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Equity Investing and Analysing businesses
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Whether you are a novice or an experienced investor, knowing how a business works and making sense of the numbers will hone your stock-picking skills
Sitting on a panel watching young students make presentations on equity investing is an interesting experience.
They displayed a lot of optimism about equity, a bewilderment at the possible gains, and were somewhat overwhelmed by the quantum of information they had to process.
Even after discounting the liberal use of second hand information that was `Googled', it emerged that many of the young students who spoke or heard the equity stories in the contest, would turn out to be eager and active investors. However, what should a first-time investor in equity, know even before beginning to stake his hard earned money hoping to hit the jackpot?
Equity investing is about funding business ideas and it requires developing the mindset of an investor in businesses. Even if you bought a few shares, you are tagging the fortunes of your savings to the possibility that someone will use it to build a great business. Therefore, the first question one must ask is who has set up the business and how they are running it. There are three primary reasons why someone sets up a business. One, they are good at it. Two, they think it serves a large need. Three, they think there is money to be made. You need to know what the motive of the promoter is. In the case of established businesses, there is enough history to understand how it was built and managed. One would have adequate information on strategic decisions; how mistakes were remedied; how the management responded to crises; how product decisions were made; what the expansion plans were; and whether the business has evolved to have an identity of its own. New businesses, on the other hand, hold out the promise of becoming big, but their ability to pull this off will critically depend on the promoters and managers. There is no formula for business success. However, spending the time to learn how businesses are created, built, managed and grown provides an equity investor with an invaluable perspective.
Equity investing requires a good understanding of finance. The outcome of business decisions is in the balance sheet of the company and a serious equity investor should know how to read and comprehend. Every business uses capital to build assets, generates revenue by using the assets, and hopes to make a profit after paying all the expenses incurred in the process. How well this cycle has been working is evident in the financial statements of the business. To begin with, just the basic questions can be asked. If a company says it is expanding into the business of technology-enabled education and is winning contracts to set up its system in schools, the question to ask would be: how long does it take for sales to be realised in cash? If a company is renting large retail spaces to sell multiple products, the financial statements should show the ratio of stocks to sales, and whether profit is made after paying the rents.
Without a sense of how assets are funded, revenue is earned and profit is made, it is not possible to see how a business can achieve sustainable growth. The depth with which an investor carries out this analysis can vary, but conjectures will not substitute for hard-nosed understanding of the finances of a business.
Equity investing also involves the crowd.
While an investor may step in the market after doing his homework, one must take note of the noise in the market created by a large number of buyers and sellers. Not all activity in the market is speculation. The motivation behind transactions may be driven by fundamental analysis, speculation or a simple need for liquid ity, but there is no way of identifying the specific motive for prices to move the way they do.
Technical analysts know how to deal with price and its signals. The others form their own views and take action, but always run the risk of being wrong. The collective wisdom of the market might turn out to be tough to beat. A speculative trader can deal with it easily, but a long-term serious investor in equity should be able to decide his comfort with the market signals, and the extent of his need for confirmation and approval for the markets. This can be difficult when the loss on a stock after careful research keeps mounting. This is tougher than waiting for prices to go up. At least there is the consolation of long-term gains in that case. Equity investing can be more about the stomach than about the head, and investors should be sure they have the right attitude.
Successful equity investors are not made overnight. They may begin with the skills of analysis, learn how to evaluate a business over time and get better as markets teach them the hard lessons. And, young investors who are enamoured by equity should pick up one stock, any stock, and see if they are able to figure it out in detail.
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