, you will learn how to understand the financial statements as presented in the annual report. The financial statement, as you might know, is the main source of all the numbers required to analyze quantitative aspects.