Thursday, February 19, 2009

Stock Market Basics: Story of Mr.X

November 10, 2001, our Hero of this story Mr. X was in his prison cell wondering why the police arrested him for a petty crime. Suddenly there was lot of commotion outside his cell and he just peeped out to see what was happening. He saw a guy surrounded by lot of police men with good enough media attention.

Warden came and opened his cell only to stand beside. Mr. X was thinking why they release him 2 days in advance. But that momentous joy vanished as the police sent the guy who was standing outside with his hands cuffed in to Mr. X prison cell. What a surprise? It was our own Harshad Mehta. Mr. X had no idea about stock markets but knew people make lot of money in stocks. After spending few hours without talking to him, he decided to ask some basic questions regarding the stock markets.

Mr. X: Sir, you look very good and why do people call you “Bull”?

Mehta: “Bull” is my nickname. I got this name because I am a guy who is very optimistic about shares and always think that the prices will go high.

Mr.X: What if you think prices will go down? Did they put you in prison for that or what?

Mehta: No. If I think that prices will go down, then my nickname would be “Bear”.

Mr. X: Why you are playing with me? OK. What did you do to come here?

Mehta: Nothing. I just diverted money from Banks to buy shares for people to make everyone rich and police say that I am doing a fraud.

Mr.X: They are always like that. Sir, what is this Share? Why companies issue share? Why people buy it?

Puzzled Mehta thinks that Police could have killed him instead of putting him along with Mr.X. But he decides to go ahead answering.

Mehta: Share is part ownership of a company and companies issue it to raise money for the business expansion since they don’t have enough money. People buy it because they want to create wealth for future and also to negate the inflation. You can’t buy the same quantity of things next year for the same amount of money. That’s why people buy shares and if the company does well, then you gain in two ways. In one way, company pays you portion of their net profit as Dividend. In another way, people’s confidence on the company goes up and you can sell your shares at a higher price.

Mr. X: Sir, what if the company does not do well?

Mehta: Then you will have to come here again to eat.

Mr.X: You look like a very rich man. Like you I too want to buy shares and become rich. Where I have to go and buy that?

Mehta: You can buy it in two places where all the companies in India sell their shares. One is Bombay Stock Exchange (BSE) and another is National Stock Exchange (NSE). But before that you have to contact a good broker like me to buy it.

Mr.X: Good Broker!!! Sir, I want to earn money like you but I do not want to end up like you. Tell me what I need to do buy shares?

Mehta: You need to open a Trading Account with a broker where you can buy shares both in primary market and secondary market. Primary market is the place where Initial Public Offering (IPO) is made and you can probably buy shares little cheap at Issue Price which is the initial price when the company offers shares. Secondary Market is a place where companies who already have shares sell it.

Mr.X: How much money I need it?

Mehta: You can start with even Rs. 5000. If you want to buy more than Rs.5000 you can always borrow money from the broker up to Rs.50000 – Rs.60000 as Margin. If you sell it for profit, you return the money to the broker and take the rest as profit. If you sell it for loss then you have to pay Broker the difference.

Mr.X: I don’t want to buy and sell daily.

Mehta: Oh. If you do not want to do Day trading, then you have to take the delivery of shares. Delivery means, you can buy it and sell it whenever you want. One more thing, you also need a Demat account which is like a bank account where you can keep all your shares safely and like in a bank, you can transfer your shares between one account to another account.
Mr.X: Ok Sir. But what is the surety that I will not end up with a loss?

Mehta: There is no surety in anything. Are you sure you will live till 60 years old? So, there is no such thing and all I can say is if you work hard diligently and buy the stocks for a long time consistently, then you will make money. Stocks have returned 17% annualized return in the past and you can take heart from that.

Mr.X: I need to know the tricks in selecting the stocks.

Mehta: It seems you want to be a good investor and I will let you know whatever I know. You need to assess you risk and then look for growth stocks or value stocks. If you want to make good money in quick time then look for growth stocks. Growth stock refers to the share of a company which has very good potential to grow in the near future with excellent revenues and grows faster than the peers. Else, if you don’t have any problem to hold the share for a long term, you can look at value stocks which means, market has not recognized the true value of the shares of certain companies and are currently undervalued. When the market understands the true potential, at that time value stocks give you excellent return. But you have to be patient for that.

Mr.X: Do I need to buy many companies?

Mehta: It is always good to have at least 15 companies as nobody knows what will happen in the market. Had you bought the shares of ACC, you could have become either a crorepati or beggar because of me (He was involved in that scam). So, to avoid this kind of situations, you need to buy 10-15 good companies and invest regularly to be successful.

Mr.X: What else I need to know?

Mehta: How much you earn?

Mr. X: Why are you asking me? If I earn well, why would I end up in Jail?

Mehta: I am not asking you. You need to ask that question to the companies before you buy shares. Like you, if the companies don’t earn any thing they will go bankrupt and end up in jail. So, you need to know how much net profit company is making, how much debt they have, whether they have been making money consistently or not, what is their product, how other companies in the same sector are doing etc.

Mr. X: Who do I contact for all these details?

Mehta: Gash…..You look like a real bull. You do not need to go anywhere. You can visit the company website to download the reports and see balance sheet, cash flow statement and profit/loss statement. You need to look at the share price, Earnings per Share (EPS), PE Ratio, Debt Equity Ratio, Return on Capital Employed (ROCE), Return on Total Assets, Return on Shareholders equity etc. Then you have to compare all these things with other companies in the same sector. You also need to look at general market trend, political situation and so many other things and finally you should not hear whatever I say when I come out of the prison(Analyst Recommendation).

Mr. X: You have told me so many things which I never heard of. Please explain one by one. What is the significance of EPS and PE?

Mehta: Earnings Per Share indicates how much a company has earned as a net profit per share. It is arrived by dividing the total net profit by total shares. Higher the EPS, better the stock value. But to understand how much people are confident in the company, we calculate PE Ratio which simply means, how much people are willing to pay for every one rupee of net profit the company has earned.

For example, If EPS of a company is Rs. 100 and the Share price is Rs. 1000, then you can understand that people are ready to pay Rs. 10 for every rupee of net profit. In another way, Rs.1000/Rs.100 = 10 and this 10 is the PE Ratio. You can use this to compare two companies. When everything else equal, if a company has PE of 20 and another company has PE of 12, then you have to look for the reasons why the company has the EPS of 12. If you do not find any bad reasons, then you should go ahead and buy it.
GMR Infrastructure is a emerging company and it's PE is 230 which means people think this company will do wonders in the future and are ready to pay 230 rupees for every rupee of earning. In these situations, you have to be very careful and unless otherwise you are sure about the success, don't buy it. Instead you can search for stocks with reasonable valuations like in the case of GE Shipping or GSFC. To be on the safer side, always buy beaten down large caps rather than small caps if you are the one who broods over the short term loses.

Mr.X: What EPS and PE Levels I should look at?

Mehta: Higher the EPS, better the stock. So, compare all the companies in the same sector and pick the one which has higher EPS with reasonable price. In general, if the PE is less than 15, then you can consider that. But there are times where you can get very good companies for for less than10 PE and you have to grab those opportunities. Also see if the company has given dividends consistently in the past or not along with its bonus and stock split history. Apart from that you need to look at their debt level and growth over a period of time.
Mr.X: How do I know if they have more debt?

Mehta: You can find the details in the balance sheet. You can also find Debt-Equity Ratio which simply says how much company has borrowed and how much promoters have invested. If it is more than 1, that means, debt is more than the equity capital and you have to be careful. If it is less than one and the company is doing well, then you can be sure of its potential.

Mr.X: What is RoCE and Return on Shareholder Equity?

Mehta: RoCE is Return on Capital Employed which measures the percentage of money the company has earned against the capital he has employed. Suppose, the company has invested Rs. 10000 for the business and the net profit is Rs.2000, then RoCE is 20%.

Likewise, you also calculate the Return on Equity by dividing the Net profit by net worth. In general, if these numbers are higher for one company when compared to other companies in the same sector, then that particular company with higher numbers is doing well financially.

Mr.X: What else I need to look for?

Mehta: You also can look at cash flow statement to understand how much money the company is able to generate from revenues and loans and how much the company have invested for future growth. If the numbers make sense to you then you can buy that company. If a company is not generating any revenues but the cash flow only comes from financing activities, then you have to stay away from it. It is better to talk to your wife for a month to know what she does to manage the family. You apply the same mindset in the stock market and I see no reason why you can’t be successful.

Mr.X: You are telling very useful ideas but why you could not follow it?

Mehta: Good question. It is not enough to do whatever I said. There are few more simple things which are difficult in practice and that’s why I am here.

Mr.X: Like what?

Mehta: You need to know when to buy and when to sell. I knew it and I did all that. But I did not know how much money I needed to satisfy myself. I became greedy and tried to earn more and more that resulted in this fashion. So, decide yourself how much money you need in next 5 years or so and then enter the market. When you reach your goal, please sell it and do not look at what others are doing or regret when the index is going higher. It is better to come out with a decent profit rather than losing your capital when the crash is imminent. Stock Market behaves like a balloon. You can inflate it only to an extent. If you inflate it more, then it will burst and you have to make small balloons out of it to satisfy yourself for sometime before buying new one.

Mr.X: Thank you very much. I have learnt more than what I have learnt throughout my life by talking to you.

Mehta: I did the same thing outside the prison educating my friends about stock markets and I ended up here.

Mr.X: Oh….You guys screwed up the Stock Market as a group…..Very Nice. If god willing, I should be able to do the same thing except ending up in Jail. Thank You!

Mehta: You are Welcome!

Our Hero Mr.X was amused by Mehta’s Welcome, came out of the prison to make money in stock market like you and me. Was he successful? No one knows.

Note: This is an imaginary story and is not true. I just tried this idea to see if the readers like it.

Kumaran Seenivasan


Anonymous,  February 19, 2009 at 10:33 PM  

Amazing explain all these concepts in very simple words so that even a layman can understand it..I am sure your blogs will be very valuable to people who want to learn art of investing !!! Nice efforts. Hope you will keep it up
All the very best -:)

DBA-Oracle-Admin/StockNvestor February 20, 2009 at 2:53 AM  

Dear Sir,

Sir you are brilliant?what a beautiful brain u have been gifted by your parents,sir you are genius,sir the way you explain is truly a class of genius,sir thanks a lot for spreading the knowledge,sir we would like to know how to read QUARTERLY results..what is OPM,NPM,OPERATING/NET PROFIT?

Mahesh February 20, 2009 at 10:11 PM  

This post delivers the exact meaning of Simplicity and Demystification next to Dictionary.

Best Work.

Vinod,  February 21, 2009 at 3:54 AM

Shabu's February 21, 2009 at 7:37 PM  

Dear Mr Kumaran,

Great work and innovative way of presentation with simplicity. Such posts will also makes worthy "The art of blogging". Hope more such posts which helps the layman investors as well as newbies.Keep it up.

Kumaran February 21, 2009 at 9:42 PM  

Dear Friends,

Thank You all for your generous comments. Seems you all have liked this post and I am sure there are many more surprises for you down the line.

Anonymous,  February 22, 2009 at 11:04 AM  

The story telling methodology is really good and i was able to understand the basic concepts behind selecting a share of the right company. -- Karthik

Sunil,  February 23, 2009 at 8:38 AM

Sir can you pls explain us what is volatility index..

None of the investors have heard about this word...

kakarla sai March 11, 2009 at 9:38 AM  

hi kumaran sir,
nice article sir. the way u are explained is fabulous. i am the new comer to stockmarket. i dont have any knoledge. i am refering a lot of websites. every one is talking about terms like pe ratio, eps and so many things. but no one is discussing about what is pe & eps and all these things. u did a great job. i got basic knowledge becoz of ur articles sir. nice article sir. i read cash flow statement, macro economics and every post. sir u told u post on balance sheet, profit &loss ratio table also. sir we are eagerly waiting for those articles also sir. keep posting. we are eagerly waiting for your posts. great work sir.

Anonymous,  August 21, 2009 at 5:38 AM  

amazing creativity..very lucid...thank you for sharing

Krishna Raaj September 5, 2009 at 2:51 PM  

THE BEST article I have ever read about stock markets.

Keep up the good work.


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