Fundamental Analysis
• Introduction
• Investor’s mindset
• Annual report reading
• P&L statement
• Balance sheet
• The cash flow
• The financial ratio
• Investment due diligence
• Equity research
• DCF primer
• Notes
2.1– Speculator Vs Trader Vs Investor
Firstly, You can opt to speculate, trade, or invest in the market depending on how you would like to get involved. Each of the three participation options is distinct from the others. One must decide what kind of market participant one wants to be. Clarifying this can have a significant influence on his profit and loss statement as well.
Let’s take a look at a hypothetical market event and determine how each market participant (speculator, trader, and investor) would respond in order to help you understand it better.
SCENARIO
The RBI is anticipated to meet over the next two days to discuss its most recent stance on monetary policy. The RBI increased interest rates throughout the previous four monetary policy reviews in response to the strong and persistent inflation. As is well known, a rise in interest rates will result in less favorable growth prospects for Corporate India, which will have an adverse effect on corporate profitability.
Assume that Sunil, Tarun, and Girish are the three market players. Each of them would act differently in the market as a result of how they each see the aforementioned circumstance. Let’s examine their way of thinking.
Sunil: After carefully analyzing the scenario, he comes to the following conclusions:
He believes that the current level of interest rates is unsustainable.
High lending rates impede India’s corporate sector’s expansion.
Additionally, he thinks that RBI has increased interest rates to an all-time high and that it would be very difficult for RBI to do so again.
He looks at what the well-known TV analysts are saying about the situation, and he is pleased to see that his ideas and theirs are identical.
He comes to the conclusion that absent a change in policy, the RBI would probably lower interest rates.
He anticipates that the market will rise as a result.
He purchases State Bank of India call options to put his ideas into action.
Tarun: He views the matter from a somewhat different perspective. His thinking goes like this:
He believes it is unrealistic to expect the RBI to lower interest rates. He believes that no one can accurately forecast what RBI is going to do.
He also notes that there is a lot of market volatility. As a result, he thinks that the premiums on options contracts are quite expensive.
He is aware from prior experience and backtesting that the volatility would probably drop significantly just after the RBI announces its decision.
He sells 5 lots of Nifty Call options to put his ideas into action, and he plans to close off the position right before the announcement.
Girish: He owns 12 equities in his portfolio, which he has held for more than two years. Despite being a close observer of the economy, he has no opinion on the likely course of action for the RBI. Also unconcerned about the policy’s outcome is the fact that he intends to keep his shares for a very long time. Therefore, from this vantage point, he believes that the monetary policy is just another short-term passing market trend and will not significantly affect his portfolio. He has the time and patience to hang onto his stock even if it does.
Girish does intend to increase his stock purchases if the market overreacts to the RBI news and his portfolio equities experience a sharp decline after the announcement.
Now, we don’t care what the RBI decides in the end or who profits. The objective is to distinguish between a trader, an investor, and a speculator based on their cognitive processes. All three men appear to have a rationale for their market actions. Please be aware that Girish’s decision to take no action constitutes market action.
Sunil’s market actions are focused on a rate drop because he appears to be very certain about what the RBI will do. It is actually quite difficult to predict what the RBI (or any regulator, for that matter) would do. These are difficult issues that require comprehensive analysis. Making a judgment based only on blind faith without any logic is conjecture. It appears that Sunil did exactly that.
Based on a plan, Tarun has determined what must be done. If you have any experience with options, he is only putting up a trade to profit from the high options premium. It is obvious from his lack of speculation that he does not care what RBI will probably do. His perspective is straightforward: when volatility is high, premiums for option sellers are appealing. He anticipates a decrease in volatility immediately before the RBI decision.
Is he making a wager that the volatility will decline? Not so, as he appears to have previously backtested his plan for situations comparable to this one. A trader does not merely guess at results; he designs all of his trades.
On the other side, Girish, the investor, doesn’t appear to be overly concerned about what the RBI is anticipated to do. He views this as brief market noise that might not have a significant effect on his portfolio. Even if it did, he thinks his portfolio will eventually bounce back from it. Markets only provide one luxury: time and Girish is eager to take full advantage of this gift. In fact, he is ready to add to his stock portfolio in the event that the market overreacts. His goal is to maintain his position for a considerable amount of time and not be influenced by swift changes in the market.
Each of the three of them has a unique mindset, which causes them to respond to situations differently. The purpose of this chapter is to explain why Girish, the investor, has a long-term outlook and isn’t very concerned with short-term changes in the market.
2.2 – The compounding effect
Understanding how money accumulates can help you understand why Girish chose to keep his investments and not really respond to short-term market movements. Simply said, compounding is the ability of money to increase when reinvested for year 2.
Consider investing Rs. 100, for instance, which is predicted to grow at 20% each year (recall this is also called the CAGR). The money is projected to increase to Rs. 120 at the conclusion of the first year. You have two possibilities at the end of the first year:
Let the Rs. 100 initial investment and the Rs. 20 profit remain invested.
Withdraw the 20 rupee profit.
Instead of taking your Rs. 20 profit, you choose to reinvest it for a second year. After two years, Rs. 120 becomes Rs. 144. By the third year’s conclusion, Rs. 144 has increased to Rs. 173. I could go on forever.
In contrast, consider removing Rs. 20 in profits each year. If you had chosen to withdraw 20 rupees annually, your profits at the conclusion of the third year would have been only 60 rupees.
However, because you chose to keep your investment, the gains after three years are Rs. 173. You chose to do nothing and elected to stay invested, which resulted in a good Rs.13 or 21.7 percent over Rs.60 being created. The compounding effect refers to this.
The growth of Rs. 100 invested at a 20 percent rate over a ten-year period is depicted in the graph above. If you look closely, it increased from Rs. 100 to Rs. 300 over the course of roughly 6 years. But the subsequent Rs. 300 was made in just 4 years, from the 6th to the 10th year.
The compounding effect’s most intriguing characteristic is, in fact, this. The money will work harder (and faster) for you the longer you keep it invested. Girish made the decision to maintain his investment precisely for this reason: to take advantage of the market’s luxury of time.
All fundamental analysis-based investments demand long-term commitment from the investors. While making his investment decision, the investor must cultivate this mindset.
2.3 – Does investment work?
Consider a sapling: Would it not grow if given the correct care, manure, and water? Naturally, it will. Consider a successful company that has strong sales, excellent profitability, cutting-edge goods, and moral leadership. Is it not evident that such companies’ stock prices will rise? Remember the Eicher Motors chart from the previous chapter? In some cases, the price appreciation may be delayed, but it will always increase. This has often occurred in marketplaces all around the world, including in India.
An investment in a solid business with investable grade characteristics will always pay off. To digest short-term market volatility, one must, nevertheless, grow an appetite.
2.4 – Investible grade attributes? What does that mean?
An investible grade company has a few distinguishing qualities, as we briefly reviewed in the last chapter. The “Qualitative aspect” and the “Quantitative aspects” are two categories under which these traits might be grouped. Examining each of these factors is part of the process of determining if a company is fundamentally sound. In my own personal investment approach, I really give the qualitative aspects a little more weight than the quantitative aspects.
Understanding the non-numerical facets of the business is the key responsibility of the qualitative component. This includes a number of things, including:
Background of the management team: Who they are, what their experience and education are, whether they are qualified to run the company, whether there have been any legal proceedings against the promoters, etc.
The management’s involvement in fraud, bribery, and unfair business practices is a matter of corporate ethics.
Appointment of directors, organizational structure, openness, etc. is all examples of corporate governance.
Minority shareholders: How does the management treat them? Do they take their interests into account when making business decisions?
Share transactions refer to when management uses shady promoter networks to buy or sell company shares.
Related party transactions: Is the corporation giving financial favors to well-known people at the expense of the shareholders’ money, such as the promoter’s friends, family members, and vendors?
Salaries paid to promoters – Does the management pay itself a sizable salary? Typically, this is done with a portion of the revenues.
Stock operator activity: Does the price of the stock exhibit anomalous price behavior, particularly when the promoter is trading in the shares?
Who are the company’s major shareholders, or those who own more than 1% of the outstanding shares, according to the shareholders’ perspective?
Political allegiance – Is the business or those who promote it too linked to a certain political party? Does the company need ongoing political support?
Promoter lifestyle: Are the promoters’ showy and obnoxious lifestyle choices too obvious? Do they enjoy flaunting their wealth?
When any of the aforementioned elements do not line up properly, a warning sign is raised. For instance, if a business engages in too many transactions with related parties, it could be seen as favoritism and misconduct. In the long run, this is bad. Therefore, even if a corporation has large profit margins, misconduct is unacceptable.
Because they are such delicate issues, qualitative elements are difficult to identify. A careful investor, however, can quickly ascertain this by paying attention to the annual report, management interviews, news stories, etc. Throughout this module, we’ll emphasize a variety of qualitative elements.
Financial figures are a part of the quantitative features. While some of the quantitative parts are simple, others are not. For instance, cash kept in inventory is simple; inventory number of days, on the other hand, is not. It is necessary to compute this metric. Quantitative factors receive a lot of attention in the stock markets. Several examples of quantitative aspects include the following:
the expansion of profitability
Margin and its expansion
earnings and their expansion
issues pertaining to costs
working effectiveness
Price influence
issues pertaining to taxation
dividends are paid
Cash flow from a variety of sources
Long-term and short-term debt
working capital administration
asset expansion
Investments
monetary ratios
Surely, We will learn how to read the fundamental financial statements that are included in the annual report over the course of the following several chapters. As you may already be aware, all the computations needed to analyze quantitative features come from the financial statement.
CONCLUSION
- Firstly, A trader and an investor have quite different mindsets.
- But, If the investor is serious about investing, he needs to establish an investment attitude.
- Definitely, For the gains to compound, the investor should keep their investment in place for a long time.
- The longer you invest, the faster your money will double, usually at an exponential rate. One of the characteristics of compounding is this.
- Each investment must be assessed from both a qualitative and a quantitative standpoint.
- The company’s non-numerical information is the focus of qualitative aspects.
- In the quantitative components, numerical data analysis is included. Finding quantitative data can often be found in financial statements.
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