Definitive-guide-to-successful-equity-investing.pdf

Thank you downloading this Money Simplified Guide. We hope you enjoy reading it, and help you become a wise investor “The greater our knowledge increases the more our ignorance unfolds” - John F. Kennedy So, here are other popular Money Simplified Guides that can prove valuable for you… 10 Steps to Select Winning Mutual Funds The Definitive Guide to Financial Planning Retirement Planning Guide Your Definitive Guide To Estate Planning For more Money Simplified Guides, visit: www.PersonalFN.com

An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

2

Foreword Many of you may have heard and read about host of things related to investing in stocks. But have you practiced the right approach to investing? While equities can help you counter the inflation bug better by accelerating the pace of wealth creation, you see, it is imperative to have a prudent and disciplined approach to investing as well. During exuberant times of stock markets, many find investing in equities tantalising and often make a mistake of ignoring fundamentals and valuations. And the result is known; they stand to lose money and blame their luck for not having created wealth through investment in equities. But here’s a famous quote by Ignas Bernstein, he said, “If you wait for luck to help you, you’ll have often an empty stomach.” This is so true and reflects the importance taking responsibility for our actions. In turbulence times such as those encountered in the past few years in the equity markets, it is vital to be a responsible investor first, to tread on the path of wealth creation while investing in equities. PersonalFN primarily would like to thank Equitymaster.com for being knowledge partners, in the endeavour to educate investors towards investing in equities successfully. Through this guide we have tried to capture expertise and experience to your benefit and explained the prudent and disciplined way of investing in stocks; which can help you make money in equities. We hope it will be an informative reading and wish you a VERY HAPPY & SMART INVESTING!! Team Personal FN

An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

3

Disclaimer This Guide is for Private Circulation only and is not for sale. The Guide is only for information purposes and Quantum Asset Management Company Private Limited (Quantum Mutual Fund) and Quantum Information Services Private Limited (PersonalFN) is not providing any professional/investment advice through it. The Guide does not constitute or is not intended to constitute an offer to buy or sell, or a solicitation to an offer to buy or sell financial products, units or securities or units of schemes of Quantum Mutual Fund. Quantum Mutual Fund and PersonalFN disclaim warranty of any kind, whether express or implied, as to any matter/content contained in this guide, including without limitation the implied warranties of merchantability and fitness for a particular purpose. PersonalFN, Quantum Mutual Fund and its subsidiaries / associates / affiliates / sponsors / trustee or their officers, employees, personnel, directors will not be responsible for any direct/indirect loss or liability incurred by the user as a consequence of his or any other person on his behalf taking any investment decisions based on the contents of this guide. Use of this guide is at the user’s own risk. The user must make his own investment decisions based on his specific investment objective and financial position and using such independent advisors as he believes necessary. Quantum Mutual Fund and PersonalFN do not warrant completeness or accuracy of any information published in this guide. All intellectual property rights emerging from this guide are and shall remain with PersonalFN. This guide is for your personal use and you shall not resell, copy, or redistribute this guide, or use it for any commercial purpose. All names and situations depicted in the Guide are purely fictional and serve the purpose of illustration only. Any resemblance between the illustrations and any persons living or dead is purely coincidental. Please read the terms of use.

An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

4

Index Section I: Fundamentals of Equity Investing

07

What affects stock prices?

07

Understanding market trends

09

Section II: Ways to Invest in Equity

14

Direct investing vs. indirect investing via mutual funds

14

Why you should consider investing in mutual funds?

17

How to select mutual funds for your portfolio?

19

Direct vs. Regular plan – Which one to opt for?

23

Benefits of SIPs

25

Section III: Building a Stocks Portfolio

27

Importance of Asset Allocation

27

Understanding Equities from a Market Capitalisation Perspective

29

Setting the Foundation for Equity Allocation

32

Section IV: How to Pick Stocks Prudently for Your Portfolio

37

Using Price to Earnings Ratio

37

Using Price to Book Value Ratio

40

Using Return on Equity Ratio

42

Using Return on Capital Employed

44

Identifying opportunities in major corporate events

46

An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

5

Section V: Value Investing

49

What is Value Investing all about?

49

What is Value?

50

4 simple steps to Value Investing

51

Section VI: Lesson from Successful Investment Gurus

57

Warren Buffett - The Legendary Investor

57

Charlie Munger - The Legendary Investor's Alter Ego

64

Peter Lynch – The Legendary Fund Manager

68

An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

6

I: Fundamentals of Equity Investing As you may know, there are thousands of companies listed on stock exchanges (where investors actively buy or sell shares among themselves). However, it is difficult to know the market mood unless the pulse of the market is felt. The number of investors willing to buy a stock vis-àvis the number of sellers helps you determine the pulse of the market. This active participation of both – buyers and sellers in the equity market helps to get a sense on the direction of the market – whether it is in the grip of the bulls or bears. Over the years along with their bellwether index, stock exchanges have launched variety of indices capturing the movement of shares of underlying companies within the respective market capitalisation, sector and theme. The index value is calculated based on a number of factors including the weightages given to different companies and change in their market capitalisations among others. The bellwether index gives idea about the broader trend of the entire market, while the indices capturing market capitalisations, sectors and themes reflect the trend within their respective domain. At the macro level, the bellwether index of the stock market is considered a barometer to measure the potential of the economy. So, when the economy is anticipated to do well, stock markets usually show a positive movement and vice-versa.

And what affects stock prices? Everything else remaining the same, stock prices are affected simply by demand-supply gap. So, typically when there are more buyers chasing a stock, the price moves up as potential sellers seek higher prices for giving way to buyers. Conversely, when there are more sellers ready to dump stocks, potential buyers seek lower prices to accept the dumped stocks. Thus, we need to see what affects the demand-supply equation of a stock.

An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

7

Factors moving stock prices

Company Specific Factors

Risk Appetite of Investors

Stock Prices

Money Supply

In a dynamic world and thus the demand and supply equations are driven by host of dynamic variables – which could be at the macroeconomic level, political level, industry level, and company level. It is a combination of all these factors that builds the investment sentiments either in the positive or negative towards stock prices. In times of euphoria when everything seems hunky-dory, it is a period of risk-on; which means investors’ appetite for risk is high, making market breath and investor sentiments positive. A supportive factor to this is also the money supply in the market, which allows the mood to be buoyant, as more money chases risky assets such as equity. Moreover, along with the domestic macroeconomic factors in play, global cues also have a bearing on domestic equity.

Domestic Economy (India) Company Specific Factors Stock Prices

Risk Appetite of Investors

Money Supply

Global Economy

An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

8

The diagram above depicts that, how every facet explained above has a bearing on stock prices and they don’t work in isolation. Each facet is subset to the other and reflects interlinks of events which have effect on stock prices. In this era of globalisation no company or no investor can stay unaffected by what happens outside the domestic economy. Interdependence of economies affects equity markets across the globe, although the degree may vary. To make it simple and easy for you to understand how stock markets are affected, we have highlighted various scenarios in the below table, which would help you assess the likely impact on stock movements.

Understanding Market Trends….

Company specific factors Positive Negative Positive Positive Negative Negative Positive Negative

Scenario Risk appetite of investors High High Low High Low High Low Low

Money supply High High High Low High Low Low Low

Impact on stock market movement Positive Moderately positive Moderately positive Moderately positive Moderately Negative Moderately Negative Moderately Negative Negative

The table presents different scenarios along with likely impact on the stock market. It is clear that, when all three factors are positive, markets would by and large have a positive impact and vice versa. But when one of the factors turns negative, markets may not benefit as much as they would have otherwise benefited when all three factors were positive. Similarly when only one of the factors is positive, markets turn moderately negative. So, before you invest in equities, analyse how these factors would play under different economic conditions. You must be wondering how you can analyse aforesaid factors if you have no prior experience. An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

9

Don’t worry; it is not impossible for you. You only need to learn few concepts, check out some indicators and apply common sense. To begin with let’s brush up some economic concepts… As you may be aware not all countries are at the same stage of economic development. A few countries are far more developed, while the others are developing and emerging. Thus when compared on infrastructure facilities, employment opportunities, education, healthcare facilities and so on, each of them will paint a different picture. Hence, some countries struggle to build infrastructure and healthcare facilities; while are way ahead in employment opportunities and education. Therefore countries are classified as developed, developing and emerging economies. Usually, the economic growth rate is higher in less developed or developing countries and is naturally lower in case of developed countries. Today, investors are not restrained by any geography. That’s why we have foreign investors participating in our economy and the domestic ones investing overseas in accordance to laws in force. In the pursuit of clocking a high returns, investors are on a lookout for promising investment destinations which leads to shift in capital across economies depending on their underlying fundamentals. While looking at promising investment destinations, it is vital to ascertain economic cycles rightly and assess the stage of development in the economy. If the economic growth of a nation is accelerating, risk appetite towards such an economy would be greater. This is because, rapid development throws ample opportunities for businesses to flourish and earn high profits. Growth springs in more employment opportunities and rise in income, which in turn facilitates a better savings rate if the inflation bug is kept in check.

Economic cycle As you may know, any economy can rarely advance unilaterally. There are four basic phases in an economic cycle. As shown in the diagram below, a phase of boom is followed by a phase of recession. A more severe recession leads to depression, but at some point in time the economy starts recovering and eventually another boom phase shapes up.

An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

10

Economic cycles

It is noteworthy that, risk taking ability of businesses and that of the investors is at the highest point when the economy is booming and it starts dipping at every stage of slowdown in the pace of economic development. Risk averseness is at the highest point when economy is depressed. But then a few businesses and investors take a counter view and start betting aggressively against the tide. As others see success of these early movers, they also start feeling confident about and risk taking ability re-emerges. There are a few indicators that help you identify the health of economy; and yes, let’s not forget stock market movement is one of them. Economic Indicators Although economic indicators may not narrate the entire story, when tracked carefully and in an appropriate manner, they can help you form a fair estimate about the health of economy. There are broadly seven economic indicators which are:       

Gross Domestic Product (GDP); Unemployment rate; Rate of inflation; Direction of interest rates; Exchange rate (currency movement); Fiscal deficit; and Performance of stock market An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

11

It should be noted that while the stock market is the barometer of the economy, it is vital to carefully study the other forces as well which guide the trend for the stock market. This is because of inter-connectivity of these indicators. Stock market phases Now that you know about economic cycles and economic indicators and recognise there pertinence; let’s move forward and understand the stock market phases. Well, like in economic cycles we have period of boom, recession, depression and recovery, in stock market we broadly have two - a bull phase and a bear phase. When indices are moving up; it is safe to assume that, the markets are in the grip of bulls while on the downward spiral it can be assumed to be in the paws of the bears. Therefore a phase where general bias of the market movement is upward is known as the bull phase, while when the general bias of the market movement is downward, it is known as bearish phase. But sometimes markets also depict a sideways movement where there is no clear indication whether it is in the hands of bulls or bears. Thus, such a phase is also called a phase of consolidation. Economic phase vs. market phase As seen above, stock market phases and the economic cycles are closely interrelated; only that they may not always move in congruence. This is because, while everything may seem hunky-dory for the domestic economy, there could be global economic headwinds in play, which may lead to the stock market behaving strange. Stock markets are always sniffing around on news. They are forward looking. They reflect the expectation about future course of economic development. In other words, markets may reach their peak before the economic cycle may float in boom and start to correct before the lowest point in the economic cycle is reached. Where you can possibly go wrong? Novice investors (and even the mature ones in some cases) while they read into the economic data and newsflashes, they make a mistake of looking at the present and speculating; which can be hazardous to their wealth and health. It is important to be forward looking and reckon the An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

12

implications and take a prudent investment decision. Often investors follow a practice of investing in euphoria and exiting in a panic; and this is why, usually, investors lose their hard earned money. Prudently, one should be investing in a panic and exiting in a euphoria, whereby you buy low and sell high. Would you go out shopping and buy something when it’s expensive? Certainly not, right? Similarly, while you invest in equities in your endeavour of wealth creation, alike prudence needs to be adopted. While investing, both positive and negative economic indicators need to be assessed. It could be economic growth, inflation (measured by Consumer Price Index), unemployment data, corporate spending and so on. If the negatives outnumber the positives, the stock market could be under the paws of the bear, while in vice versa, locked up in the horns of bulls. Therefore sensing this animal spirit of the market is imperative. Investors often miss the transitions in the equity market phases as the data points fail to convince them. And mind you, it would be incorrect to be under the impression that the transition from bull phase to bear phase and vice-a-versa would be immediate. Since we are in the midst of discussing economic cycles and stock market phases, allow us to take you some historical facts to recognise how long a cycle can last and how would it impact your investments. Every economy goes through cycle of boom, recession, depression and then a recovery. Usually, average time lag between the peak of one cycle and the peak other, is about 55 months or close to about 5 years. Similarly, average time lag between two troughs (or bottom of economic cycle) is about 56 months; which is again close to 5 years. The minimum time taken to reach from a peak to peak (or even from trough to trough) has rarely been less than 3 years. Another theory (Monte Carlo Simulation) suggests that losses may less frequently occur if the investor stays invested for longer duration. Therefore, concept of staying invested in equities with a minimum time horizon of 3-5 years has been largely and rightly been advocated, which is backed by actual data and proven theories. The idea is to stay invested for the entire economic cycle. However, using this as rule of thumb overlooking some compelling facts may not be advisable. To gain more insights while investing in equity, it is imperative to study the relation between equity market phases and economic market cycles.

An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

13

II: Ways to Invest in Equity Today with advancement of technology investing in equities is been made simple. It’s just a click away. Broadly, there are two ways you can invest your hard-earned money in equities…

Direct Investing: You could opt to invest directly into stocks. Direct equity investing is considered more dynamic by the investor community and thus, those who can keep a continuous tab on the equity markets prefer the direct equity route as it gives them much needed zing and excitement. However, the dynamism in the direct equity investment comes with risk. Now while this is considered to be a dynamic and active approach to invest into equities, you need to be confident, well-versed and keep a continuous tab on the equity markets. Hence, only if you are able to understand the nitty-gritty of the equity markets and are able to devote time and energy, you can adopt this route to equity investments. So, here’s what you need to have if you wish to directly invest in equities:  A trading account with a registered stock broker  A demat account with a depository participant, which may be a registered broker or a bank  And of course, the capital to invest - the money!  Apart from aforesaid things, you need to also have a savings bank account which can be linked to your demat account and also comply with the Know Your Client (KYC) requirements by furnishing the requisite documents. Moreover, access to internet based platforms would allow you to perform real time transactions on your own without much of hassles, rather than calling up your broker to transact. But there are some limitations of investing in stocks directly: - Selecting and monitoring the stocks is a time consuming task An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

14

-

Stock selection requires a skill of being able to foresee industry trends and assess the potential of a company to capitalise on opportunities At times you might wrongly interpret the situation, based on your rationale towards a company or the group Moreover, there are chances of you missing key information about a stock and taking investment decision based on inadequate information To avoid the above mentioned circumstances, while investing directly in stocks you might always take help from professionals who can provide you unbiased researchbacked views and guidance.

Indirect Investing: Not all investors are same in their intelligence and understanding levels. And even if someone has the ability to understand the direct equity route, he or she lacks the time to devote to such investment activity and thus prefer taking the indirect route to equity investments via mutual funds. So, if you aren’t able to understand the nitty-gritty of the equity markets and devote time; look out to invest in equity via the second option i.e. through equity mutual funds, which is an indirect way. Mutual funds provide the much needed ease while investing in the equity asset class. So let’s quickly understand what is a mutual fund? A mutual fund is a legal vehicle that enables a collective group of individuals to: Pool their surplus funds and collectively invest in instruments / assets for a common investment objective. - Optimize the knowledge and experience of a fund manager, a capacity that individually they may not have. - Benefit from the economies of scale, which size enables and may not be available on an individual basis. Investing in a mutual fund is like an investment made by a collective. An individual as a single investor is likely to have lesser amount of money at disposal than say, a group of friends put together. Now, let’s assume that this group of individuals is a novice in investing and so the group turns over the pooled funds to an expert to make their money work for them. This is what a professional Asset Management Company (AMC) does for mutual funds. The AMC invests the investors’ money on their behalf into various assets towards a common investment objective. An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

15

Hence, technically speaking, a mutual fund is an investment vehicle which pools investors’ money and invests the same for and on behalf of investors, into stocks, bonds, money market instruments and other assets. The money is received by the AMC with a promise that it will be invested in a particular manner by a professional manager (commonly known as fund manager). The fund managers are expected to honour this promise. The SEBI and the Board of Trustees ensure that this actually happens. The AMC employs various employees in different roles who are responsible for servicing and managing investments. It offers various products i.e. Mutual Fund Schemes, which are structured in a manner to benefit and suit the requirement of investors’. Every scheme has a portfolio statement, revenue account and balance sheet.

Equity mutual funds As the name suggests, equity mutual funds invest in equity markets on behalf of investors. They come in variations. Some of them are diversified equity funds while the others are sector funds, or maybe thematic funds. Diversified equity funds These funds diversify the equity component of their Asset Under Management (AUM), across various stocks and sectors. Such funds offer the benefit of true diversification and avoid taking sectorial bets i.e. investing more of their assets towards a particular sector such as banking, oil & gas, etc. Thus, they use the diversification strategy to reduce their overall portfolio risk. Sector Funds These funds are expected to invest predominantly in a specific sector, as per their investment mandate. For instance, a banking fund will invest only in banking stocks. Generally, such funds invest a dominant portion of their total assets in a respective sector. Index Funds These funds seek to have a position which replicates the index, say S&P BSE Sensex, NSE Nifty or CNX Midcap, etc. They maintain an investment portfolio that closely replicates the composition of the chosen index, thus following a passive style of investing.

An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

16

Why you should consider investing in mutual funds? Well, mutual funds offer several important advantages over direct stock-picking. These are… 

Diversification: Investing in stocks directly has one serious drawback - lack of diversification. By putting all money in just a few stocks, the investor subjects himself to considerable risk should even one of those stocks decline. On the other hand, a mutual fund scheme by investing in several stocks tries to overcome the risk of investing in just 3-4 stocks. By holding say 20 to 30 stocks or even more, the fund avoids the danger that one rotten apple will spoil the whole portfolio. Mutual fund schemes own a couple of dozen stocks in their portfolio. A diversified portfolio can generally hold its downside even if a few stocks fall dramatically. This helps in containing the overall risks. 

Professional management: No matter how sound an investment sense a stock investor may have, a noteworthy point is active portfolio management requires considerably more skills, not to mention a lot of time too. There is an ocean of difference between part-time stock-picking and full-time fund management. Now compare this to mutual fund investing; the mutual fund investor does not have to track the prospects and potential of each and every company in the portfolio. Mutual funds are managed by skilled professionals who continuously monitor these companies and take decisions on whether to buy, sell or hold a particular stock in the portfolio.



Lower entry level: There are just few quality stocks today an investor can enter into, with Rs 5,000 – Rs 10,000. Investing in stocks can be an expensive affair. Sometimes with as much as Rs 5,000 an investor can buy just a single stock. The minimum investment in a mutual fund may be as low as Rs 500. This implies that with just Rs 500, a mutual fund investor can take exposure in a fund portfolio of 20-30 stocks. The entry barrier in mutual funds is low so as to encourage investor participation.



Economies of scale: By buying a handful of stocks, the stock investor loses out on economies of scale. This tends to pull down the profitability of the portfolio. If the investor actively buys and sells stocks in his personal capacity, it would also impact his profitability due to various charges involved.

An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

17

Due to frequent purchases/sales, mutual funds incur proportionately lower trading costs than individuals. Lower costs translate into significantly better investment performance and returns to the investors. 

Liquidity: A stock investor may not always find the liquidity in a stock to his liking. There could be days when the stock keeps hitting the up / down circuit and buying/selling is curtailed. This does not allow him to enter / exit a stock. Such liquidity problems are not confronted by a mutual fund investor. Sometimes a mutual fund may be more liquid than other investment avenues. For instance, there are days when there are no buyers or sellers for an individual stock. But an open-ended fund can be bought / sold at that day's Net Asset Value (NAV) by simply approaching the fund house or its registrar or AMFI registered distributor, or with technology at your recourse you could do it by yourself.



Minimises losses: Investing in mutual funds assures more safety of investment than investing directly in stocks. A company may shut shop or may go bankrupt. According to the law, the equity shareholders are paid last, after paying all dues to the creditors of the company. A mutual fund may lose money, but may not go down as easily as a company. The legal structure and stringent regulations that bind a mutual fund safeguard a unit-holder's interests far better.



Innovative plans for investors: By investing in the stock market directly, the investor deprives himself of various innovative plans that are offered by mutual funds. Mutual funds offer automatic re-investment plans; systematic investment plans (SIPs) and features therein (viz. step-up, flex, trigger, pause, or perpetually continue your SIPs), systematic withdrawal plans (SWP), asset allocation plans, triggers, etc. These features allow investors to enter/exit or switch from funds seamlessly and on the whole facilitate investment ease significantly. This is something an investor can never duplicate individually.

So as highlighted above, investing in mutual funds offers some unique benefits that may not be available to direct stock investors. However by no means are we insinuating that investing via mutual funds is the only way of clocking growth. This can also be done even by investing directly into the right stocks. However, mutual funds offer you the investor, a relatively safer and surer way of picking growth minus the hassle and stress that has become synonymous with stocks over the years. An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

18

On account of the aforementioned advantages which mutual funds offer, they (mutual funds) have emerged as immensely popular investment vehicle, especially for retail investors, and for investors looking for growth with relatively lower risks. Investors should also keep in mind that selecting a mutual fund scheme is not alike buying vegetables from a grocery store. A thorough analysis is required to select winning mutual funds for one’s portfolio in order to create wealth over the long term.

How to select mutual funds for your portfolio? There is a plethora of mutual fund schemes available today and hence the confusion while selecting the best mutual fund schemes. But here are some vital points that can help you prudently select mutual fund schemes for your portfolio… 

Performance: The past performance of a fund is important in analysing a mutual fund. But, remember that past performance is not everything, as it may or may not be sustained in future and therefore should not be used as a basis for comparison with other investments. It just indicates the fund’s ability to clock returns across market conditions. And, if the fund has a well-established track record, the likelihood of it performing well in the future is higher than a fund which has not performed well. Under the performance criteria, we must make a note of the following: 1. Comparison: A fund’s performance in isolation does not indicate anything. Hence, it becomes crucial to compare the fund with its benchmark index and its peers, so as to deduce a meaningful inference. Again, one must be careful while selecting the peers for comparison. For instance, it doesn’t make sense comparing the performance of a mid-cap fund to that of a large-cap. Remember: Don’t compare apples with oranges. 2. Time Period: It’s very important that as an investor you have a long-term horizon (of at least 3-5 years) if you wish to invest in equity oriented funds. So, it becomes important for them to evaluate the long-term performance of the funds. However this does not imply that the short term performance should be ignored. Besides, it is equally important to evaluate how a fund has performed over different market cycles (especially during the downturn). During a rally it is easy for a fund to deliver above-average returns; but the true measure of its performance is when it

An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

19

outperforms its benchmark and peers during the downturn. Remember: Choose a fund like you choose a spouse - one that will stand by you in sickness and in health. 3. Returns: Returns are obviously one of the important parameters that one must look at while evaluating a fund. But remember, although it is one of the most important, it is not the only parameter. Many investors simply invest in a fund because it has given higher returns over the past few years. In our opinion, such an approach for making investments is incomplete. In addition to the returns, one also needs to look at the risk parameters, which explain how much risk the fund has undertaken to clock higher returns. 4. Risk: To put it simply, risk is a result or outcome which is other than what is / was expected. The outcome, when different from the expected outcome is referred to as a deviation. When we talk about expected outcome, we are referring to the average or what is technically called the mean of the multiple outcomes. Further filtering it, the term risk simply means deviation from average or mean return. Risk is normally measured by Standard Deviation (SD or STDEV) and signifies the degree of risk the fund has exposed its investors to. From an investor’s perspective, evaluating a fund on risk parameters is important because it will help you to check whether the fund’s risk profile is in line with their risk profile or not. For example, if two funds have delivered similar returns, then a prudent investor will invest in the fund which has taken less risk i.e. the fund that has a lower SD. 5. Risk-Adjusted Return: This is normally measured by Sharpe Ratio (SR). It signifies how much return a fund has delivered vis-à-vis the risk taken. Higher the Sharpe Ratio better is the fund’s performance. As an investor, it is important to know the same because you should choose a fund which has delivered higher risk-adjusted returns. In fact, this ratio tells us whether the high returns of a fund are attributed to good investment decisions, or to higher risk. 6. Portfolio Concentration: Funds that have a high concentration in particular stocks or sectors tend to be very risky and volatile. Hence, you should invest in these funds only if you have a high risk appetite. Ideally, a well-diversified fund should hold no more than 50% of its assets in its top-10 stock holdings. Remember: Make sure your fund does not put all its eggs in one basket. 7. Portfolio Turnover: The portfolio turnover rate refers to the frequency with which stocks are bought and sold in a fund’s portfolio. Higher the turnover rate, higher the volatility. The fund might not be able to compensate you adequately for the higher An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

20

risk taken. Remember: Invest in funds with a low turnover rate if you want lower volatility. 

Fund Management: The performance of a mutual fund scheme is largely linked to the fund manager and his team. Hence, it’s important that the team managing the fund should have considerable experience in dealing with market ups and downs. As mentioned earlier, as an investor, you should avoid fund’s that owe their performance to a ‘star’ fund manager. Simply because if the fund manager is present today, he might quit tomorrow, and hence the fund will be unable to deliver its ‘star’ performance without its ‘star’ fund manager. Therefore, the focus should be on the fund houses that are strong in their systems and processes. Remember: Fund houses should be processdriven and not 'star' fund-manager driven.



Costs: If two funds are similar in most contexts, it might not be worth buying mutual fund scheme which has a high costs associated with it, only for a marginally better performance than the other. Simply put, there is no reason for an AMC to incur higher costs, other than its desire to have higher margins. The two main costs incurred are: 1. Expense Ratio: Annual expenses involved in running the mutual fund include administrative costs, management salary, overheads etc. Expense Ratio is the percentage of assets that go towards these expenses. Every time the fund manager churns his portfolio, he pays a brokerage fee, which is ultimately borne by investors in the form of an expense ratio. Remember: Higher churning not only leads to higher risk, but also higher cost to you, the investor. Invest in a fund with a low expense ratio and stay invested in it for a longer duration. 2. Exit Load: An exit load is charged to you when mutual fund units are sold within a particular tenure. Most equity funds charge exit load if the units are sold within a period of one year from the date of purchase. As exit load is a fraction of the NAV, it eats into your investment value.

Among the factors listed above, while few can be easily gauged by you, there are others on which information is not widely available in public domain. This makes analysis of a fund difficult and this is where the importance of a prudent and unbiased investment adviser or Certified Financial Guardian comes into play.

An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

21

Now one may say, why not go by fund ratings instead. While you can do that, as such ratings are easily available on many online portals, here are some words of caution on that…. In the recent times, giving "star ratings" to a fund has been the trend adopted by many mutual fund research houses / rating agencies, in an effort to help investors to pick the "right" mutual funds. And influenced by them, investors too fancy having star rated mutual fund schemes in their portfolio. But the question which arises to our mind is, can these star rated funds be like real rock stars in the portfolio. Today, interestingly the media —both print as well as the electronic media, also sermon about star rated funds so often, that it has an influencing impact on the minds of many of you. Banking on this environment, mutual fund distributors / agents / investment advisers / relationship managers too are busy persuading their clients to invest in star-rated mutual funds. But question still remains unsolved, "are you buying rock stars or winning mutual fund schemes to your portfolio?" It is vital to recognise that just having blind faith and following the norm that more "stars" there are on the scorecard, better is the fund's performance; sounded good or logical during our school days when a 5 star for our homework, connoted that we were good students. But it is vital to recognise that evaluating a mutual fund's performance is far different! It is noteworthy that most star ratings take into account only quantitative methodology considering the past performance (returns), expense ratio, risk (Standard Deviation) and risk-adjusted returns (Sharpe Ratio) of the respective fund. But they ignore the qualitative factors such as the fund house history, its credentials, the investment systems and processes followed by the fund house, portfolio characteristics, adherence to the stated investment objectives etc.; which drives the performance of the fund in future. Remember, forecasting the fund’s future performance is no cakewalk. It is not a simple function of "sorting" on excel - as used in most of the rating methodology. Moreover ratings subscribe to the "one size fits all" approach. They seem to suggest that if a fund has earned a top-notch position, investors across categories can invest in the same. But remember investing and financial planning are personalised activities. Hence, a fund could be right for one investor and (despite its sterling performance) be completely unsuitable for another. Yes, they could perhaps serve as starting points for identifying a

An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

22

broader set of investment-worthy funds; but investing in a fund, based solely on number of stars against its name may not be the right move. The fact is, not all mutual funds are same. There are various aspects within a mutual fund scheme, which are vital for you as an investor to study carefully before investing.

Direct vs. Regular plan – Which one to opt for? In January 2013, the Securities and Exchange Board of India (SEBI) made it mandatory for all mutual fund houses to launch ‘Direct Plans’ for all schemes. The rationale behind the introduction was: simplify investing and provide the benefit of lower expense ratio to those opting for ‘Direct Plan’ vis-à-vis a ‘Regular Plan’. Here are some distinguishing features of a direct plan vs. a traditional regular plan: Regular Plan

Direct Plan

You transact through mutual fund distributor / investment advisor / relationship manager The recommendation are guided by the mutual fund distributor / investment advisor / relationship manager, and there is after sales support service Indirectly commission is paid by the fund house on the money you invest You incur a higher expenses ratio (due to the distributional cost involved)

You directly invest either physically or online visiting registrar's or mutual fund company's office There’s no guidance. You do your own research to invest and selfhelp

Since you invest directly, no commission is paid by the fund house on the money you invest The expense ratio is lower as there is no commission to be paid to the distributor

So, when you finally invest in a mutual fund scheme after doing thorough research, opt for ‘Direct Plans’ over ‘Regular Plans’. A comparative lower expense ratio charged by ‘Direct Plans’ translates into better returns for you aiding you to create better wealth in the long run. ‘Direct Plans’ generate roughly 0.5% to 1.0% additional returns every year, thanks to lower costs. It may not seem much at first, but, if you sow seeds of these small savings, you may harvest rich rewards over 15- 20 years — thanks to the power of compounding.

An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

23

Save Huge Costs Over The Long Term

(Source: PersonalFN Research)

As can be seen in the chart above, a small difference in costs can result in savings of anywhere between Rs 8-17 lakh over 20 years, on a Rs 10 lakh investment. Yes, you can earn an additional amount of as much as Rs 17 lakh, if the difference in costs is as much as 1% point. The final portfolio value varies with the magnitude difference in expenses. Every 0.25%-point difference in the expense ratio works out to an additional earning of Rs 4.50 lakh in 20 years’ time, if Rs 10 lakh is invested. So, adopt a prudent approach and opt in for ‘Direct Plan’ as against a regular plan while investing in respective mutual fund scheme. It can help in big way when you’re addressing long-term financial goals of your life such as child’s future or you own retirement.

SIP into mutual funds to achieve your long-term financial goals Systematic Investment Plan (or SIPs) is a mode of investing in mutual funds. It is alike to investing in a recurring deposit of a bank, where you deposit a fixed sum of money into your recurring deposit account, and enjoy a fixed rate of interest. But the only difference in case of SIPs is that, your money is deployed in a mutual fund scheme (equity schemes and / or debt schemes), and the returns generated for you by the respective funds are variable and are subject to market risks. In case of SIPs, a fixed amount as desired by you, is debited from your bank account on a specified date. And this is not it! You also have the flexibility to make your SIPs on a daily, monthly or a quarterly basis. Today, SIPs have evolved; you can make flexi-SIPs, step-up (or top-up your SIPs), trigger you SIPs at a particular index level, pause SIPs, and even opt for perpetual SIPs —these are the 5 features that available while SIPping into mutual funds, but An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

24

not all mutual fund houses offer all the features. You can enrol for SIP either through an ECS mandate, NACH mandate or through post-dated cheques. The amount so debited from your bank account is invested in the scheme(s) as selected by you for a specified tenure (months, years). This thus enables you to invest regularly and build wealth over the long-term. Hence SIP enforces a disciplined approach towards investing, and infuses regular saving habits which we all have probably learnt during our childhood days when we used to maintain a piggy bank. Yes, those good old days where our parents provided us with some pocket money, which after expenditure we deposited in our piggy banks and at the end of particular tenure we saw that every penny saved became a large amount. Today, thanks to technology that some Asset Management Companies (AMCs) / mutual fund houses and investment transaction portals also provide the ease and convenience of transacting online. Here are some benefits of investing in equity mutual funds through SIPs… 

Light on the wallet: The SIP route enables you to invest in smaller amounts at regular intervals (daily, monthly or quarterly). This in turn reduces your burden of defraying a lump-sum at one go from your bank account. So, if you cannot invest Rs 5,000 in one shot don’t worry. You can simply take the SIP route and trigger the mutual fund investment with as low as Rs 500 to begin with an in multiples of Rs 100 thereafter. Mind you, a daily SIP is also possible (if you want to manage the volatility of the equity markets on daily basis).



Makes market timing irrelevant: Most investors try to time the stock markets; which in our opinion is a complete waste of time and hazardous to your wealth as well as your health! Remember having a long-term investment horizon is the key to wealth creation. If bearish market conditions (as experienced during the turmoil of 2008 and early 2009), gave you the jitters and made you feel that you had never invested in equities; then SIPs would have been of help. Timing the markets, apart from requiring a full time attention also requires expertise in understanding economic cycles and market scenarios, which you may or may not possess.

An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

25

But, that does not necessarily make equities a loss-making investment proposition. Studies have repeatedly highlighted the ability of equities to outperform other asset classes (debt, gold, even real estate) over the long-term (at least 5 years) as also to effectively counter inflation. So, now one may ask if equities are such a great thing, why are so many investors complaining. Well, it’s because they either got their stock or the mutual fund scheme wrong or the timing wrong. In our opinion both these problems can be solved through SIP in a mutual fund scheme having a steady track record, as the SIP route enables you to even-out the volatility of the equity markets effectively. 

Power of compounding: Your regular investments through the SIP route will help your wealth grow by leaps and bounds. So, say you start a SIP of Rs 1,000 today, in a mutual fund scheme following prudent investment system and processes, with a SIP tenure of 20 years. You will be amazed to see that your small savings of Rs 1,000 has grown into a huge corpus of around Rs 10 lakh in 20 years (assuming a modest return of 12% p.a.).



Rupee cost averaging: In order for you to absorb the shocks of the volatile equity markets well, SIP works better as opposed to one-time investing. This is because of rupee-cost averaging. Under rupee-cost averaging you would typically buy more of a mutual fund unit when prices are low and similarly buy fewer mutual units when prices are high. This infuses good discipline since it forces you to commit cash at market lows, when other investors around you are wary and exiting the market. It also enables you to lower the average cost of your investments.

An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

26

III: Building a Stocks Portfolio In our ambition to make money, we often get attracted towards equity markets, and why not? Equities carry a history of being the most rewarding asset class in the long run. We all vie to invest in stocks or equity mutual funds and most often get fascinated with the excitement created with equity investing. But investing based on calls and tips that come from our brokers, friends, newspapers, news channels etc., may not work. You need to scientifically think through and devise an investment strategy that’ll augur well for your long-term financial health. The best strategy is to have a systematic and well aligned portfolio. So here we explain the prudent approach to equity investing and how to go about building your portfolio. Let us start with Asset Allocation.

Importance of Asset Allocation Over the past few years, the stock market has been on a roller coaster ride. Investors have seen the S&P BSE Sensex reach dizzying heights and then crash with equally dizzying speed. Although the market today may look promising, many investors are still confused. "How and where do I invest my money," is the question on everyone's mind. While many know that equities should form a key component of their investments, they still do not know how they should go about deciding which companies to invest in when it comes to direct equity investing. So, they usually tend to rely on 'tips' or on their broker's or friends' advice. Then when an unforeseen situation like the stock market crash is witnessed, that is when the proverbial cookie crumbles. In order to safeguard one's investment, it is essential to follow the principle of "asset allocation" while investing in equities. So what exactly do we mean by 'asset allocation' with regards to a stock portfolio? To simply put, asset allocation in equities is just a practical extension of the age-old adage – “Do not put all your eggs in one basket.”

An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

27

It advocates the need to have a portfolio where your investments are distributed over not only different companies and sectors, but also cover different types of equity groups such as large caps, mid caps and small caps and even various mutual fund schemes. But you see, ideal allocation should be a function of your investment objective and also your appetite for risk. When you smartly allocate your 'equity money', the risks you take get distributed. Suppose, for instance, there is a drought and as a result of which consumer demand in the country is expected to suffer a setback. Now, companies which are focused on selling their goods and services to the domestic market are likely to take a hit as their near term prospects no longer look great. But on the other hand, a company that is selling software services in the global market will be relatively isolated from these developments. So, having both such companies in a portfolio has the impact of reducing the volatility in returns over time. Thus investing across sectors is a step towards investing wisely. Holding stocks of companies or equity mutual fund schemes with different market capitalizations (such as small caps, mid caps and large caps) is a step further in the same direction. A small cap software company, with a market cap of say Rs 3.49 billion, may promise greater rate of returns compared to say a large cap software company which has a market cap of say about Rs 1,700 billion. However, the security of having a blue-chip company cannot be matched by small caps. This is of course a very simplistic example. We will further discuss the pros and cons of companies with different market caps even further, but the core idea is to have a mix of companies in a portfolio. Let's take another very well-known example: During the late 1990s everyone was talking about and investing in what they called "Tech stocks" as technology was perceived to be a booming sector. Everyone wanted to position their portfolios and capitalize on what was then called the 'new economy'. And we know what happened soon after... tech stocks crashed. In fact hundreds of these tech wonders actually disappeared (mostly the smaller companies) leaving a big hole in investors' portfolios. A smart investor, who had a welldiversified portfolio, though impacted, far outperformed 'tech' leveraged investors over the years that followed. And at the end of the day, that's what matters the most - what you earn from your portfolio over the long-term. After all, equities are best suited for generating long term wealth! An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

28

Why should allocation be done? We need returns on our investment for different reasons. Some invest in equities to secure their life after retirement. For others, equities are meant to be used for their child's marriage or education. For some others it may just mean funds for planning a world tour two years down the line while for some it may be a combination of all these goals. As our needs differ, so does the time period needed to fulfil them. While planning for a world tour may be viewed as a short-term (2-5 yrs) objective, investments done for a child's education may be done keeping in mind a time period of 5 - 15 years. So based on the duration for which you require to keep your money invested in, you need to accordingly allocate your 'equity money'. How do you draw the ideal asset allocation plan? Each individual is different so an asset allocation plan will differ from person to person based on his or her personality traits, age, risk taking capacity and the ultimate investment objective in mind. One cannot take a 'one size fits all' approach. Building a equity portfolio is a complex activity. It is vital to focus on the key aspect i.e. allocation of your portfolio between large cap, mid cap, small cap and micro-cap stocks (which aids diversification), along with the other critical aspects related to investing in equities.

Understanding Equities from a Market Capitalisation Perspective You see, before understanding how to allocate funds for investing in equities, it is important to understand both your expectation of return (which can be a function of your financial goals) and also your risk appetite. Once you are clear on these, it will be a lot easier for you to allocate money between equities with different market capitalisation segments. When it comes to stocks, there are three main classifications 1. Large Cap stocks; 2. Mid Cap stocks; and 3. Small Cap stocks. An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

29

Here, the term 'cap' simply refers to the 'market capitalisation' of the stock. And what is market capitalisation? It is the value of the stock that you arrive at by multiplying the stock price by the company's outstanding number of equity shares.

Market Capitalisation = Current Stock Price x Number of Shares outstanding

For a better understanding, let us see an example: Company XYZ has 1,00,00,000 shares outstanding and its current share price is Rs 8. Based on the above formula, we can calculate that Company XYZ's market capitalisation is Rs 80 million, or 10,000,000 shares x Rs 8 per share. Large cap stocks As we mentioned above, the first category based on market capitalisation is that of 'large cap stocks'. One can look at the S&P BSE-Sensex or S&P BSE-100 Index as a reference point for large cap stocks. Market capitalisation for stocks in the S&P BSE-100 Index, for instance, ranges from Rs 200 bn to Rs 3,500 bn. These are stocks of usually large and well-established companies that have a strong market presence and are generally considered as relatively safe investments. One important fact about large caps is that information regarding these companies is readily available in newspapers and magazines. Most of the large cap companies have good disclosures and therefore there is no dearth of information for an investor looking into them. Large companies such as Infosys, TCS, and Wipro are classified as large cap stocks. These companies have been around in the industry long enough and have firmly established themselves as leading players. Their stocks are publicly traded and have large market capitalisations.

An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

30

Mid cap stocks Mid caps lie between large cap stocks and small cap stocks. Mid cap stocks are those that generally have a market capitalisation within the range of Rs 50 bn and Rs 200 bn. These represent mid-sized companies that are relatively more risky than large cap as investment options yet, they are not considered as risky as small cap companies. They rank between the two extremes on all the important parameters like size, revenues, employee and client base. When one invests in mid caps for the long term, he may be investing in companies that could become tomorrow's runaway success stories. Generally speaking, mid cap stocks as an investment can bring you higher returns in 3 to 5 years as opposed to their big brother large cap stocks that can bring you moderate (yet safer) returns during this timeframe. Small cap stocks Lying at the lowest end of market capitalisation, small cap stocks are generally viewed under the misconception of being hazardous or 'quick rich' stocks. However, both these labels are untrue. Small cap companies have smaller revenue and client bases, and usually include the startups or companies in the early stage of development. Small cap stocks are potentially big gainers as they are yet to be discovered within the sector and can show growth potential in large numbers once unfurled in the market. However, as these enterprises are small ventures, these should be researched properly. This is considering that a lot of small companies do not have the financial strength to survive bad times and some of them might be mismanaged businesses run by greedy promoters. Hence it is essential, especially in the case of small caps investments that you do thorough research regarding the promoters' credentials, management strength and track record, and long and short-term growth plans of the company before investing. Small caps are often stated to be a platform to make big returns in a short span of time. However, we would state that small caps can prove to be a very wise 'long term' investments especially if the chosen companies are good businesses and are well-managed.

An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

31

So to conclude… As seen from the above, you as an investor have three options to choose from as far as allocating money to stocks is concerned. And as mentioned earlier, the allocation is dependent entirely on your risk appetite. All these categories consist of some really good long term investment opportunities. But you need to decide the allocation based on the opportunity's merit and not just whether it is a large cap, mid cap, or small cap. Purely as a matter of prudence and safety, if you have an investment time horizon of 10 to 15 years, 60-70% of your investible surplus can be allocated to large caps and 10-15% each to mid and small caps. This allocation is just a guideline, and we repeat, allocate to equities based on a thorough understanding of different kinds of companies across different levels of market capitalisation.

Setting the Foundation for Equity Allocation Now that you have understood the categorisation of equities in terms of market capitalisation, we can get into the more specific need of building a stocks portfolio that fits your needs. Along with keeping in mind your risk appetite, it is firstly important to identify your age factor, earnings, and objectives for creating wealth. Keeping in mind that we can't have a 'one-size-fits-all' strategy, we have discussed broadly the different and necessary key assumptions required towards an investor: If you’re single As the old saying goes, what the wise man does in the beginning, fools do in the end. When you're young and without a care in the world, life seems perfect. If you haven't crossed the 30 mark, and are still single, planning for your retirement or even your future seems a distant thought. But wise are those who start planning from the start! Life as a singleton is often a lot more carefree and individualistic. You tend not to think of additional responsibilities such as kids, housing, schooling etc. It's all about working hard, partying harder and living it up. But somewhere reality sets in and that's when you start preparing to plan for your future.

An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

32

Indicative asset allocation portfolio for a singleton Single

Large cap Mid cap Small cap

<30 years Carefree 70-80% 5-10% 5-10%

30-45 years 45-55 years >55 years Building Wealth Adding To Wealth Carefree Retirement 60-70% 70-80% 80-90% 10-15% 10-15% 0-5% 10-15% 0-5% 0-5%

As a young and single individual, under the age of 30, you would enjoy a carefree lifestyle. As a single person you would have lesser earnings due to a single source of income, and would most definitely have more expenses keeping in mind the way most people enjoy a high profile lifestyle. Then, for a person like you, the best kind of investments would be those of investing into safer large cap stocks which would ensure a safe return at the end of a longer tenure. As you progress through the years and become stable in your career, your income starts to rise and you can ideally afford to take a slight amount of risk towards wealth creation. It would be advisable at this juncture to invest in mid and small cap stocks as you cross 30 years of age. Being in your 30’s and early 40’s, mid and small caps are usually suggested at this juncture as they bring higher returns in a shorter span of time or even if you invest in small caps for a long period of time they will bring you higher returns than that of simply investments in large caps. As your age advances, the inherent urge to take risks reduces. So, as you approach the 45 to 55 age bracket, you would want to take lesser risks, and therefore your concentration shifts from simply building wealth as you may have done earlier. At such a stage, the majority of your portfolio (70-80%) should be in large caps. This not only ensures safety of the original capital invested, but also ensures relatively safer returns on the said capital. Once you cross 55, it's all about looking towards building a safe retirement plan at around 60. This is the time to start increasing allocation to large caps in the equity portfolio. Allocation to mid and small caps should reduce, while the same towards large caps should increase to 80-90% of the total equity portfolio. And ideally while you are around the retirement age, you should not have a dominant portion allocated towards equities as an asset class, and the focus should shift towards wealth preservation, wherein fixed income instruments could be considered.

An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

33

Two's company There are those who enjoy their single status in life, and then there are those for whom life is about having someone to share it with. Sharing joys and sorrows, sharing health and wealth; it's all about being a couple for some. Indicative asset allocation portfolio for a person who is married and has no kids <30 years Property Top Priority Large cap 70-80% Mid cap 5-10% Small cap 5-10%

Married- No kids 30-45 years 45-55 years >55 years Building Wealth Planning Retirement Carefree Retirement 60-70% 70-80% 80-90% 10-15% 10-15% 5-10% 10-15% 0-5% 0-5%

There is a famous acronym for working couples in the West - DINK, deciphered as a 'Double Income No Kids' family. This concept is also now being adopted within the Indian culture amongst the youth, who work harder to earn and enjoy spending their wealth between the husband and wife only. However despite the 'double income', as a married person you would still have more expenses compared to the earnings, as there is a second person to fend for as well. The most practical approach to investing at this point would be to invest a greater portion of your equity investments into safer large caps. Similarly as it is with singletons, once you cross the 30 age mark and your income has risen, there is a sense of having achieved financial stability. You feel more secure in your financial growth and hence find it easier to allocate a slightly larger amount (10 to 15%) as opposed to earlier, towards small and mid cap space, in order to fasten the process of wealth creation. Once as a couple you reach the circle of 45 to 55 years of age, you usually start thinking and planning for your retirement as opposed to creating wealth for goals such as buying a house, holidays, jewellery etc. Hereon it would be best to allocate a significant portion of your funds (70-80%) towards large caps and pare down the investments in small caps. Once the magical number of 55 years hits you, the main focus remains the retirement plan you have been building. As a couple without children to support, this is a very important corpus. It would be best to further increase allocation to safer large caps while reducing

An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

34

allocations to mid and small caps, so as to ensure that you have built a safe and secure corpus funding for your retirement. Family matters There is a famous line - 'Small family, happy family', but where exactly is that line drawn today? Would it end at being a happy couple, or would it end with the proverbial husband-wife and child scenario? If we were to go by the population of India, it would most definitely be a family inclusive of kids. Yes, there are the rare exceptions to the norm, but on an average the idea of a happy family consists of a set of parents with 2 kids. Indicative asset allocation portfolio for a person who is married with two kids

Large cap Mid cap Small cap

<30 years Property Top Priority 70-80% 5-10% 5-10%

Married-2 kids 30-45 years 45-55 years Planning Children's Property For Future Children 50-60% 70-80% 25-30% 10-15% 5-10% 0-5%

>55 years Retired/Children On Own 80-90% 0-5% 0-5%

Being a married couple is not easy, and especially if you are a married couple with 2 kids. Your main priority at the age of 30 or so would be to ensure you provide your family with housing. A crucial factor at this point would be that even if there are two incomes, the expenditure would most definitely be more, given the fact that there are more than two mouths to feed. It would be best for you to allocate a greater portion of your equity investments into relatively safer large caps. As you cross the 30 year mark, the main focus would be creating wealth for the future needs of your children. As kids start growing up the responsibilities that arise along with them need to be addressed and planned for in advance - such as children's education, marriage and property plans, too. At this juncture since your earnings have increased and your career has gained more stability, you are better positioned to take more risks towards portfolio management. Hence you can invest a slightly large sum (10-30%) towards mid and small caps.

An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

35

As you grow in age, so do your kids and so do their needs and demands. Once the 45 age mark is crossed, your main concern becomes fulfilling the immediate needs of your kids, such as t higher education and perhaps even marriage plans, within the time span of another 5-7 years or so. Keeping this time factor in mind, it is best to redirect your equity allocation more towards large caps (70-80%) which will bring you relatively safe returns, and minimise your sum invested in Small and midcap (5-15%). Once you are > 55 years and your children have been educated and are settled with their own lives, you tend to be concerned with your own plans of creating sufficient wealth for an easy and relaxed retirement, which will soon be approaching. At this point it is best to switch most of your equity allocation into large caps, while reducing investments in small and mid caps, and ensure that you are not dominantly skewed towards very high risk equities. So to conclude… There's a saying "Boulders we cross, it's the pebbles that we stumble over". That is exactly what happens as we strive hard to build our wealth. We work hard, scrimp, save, make adjustments and finally save money - for us, our dreams, our children and their dreams. Somewhere, however, we are so busy trying to survive in our race against time, that the money that we earn so hard is invested quite quickly, without giving due thought: “Are our investments are in tandem with our current and future needs?” Further, thorough research is not conducted and more reliance on tips which can be hazardous to your wealth and health. In the interest of your long-term financial wellbeing, your hard earned money – the investible surplus – is allocated wisely to various asset classes, whereby your portfolio is well-aligned, so that your dreams, financial goals come true. Remember, asset allocation is one of the basic tenets of investing and cannot be ignored.

An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

36

IV: How To Pick Stocks Prudently For Your Portfolio

Now, while you know how to go about building a stocks portfolio, the next significant step is to pick the right stocks for your portfolio. Though many of us aim to get the best money making stocks for our portfolio, selecting the right stocks may not be an easy task. Apart from the required skill sets and knowledge, it needs understanding of some basic concepts based on which you can measure if the stock is worth buying for your portfolio. Here are few important ratios which you can use to compare and prudently choose the right stock for your portfolio…

Price to Earnings Ratio (P/E Ratio) The most commonly used valuation metric by investors is the price to earnings ratio or commonly referred to as the P/E ratio. Though commonly used, it is also misunderstood for various reasons. In simple terms, P/E Ratio indicates how much an investor is willing to pay to earn every single rupee from each share he holds. Or to put it the other way, P/E indicates the approx. time (in years) an investor would take to realize the money invested, provided the company grows at the same pace. How is P/E Ratio calculated? P/E Ratio is calculated by dividing market price of a stock by EPS (earnings per share). EPS in turn is calculated by dividing the net profit of the company by the number of shares outstanding. Having calculated the P/E, what does it stand for? Let’s assume a stock ‘XYZ’ is trading at Rs 100 and its EPS is Rs 20. The P/E multiple is 5 (100 upon 20). Assuming that the company's EPS is likely to be Rs 20 each year, it will take 5 An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

37

years for the investor to realize Rs 100. Of course, the assumption here is that the company's EPS is not growing at all. You may at times find wide difference in P/E multiple of two different companies from different sectors. Why is it so? It is believed that the stock price of a company tracks its long-term earnings growth potential. In an economy, some companies (or sectors) are likely to grow at a faster rate; so, the P/E multiple of companies from these sectors are likely to be higher and vice versa. Depending upon growth expectations, the P/E multiple could vary. Determining the ‘right’ P/E multiple for a stock/sector Unlike metrics like discounted cash flow method and so on, P/E is relatively a simple and at the same time, a powerful metric from a retail investor perspective. Though the factors behind determining the 'right' P/E multiple are important, a historical perspective of a stock's P/E could make this exercise less complex. A person X may assign a higher P/E multiple to the stock as compared to a person Y depending on the risk profile and growth expectations. But in the end, it all boils down to how the company is likely to perform. To determine the P/E multiple for a stock/sector, it is also important to understand industry characteristics of the company. For a stock of a steel manufacturing company, EPS tends to grow at a faster rate when steel prices are recovering or are at the peak and the EPS is likely to decline at a faster rate during downturns. So, if one believes that steel demand is likely to trace long-term economic growth and that 15% growth is unsustainable, the P/E multiple should be ideally much lower than 15 times. Similarly, the long-term growth prospects for software companies could be much higher than commodities. So, the P/E multiple for software stocks could be at a premium. Determining the P/E multiple for a stock/sector also depends on: 1. Historical performance - Why does a stock of a reputed software company trades at a higher P/E multiple compared to a newly founded software company? By historical performance, we mean, focus of the management (without unrelated diversifications), ability to outperform competitors in downturn/upturns and promise vs. performance. This can be gauged if one looks at the last three to five year annual reports of a company. An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

38

2. The sector characteristics - Margin profile, whether it is asset intensive and intensity of competition. Less asset intensive sectors (say, FMCG) are considered defensive and therefore, could trade a premium to the overall market. 3. And more importantly, expectations. Take the case of textile stocks. Expectations of significant growth opportunities post the 2005 quote regime phase out has resulted in upgradation of P/E multiple of the textile sector. When is P/E not useful? 1. Economic cycles - Businesses operate in cycles. During downturn, EPS will be low but P/E will be inflated and vice versa. At the same time, during expansionary phase, corporates invest in capacities. In this case, high depreciation costs suppress earnings. P/E, in this context, may mislead investors. 2. Not actively tracked - There are number of companies in the Indian stock market that are not actively tracked by investors, analyst and institutions. For example, Infosys' average price was Rs 2 in FY94 and the P/E multiple was 17 times. At times, P/E multiple may be lower because some sectors/stocks are not in the limelight. 3. Expectations - On the downside, some stocks may be trading at a significant premium because earnings expectations are higher. High P/E also does not mean a good stock to buy. What if the expectations are unrealistic? One needs to exercise caution to this extent. 4. Means little as a standalone number - P/E, as a standalone number, means little. Besides P/E, it is also important to look at margins, return on net worth, cash generating ability and consistency in performance over the years to assign a value to a stock. 5. Market sentiment - During bear phases or when interest in stocks is low, valuations could be depressed. Since equities are considered less attractive during these periods, valuations are likely to be below historical average or below earnings growth prospects.

An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

39

Price to Book Value Ratio (P/BV Ratio) The price to book value (P/BV) ratio is a widely used valuation parameter used for valuing stocks. P/BV ratio indicates if we are paying more or less for a stock when compared to its book value. This ratio will help you determine if you are paying more for the value of what you can recover if the company decides to dissolve or goes bankrupt immediately. You as an investor should know how to use this parameter to value your investments. How is price to book value calculated? P/BV is arrived at by dividing the market price of a share with the respective company's book value per share. Book value (BV) is equal to the shareholder's equity (share capital plus reserves and surplus). BV can also be derived by subtracting current and non-current liabilities from total assets. For the banking and finance companies, book value is calculated as 'share capital plus reserves minus miscellaneous assets not written-off. This formula then takes care of the bank's NPAs (Non Performing Assets) and gives a correct picture. Let us take up a hypothetical example to calculate the book value: FY17 Balance sheet of company ‘XYZ’ Liabilities Rs bn Assets Rs bn Equity capital 3 Cash 206 Reserves & surplus 310 Other current assets 97 Current liabilities 69 Fixed assets 61 Non-current liabilities 4 Non-current assets 17 Deferred tax assets 5 386 386 (The above examples are hypothetical and used for illustration purpose only)

If one were to take a look at consolidated balance sheet of company ‘XYZ’ for FY17, as mentioned above, book value will be arrived at by adding Rs 3 bn (equity capital) and Rs 310 bn (reserves and surplus), which equals to Rs 313 bn. Conversely, when we deduct current and non-current liabilities from total assets, we shall arrive at a similar figure. Now, by dividing this book value (Rs 313 bn) by the issued equity shares of the company (say approx 574 m), we would arrive at the book value per share figure, which is Rs 545. Say if the current market price of company ‘XYZ’ is Rs 2,438; taking Rs 545 as denominator for calculating the P/BV for the stock, the P/BV will stand at about 4.5x.

An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

40

What does P/BV indicates? Usually, P/BV figures for companies in the services industries like software and FMCG are high as compared to those of companies in the sectors like auto, engineering, steel and banking. This is due to sectors such as software and FMCG have low amount of tangible assets (fixed assets etc.) on their books and therefore, the P/BV may not be a correct indicator of valuation. On the other hand, capital intensive businesses such as auto and engineering require large balance sheets, i.e., they have a large amount of fixed assets and investments. P/BV is a good indicator for measuring value of stocks from such capital intensive sectors. If a company is trading at a P/BV of less than 1, this indicates either or both of the two 

Investors believe that the company's assets are overvalued, or



The company is earning a poor return on its assets.

A high P/BV indicates vice versa, i.e., markets believe the company's assets to be undervalued or that the company is earning and is expected to earn in the future a high return on its assets. Book value also has a relationship with the Return on Equity of a company. In fact, book value can also be termed as equity (equity capital plus reserves and surplus). As such, for a company that earns a high return on equity, investors would be ready to give the stock a high P/BV multiple. What does P/BV fail to indicate? P/BV indicates the inherent value of a company and is a measure of the price that investors are ready to pay for a 'nil' growth of the company. As such, since companies in the services sectors like software and FMCG have a high growth component attached to them, P/E Ratio would be a better method of gauging valuations. Investors would do well to note that P/BV should not be used for valuing companies with high amount of debt. This is because high debt marginalizes the value of a company's assets and, as such, P/BV can be misleading. Though P/BV ratio offers an easy-to-use tool for identifying clearly under or overvalued companies, it also has its shortcomings that investors need to recognise.

An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

41

Return on Equity (RoE) Ratio Return on Equity (RoE) ratio is one of the most important ratios that every investor must understand. RoE ratio is used to measure the efficiency with which a company utilizes the equity capital. How is RoE calculated? RoE is calculated by dividing the 'profit after tax' earned in an accounting year with the 'equity capital' as mentioned in the balance sheet of the company. Let us take a hypothetical example of company ‘XYZ’. The company earned a profit after tax of Rs 59,880 m in FY17. Also, its average equity capital for FY17 was Rs 182,540 m. Thus, RoE of the company ‘XYZ’ in FY17 was 32.8% i.e. Rs 59,880 m divided by Rs 182,540 m. Thus, RoE, when used correctly, can easily measure the management's capability on the three fronts – 1) Profitability (PAT/Sales), 2) Asset turnover (Sales/Assets), and 3) Financial leverage (Assets/Equity) This can be made simpler when we break down the calculation of RoE into these three parts. As such, RoE can also be calculated as Return on Equity = (PAT/Sales) * (Sales/Assets) * (Assets/Equity) OR Return on Equity = Profit margin * Asset turnover * Leverage 1. RoE and Profit margins Profit margins are, most importantly, a measure of the company's pricing power. Consequently, pricing power is a function of – a. Competition: The price a company can charge to its customers depends a lot on the level of competition that it faces. Higher the competition, higher will be the bargaining power of customers and thus, lower will be the pricing power. An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

42

b. Quality of offerings: When competition increases, a company can still charge higher for its products if it moves up the value chain. Another factor that can impact the company's margins is its aggressive investments in building up physical (infrastructure) and human (manpower) resource base. Spending consistently towards employees and marketing initiatives may affect company’s margins, though at a slower rate. And will affect the company's RoE. 2. RoE and Asset turnover Although margins play a crucial role in influencing the RoE of a company, the sales generated for each rupee of assets also plays a very important role. Generating, more sales on less assets means tying up of less capital that a business generates on its assets. As such, determining the asset management capability of a company is the key to gauging the quality of its RoE. 3. RoE and leverage Leverage (the other name for debt) is a tool finance managers can use to perk up a company's RoE in the short term. They can simply take on more of debt than equity to finance their expansion plans. And wow, what investors see is an improved RoE (since debt is deducted from assets to calculate the value of equity)! However, over the longterm, the fact that the company has to pay interest on this debt, reduces its profit margins. This acts as a counter to the rise in RoE due to increased debt levels (if the debt is not productively employed). Thus, investors need to also study debt levels of a company, as this would make their understanding of RoE even simpler. In case of companies with high levels of debt (those in capital intensive industries like steel and automobiles), the leverage ratio will play a very important role in understanding the RoE While RoE is important, it is not everything RoE suffers from one drawback. As mentioned earlier, a company that takes high levels of debt will show up a high return on equity. As such, 'Return on Invested Capital (RoIC)' and not RoE will be a good indicator of testing the company's efficiency levels. However, for understanding the value of companies with nil or marginal amounts of debt, RoE is of great help. We shall explain this with an example:

An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

43

Company 'A' is a debt-free company with a networth of Rs 100 m. During FY17 it earned a net profit of Rs 15 m. As such, its RoE would stand at 15% for the year. Now, in another case, company 'B' has a net worth of Rs 50 m and a debt to equity ratio of 1:1. This means it would have taken up debt to the tune of Rs 50 m. Capital employed in the business is the same amount as of company 'A' i.e. Rs 100 m. Now, as the company has taken up some debt, it would have to pay a certain amount of interest on the debt. For instance, the interest rate on the debt is 10% for the year. As such, the interest cost for the company will be Rs 5 m (10% * Rs 50 m) for the year. The net profit for the year will stand at Rs 10 m (Rs 15 m – Rs 5 m). Now, if we calculate RoE on this basis, it would stand at a high rate of 20% (Rs 10 m / Rs 50 m). This does show the wrong picture. As such, it helps investors to look at trends in RoE over a number of years and analyse each of its components (as mentioned above). It will not only help them understand the P&L account, but also to balance this against the much overlooked left and right sides of the balance sheet.

Return on Capital Employed (RoCE): RoCE is a measure of how effectively a company is able to deploy its capital base (debt and equity) to generate returns for the capital providers. A company which can generate higher return from a lower capital base and continues to improve on the same, should in theory, always be preferred over its peers which need higher capital to generate the same level of return and which cannot sustain the growth in RoCE. As a corollary, this superior RoCE performance should get reflected through the growth in share price. Let’s understand this with a hypothetical example of three companies with increasing RoCE trends: To test the above hypothesis, we analyze three companies with dissimilar market capitalization and with increasing RoCE trends for the period FY12 to FY17. Key parameters of Company A, Company B and Company C (Rs million)

Gross Sales PBIT Capital Employed ROCE

FY12 FY13 21,369 30,466 1,706 2,100 5,807 6,561 32.1% 34.0%

Company A FY14 FY15 FY16 FY17 38,787 47,069 65,850 89,831 2,669 3,480 6,378 8,842 7,244 8,049 10,906 15,376 38.7% 45.5% 67.3% 67.3%

An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

CAGR(12-17) 27% 32% 18%

44

PBIT Margin

Gross Sales PBIT Capital Employed ROCE(%) PBIT Margin

Gross Sales PBIT Capital Employed ROCE(%) PBIT Margin

8.0% FY12 7,948 471 2,421 19.5% 5.9% FY12 2,377 345 2,558 15.2% 14.5%

6.9%

6.9%

7.4%

9.7%

9.8%

FY13 8,908 560 2,698 21.9% 6.3%

Company B FY14 FY15 FY16 FY17 10,131 11,133 12,947 15,711 809 1054 1,438 3,628 2,966 3,282 4,343 5,623 28.5% 33.7% 37.7% 72.8% 8.0% 9.5% 11.1% 23.1%

FY13 3,210 652 2,956 23.7% 20.3%

Company C FY14 FY15 5,304 5,902 895 1,039 2,898 3,689 30.6% 31.5% 16.9% 17.6%

FY16 FY17 7,243 10,317 1,403 1,775 3,902 5,231 37.0% 38.9% 19.4% 17.2%

CAGR(12-17) 12% 41% 15%

CAGR(12-17) 28% 31% 13%

(The above examples are hypothetical and used for illustration purpose only)

From the above table, it is evident that Gross Sales, Profit before Interest and Tax (PBIT), and Capital Employed (CE) have grown for all the three companies across the period FY12 to FY17. The compounded annual sales growth rate (CAGR) was 27% for Company A, 12% for Company B and 28% for Company C. PBIT grew at a CAGR of 32%, 41% and 31% for Company A, B and C respectively, while Capital Employed (CE) grew at a CAGR of 18%, 15% and 13% respectively for Company A, B and C. So, for each of these companies, PBIT increased at a higher rate than CE, and as a result RoCE grew significantly from FY12 to FY17. In fact, as the table shows, RoCE for Company A more than doubled, for Company B it nearly quadrupled and for Company C it also got more than doubled. These RoCE trends thus clearly highlight efficient capital management by each of the companies. RoCE is just one of the parameters A company with superior and consistent RoCE growth can reward its shareholders handsomely over the long run. We can also say that 'bottom-up' stock picking with a long term horizon can be more rewarding for shareholders rather than trying to time the market or investing blindly in an index.

An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

45

RoCE is just one of the parameters that an investor should keep in mind while picking stocks. Other parameter like RoEs' can be artificially inflated by taking resort to higher debt levels and often companies which rely on higher gearing (debt to equity ratio) tend to fare badly in cyclical downturns Finally, an investor should also keep in mind other valuation metrics like the Price to Earning (P/E) ratio and the Enterprise Value to Earnings before Interest, Tax and Depreciation (EV/EBITDA) ratio on trailing and projected bases. While historical data may be readily available, projection of financial metrics is a combination of art and science and requires pain-staking research.

Identifying opportunities in major corporate events To understand how you can identify profitable corporate events, let’s take a reference from a book 'You can be a stock market genius'- authored by Joel Greenblatt. Greenblatt runs a private hedge fund called Gotham Capital. His firm achieved 50% average annual return over a 10 year period which spanned from mid-1980's to the mid-1990’s. In his book, Greenblatt advises investors to keep their eyes open to opportunities which do not come out of the ordinary course of business. These could be specific corporate events such as spin-off, business restructuring, bankruptcies, risk arbitrage and mergers which may result in large profits. As per Greenblatt, individual investors can have long-term investment horizons as their performance is not being evaluated every quarter unlike money managers. Hence, they can patiently wait for special corporate events/situations to fold out. Here are some important corporate events, which occur quite often. Corporate Spin-off In spin-off; companies separate a subsidiary, division or a business segment from its parent to create a new, independent company. The motives behind spin-off can be many. It includes unlocking a business division's hidden value, separating out a bad business or tax considerations. Moreover, sometimes a spin-off is a way to get value to existing shareholders for a business division which can't be easily sold. -

As per Greenblatt, insider participation is one of the key areas to identifying a profitable spin-off. One has to ascertain if the management is being incentivized for the spin-off. If the management is going to receive a good part of their compensation in form of stock An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

46

-

or options; chances are high that they will be motivated to work hard and perform well which will boost stock returns. Spin-offs could also uncover a hidden opportunity in terms of a good business or a cheap stock. Also, non-core divisions are a usual candidate for spin-offs. Since these divisions have always been neglected when they are a part of a bigger corporation. Once they are spun-off, their management can focus to improve their business.

Greenblatt says that irrespective of the institutional motive behind a spin-off; it has been proven time and again that stock of spun-off companies and parent companies have significantly outperformed the market averages. But he also reinstates that there can always be few exceptions and you cannot always blindly follow this observation. Instead, you should weigh the pros and cons of a spin-off carefully before jumping the gun too quickly. Corporate Restructuring Restructuring is another significant event which if evaluated appropriately can help investors make a fortune. Greenblatt states that remarkable value in a stock can be uncovered through corporate restructuring if one carefully assesses 'big' changes. This means sale or liquidation of an entire division. The most viable investment opportunities are; where companies sell or close major divisions to stop losses, pay off debt or rather focus on more promising business. Many a times, it may be the case that the division being sold out or liquidated has actually hidden the value inherent in the company's other businesses. E.g. a conglomerate has earnings per share of Rs 20 and its stock trades at Rs 300 per share. Actually, that Rs 20 earnings may combine Rs 30 earnings of two businesses and loss of Rs 10 of another business. So, if one liquidates the loss making business, the conglomerate's earnings increase to Rs 30 and P/E multiple declines from 15x to 10x; creating enough headroom for returns. Restructuring can reap benefits if timed correctly. Before evaluating any restructuring prospect, it is important to look at the company size as well as current business environment to assess whether it can pull off restructuring smoothly. It will also be more fruitful for investors if the company not just aims at increasing its profitability but also keeps in mind the interest of its minority shareholders.

An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

47

Corporate Mergers Corporate mergers can prove to be another significant event for investors if appraised appropriately. As per Greenblatt, a general rule he follows for merger is to believe that no one wants merger securities! This means that people generally sell shares in merged entities. This could be because of complexity of the merged entity or lack of transparency in valuations. Greenblatt says that this is indeed a chance for you to pick the stocks at dirt cheap prices. However, not before doing your homework! He advises investors to go through merger filings and look for explanation for the consideration that is being paid to the target for merging the entities. So in short, thoroughly study the rationale of a merger as well as compensation being provided for a merger. Many a times; the complexity and circumstances of the merger makes assessment very difficult. Corporate event like mergers need to be evaluated very carefully and investors should not make a hasty decision. Simply following the market may not help all the times. It is essential for investors to do their own research also about the management, integration process of the merger and value accrued to minority shareholders before making an investment decision.

An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

48

V: Value Investing It is most common for investors to get lured into buying the stock of a company that is very popular, is being talked about by a lot of people, and is said to be certain to do fabulously well in future. The stock is on business channels all the time, its prospects are mouthwatering, its profits are set to grow exponentially, and its products are seeing demand like never before. It seems almost obvious that there could be no better company to invest in. However, if that's how you feel, be sure that the guru of value investing - Benjamin Graham would definitely not agree with you. More specifically, he sees two problems imminent for someone making investing decision based on such a strategy. For one, placing all the emphasis on choosing and investing in such a company can often lead one to get tempted into paying too high a price for such a 'great' stock. The buying price is as important, if not more, as choosing a company to invest in. The second problem is that the company itself may be chosen imprudently. It would be instinctive to choose a company that is large and well managed, has a good record, and is expected to show increasing earnings in the future. But such expectations are highly vulnerable to subjective interpretation, and so are putting a price on such qualitative factors. Thus, wherever such factors come into the picture, prices are frequently overdone.

What is Value Investing all about? Although investors appear to pay somewhat more attention to growth-oriented strategies, research has shown that a value approach to portfolio management tends to provide superior returns. It is tempting to conclude that value is clearly superior to growth as an investment style. However it is important to note that, although value investing produces higher average returns than growth investing, this does not occur with much consistency from one investment period to another. One of the most important developments in equity management during the last decade has been the creation of portfolio strategies based on "value" or "growth" oriented investment style. It is now common for money management firms to define themselves as "value stock managers" or "growth stock managers" when selling their services to clients.

An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

49

What are the thoughts that come to your mind when you think of value investing… Is it about buying cheap stocks? Is it buying stocks and holding them for a very long term? Is it to do with buying companies with fantastic fundamentals that are valued relatively cheap to their peers?; Or Is it about following the portfolios of legendary value investors and creating a similar one for yourself? Well, there is nothing wrong with either of these approaches. The conceptual difference between the value and growth investing may be reasonably straight forward. The growth investor focuses on the current and future economic story of a company with less regard to valuation. The value investor, on the other hand, focuses on the share price in anticipation of a market correction and possibly improving company fundamentals. However, it could be dangerous to assume that using any one of these approaches without paying heed to the others could be rewarding.

What is value? Value lies in something that is available at a discount. You as an investor may find value in buying something that is available at a price lower than its actual worth. Value investing is, knowing exactly what you are paying for today rather than speculating over what you could possibly get in future. And in order to know the correct price to be paid, you need to assess the value of the underlying asset correctly. Only when the investor understands the moat the business enjoys and the risks it takes, you can determine the intrinsic value and price you should be paying. There must be adequate margin of safety.

An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

50

Now the obvious question that may come to your mind is how should one go about choosing the right kind of stocks and then eventually calculate its intrinsic value. It’s a process and let us now discus how does this process exactly works…

4 simple steps to Value Investing Step 1: Identifying your circle of competence This comprises all the businesses that you are familiar with and thoroughly understand. For a value investor it is important to invest only in businesses that he understands. A value investor must focus solely on areas of business where he believes he has an edge over the average investor. Say you're a doctor. Being an insider to the healthcare industry, you would most likely have a pretty good first-hand understanding of the sector. You may have knowledge of various drugs by pharma companies. An analyst, on the other hand, would not have access to this valuable information. This puts you in a position of advantage. Of course, this does not mean you are already an expert on pharma stocks. But you are at a great starting position. Similarly, many products and services that you use in your daily lives are often listed companies. As a regular consumer and visitor to the mall, you may have a good starting knowledge about product quality, pricing and competitors. Likewise, staying away from what you don't understand is equally important. Step 2: A 'moat' to protect your castle If we look at the castles, there is one feature which is pretty much common across all of them. The feature is a deep trench all around the castle. In the old days this trench was typically filled with water and crocodiles or other predatory reptiles. The idea was that the trench would keep the enemy away from the walls of the castle, thereby acting as an important security measure. This trench is called a moat. Since they provided security, the kings of the time were obviously big fans of moats. In value investing too, you should look to protect your castle. In simple words, you should look for companies with a sustainable competitive advantage. Larger the advantage wider is the moat. This moat would protect the business from competition. And if the company is able to use its competitive advantage to widen the moat over time, then it is the perfect business to be in. An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

51

Companies that have a wide moat are able to earn higher returns for its shareholders. And it is able to do so consistently year after year, every year. This in turn propels its stock value over years. The best part about such companies is that they are able to do well even when conditions are bad. Given the gloomy picture that the current macroeconomic scenario paints, won't such a stock be a good idea? But how do you identify a stock with a solid moat? For this you need to understand how a company can build a moat. How to build a moat This safety moats can be built by the business in a lot of ways. 1. Brand: A good way for a business to build a competitive advantage is by building a brand. A brand that has consumer recall. It would take years and lot of investment for another company to challenge the authority of a good brand. Take the example of Coca cola. It is one of the most well-known brands in the world. This brand gives it the pricing power. Despite the number of soft drink manufacturers who have been in existence, none has been able to dethrone Coke as a leading soft drink brand. 2. Economies of scale: A good way to look at economies of scale is to think of a company that can increase its operations without increasing its costs at the same pace. Such companies tend to have a massive size of operations. They have already incurred huge fixed expenses. Additional costs that are more variable in nature are not very high. So as sales increases, these companies are able to expand their operating margins. The economies of scale help the company makes a moat because for any competitor to enter the market, it would need to make a huge investment. Something that is only possible if it has very deep pockets. And even if it is able to make such an investment, it would still take time for it to become a low cost producer something that economies of scale can help in. As a result, the dominant company could cut prices to retain its competitive advantage. Think of Walmart. The company has been able to reach the size where it is today simply due to the economies of scale. 3. Switching costs: When you buy a laptop or a computer, more often than not it comes loaded with the Microsoft operating system. Have you even thought about changing the operating system? The answer would most probably be no. Why? Because there is a cost involved. This is what is called a switching cost. High switching costs make it costly for a customer to switch from one product to another. Or from one company to another if a company is able to create this moat, then it ends up having a customer following without the threat of competition. Switching costs create a barrier of entry in a way that it deters competition. An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

52

4. Patents: A great way to build a moat is to simply patent the product. If competition has to enter, then it has to wait till the patent expires. Or will have to buy the patent from the company. Typically pharma companies have been able to build such moats. 5. Monopoly: Being in a unique or niche business makes for a good way to create a safety moat. Being the only company in the area means that there is literally no competition. But there is something important to note here. The company should not be a monopoly in a business that has demand. However, this advantage is something that needs a lot of work to be sustained. The higher returns that a monopoly earns can and does end up attracting competition. Therefore the test for the company is whether it can defend its competitive advantage over long-term. These are just some ways in which a company can create a safety moat. Other ways include creating network effects, having cheaper access to raw materials, government regulations that favour one company over another are among others. The bottom line is that the company should have a competitive advantage. The advantage should help it generate superior returns over time. And the advantage should ideally be growing over time. If the moat is too tiny, then competitors can easily cross it over time. So safety moats need to be getting wider and/or deeper as the years go by. And if you find such a company, then make sure you invest in it when it is available at cheap valuations. Such a stock can help you earn superior returns in the long term. Step 3: A word about management Perhaps among various factors that need to be looked at before investing in a company, the management is the most important. But that is also where the difficulty lies. After all, how do you assess management? Unlike company financials, ratios and valuation methods which can we quantified and expressed in numbers, management quality is more subjective. No number can be assigned to it. And yet it is one of the most crucial elements in value investing. There are three main factors in assessing management: 1. The results of the company 2. The treatment of the company's shareholders 3. How well it allocates capital An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

53

Let us consider these separately. 1. Results: Past performance is highly indicative of how well the management has been able to steer the growth of the company. This is through both good times and bad. Indeed, a good management needs to be proactive and should have the ability to respond to changes, competition, opportunities and threats. Having said that, what needs to be noted is that the management track record has to be evaluated in context of the sector dynamics in which companies operate.

2. Treatment of shareholders: Shareholders obviously stand to benefit if the management has been able to provide healthy returns on capital and dividends on a consistent basis. Return on invested capital and dividend yield are some of the important parameters to be looked at while determining whether a shareholder is getting the most of what he has put into the company.

3. Allocation of capital: How effectively the management is able to allocate capital is a very good indicator of its quality. For instance, one needs to evaluate whether this capital is being invested in projects or activities in line with the company's overall growth strategy. Moreover, are these investments generating good returns? If the capital is not being invested, then whether the same is being distributed to the shareholders. There have been instances in the past where the management of cash rich companies has made ill-suited acquisitions which have been a drag on the overall company performance. Instances such as these are examples of misallocation of capital by the management. Management strength at the end of the day is a qualitative factor. But investors need to have a grasp on the people at the helm of affairs before they decide to invest in the stock of a particular company. This would mean reading annual reports, analysing company performance and keeping check on the management's communication with the shareholders. This may not be as concrete as numbers, but it certainly helps in forming a reasonable judgment on what the management's objectives are and what it intends to do to drive company performance going forward. Step 4: Valuations The last step pertains to valuations. It is most important of all the steps since valuations decide the action points (buy or sell) of investors. An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

54

How to estimate intrinsic value? Determining value is a tough task. That's because it involves forecasting future cash flows which in itself is a challenge. Discounting those cash flows at an appropriate rate gives us an estimate of value. However, forecasting cash flows for a business is not easy because of the uncertainty involved with the future, unlike coupon bonds. Valuing coupon bonds is relatively easier since you know the coupon payments of future. But that is not the case with businesses. So, basically the mantra is to look out for businesses that resemble coupon bonds. This would make the valuation exercise easier. In other words, businesses where forecasting future cash flows is relatively easier are the ones that should be on the radar. Once you have the estimate of cash flows discount it with the appropriate interest rate and compare it with your purchase price. The decision then needs to be taken accordingly. Predicting cash flows for cyclical businesses But, say you are looking at a business where forecasting free cash flow is difficult. Say for example a capital intensive business. How to forecast cash flows then? Also, what kind of discount rate should be used here considering the riskiness in cash flows? The legendary investor - Warren Buffett feels that for cyclical business the estimates for cash flows have to be conservative. Also, since he focuses on long term investing, the discount rate used is constant across securities. And that figure is arrived at by using the government bond rates. An appropriate premium over that and you are on the right track. No complicated financial models like risk premiums, sensitivity analysis, scenario framework and betas, just simple logical mathematics. Word on relative valuation You might have known by now that Buffett is not a big fan of relative valuation because of his focus on cash flows. Nonetheless, if used, appropriate relative multiples need to take into account the return generating capability of the business like shareholder returns return on equity, return on capital employed etc. How to estimate growth rates? Forecasting future cash flows involves an estimate of growth rate. The mantra here is to be conservative. If the growth rates are higher, then the estimate of intrinsic value will increase. And investment decisions are based on comparing intrinsic value with the market An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

55

price. Thus, your estimate of intrinsic value has to be as accurate as possible. High growth rates make intrinsic value more susceptible to changes. Hence being conservative pays off. Margin of safety The concept of margin of safety is the essence of valuation. Since the estimates of intrinsic value involve subjective judgments there is a possibility of being overly optimistic. Margin of safety provides cushion by adjusting the optimism from the forecast. Say for example your estimate of intrinsic value is Rs 100. Taking into consideration a margin of safety of 20% you can adjust the value to Rs 80. This will ensure that you do not overpay for any asset.

An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

56

VI: Lessons from Successful Investment Gurus While we may have read or heard about many people who would have made fortunes in investment world and equity markets; there are very few who are successful and are role model for equity investors. Let us share with you some important lessons that we have picked from the number of lessons these Investment Gurus have set for investors.

Warren Buffett - The Legendary Investor Warren Edward Buffett is an American business magnate, investor, and philanthropist. He is widely considered the most successful investor of the 20th century. Buffet is the primary shareholder, chairman and CEO of Berkshire Hathaway and consistently ranked among the world's wealthiest people. He was ranked as the world's wealthiest person in 2008 and as the third wealthiest person in 2011. In 2012, American magazine Time named Buffett as one of the most influential people in the world. Buffett is called the "Wizard of Omaha", "Oracle of Omaha", or the "Sage of Omaha". He is known for his adherence to the value investing philosophy and for his personal frugality despite his immense wealth. Buffett is also a notable philanthropist, having pledged to give away 99 percent of his fortune to philanthropic causes, primarily via the Gates Foundation. On April 11, 2012, he was diagnosed with prostate cancer, for which he completed treatment in September 2012. - Wikipedia Mr Buffett says, "Only follow two rules in investing Rule#1: Do not lose money, and Rule#2: Do not forget Rule no. 1"

Warren Buffett's investments have grown a whopping 5,000 times over the last few decades. Well, it may or may not be possible for you to repeat EXACTLY the same feat. Nonetheless, if one devotes his investment lifetime to following Mr Buffet’s disciplined approach and timeless philosophies austerely embracing the above quote, he is likely to emerge a much successful investor. An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

57

1. Quality Over Quantity Mr Buffett says, "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price. Charlie (Buffett's business partner) understood this early; "I was a slow learner. But now, when buying companies or common stocks, we look for first-class businesses accompanied by first-class managements. Good jockeys will do well on good horses, but not on broken-down nags. The same managers employed in a business with good economic characteristics would have achieved fine records. But they were never going to make any progress while running in quicksand." It is worth mentioning here that in the early years of his career, Mr Buffett bought into businesses based on statistical cheapness rather than qualitative cheapness. While he experienced success using this approach, the difficult time faced by the textile business made him realise the virtue of a good business i.e., businesses with worthwhile returns and profit margins and run by exceptionally smart people. In his letters to the shareholders of his investment vehicle, Berkshire Hathaway in 1978 he said, "The textile industry illustrates in textbook style how producers of relatively undifferentiated goods in capital intensive businesses must earn inadequate returns except under conditions of tight supply or real shortage. As long as excess productive capacity exists, prices tend to reflect in direct operating costs rather than capital employed. Such a supply-excess condition appears likely to prevail most of the time in the textile industry, and our expectations are for profits of relatively modest amounts in relation to capital. We hope we don't get into too many more businesses with such tough economic characteristics." The above paragraph once again highlights the fact that no matter how good the management, if the economic characteristic of the business is tough, then the business will continue to earn inadequate returns on capital. This can be further gauged from the fact that despite all the capital allocation skills at his disposal, the master was not able to turnaround the ailing textile business that he had acquired in the early years of his investing career. He further adds that such businesses have little product differentiation and in cases where the supply exceeds production, producers are content recovering their operating costs rather than capital employed. While the comment is reserved for the textile industry, we believe it can be extended to all commodities like cement, steel and sugar. Say a sugar industry may face downturn due to supply far exceeding demand and this in turn may have a great impact on returns on capital employed by these businesses. The only hope for them is a scenario where demand will exceed supply. An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

58

Buffet adds "We get excited enough to commit a big percentage of insurance company net worth to equities only when we find (1) businesses we can understand, (2) with favourable long-term prospects, (3) operated by honest and competent people, and (4) priced very attractively. We usually can identify a small number of potential investments meeting requirements (1), (2) and (3), but (4) often prevents action. For example, in 1971 our total common stock position at Berkshire's insurance subsidiaries amounted to only US$ 10.7 m at cost and US$ 11.7 m at market. There were equities of identifiably excellent companies available - but very few at interesting prices." Buffett then goes on to make a very important comment on valuations and says that no matter how good they are, there is a price to pay for businesses and he in his investing career has let many investing opportunities pass by because the valuations were just not right enough. Comparison can be drawn to the tech mania in India in the late nineties when good companies with excellent management like Infosys and Wipro were available at astronomical valuations. While these companies had excellent growth prospects, investors had become far too optimistic and had bid them too high. Thus, investors who would have bought into these stocks at those levels would have had to wait for five long years just to break even! Hence, no matter how good the stock is, please ensure that you do not pay too high a price for it. According to him, while one may make decent profits in an ordinary business purchased at very low prices, lot of time may elapse before such profits can be made. Hence, Buffet feels that it is always better to stick with a wonderful company at a fair price, as according to him, time is the friend of a good business and an enemy of a bad business.

2. Circle Of Competence Focus on what you know and leave aside what you do not. Simple, isn't it? In other words, define your 'circle of competence'. Your 'circle of competence' would comprise all the businesses that you are familiar with and thoroughly understand. As Buffett puts it "Everybody's got a different circle of competence. The important thing is not how big the circle is. The important thing is staying inside the circle." As simple as it sounds, it is the most difficult principle to follow. And wandering away from it can cause investors the biggest harm. A value investor must focus solely on areas of business where he believes he has an edge over the average investor. As we mentioned this earlier, say you're a doctor. Being An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

59

an insider to the healthcare industry, you would most likely have a pretty good firsthand understanding of the sector. You may have knowledge of various drugs by pharma companies. An analyst, on the other hand, would not have access to this valuable information. This puts you in a position of advantage. Of course, this does not mean you are already an expert on pharma stocks. But you are at a great starting position. Similarly, many products and services that you use in your daily lives are often from listed companies. As a regular consumer and visitor to the mall, you may have a good starting knowledge about product quality, pricing and competitors. Investing in what you know is one thing. But there is another very important aspect which is often ignored. And this is where the likes of Buffett have a significant edge over others. Great investors have a very clear understanding of what they do not know. Buffett is known to be quite disciplined as far as staying within the 'circle of competence' is concerned. He avoids businesses whose dynamics he does not understand well. But he is also famously known to have shunned technology stocks in the late 1990s at a time when they were a rage and anyone not owning them was labelled as stupid. At that time, he had argued that technology stocks fell outside his circle of competence and hence, he was not comfortable owning them. It turns out that most people who actually invested in technology stocks, some of who ridiculed Mr Buffett, did not understand them either! Investors can draw some very big lessons from this incident and develop a discipline that makes them avoid anything that falls outside their circle of competence. Invest in companies whose businesses are within your circle of competence and keep it easy and simple. According to Mr Buffett, human beings have this perverse tendency of making easy things difficult and one must not fall into such a trap. This brings us to another very useful insight. Great familiarity may not always result in great understanding. Buffett has been a long-time friend of Bill Gates, the billionaire founder of Microsoft. While he donated a significant part of his wealth to Bill & Melinda Gates Foundation, he never invested in Microsoft. The reason has been simple. He did not know that industry very well. He could not clearly envision what the business would be like 5 to 10 years later. As such, he was willing to let go of a seemingly great investment opportunity. It is this discipline that has made him one of the world's richest investor.

An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

60

3. Discounted Cash Flow Mr Buffett quotes, "In The Theory of Investment Value, written over 50 years ago, John Burr Williams set forth the equation for value, which is condensed here: The value of any stock, bond or business today is determined by the cash inflows and outflows discounted at an appropriate interest rate - that can be expected to occur during the remaining life of the asset. Note that the formula is the same for stocks as for bonds. Even so, there is an important, and difficult to deal with, difference between the two: A bond has a coupon and maturity date that define future cash flows; but in the case of equities, the investment analyst must himself estimate the future 'coupons'. Furthermore, the quality of management affects the bond coupon only rarely - chiefly when management is so inept or dishonest that payment of interest is suspended. In contrast, the ability of management can dramatically affect the equity 'coupons'." As evident from the above paragraph, Mr Buffett seems to be a firm believer in using the 'Discounted Cash Flow' approach or what is more popularly known as the DCF approach to valuations. So, what is DCF and how does it work? DCF is a valuation technique, the purpose of which is to arrive at future cash flows that the company is expected to generate over its lifetime and adjust it for time value of money. The resultant value is nothing but an 'intrinsic value' (since different people will have different assumptions about a company's future cash flows, intrinsic value might vary from person to person) and which is then compared to the prevailing stock price to judge the investment worthiness of the stock. If the intrinsic value is higher than the actual stock price of the company, then the stock offers an investment opportunity; the greater the discount to the intrinsic value, the more attractive the investment opportunity. Conversely, if the intrinsic value is lower than the current market price, then the stock is 'over valued' and should be avoided. Mr Buffett also goes on to recommend further that an investment that appears to be the cheapest under the DCF analysis should be bought irrespective of what the other valuation techniques such as P/E (price to earnings) or P/BV (price to book value) indicate. Investors who've tried using the DCF would know that cash flows of not all companies can be predicted with great degree of certainty given their past history of inconsistent performances and the nature of their businesses. Furthermore, even in cases where cash flows can be predicted with some degree of certainty, one is not sure whether they An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

61

will actually fructify. What should be done in such cases? Mr Buffett has dealt with these two issues as well and this is what he has to say on them. Mr Buffett says, "Though the mathematical calculations required to evaluate equities are not difficult, an analyst - even one who is experienced and intelligent - can easily go wrong in estimating future "coupons." At Berkshire, we attempt to deal with this problem in two ways. First, we try to stick to businesses we believe we understand. That means they must be relatively simple and stable in character. If a business is complex or subject to constant change, we're not smart enough to predict future cash flows. Incidentally, that shortcoming doesn't bother us. What counts for most people in investing is not how much they know, but rather how realistically they define what they don't know. An investor needs to do very few things right as long as he or she avoids big mistakes." Now that one has performed a DCF on the company that falls under one's circle of competence and has found out that the value arrived from DCF is greater than the market price, should he go ahead and invest in the company? Mr Buffett thinks otherwise.

4. Margin of Safety Mr Buffett has often emphasized the fact that when investing, only two skills are of paramount importance: ‘One is that of valuing a business, and other of knowing how to think about market prices.’ Through this important concept of ‘Margin of Safety’ Mr Buffet simply states - Pay as little as possible for your mistakes! As the master himself explains the concept in one of his letters to his shareholders, "We insist on a margin of safety in our purchase price. If we calculate the value of a common stock to be only slightly higher than its price, we're not interested in buying. We believe this margin-of-safety principle, so strongly emphasized by Ben Graham, to be the cornerstone of investment success." Civil engineers, who construct bridges, always insist on using a 'margin of safety' in the maximum load a bridge can carry at any given time. Thus, if a signpost on a bridge says 'maximum payload capacity 1,000 tonnes, one can be sure that the engineers have designed the bridge in such a way that it can carry weight 20% to 30% more than the designated payload capacity. This is done to not only account for any errors that must

An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

62

have crept in while designing but also for the errors made while projecting the future traffic needs of the bridge. Similarly, since doing DCF involves predicting the future, which as we all know is uncertain; errors are bound to creep into our analysis. Thus, having a margin of safety is important, as in the case of a bridge construction. Mr Buffett learnt this technique from his mentor Benjamin Graham and widely believes it to be the cornerstone of investment success. Thus, whenever you do DCF next, consider buying only if your estimations are at least 50% more than the current market price of the stock, so that even if you go wrong in your assumptions, capital loss can be minimised. Warren Buffett has always been a believer of the theory that stock investments should be made after taking into account an adequate margin of safety. But in euphoric times such as the current one on the Indian bourses, it is difficult to come across a good quality stock with an adequate margin of safety. However, when markets tumble and panic sets in, quite a few stocks start trading at an adequate margin of safety but the same stocks become risky for investors who not so long ago where willing to pay a hefty premium for them. The master believes, "The most common cause of low prices is pessimism - sometimes pervasive, sometimes specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It is optimism that is the enemy of the rational buyer." However, he cautions that not everything should be bought at low prices and this is what he has to say on the issue. "None of this means, however, that a business or stock is an intelligent purchase simply because it is unpopular; a contrarian approach is just as foolish as a follow-the-crowd strategy. What is required is thinking rather than polling. Unfortunately, Bertrand Russell's observation about life in general applies with unusual force in the financial world: "Most men would rather die than think. Many do." Thus, while low price scenario may be a good time to buy stocks that provide adequate margin of safety, one should look for good quality businesses that have delivered consistently on a long-term basis and are being run by shareholder friendly managements. Please bear in mind that long-term wealth has been made in the market not by investing in the latest overpriced fads but by investing in a good quality company trading at valuations that have built in a considerable margin of safety.

An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

63

Charlie Munger - The Legendary Investor's Alter Ego "When you locate a bargain, you must ask, 'Why me, God? Why am I the only one who could find this bargain?" - Charlie Munger Charles Thomas Munger (born January 1, 1924, in Omaha, Nebraska) is an American business magnate, lawyer, investor, and philanthropist. He is Vice-Chairman of Berkshire Hathaway Corporation, the diversified investment corporation chaired by Mr Warren Buffett; in that capacity, Buffett describes Munger as "my partner." Munger served as chairman of Wesco Financial Corporation from 1984 through 2011 (Wesco was approximately 80%-owned by Berkshire-Hathaway during that time). He is also the chairman of the Daily Journal Corporation, based in Los Angeles, California, and a director of Costco Wholesale Corporation. Like Buffett, Munger is a native of Omaha, Nebraska. After studies in mathematics at the University of Michigan, and service in the U.S. Army Air Corps as a meteorologist, trained at Caltech, he entered Harvard Law School, where he was a member of the Harvard Legal Aid Bureau, without an undergraduate degree. - Wikipedia The Use and Abuse of Incentives Munger is a generalist for whom investment is only one of a broad range of interests. In many ways, his personality has traces of his own hero-Benjamin Franklin, who along with being a great scientist and inventor, was also a leading author, statesman and philanthropist, and played four instruments. On similar lines, Munger hops around science, architecture, psychology and philanthropy with as much passion and curiosity as he does with business and investments. Munger very aptly follows this multidisciplinary approach in all kind of situations. He draws influences from fields as diverse as physics and psychology to his investment process. For long, he had been interested in standard thinking errors. Without diving much into academic psychology textbooks, he developed his own system of psychology more or less in the self-help style of Ben Franklin. Munger once gave a speech on "24 Standard Causes of Human Misjudgement", which have very powerful implications for investors. Of the many causes of Human Misjudgement, Munger finds incentives one of the most difficult to understand. In other words, Why do we do what we do? Why are we tempted to do certain things while refraining from others? Well, all creatures seek their own self-interest. Our innate drive is to maximise pleasure, while at the same time avoiding or reducing pain. In any given circumstance, we assess the An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

64

risks and the associated rewards and respond in a way that seems to best serve us. With this premise, it is imperative to understand the role of incentives and disincentives in changing cognition and behaviour.

1. The power of incentives There is this interesting case of the logistics services major FedEx Corporation. The integrity of the FedEx system required that all packages be shifted rapidly among airplanes in one central airport each night. And the system had no integrity for the customers if the night work shift couldn't accomplish its assignment fast. And FedEx had a tough time getting the night shift to do the right thing. They tried moral persuasion. They tried everything in the world without luck. Finally, somebody thought it was foolish to pay the night shift by the hour. What the employer wanted was not maximized billable hours of employee service but fault-free, rapid performance of a particular task. So maybe if they paid the employees per shift and let all night shift employees go home when all the planes were loaded, the system would work better. And that solution worked just perfectly. This is a classical case of the power of incentives and how they can be used to produce desirable behavioural changes. 2. The abuse of incentives

One of the most important consequences of incentives is what Munger calls "incentivecaused bias." The following example will explain the same. Early in the history of Xerox, Joseph Wilson, who was then in the government, had to go back to Xerox because he couldn't understand why its new machine was selling so poorly in relation to its older and inferior machine. When he got back to Xerox, he found out that the commission arrangement with the salesmen gave a large and perverse incentive to push the inferior machine on customers. An incentive-caused bias can tempt people into immoral behavior, like the salesmen at Xerox who harmed customers in order to maximize their sales commissions. The story of mutual funds in India is quite similar to that of the Xerox case. Few years ago mutual funds that offered the maximum commission to distributors were the best sold funds. Also, consider your own stockbrokers. There will be seldom one who will not lure you to trade too often. And seldom will a management consultant's report not end with an advice like this one; "This problem needs more management consulting services." Such behavioural biases exist in most places and situations. And human nature, bedevilled by incentive-caused bias, causes a lot of ghastly abuse. An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

65

For you investors, we believe it is important to understand the motives and incentives of people and organisations you're dealing and investing with. Everyone ranging from the company you're investing in, to your stockbroker, your mutual fund agent and your equity advisor must pass your scrutiny. Widespread incentive-caused bias requires that one should often distrust, or take with a grain of salt, the advice of one's professional advisor. The general antidotes here are: i)

Especially fear professional advice when it is especially good for the advisor.

ii)

Learn and use the basic elements of your advisor's trade as you deal with your advisor.

iii)

Double check, disbelieve, or replace much of what you're told, to the degree that seems appropriate after objective thought.

3. Doubt -Avoidance Tendency The name itself is quite self-explanatory. Doesn't our mind often display a tendency to steer clear of doubts to quickly reach a decision or conclusion? It surely does, and at times to our own disadvantage. Charlie Munger presents an evolutionary perspective about how this tendency must have developed in humans from their non-human ancestors. He asserts that it would be suicidal for a prey animal threatened by a predator to take a long time to decide what to do. The development of this tendency has come as a survival tactic in times of stress and confusion. So the evolutionary justification of this tendency is reasonable. But the problem with any kind of psychological tendency or mental programming is that it doesn't work well in all situations. Say, a person who is neither under pressure nor threatened should ideally not be prompted to remove doubt through rushing to some decision. Yet, more often than not we find ourselves doing exactly the opposite. Doubt-avoidance tendency in stock markets How often do you trade on impulse without asking the right questions? How open are you to hear negative things about stocks that you are very optimistic about? When a person comes to the stock markets with a bag full of money to invest, he is usually inclined to fall in love with any stock that seems promising. The boredom and pain that is usually part of a thorough scrutiny and analysis of a stock is often avoided. Quick conclusions and quick decisions are often preferred instead of the burden of doubts and ambiguity. An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

66

Without any exaggeration, it is strongly believed that if you learn how to reign over the doubt-avoidance tendency while you conduct your business in the stock markets, there is little that can stop you from becoming a successful investor. 4. Liking and Loving Tendency There is another very common error that most investors do with stocks that they own. Once they have bought a stock, they automatically start developing a feeling of affection towards it. This is the liking and loving tendency. Don’t we often hear people raving about certain blue chips with an admiration that borders around reverence? Any negative comment about them will either be ignored, dismissed or defended. It almost seems like a marriage brimming with loyalty and affection. Take the so-called "hot" sector stocks. Don’t they often cause many a feeble hearts to melt? And what happens to all thoughts about business and valuation? Well, you know best. We dislike challenging and reasoning with things and ideas that we love. Our bottom line is this. Do fall in love, but not with your stocks. Love your capital and do the best you can to protect it and to help it grow. And what better way of doing that than being a disciplined value investor! Inconsistency-avoidance tendency in stock markets Charlie Munger says, "People tend to accumulate large mental holdings of fixed conclusions and attitudes that are not often re-examined or changed, even though there is plenty of good evidence that they are wrong." Another extremely important human tendency that every serious investor should be well aware of is the inconsistency-avoidance tendency, which is very rampant amongst human beings. In simple words, we filter away any piece of information which may be inconsistent to our ideas and beliefs. You may have read as students how many great scientists and discoverers were often discredited and ridiculed for their so-called lunacies. Many were acknowledged for their great work only after their death. Do you see how the inconsistency-avoidance tendency works? Not just history, even our day-today life is filled with such stories. Our aim is not to profess psychology for its own sake but to attempt to relate it to human behaviour in the stock markets. Stock markets are largely driven by sentiment. So you must do your best to be as objective as you can and guard yourself from the lures of greed and fear.

An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

67

Getting back to inconsistency-avoidance tendency, can you remember instances when you have used this tendency to your own peril? We'll point out a few for your benefit: Have you lost money on your favourite stock that had once been an outperformer? The company's prospects may have changed, it may no longer be worth putting your money into, but you still couldn't let go of it. Why? Because letting go of it would be inconsistent with your original beliefs about it. So you did everything to console and convince yourself that nothing was wrong. But your portfolio losses have a different story to say, don't they? Each investor will have innumerable such instances to share. Now the more important question, how exactly do you get rid of this tendency? There are several ways to do that, but more than anything else, you need to be very disciplined with your investment approach. One great way is to play the devil's advocate. If you find a prospective company very compelling, first start with rejecting the hypothesis. In other words, try to gather facts and arguments that will prove that the stock is a bad investment. After all your analysis, if you arrive at the conclusion that the stock is still good, then it has passed the bar. You can also take a good lesson from the court of law. Law courts have processes and procedures in place that tend to minimise hasty and biased decisionmaking, which can cost someone's life. As investors, you must learn not to be hasty. Adjourn your stock purchases till you're not clear in your mind. Always remember, stock markets will always keep swinging higher and lower. Investing opportunities will be there. If you can tackle with your inconsistency-avoidance tendency, money will consistently keep pouring into your bank accounts.

Peter Lynch – The Legendary Fund Manager Peter Lynch is an American businessman and stock investor. He is a research consultant at Fidelity Investments. Lynch graduated from Boston College in 1965 and earned a Master of Business Administration from the Wharton School of the University of Pennsylvania in 1968. – Wikipedia In this age of information overload, picking the wheat from the chaff is difficult. And that is so true in the world of investing. Hot stock tips, recommendations and run of the mill research reports leave a common man clueless as to where to begin, what to follow and what to ignore.

An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

68

And here to his rescue is Mr Peter Lynch, the man who believes that 'Everyone has the brainpower to follow the stock markets. If you made it through fifth-grade math, you can do it'. 1. Invest In What You Know It is human nature to discount what one already knows, and put a premium to what is unknown and esoteric. That perhaps is the biggest irony as far as investing is concerned. Because this behavioral pattern makes one ignore the basic tenet of investing - Invest what you know/understand. The first step to investing is screening stocks. And the power of common knowledge at this stage can help you get that 'multibagger'- a term made famous by none other than Mr Lynch. It's all about keeping eyes open and using a bit of logic. Next time you visit a shopping mall, keep an eye for the products that are popular and attract mob. The next step would be to check out if the company making the product is listed. Keep an ear open for what a direct consumer has to say about a product. For every stock has a company tagged to it, and each company is associated with either the products or services. So, the starting step to stock analysis can be as simple as product/service analysis for which one needs not be a financial expert.

2. Your edge over a fund manager Investing is more of an art combining logic than numbers and statistics. It is the power of common knowledge that counts. And as far as that is concerned, a common investor is as good as or may be even better than a fund manager. Even if you can pick up one multibagger, it can make a huge positive difference to your small portfolio. So much so that you can afford to sleep a bit on the rest and still outdo the markets and the experts. And that can be your advantage over a mutual fund manager. This is because while a multibagger can make a huge difference to your 'small' portfolio, the economies of scale are unlikely to work the same way for your fund manager. Hence before becoming an investor, step into the shoes of a customer and try to know the potential of the product. Over a period of time, you will know what's good and what isn't, what sells and what doesn't. The common perception is that best investment ideas are a rare commodity that gets exchanged amongst privileged people surrounded by stock quoting terminals. But the fact is - it is the ground level knowledge that counts. You just need to be alert and use common sense to make use of this knowledge. An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

69

Using this approach, you will avoid falling for recommendations blindly. And that is likely to pay off in the long run. It will also keep you shielded from the herd mentality that more often than not leads to losses, and at times when right, limits the gains. But there is a caveat. A great service or a popular brand need not always translate into a great investment for shareholders. So far, the impression that one gets is that what is popular today and has the potential to remain so could be a good option. However, there is nothing sacrosanct about it. Take the example of Facebook. Despite being immensely popular (and holding the promise to remain so) has not been a smart investment This is a great lesson for all investors. A company like Facebook enjoys great brand equity and a huge user base. Yet it has no clear plan that will drive revenues and profits. And it's important to understand that the most vital factor that drives share prices is earnings. So, though it is a great idea to look at businesses around you, this should only be the starting point. It is crucial to take into account factors that would drive earnings over the long term. And finally, the most important aspect is valuations. Investors must always buy stocks at a sufficient margin of safety.

3. The right approach to invest in the markets As a beginner in the stock markets, one is likely to start straight with the stock screeners to select the stock that fulfills qualifying criteria. However, in doing so, a key step in investing that decides final outcome gets skipped. We are referring to an unbiased selfassessment of investor's requirements, attitudes, psychology and emotions. Even if two different investors start with the same portfolio, they are likely to end with different results. This is because markets tend to be volatile to which every individual will react differently. For e.g., while decline in the price of a stock may look like a perfect buying opportunity to one investor, it may trigger a panic button reaction from another and make him sell at a loss. This is where Behavioral Aspect of Finance comes into play which most of us hardly ever spend any time to analyse. Our investment choices should be based on our liquidity requirements, horizon period, and most importantly, the risk appetite. Hence, before doing a stock analysis, a self-analysis of attitudes and objectives is must.

An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

70

"There seems to be an unwritten rule on Wall Street: If you don't understand it, then put your life savings into it. Shun the enterprise around the corner, which can at least be observed, and seek out the one that manufactures an incomprehensible product." - Peter Lynch 4. Look for Specific Edge Once as an investor you have done a self-assessment, there is one fact that you are better off knowing from the start. That there is no good market. Infact, no one can predict good or bad market. It may sound quite discouraging to some. But the good news is - this is not what you need to know to make money in the stock markets. Mr Lynch believed that it is a futile exercise to predict the economy and interest rates. Making money in the stock markets is all about buying underappreciated companies, irrespective of the markets. In short 'Invest in companies, not in stock market'. For picking up underappreciated companies, one needs to have an edge. The specific edge will be different for different investors. It could be a knowledge or news that can give you significant head start. For example, if you are employed as a sales person at cosmetic store, you will know which brands are in fashion and likely to remain in demand. The next step will be to find which company they belong to. By virtue of your job, you will have a better idea of the sales trends than an analyst covering the industry. If the stock satisfies other criteria, you will be able to pick up stock before the premium starts getting reflected in the stock price. One of the very simple examples of how to spot an opportunity is using online shopping websites. For e.g., Flipkart offers the option to sort products under categories 'most viewed' and 'best-selling'. It also offers users reviews and product comparisons on quality and price. Such websites could be a good option to begin your research. Mr Lynch has drawn an interesting comparison between stock markets and game of stud poker. So while there is no winning formula, the player always has some open cards that can offer you insight and tilt the odds in your favor. Investing without research is like playing stud poker and never looking at the cards. "Although it's easy to forget sometimes, a share is not a lottery ticket. It's a part ownership of a business." - Peter Lynch

An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

71

5. Understand the business Since you are picking up the stock based on the popularity of a product/service, it is important to find out what is the contribution of that product /service to the company's topline and bottomline and thus the stock valuation. Ratios and numbers without the correct interpretation and understanding mean nothing. Mr Lynch suggests that if you don't understand the industry and the business, don't go further. Otherwise, you may end up comparing apple with oranges and making some flawed assumptions. For e.g. a high debt to equity ratio is generally undesirable. However, there are some capital intensive industries such as construction that have inherently high debt on their balance sheets, purely because of the nature of the business they are in. Hence, comparing FMCG or service based company with construction based on this parameter will make little sense. Similarly, if you are thinking of a pharma based company and have no knowledge about patents, competition and different market and regional /geographical dynamics, you might end up burning your hands. 6. Annual report - your best friend These days, lot of websites are available that give a decent snapshot of financials. As Mr Lynch suggests, investing in stock markets is a matter of hard work and not gambling. If you want to be confident and convinced about your story, you cannot ignore the annual report. Infact, it can be your best friend as far as research and building a story is concerned. One of the important data that is likely to be found mostly in annual reports only is the data on contingent liabilities and off balance sheet items. Lot of behemoths have fallen, the symptoms of the upcoming doom reflected only in off balance sheet items that was unfortunately ignored by the investors. Further, an annual report gives us an idea of not just the performance in the past year, but also management's outlook and comments that give valuable insight on where the company is heading. Research is an open ended concept. Hence, unless you do it in a systematic way, you can feel totally lost. While annual report in itself offers a lot of data, you as an investor are better off following a systematic approach not to get bogged down by the sheer amount of information.

An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

72

The content of this guide is powered by PersonalFN in association with www.equitymaster.com

Mutual Fund Investments Are Subject To Market Risks, Read All Scheme Related Documents Carefully.

CONTACT US Quantum Asset Management Company Private Limited

Quantum Information Services Private Limited [PersonalFN]

Regd. Office: 505, Regent Chambers, 5th Floor, Nariman

Regd. Office: 103, Regent Chambers, 1st Floor, Nariman

Point, Mumbai - 400021, India

Point, Mumbai - 400 021, India

Toll Free No.: 1800-209-3863 / 1800-22-3863, Telephone

Telephone No.: 91-22-61361200 Fax.: 91-22-61361222

No.: 91-22-61447800, Toll Free Fax no.:1800-22-3864

Email: [email protected], Website: www.PersonalFN.com CIN: U65990MH1989PTC054667

Email: [email protected], Website: www.QuantumAMC.com CIN: U65990MH2005PTC156152

An Investor Education and Awareness Initiative by Quantum Mutual Fund in Association with PersonalFN

73