Do your Home-work before Investing

A successful self trader – Rule # 41

Your financial advisor can guide you and your broker can advise you. But there is really no substitute for doing your own homework. I always insist that any trade or investment should be backed by your own homework. There are simple tests you can run like business prospects, solvency, profitability, growth, promoter holding and market liquidity. Remember, nobody made money with hot tips.

HOW DOING YOUR HOMEWORK CAN MAKE A HUGE DIFFERENCE

Back in 2002, a harried senior citizen called me up for a quick second opinion. One of my sales guys had asked this senior citizen to sell of his shares in Hindustan Lever and instead buy shares of Himachal Futuristic. He was probably lucky that he did not listen to the sales guy and continued to hold on to HLL. We all know where both those shares are today.

The moral of the story is that you need to do your homework before taking any decision in the market. Back in 2002, I did not advise the investor to buy or sell HLL. I just called him to my office opened the balance sheets of the two companies and the price history and allowed him to decide. Even for a layman, the decision not to substitute HLL with HFCL was apparent. Period!

Today any investor who has a trading account with a broker can access a plethora of information and analysis available at their fingertips. At least you can use this information to ratify your broker’s recommendation. There are 3 basic checks every investor should run. Check the profitability, the return on equity and the promoter holdings. Forget profits, your capital will surely be safe.

3 STRONG REASONS FOR YOU TO DO YOUR HOMEWORK

IT IS YOUR MONEY, AFTER ALL

No advisor or broker takes responsibility for your money. You alone have to do it. If you know that the buck stops with you; you may as well do a thorough job before investing. Advisors will also be more focused with well-prepared investors.

ONLY YOU KNOW YOUR ACTUAL GOAL

You get into any position with a goal and time perspective in mind. If you need liquidity in 3 months, no point in buying a stock that will fructify after 3 years. Ask yourself if the stock fits into your goal. Only then must you decide!

IT IS ACTUALLY MUCH SIMPLER THAN YOU IMAGINE

Investing is not rocket science. If you understand the business and invest at a decent price, you will surely make money. You just need to look at a few parameters to take a decision. Then why be at someone’s mercy?

“An investment in knowledge pays the best interest” – Benjamin Franklin

6 CHECKS YOU NEED TO RUN BEFORE INVESTING IN A STOCK

  1. Is the company in too much debt? This is the first question you need to ask yourself. Avoid the debt burdened companies like the plague. They will never earn enough to pay shareholders anything after paying the interest on bonds. Also in any business down-cycle, companies in debt are most vulnerable.
  1. Are you buying a profitable company or a company you expect to turn around? If the latter is the case, be prepared to wait longer. Also look at the quality of profits. If major profits are coming from treasury and accounting jugglery and too little from operations, it’s not a great sign.
  1. How much do the promoters hold? This shows the commitment of the promoters to the business. Falling promoter’s stake is also a sign that the promoters are looking for an exit route. You must avoid companies where promoters have pledged too much shares. Remember GTL, Orchid. They saw huge price damage.
  1. Is the business model grounded or too futuristic? We surely remember the tech boom of 1999, when eyeballs determined valuations and then they fell like a pack of cards, when reality dawned. When you invest in an Alibaba or Amazon, be informed of the risks you are taking on. Cash is always king!
  1. The market always pays a premium for growth businesses and so should you. The logic is simple. Higher growth leads to higher future profits; which in turn results in higher future valuations. This translates into higher current P/E ratio. A stagnating company never gives high returns. Forget it.
  1. And finally run the macro check. At market highs it is very tempting to buy. You not only get great tips from brokers but also see notional profits each day. Don’t get carried away. Buying high and selling higher is for professional traders. Smart investors should never buy at fancy valuations!

WHEN HOMEWORK COULD HAVE HELPED

The legendary Sir John Templeton rightly said, “The four most danger words in investing are – This time it is different”. Each time sectors got into fancy valuations, we believed it was different. Cement in 1992, technology in 2000 and real estate in 2008 are cases in point. Each time we ran with the flow forgetting that eventually every valuation anomaly reverts to the mean. Remember, markets are a slotting machine only in the short term. Over the long term, markets will always be a weighing machine. Always be fearful when markets are greedy.

The exact reverse holds true at market bottoms. In the post 9/11 scenario, everyone predicted that markets were doomed. But driven by cheap valuations and an industrial revival, markets multiplied manifold from those levels. Same was the case in 2009 March after the Lehman crisis. Always be greedy when markets are fearful!

TAKEAWAYS FROM THE “DO YOUR HOMEWORK” DEBATE

As Ben Graham put it, “Individuals should think and act like investors, not like speculators”. All that it requires is a little bit of patience, a little bit of diligence and a little bit of analysis. You obviously want to be buying companies that are robust, growing and have healthy cash flows. The data is available for the asking. You just need to do you basic homework.

The next time your broker or advisor comes to you with that million dollar tip, remember Peter Lynch; “Know what you own and why you own it”. Take the trouble to understand the stocks you are buying and the businesses behind them. Also make it a point to monitor stocks for news, board meetings and announcements. These little efforts will go a long way!

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