Value Investing

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Lesson #1: Why Invest in Stock Markets?
Value Investing for Smart People is a course that will teach you the simple and sensible
strategies to invest in the stock markets to grow your wealth over the long term.
But since this is the very first lesson, let us answer this question to start off with…
Why invest at all?
All of us have a long list of financial goals, starting with things like paying the EMI of our house,
putting food on the table, and paying all other bills so that we live comfortable lives.
When you work your way down the list, you get to things like replacing the old car, buying a
second house, putting the kids through college, and retiring.
You see, most of our wants – and you might associate with this – will exceed our expected
lifetime earnings. This is even before you include a luxury car and a foreign holiday that you’ve
promised your wife.
How to you plan to meet all these expenses? Remember, we’ve already said that most of these
expenses will exceed your expected lifetime earnings.
So how do plan to meet at least the critical financial needs that will arise in the future – like
putting the kids through college, and your own retirement?
You already work so hard to earn money to meet your expenses and save for the future. You toil
hard, you sacrifice your personal life, and sometimes your health in the race to earn more and
more money.
But amidst all this, how much thought do you give to that fact that you can take help from
‘someone else’ as well to earn us more money to help you meet all your financial goals in the
Let me cut it short here. That ‘someone else’ is none other than your own money – what you are
earning and saving today.
Yes, your own money can earn money for you…and lots of it! People who are rich know this for a
fact. But most of us in the middle class don’t.
After all, our school and college education has never taught us this way to earn money. And
neither have our parents.
What we have always learnt is to study well, get a good job, earn money, and save for the
future. Nobody has really told us that there’s one more aspect to our working and earning life –
investing for the future.
This is the reason most Indian middle-class households ‘save’ money – in safe deposits of banks
and post offices, or in the form of gold and silver – and rarely ‘invest’. You might be one of them
But do you know how much our money grows when kept in these ‘safe’ places?
A bank account can give you a maximum of 3-4% interest per year. A bank fixed deposit or a
post office saving will give you somewhat better, but only 6-7%. Gold and silver won’t earn you
anything till the time you don’t sell them. And as far as property is concerned, in a normal year,
it can rise at an 8-10% rate as well.
“Aren’t these good returns?” you might ask. Not really, let me say!
While calculating your ‘real’ return from all these or any other avenue, we must also take into
account the ‘inflation’ factor.

In simple terms, inflation is nothing but a rise in prices of things that we consume. So, if we are
paying Rs 50 a kg for onions today while these were costing Rs 10 a kg one year back, the rate
of inflation is a whopping 400%. But this is an exception.
Inflation is India has generally been in the 5-7% range over the past many years. And it is
expected to remain in this range in the future as well, notwithstanding sharp spikes and falls in
So, when you calculate the ‘real’ return on your investment, you must reduce the inflation rate
from your total return. Like, if your bank account gives you an annual interest of 4% while
inflation is at 5%, your real return equals a negative 1% (-1%). And if a fixed deposit gives you
8%, your real return will stand at 3% (8% minus 5%).
Now do you think that this kind of return is fine, especially when inflation rate is only going to
rise in the future (given the rising shortage of everything we consume)?
It isn’t. I mean this is not what we can call ‘growth of our money’. Inflation actually eats into our
money. And how?
Let’s assume that you have Rs 100 with you are looking to buy onions. At a rate of Rs 10 per kg,
you will end up buying 10 kg of it. But what is the price rises to Rs 50 a kg after one year while
you still have only Rs 100 to spend?
In that case, you will be able to buy only 2 kg of onions. That’s the negative effect of inflation –
the value of every rupee you will have in the future will be lesser than the value of that one
rupee today. And that’s the where the concept of investing and inflation comes into play. To grow
your money fast at a time when inflation is eating into it is very important.
Forget onions. Look at the total cost of living that is rising at such a fast pace these days that
that we need to prepare ourselves well to meet our future financial obligations. And these can
include our children’s high education and marriage, our parents’ healthcare needs, and our own
retirement. All these are big expense items and as such we need to save and invest a lot to
collect their kind of money over the next 5, 10, 15, or 20 years.
Let us now look at how many years you will take to accumulate Rs 10 lac for your new born
daughter’s higher education 18 years down the line, if we start with Rs 2 lac today. We will
assume real returns (total return minus inflation of 5%) of different avenues to arrive at this
Here’s the chart that shows it all.

Note: Real returns (shown inside brackets) are calculated assuming inflation rate of 5%
As the above chart shows, the only way to meet you target of reaching Rs 10 lac (if you start
with Rs 2 lac today) in 18 years is to invest in stocks. While your bank FD will not get you
anywhere, the property route will take a much longer time that what your requirement (of 18
years) permits.

These calculations are not based on some random numbers. These are exactly what these
investment avenues have earned over the long term in the past.
Thus we arrive at the fascinating (though risky) world of stock markets – one of the most critical
investment avenues that can help you achieve your long term financial goals.
I just said that stock market is a risky place, but so are our lives. There is always a risk in
anything we do. But then, with the right education and research, we can minimize that risk. And
as we get more education, we can better decide how much risk we want to take and conversely
how much return we can make safely.
Understanding the risks is the first step toward minimizing them. In fact, it is possible to make
10-15% annual return on your stock market investment with almost no risk. But only if you know
what you are doing.
There are many paths you can go down when you get into investing in the stock market. But
there’s one thing you can be sure of. With education and research you will make money.
You are already beginning your education here. That’s a great start! Continue on this road and
make your money work for you.
Lesson #2: Hey, You Call This Investing?
“I am really shocked to hear your story, Ravi! But how did you manage to do this?” I said in a
tone of sympathy mixed with sarcasm.
“I don’t know Vishal. I had been so careful all this while with my investments. But despite that, I
have lost everything in the crash. My stock portfolio is down in the dumps!” Ravi sounded
utterly depressive.
“You call that investing? Buying stocks without a hint of what you were getting into? It’s like
flirting with someone and then saying that you were serious all this while!”
I still remember this small conversation with a friend sometime in October 2008. This
gentleman, my classmate from school, had been a bright student in the past. He was a
practicing doctor, but had no clue about investing in the stock markets.
But one fine day, on advice from some of his patients (yes, even patients can give doctors some
‘painful’ advice), took his first step into the stock markets only to see his savings burn in the
crash that followed.
Sometimes I wonder how even intelligent people (like my doctor friend) fall into the trap of
playing with their hard-earned money without knowing what they are getting into.
They work so hard for many years to become successful students, professionals, and
businessmen. And then, in a small phase of mindlessness, lose their entire savings just because
‘someone’ advised them a way to become rich fast.
Most of such people I have had the luck to meet call what they are doing as ‘investing’.
If the father of investing – or let me say ‘sensible investing’ – Benjamin Graham were to hear
that, he’d turned over in his grave!
Graham was the first to clearly define what ‘investing’ actually is, and how it differs from what
most people do in the stock markets (like my friend did) i.e., speculate.
In what is known as the best book on investing ever written – The Intelligent Investor – Graham
differentiated investment and speculation as:

“An investment operation (investing) is one which, upon thorough analysis, promises
safety of principal and an adequate return. Operations not meeting these
requirements are speculative.”
This definition of investing isn’t difficult to understand.
In fact, it can easily be understood if we break it down to its three key elements.
1. First, Graham says that you as an investor must thoroughly analyse a company, and the
soundness of its underlying business operations. What he means alternatively is that an
investment in a stock without understanding its underlying company is purely
2. The second important task for you is to identify all the potential risks associated with the
investment so that you can protect yourself against chances of serious losses.
3. The third key element of Graham’s definition is that an investor must aspire for only an
‘adequate’ return on his stock market investments – any rate if return, however low,
which the investor is willing to accept, provided he acts with reasonable intelligence. He
must not go after ‘extraordinary’ performance, which is what the stock market experts
usually promise to dupe gullible investors.
The combined practice of these key elements is what investing is all about.
Invest, to meet your life’s goals
You must have some dreams and goals in life. You also realise that most of these dreams and
goals require money.
So whether it is the dream of spending your 25th wedding anniversary traveling around the
world, or the goal of saving enough money for your child’s higher education, you need to have
enough money at your disposal whenever you need it.
The good part here is that you usually need this kind of money 10-15, or sometime even 20
years from the time you first start investing your savings.
So you have ample time to see your investments grow and build into a huge corpus that you
can use to meet your dreams and goals.
But just because someone advises you a ‘sure-shot’ way to get rich fast by speculating in the
stock markets, you spend your entire life’s savings in speculation only to lose everything when
the markets take a bad turn.
“But, is speculation a sin?”
This is what most of my friends whom I warn against speculating in the stock markets ask me.
And I’m glad you also want to know this.
See, there is no doubt that speculation is bad. Speculators are always obsessed with predicting
the future of stock prices, which is in fact a near impossibility.
Speculators thus depend not only on their own forecasting skills, but they also go by the
baseless and biased predictions of brokers or stock market experts appearing on business
channels. They try to guess the future, which is next to impossible!
But for better or worse, the speculative or gambling instinct is a core part of every human’s
You and I both want to speculate at some points in our lives. And stock markets are no different.

So what Graham has also said is that
even if an investor wants to speculate,
it (speculation) must be a restrained
activity. It must be controlled by the
amount of money you use in
You can call it ‘sin money’, and it must
be not more than 5% of the total funds
you have for investment.
Never increase this level of sin money
i.e., money you use to speculate in
stocks. This way you won’t go
overboard with your speculation.
The InvestmentSpeculation Pyramid

But this requires a lot of discipline. And the discipline says that you must never equate
speculation with serious investing. This is because as soon as speculation becomes a serious
activity, it gets extremely dangerous for you.
Here, I remember what the famous American author Mark Twain once said:
“There are two times in a man’s life when he should not speculate: when he can’t
afford it, and when he can.”
Anyways, stay tuned for the next lesson, because here’s where things start to get interesting.
I’m going to give you some specifics about the kinds of strategies that work well to make money
from stock markets, and in a sensible and easy-going way.
Lesson #3: There’s A Business Behind Every Stock
If I were to ask you to bet your money on the future success of one of your classmates or
colleagues, whom would you choose?
Would you bet on your best friend amongst these people?
Or would you bet on the most capable person (assuming that you friend is not the most capable
out there)?
If I can trust your IQ, betting on the most capable person would make greater sense for you than
betting on your best friend.
The same philosophy holds true while investing in stocks. You must not put your money on a
stock whose name you like the most or whose chairman is your best friend.
Instead, you must invest in the stock of a business you believe has the maximum potential.
But this is one reality that most investors forget – that…
“… a stock is not just a piece of paper that has a name, but a share of a business that
has real assets and profits.”
While buying a stock, you should take the same approach as you would if you were buying an
entire business. The only difference is that instead of buying the whole of the business, or a
partnership in the business, you are only buying a tiny share.
Investing’s nine most important words
“Investing is most intelligent when it is most businesslike,” said Ben Graham.
As per Graham’s best student Warren Buffett, these are the nine most important words ever
written about investing. And rightly so!
The biggest differentiating trait of Buffett’s own investing philosophy is the clear understanding
that stocks are representative of businesses, and not just pieces of paper.
The idea of buying a stock without understanding the company’s operating functions – its
products and services, management quality, employee relations, raw material sources and
expenses, plant and equipment, capital reinvestment requirements, and needs for working
capital – is unacceptable.
This mentality reflects the attitude of a business owner as opposed to a stock owner, and is the
only mentality an investor should have.
Owners of stocks who perceive that they merely own a piece of paper are far removed from the
company’s financial statements.

They behave as if the stock market’s ever-changing price is a more accurate reflection of their
stock’s value than the business’s balance sheet, income statement, and cash flows.
For Buffett and all other successful investors , the activities of a stock owner and a business
owner are closely connected. Both should look at ownership of a business in the same way.
As Buffett says:
“I am a better investor because I am a businessman and a better businessman
because I am an investor.”
As explained in ‘The Warren Buffett Way’ by Robert Hagstrom, these are some of the key
questions that you must answer to understand the business of a company.
Questions you must answer to understand a company’s business

Let’s discuss them in some detail here.
Questions on the core business
1. Is the business simple and understandable?
Never invest in a business you do not understand, for you can’t see the future opportunities and
challenges before they arise.
2. Does the business have a consistent operating history?
Past performance is no guarantee for future success, but it shows if a business can operate
under varying business conditions.
3. Does the business have favourable long term prospects?
‘Sustainable business’ is the key word here. Stay away from companies that operate on trends
and fads that can go out-dated in the future. Look for business that can sustain in the long term.
Questions on management quality
4. Is management rational?
Now this is a very important part of an investor’s business analysis. The rationality of the
management and its ability to deploy cash in a profitable manner is what separates a good
business from a bad one.
5. Is management candid (frank) with its shareholders?
You don’t want to get into a future Satyam, right? Look for managers that admit mistakes and
take complete responsibility of their actions.
6. Does management resist the institutional imperative?
Institutional imperative is the need for managers to act like their peers, no matter how irrational
their actions may seem. Avoid managers who have the tendency to give in to peer pressure.

Questions on financial position
7. What is the return on equity?
As we will understand later, return on equity is one of the most important metric for evaluating
the profitability of companies. Earnings can be manipulated, but return on equity will show how
worthy a business is.
8. What are the profit margins?
A company that can convert its sales into profits is a successful business. The key is to keep
costs at the minimum, and go for higher profits instead of higher market share. Avoid companies
with low margins.
We will discuss all these above-mentioned points in the subsequent lessons of ‘Value Investing
for Smart People’. Till then, just remember what Buffett said:
“If a business does well, the stock eventually follows.”

Lesson #4: Know Your Circle of Competence, and Stay Well Within It
“What did you study in your college, Ravi?” I asked my friend.
“You know Vishal that I am a doctor! Why are you asking this unintelligent question?” Ravi
looked at me with disgust. He was already disappointed seeing his stocks crash and savings
wiped out. And now he had to face such questions from me.
“Oh okay, so you studied how medicines work on a human body, right? But what made you
invest in a banking company then? Do you know how a bank works?”
“No Vishal! But are you telling me that a doctor can’t invest in a banking stock?”
“No, I am not saying that! What I am saying is that you must not invest in a banking stock if you
don’t understand how a bank works.”
Ravi looked with confusion at me as I continued, “If you don’t know why rising interest rates
suggest and how it is different from what rising blood pressure indicates, you have no right
investing in a banking stock.”
You see, we generally do not know the answers to questions from subjects we have not studied
in the past. And we are humble in accepting our ignorance on such subjects.
But things get different when it comes to investing in the stock markets. We have no qualms in
going beyond the boundaries of what we know.
We have no doubts before treading beyond our ‘circle of competence’.
For most investors, investing outside their ‘circle of competence’ is what creates the maximum
What’s your ‘circle of competence’?
In simple terms, your circle of competence with respect to investing defines your understanding
about certain businesses.
The businesses that you understand fall within the circle, and the ones you don’t understand fall
outside it.
As Warren Buffett, the world’s most successful investor ever, has said so often:
“You don’t have to be an expert on every company, or even many. You only have to
be able to evaluate companies within your circle of competence. The size of that
circle is not very important; knowing its boundaries, however, is vital.”

This means that you as an investor need to restrict yourself to the businesses you know –
businesses you can understand.
Understanding one’s circle of competence is a very necessary discipline in investing. Those who
do not do this are left to suffer.
Draw your own circle as Buffett did his…
Buffett’s investing process involved creating three lists of companies – In, Out, and Too Hard.
Buffett’s List of Companies

This was his way of sticking to his circle of competence, however small it was.
As he said, “We have a ton of doubts on all kinds of things, and we just forget about those.”
Interesting, isn’t it?
But then…
The key idea behind the circle of competence is not its size – the number of
businesses you can understand – but your awareness about its size – the number of
businesses ‘you know’ you can understand.
This means that a simple and understandable business is one within your ‘circle of competence’.
It isn’t important how big that circle is. It is important how well you have defined its perimeter.
A business will be ‘within’ your circle of competence if you fully understand the underlying
economics of it:

How it works?

What drives its growth?

What makes it profitable?

How does it stand against its competitors?

How does it manage its raw material costs?

You need to have the answers to such questions, and others like these to make sure that you
understand the business. To invest in something you do not understand can have disastrous

Ask your doctor friend who invested in dotcom companies in 2000 without understating what
the underlying businesses were.
Or ask your software engineer cousin who invested in real estate companies in late 2007,
without understating the huge risks that lied on the balance sheets of these companies.
If you can’t find businesses within your circle of competence, don’t just expand the circle…or at
least spend some time studying industries outside your circle before crossing the boundaries.

Lesson #5: Know The Language of Business
Getting Started: It isn’t rocket science! “When in Rome, do as the Romans do,” goes the famous
saying. What this saying suggests is that you need to know the language and customs of people
when you visit an unknown society. Doing so is polite, and also advantageous.
The same holds true when you enter the ‘investing society’. Before you enter, your gate pass
must show that you understand the language of business.
And what’s the language of business? Numbers.
Numbers speak the language of business.
If you don’t understand the numbers that businesses use to communicate with you, the
investor, the investing society can be like a maze. You won’t know where you are, and you won’t
know how to come out in case of a fire.
But believe me, if you can read a nutrition label on your box of corn flakes, or you know how to
read your home loan statement, you can learn to read basic financial statements.
The basics aren’t difficult and they aren’t rocket science.
We all remember Cuba Gooding Jr.’s immortal line from the movie Jerry Maguire, “Show me the
That’s what financial statements do.
These statements appear in the company’s annual report, and are broadly classified into three

Show me the money:
1. Balance Sheet
It is also known as the Statement of Financial Position and reports on a company’s assets,
liabilities, and equity (also known as shareholders’ funds) at a given point in time.
The assets side of a balance sheet shows what a business ‘owns’ – the factory, building, car,
machines, computers, etc. The liabilities side represents what a business ‘owes’.
Assume you bought a house using a housing loan, and also put in some money from your own
pocket. In this case, your house will fall on the asset side of your personal balance sheet. The
housing loan will be a liability. The money you infused from your own pocket will be your equity.
There are several others assets and liabilities that are included in a balance sheet, as you can
see in the following image of an actual balance sheet. Pick up a high school accounting book,
and you can learn it all from there.
Sample Balance Sheet

In simple terms, a balance sheet shows how a company stands at a given moment. There is no
such thing as a balance sheet covering the year 2010. It can only be for a single date, for
example, March 31, 2010.

2. Profit & Loss Statement
Also known as the Statement of Comprehensive Income, the Profit and Loss statement (or a
P&L) reports on a company’s income, expenses, and profits over a period of time.
So if you start a business manufacturing televisions, all the money you spend on buying raw
materials for manufacturing television sets, and all money you earn selling them in a year will
come in the P&L.
Sample P&L Statement

3. Cash Flow Statement
The cash flow statement is the most important of all statements, because it shows the
movement (inflow and outflow) of all cash during a year. And cash, as you must know, is the
most precious resource for a business.
Sample Cash Flow Statement

How these statements help?
So these were the three key financial statements through which businesses talk to investors.
These statements help businesses showcase:
1. Performance during the year gone by – Whether the year was a good one of bad one for
the company.
2. How strong the business is – The stronger a business, the more capable it is to face
slowdown and competition.
3. The level of profitability – a highly profitable business gets the maximum investor
4. Whether the business is guzzling cash or releasing a lot of it – The former type of business
is hated by intelligent investors, and the latter loved.
The ability to read financial statements and understand what they convey will open up several
areas for you to analyse stocks, buy the good ones, and ignore the bad ones.
By knowing how to read and analyse financial statements, you will be able to:
1. Understand how a specific company has performed in the past.
2. Understand whether the company is doing a profitable business or is running loss-making
3. Separate well-performing companies from the bad ones that are losing money for
4. Know if a company is using faulty accounting to inflate its sales and/or profits.
5. Realise that some stocks you already own in your portfolio, are actually dud businesses
that are doomed to fail.
Yes, this fifth realisation is the most striking aspect of your understanding of the financial
I have met several investors over the past few years – some from within my extended family,
some from among my previous company’s clients, and some just by the way.
What has amazed me is that a majority of these investors – and several have been old timers in
the stock markets – know little or nothing about identifying a good balance sheet from a bad
one. And it’s not by chance that almost all these investors have a large proportion of their
portfolios invested in bad stocks/weak companies.
But I don’t blame them for their ignorance, which they have misunderstood for bliss all these
Their source of stock ideas have been brokers, friends and relatives – people whom you can
consider least likely to tell you how a good/bad balance sheet looks like.
Probably you might have been one of their types. And if that’s the case, don’t worry.
We have just studied the key financial statements that you need to read in a company’s annual
report to make out how it is doing.
Now, let us move a bit deeper, and understand some key financial terms and ratios that you
must know in order to make a judgement on a good business versus a bad business.

This is going to be a pretty long lesson, so you can read it over the next few days before you get
the next lesson. While the subject is boring by nature, I’ve tried to make it as easy and
interesting as possible.
So let’s get started.

10 Financial terms you must know:
1. Sales/Revenue
Sales is what a company earns by selling its products or services. For example, if Company A
sells 100 units of a product at Rs 50 per unit, its sales will be Rs 5,000 (or 100 multiplied by 50).
While the sales figure is just the entry point to your understanding of a company’s financials, it
is important to know how the company is doing on this front. For, without sales, there won’t be
any business.
Tracking a company’s sales growth over a number of years (at least 10 years) gives a good
indication of its size and stability. A company with a stable growth in sales over a 10-year period
is generally considered better as compared to a company that has a rapid yet volatile sales
growth history.
2. Net Profit
This is ‘the’ figure most investors look out for in a company’s P&L account. Net profit represents
the money left over with a company after reducing all kinds of expenses from its sales. Net
profit is akin to your monthly savings after paying for all household expenses from your monthly
income. Like sales, looking at the long term performance of net profits gives a good indication of
a company’s financial health and stability.
3. Operating margin, or Profitability
Profit (like net profit, as we discussed above) is what a business earns after it reduces all
expenses from its sales. But profit is a number and does not explain much on an as-is basis.
What is more important for you as an investor is the ‘profitability ‘, which is equal to the money
a business makes for every rupee of its sales.
Assume Company A sells toys worth Rs 100 in a year and earns a profit of Rs 40. Company B
sells toys worth Rs 50 in the same year and earns a profit of Rs 30. Here, the profit of company
A is higher than profit of company B (40 > 30).
But when to comes to profitability, that of company B is better than that of company A (30
divided by 50 is greater than 40 divided by 100). Always remember, profitability is more
important than profit in understanding how a business is doing.
In highly competitive industries, a more profitable business has a greater flexibility to reduce
prices to fight competition. A more profitable business also generates more cash to spend on its
expansion and pay dividends to its shareholders.
4. Depreciation
All the fixed assets, except land, that a company owns (like plant, machinery, computers,
automobiles, etc.) are subject to a gradual loss of value through age and use. The allowance
made for this loss of value is known as depreciation (or obsolescence, depletion, and
The amount of depreciation to be charged each year is based on the value of the property
(usually taken at the cost it was bought at), its expected life, and the salvage or scrap value
when it is retired.
Let’s understand with an example. You buy a car for your personal use at a cost of Rs 500,000.
The expected life of this car is 5 years, and your expected scrap value is Rs 50,000 (at which it
can be sold off after 5 years). In this case, the annual depreciation charge will be 1/5th of Rs
450,000 (Rs 500,000 minus Rs 50,000). This gives Rs 90,000 as the annual depreciation charge.
A company will reduce such an amount from its operating profits every year.

However, note one important thing here. Depreciation is a non-cash charge i.e., a company does
not have to ‘pay’ depreciation to anyone. It only needs to reduce the depreciation amount from
its operating profits.
Now, since it reduces this amount from its operating profits, the tax it has to pay to the
government also gets reduced (as net profit before tax comes down due to reduction of
depreciation expenses from the operating profit. Money so saved can be used by the company
to replace the depreciated asset after the end of its useful life.
This is the core reason behind the concept of depreciation – it enables companies to save taxes
every year so that it can accumulate money so saved to buy replace its old assets after cross
their useful lives.
Note: In case you have any doubts/problems understanding the financial concepts as explained
in this lesson, please fee free to send me a message using the Contact page, and I’ll be able to
explain you further.
5. Equity
Also known as shareholders’ funds or book value, equity is the money shareholders (like you)
put in the business. Equity is a very important concept in financial analysis because a very
rough relationship tends to exist between the amount invested in a business and its earnings.
It is true that in many individual cases we find companies with small book values earning large
profits, while others with large book values earn little or nothing. Yet, as Benjamin Graham
suggests in his The Interpretation of Financial Statements (one book you must read to
understand financial statements), in these cases some attention must be given to the book
value situation, for there is always a possibility that large earnings on book value/invested
capital may attract competition and thus prove temporary.
6. Debt
Equity is what belongs to the owners of the business (shareholders like you), debt is what is
borrowed (from banks and others) by the owners of the business. While the owners of equity
(shareholders) have a claim on the company’s earnings (by way of dividends), those that extend
debt to companies (like banks) receive interest payments every year.
While debt isn’t a dangerous figure on the balance sheet, too much debt can be a cause of
concern. This is especially when this debt is not backed by almost equal or higher amount of
So, as a thumb rule, a debt to equity ratio (D/E) of higher than one, and consistently for several
years, is a cause for concern. However, a reducing level of D/E, or one that is already less than
0.5x (or 50%), is a comfortable situation.
7. Working Capital
As you can see in the sample balance sheet as shown above, there are two items named
‘current assets’ and current liabilities’.
Current assets are those that are immediately convertible into cash or which, in due course of
business, tend to be converted into cash within a reasonably short time (maximum one year).
Such assets include:
1. Cash and equivalents
2. Receivables (money that a company has to receive from its customers for the goods or
services that have already been sold)
3. Inventories (goods that the company has produced but are waiting to be sold, or raw
materials and semi-finished goods that the company holds in its stock)

Since these assets can be converted into cash in a short time, they are collectively known as
‘current assets’.
On the other side, i.e., on the liability side of the balance sheet lie ‘current liabilities’ that
represent the amount a company owes to its vendors who have supplied it with raw materials to
semi-finished goods, and are waiting to be paid. Such vendors are known as creditors of the
company. Apart from creditors, all the debts of the company that will be repaid within one year
are classified under current liabilities.
Now, coming to ‘working capital’, it is the figure arrived at by reducing current liabilities from
current assets. So,
Working capital = Current Assets – Current Liabilities
Working capital is a consideration of major importance in determining the financial strength of a
manufacturing company. This is because the study of working capital results in knowing whether
the company is in a position to carry on its normal day-to-day business comfortably without any
financial constraints.
Shortage of working capital (when current assets that can be converted to cash and not enough
to cover current liabilities that must be paid out soon) results in slow payment of bills.
This results in poor credit rating of the company, which subsequently means that the company
not just needs to borrow short term funds to meet its day-to-day expenses, it also has to pay
higher interest in the money so raised.
An important ratio you can work out here is the amount of working capital per rupee of sales.
Lower the ratio, lower is the working capital requirement of the company, and the more
financially strong it is.
Note: In case you have any doubts/problems understanding the financial concepts as explained
in this lesson, please fee free to send me a message using the Contact page, and I’ll be able to
explain you further.
8. Free Cash Flow
Cash (as you can see in the balance sheet above) is what a business holds in banks and other
investments. But the concept of free cash flow (FCF) is entirely different.
FCF is what a business is left with at the end of every year after it takes care of its capital
expansion and working capital needs. So if you look at the cash flow statement in the previous
slide, the FCF will be calculated as:
FCF = Cash flow from operations – Capital expenditures
= Rs 3055.79 lac – Rs 722.13 lac
= Rs 2333.66 lac
In simple terms, FCF tracks the money a business has generated by the end of each year. It’s
the cash that is left over with the company at the end of the year, after it pays all its bills and
pays for any new capital expenditures. It is what it has left over to pay investors. And that is
why FCF is one of the most important numbers you must track as a shareholder in a company.
9. Return on equity
Return on equity, or ROE, is one of the most useful tools to determine how well management
creates value for shareholders. The formula is:
ROE = Net profit / Equity
We’ve already discussed both ‘net profit’ and ‘equity’ in this lesson, so you must not have any
problem calculating the ROE.

The legendary investor, Warren Buffett believes that the return that a company gets on its
equity is one of the most important factors in making successful stock investments.
As such, the higher the ROE, the better it is for shareholders, as it indicates that the
management has allocated capital (equity) in a profitable way.
A higher ROE also means that surplus funds can be invested to improve business operations
without the owners of the business (shareholders) having to invest more capital.
It also means that there is less need to borrow, which is a positive sign for the business (we read
above the perils of borrowing more).
10. Dividend
One of the most loved words in a shareholder’s dictionary, ‘dividend’ is a payment made to the
shareholders (owners) of a company, out of the company’s profits. Most Indian companies
usually pay dividends on a yearly basis while some also do it quarterly.
So why is dividend important? Simply because it comes out of a company’s profits. Or, more
specifically, its free cash flow. A consistent, rising dividend payment is usually a hallmark of a
solid, well-run business that generates substantial, consistent cash flow.
All things equal, that equates to a relatively stable business and a stock that might be a little
less volatile than the market at-large. In other words, companies that pay consistent and rising
dividends are usually lower risk than companies that don’t pay dividends.
Parting thoughts
See, these are some of the basic yet among the more important concepts that you must know
as an investor. You will get data for all these terms and ratios in a company’s annual report.
Your just need to pull out the relevant data, make necessary calculations, and check for yourself
the financial health of the company.
Anyways, I won’t go further into the subject here, as that would require the space of a book.
What you can do is pick up a high school accounting book or basic book on finance and that will
teach you everything you’ll need to know about understanding financial statements.
You might ask – Is there a way I can invest without understanding financial statements?
Of course, there’s a way. But it’s very much like climbing Mount Everest without knowing
You might still reach the peak, but the chances are miniscule.
You know that, don’t you?
Anyways, we’ve covered the following key topics in the first four lessons of ‘Value Investing for
Smart People’:

Lesson #1: Why invest in the stock markets

Lesson #2: What is investing and how it is different from speculation

Lesson #3: Importance of understanding the business behind a stock

Lesson #4: Identifying your circle of competence – businesses you can understand

Lesson #5: Importance of understanding the language of business (the current lesson)

Over the next few weeks, we’re going to talk about how you can value a business to ascertain
whether its stock is available cheap or expensive.
This is where we would work on some basis maths related to investing.
Don’t worry a bit! I promise that you’ll find it a cakewalk with Safal Niveshak on your side.

Lesson #6: It’s All About The Intrinsic Value
Can you compare the price of a Mercedes S-Class and that of a Maruti-800?
Of course, one costs Rs 60 lac while the other costs less than Rs 3 lac. And you can compare Rs
60 lac with Rs 3 lac.
But then, is that the right comparison? I mean, isn’t this the same as comparing apples to
The two cars have different values in terms of luxury, safety, quality, and brand value. So
comparing them just on their prices won’t be the right idea. You need to see the difference in
their values.
After all…
“Price is what you pay. Value is what you get.”
The same goes for stocks. A Rs 50 stock might be considered cheaper than a Rs 500 stock. But
that’s an incorrect way of looking at it, just like comparing the price of a Mercedes with a Maruti800.
As we learnt in the third lesson, a stock is not a piece of paper but a share in a business. So it is
important to compare a stock’s price with the company’s business value (and not with anything
else, ever!) to ascertain whether it is cheap or expensive as compared to another stock, and
also in isolation.
The Rs 50 stock might be backed by a business whose value is Rs 25 – thus a price-to-value of 2
times (50 divided by 25). On the other hand, the Rs 500 stock might be backed by a business
whose value is Rs 1,000 – thus a price-to-value of just 0.5 times (500 divided by 1,000).
What this means is that the first stock is priced at 2 times the business value, while the second
stock is priced at thus 0.5 times (or 50%) the business value.
Now, which is cheaper? The Rs 50 stock, or the Rs 500 stock? Based on this short analysis, the
Rs 500 stock definitely looks cheaper. Isn’t it?
Anyways, the idea of this discussion is to bring to light the key investing concept of ‘intrinsic
value’. In simpler terms, you can also call it the ‘core business value’.
So, why you should calculate intrinsic value?
“To calculate intrinsic value is vital. It is one secret to successful investing that you
can’t afford to ignore. You need to calculate the intrinsic value because you must not
buy any stock at any price.”
The price you are paying is the ultimate determinant for the rate of return that you’ll be earning
from a stock. The higher the price you pay for it, the lower will be your return. As simple as that!

And that is why you need to know how much a stock is really worth. Once you know its intrinsic
value, you can identify if the stock is trading cheap or expensive. A very high stock price as
compared to the business’ intrinsic value means that the stock is expensive (like our first stock
above). And a low price as compared to the intrinsic value means that the stock is cheap (like
the second stock as discussed above).
These are general rules of thumb. We will understand the specifics of how much price to intrinsic
value makes a stock cheap or expensive in the next two lessons. And we will also study the
different ways you can calculate the intrinsic value of a stock.
But for starters, remember that intrinsic value is an estimate rather than a precise figure. And it
is an estimate that must be changed with changes in the variables that are used to calculate it
(don’t worry, we will study all that in the next two lessons!)

Lesson #7: Calculating Intrinsic Value-Part I
Moving ahead from the previous lesson on the basics and purpose of intrinsic value, let’s now
move a bit further into this very important subject for value investors.
Let’s learn something about the different ways you can calculate the intrinsic value of a stock.
But first, here’s the easiest and the most important definition of intrinsic value that you’ll come
across anywhere. This is what Warren Buffett wrote to his company’s shareholders in 1994:
“We define intrinsic value as the discounted value of the cash that can be taken out of a
business during its remaining life.”
In simpler terms, intrinsic value of an asset is the discounted value of the expected cash flows
that that asset can earn over its life.
‘Cash’ I know, but what’s the ‘discounted value’?
In his definition of intrinsic value, Buffett mentions that the intrinsic value is nothing but the
‘discounted value of cash’ that can be taken out of a business.
Let’s understand these two key terms –
1. Cash
2. Discounted value
Most investors believe that understanding the term ‘cash’ is akin to understanding the English
But your see, cash isn’t as simple as C-A-S-H.
Cash is not what a company earns when it sells its products or services. And it is neither the
profits a company makes during the year after paying its operating expenses (like raw material
costs, employee salaries, sales & marketing costs, administrative costs), interest, depreciation
and taxes.
Cash is beyond these – sales and profits.
Cash is what remains with a business at the end of a year and after paying for the
cost of anything and everything a business buys and pays for during the year.
So it is a much-refined form of profits. But it is what remains with a company after also paying
off the dividends, cost of new plant & machinery and buildings (or capital cost), and working
capital changes (and adding back depreciation which is a non-cash charge).
This cash is also known as ‘free cash flow’, and it is the ultimate measure of a company’s

By looking at free cash flow, you can see whether a company is actually making any money and
you can get a sense of what it’s spending its money on.
Let’s now turn our attention to the second critical element of Buffett’s definition – the
‘discounted value’.
Discounted value is used to define the present value of future cash flows. So it is also known as
the ‘present value’.
Let us understand this concept using a simple example.
If I offer you Rs 100,000 and you could receive it now or in 10 years, when would you take it?
Most likely you would say, “Now.”
This is because you already know that money received now is more valuable to you than money
received in the future, simply because you can invest this money (Rs 100,000) to earn interest
on it for the next 10 years.
Now assume that the interest rate that a bank is willing to offer you for Rs 100,000 that you
deposit it there now is 10%. So your cash flow for the next 10 years will look like this:
PV when cash flows are constant (as in bank deposits)
* Assuming interest rate of 10%, which will also be
the discount rate
What this table shows is that if you deposit Rs
100,000 in a bank at 10% interest rate, you will earn
Rs 10,000 as interest (cash flow) for the next 10
years, plus your capital (Rs 100,000) at the end of
the tenth year.
Now, when you calculate the present value of each
of these cash flows (as shown in column C), and
total it, the sum comes to Rs 100,000, which is the
present value of all these cash flows (that total to Rs
200,000 over this 10 year period).
So, as you can see from the example, while you receive a total of Rs 200,000 over these 10
years, when you calculate the present value, the number comes to Rs 100,000 or exactly what
you had deposited in the bank.
Now, the question is, if the present value of Rs 100,000 deposited for 10 years at 10% per year
is Rs 100,000, why would someone deposit or invest money at all?
Nice question, I must say.
But please know that this is a very simplified explanation of present value. In reality, what it
means is that when I offer you Rs 100,000 and you want it now, you have the flexibility to invest

in a business where you expect cash flows to grow by 10% per annum, instead of depositing in a
bank where the cash flows remain at 10,000 each year for the next 10 years.
PV when cash flows are growing (as in a business)
* Assuming annual growth in csh flow of 10%, and
discount rate of 10%
As you can see from the table above, Rs 100,000
invested in a business earned you a cash flow of Rs
10,000 in the first year, which is exactly same as the
bank deposit earned you in the first year. But from
second year onwards, this cash flow grew by 10%
every year.
So at the end of 10 years, your total cash inflow
totalled Rs 259,374, and the present value of this
cash flow stood at Rs 129,463.
So, while you invest Rs 100,000 today, the present
value of your total cash flows stands higher by Rs 29,463, which makes it a profitable
This calculation of Rs 129,463 minus Rs 100,000 is called as ‘net present value’ or NPV and is at
the heart if all business decisions.
A company takes up a project or enters a new business only when the NPV is a positive number,
as in the second example above. If the NPV is zero, like in the first example where you deposited
Rs 100,000 and the present value of all cash flows for 10 years was Rs 100,000, it is a neutral
As an investor, you must invest in stocks of businesses where you expect to earn a positive NPV
over your investment horizon.
And you can calculate the NPV using the free cash flows a business is estimated to earn over the
next 10 years.
Know that the Rs 129,463 that we calculated as the present value of future cash flows, is the
‘intrinsic value’ of this business. And since this is higher than the original investment of Rs
100,000, it makes for a good investment opportunity if the business were to be listed on the
stock exchanges.
Here is the formula for calculation of discounted cash flow (DCF) or present value (PV) of future
cash flows:
PV = CF1 / (1+k) + CF2 / (1+k)2 + … [TCF / (k - g)] / (1+k)n-1
PV = present value
CFi = cash flow in year i

k = discount rate
g = growth rate assumption in perpetuity beyond terminal year
TCF = the terminal year cash flow
n = the number of periods in the valuation model including the terminal year
If you were to go through the DCF calculation excel, there are three key variables you need to
calculate the DCF value of a company:
1. Estimates of growth in future free cash flows (FCF): Growth in FCF over say the
next 10 years, using last 3 years average FCF as the starting point. (Click here to see the
calculation of FCF from a company’s cash flow statement)
2. Terminal growth rate: Rate of growth in FCF after the 10th year and till infinity.
3. Discount rate: Rate at which the future cash flows must be discounted to bring them to
present value.
Now there are three key issues that arise with
these variables:
1. What growth rate to assume for future FCF
2. What discount rate to assume?
3. What terminal growth rate to assume?
Let me help you with how do I answer these
questions for calculating DCF valuations myself.
1. How do I predict future FCF?
As an analyst, I always found it difficult to predict
growth rate in volumes, sales and profits. But I
still tried to do that – after all, I was paid to predict the future!
However, as I’ve realised over the years, trying to find a perfect answer to the question “What
growth rate to assume?” is like trying to find a “perfect couple”. None exist!
Given this limitation of trying to predict the future, I’ve changed my way of analysis to value
stocks based on the present data rather than what will happen in the future.

That’s why I now don’t try be accurate with my
FCF growth estimates. I just try to be
reasonable and use common sense.
For most stocks, I generally perform a 10-year
2-stage DCF analysis. What this means is that I
assume a particular growth rate for the first
five years of my FCF calculations (as you can
see in my DCF excel), and then another number
for the next five years.
I rarely go above 10-12% annual growth rate
for the first five years, and 6-8% for the next
The best practice is to keep growth rates as low
as possible.
If the company looks undervalued with just 5%
annual growth in FCF over the next 10 years,
you have more upside than downside.
The higher you set the growth rate, the higher
you set up the downside potential.
To repeat, while assuming FCF growth rate for
the future, just be reasonable and use common
A caveat – don’t take cues from the past as the
past performance is rarely repeated in the
2. How much discount rate do I assume?
In simple words, discount rate is the rate at which you must discount the future cash flows (as
estimated using above growth assumptions) to the present value.
Why present value? Because we are trying to compare the company’s intrinsic value with its
stock price “now”….in the present.
Just to help with an example, what price would you pay for an investment today if company
ABC’s future cash flow is worth Rs 1,000 after 1 year?

If the discount rate is 5%, you must pay Rs 952 now (1000/1.05).

If the discount rate is 10%, you must pay Rs 909 now (1000/1.1).

If the discount rate is 15%, you must pay Rs 870 now (1000/1.15).

In other words, the higher the discount rate you assume, the lower you must pay for the stock
as of now.
Finance textbooks and experts would tell you to use Capital Asset Pricing Model (CAPM) to
calculate discount rate. I used CAPM myself to arrive at discount rates in the past.
However, if you are worried what CAPM is, don’t be because you can avoid knowing about it and
still live happily ever after….like I am living.
Look at discount rate as the “annual rate of return” you want to earn from the stock.
In other words, if you are looking to invest in a business that has comparatively higher
(business) risk than other businesses (like in case of most mid and small cap stocks), you may
want to earn a 15% annual return from it.
For valuing such businesses, take 15% as the discount rate.
In case of relatively safer businesses (think Infosys, HUL, Colgate), earning around 10-12%
annual return over the long term is a good expectation (because these businesses will also
provide some stability to your portfolio during bad times).
For valuing such businesses, take 10-12% as the discount rate.
Better still, assume a constant discount rate for all companies. I am gradually turning to this
model – of taking a constant 15% discount rate for all kind of businesses (safe or risky).
“But this way, how would you adjust for the risk in each business?” you may ask.
Simple – adjust the risk in FCF growth estimates. That is where the real risk lies, right?
3. How much terminal growth rate do I assume?
As I mentioned above, I do a 10-year FCF calculation for arriving at a stock’s DCF valuation.
But the companies I’m valuing won’t cease to exist after 10 year. Some will survive for 10 more
years, some for 20 years, and very few for 50 years.
That is where the concept of “terminal value” (or the value after 10th year and till eternity)
comes into picture.
The terminal value I generally assume lies between 0% and 2%. Assuming higher terminal value
(>3-4%) is like assuming the company to grow bigger than the world economy in the infinity,
which isn’t possible.
So the idea is to keep it as low as possible. Best to keep it at 0%.

Lesson #8: Calculating Intrinsic Value-Part II
If you are a reader of financial newspapers, or watch business channels, you must have come
across stock market experts and analysts blabbering terms like ‘P/E’ or ‘P/BV’.
You must have even cursed the speaker for using such difficult terms that bounced above your
head. If that’s the case, you are not alone.
I have come across many investors who have been in the market for years, but who still do not
understand the basic difference between ‘price’ and ‘value’ (the intrinsic value as we discussed
earlier), forget understanding terms like P/E or P/BV.
But like investing isn’t difficult (it’s just made out to be difficult), understanding these terms and
their relevance isn’t hard as well.
So let’s start with the superstar of them all – the P/E ratio or price to earnings ratio. Why
superstar? This is because P/E is by far the most popular valuation metric used by investors and
analysts to assign an intrinsic value to a stock.
The P/E ratio of a stock is a simple tool for measuring the markets’ temperature. It is calculated
by dividing a stock’s price by the company’s earnings per share or EPS.
P/E Ratio = Price per share / Annual earnings per share
So if a company’s latest year’s earnings (or profits) per share stand at Rs 10, and its stock is
trading at Rs 120, the P/E of this stock is 12 times. If the same stock moves up to Rs 150 while
the earnings of the company remain at Rs 10, the P/E moves up to 15 times. So both the change
in a stock’s price and the company’s earnings define how a P/E ratio moves.
As a general rule of thumb, higher a P/E, more expensive is a stock as investors are paying more
for each rupee of a company’s earnings.
P/E – What’s the right number?
The question is – what is the right P/E ratio that an investor must pay for a stock?
The answer – it depends. It depends on the company’s past track record, its business strength,
its financial performance, its management quality, its competitive position, and its past P/E.
A safe company with slow yet steady growing earnings (like one from the consumer goods
sector) can easily command a P/E of 20-25 times across several years.
On the other hand, a fast growing company can sometimes trade at a P/E of 30-40 times.
So the point is that the P/E of a stock depends on the company’s quality as also the overall
market sentiment towards that stock.
And given this – that market sentiment also has a role to play in the determination of the P/E – it
isn’t a perfect way to calculate intrinsic value despite the importance it gets.
In fact, when you calculate a company’s intrinsic value using the P/E, don’t forget to cross-check
with the value you get using the DCF calculation (which we discussed in the previous lesson).
P/E close cousin – P/BV
Book value gets a lot of attention like earnings. This is simply because this number is widely
available and is very easy to calculate.
Book value of a company is simply its net worth or equity. Book value per share is the net worth
divided by the number of shares outstanding.

Price to book value is thus:
Price to book value (P/BV) = Price per share divided by Book value per share
Before we move further, let’s simplify the calculation of book value.
Here is the table showing the latest balance sheet of Swaraj Engines.

Look at the top of this Balance Sheet. The formula to calculate book value is:
Book Value = Equity capital (A) + Reserves & Surplus (B)
= Rs 1241.98 crore + Rs 13979. 94 crore
= Rs 15221.92 crore
Let’s now understand what book value exactly means.
In most cases, book value is an artificial value that appears on the liability side of a balance
sheet (as shown above).
Also known as shareholders’ equity, book value represents what investors have put into a
business, including the company’s undistributed earnings (part of profits that is not paid out as

It is assumed that if the company were to liquidate (close down its business and sell its assets),
it would receive in cash the value which is at least equal to its book value – the value at which
its tangible assets are carried on the books.
However, as a matter of fact, if the company were actually liquidated, the value of the assets
would most probably be much less than their book value as shown on the balance sheet (and
thus the book value as shown on the balance sheet is an artificial value).
The sale of inventory would most likely be at some loss. And the fixed assets will also be sold at
a substantially lower price than what these are shown in the book (balance sheet).
In general terms, book value is considered a measure of what shareholders can take out from a
company when it is liquidated.
In reality, book value is the money that shareholders have ‘put’ into the business.
And what they get in a business’ liquidation is mostly less than what they have put in.
The book value is of some importance in analysis because a very rough relationship tends to
exist between the amount invested in a business and its average earnings (calculated as return
on equity).
It is true that in many individual cases, we find companies with small book values earning large
profits, while others with large book values earn little or nothing.
Yet in these cases, some attention must be given to the book value situation, for there is always
a possibility that large earnings on the invested capital may attract competition and thus prove
It is also possible that companies with large book values, not earning meaningful profits now,
may later be made more productive.
Overall, P/BV is often used to gauge a stock’s relative value.
A company trading at a low P/BV, particularly when compared to other companies in its industry,
is thought to be undervalued relative to its share price.
However, a low P/BV could also be an indication of negative investor confidence towards the
company, most likely for the reason when the company is not earning good returns on book
As such, when used in calculating the intrinsic value of a stock, P/BV must be coupled with
metrics such as P/E and Return on Equity to get a better snapshot of the company as a whole.

Lesson #9: Insure Your Investments With a Margin of safety
Before we move ahead into this ninth lesson, just answer Yes/No to these five simple questions:
1. Do you own an insurance policy?
2. Do you save money?
3. Do you keep extra cash (more than you will need) with you when you travel?
4. Do you reach the railway station an hour before the scheduled departure of your train?
5. Do you believe that prevention is better than cure?
If you answer ‘Yes’ to all or most of the above questions, you are a practitioner of ‘margin of
You keep some extra time and money on your hand in case things do not go as planned – like if
you run out of cash during your travel, or you get stuck in a traffic jam while going to the catch
a train.
The same ‘margin of safety’ applies even to stock market investing.
In fact, these are often considered the three most important words in investing.

The principle of margin of safety in investing was first introduced by the ‘father of value
investing’ Benjamin Graham.
In simple terms, for stocks…
“Margin of safety if the difference between the intrinsic value of a stock and its
market price.”
This principle suggests that you must buy a stock only when it is worth more than its price in the
So if a stock is trading at Rs 100 in the market, and you calculate the company’s intrinsic value
as Rs 150, you have a margin of safety of Rs 50 (150 minus 100). In other terms, the stock is
trading at a 33% discount to the company’s intrinsic value.

If the said stock is of a high quality company, it is advisable to buy it at any price that is 80% or
lower than the company’s intrinsic value (any price lower than Rs 120).
And if the said stock is of a company that is not an exceptional one (but worthy enough for
investment), you must not buy it for more than 50% of the intrinsic value (only if the price is
lower than Rs 75).
“What margin of safety does is that it protects you from poor decisions and
downturns in the market.”
So if you pay just Rs 100 for a stock that you believe is worth Rs 150, even if your analysis goes
wrong and the stock is actually worth less than Rs 150, your investment will still be safe.
Given that the calculation of intrinsic value (of Rs 150 in this example) is subjective in nature, it
is always better to have a good margin of safety while buying a stock. A 30-40% margin of
safety is what Graham recommends.
This disciplined pursuit of bargains (stocks that are available for 30-40% less than their intrinsic
values) makes value investing very much a risk-averse approach.
But the greatest challenge for you as an investor is to maintain that required discipline.
The trap of a rate race
Most of us generally fall in the trap of following the herd. So we buy stocks when the prices are
rising, just because we do not want to miss out on the paper profits that our friends, colleagues,
or relatives are making by betting on rising stocks.
But then, being a value investor means standing apart from the crowd, and challenging
conventional wisdom.
It can be very lonely being a value investor practising a concept like margin of safety.
But if you can do it with utmost discipline, you can earn great returns from the stock markets
over the long run.
With respect to margin of safety, here is what Warren Buffett, whom Graham considered his best
student, has to say:
“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.”
Buffett describes margin of safety concept using this example – “When you build a bridge, you
insist it can carry 30,000 pounds, but you only drive 10,000-pound trucks across it. And that
same principle works in investing.”
How much margin is good margin?
Coming again to the question of what is an adequate margin of safety, the answer varies from
one investor to the next. But it chiefly depends on –
1. How much bad luck are you willing and able to tolerate?
2. How much volatility in business values can you absorb?
3. What is your tolerance for error?
In short, it all boils down to how much you can afford to lose.

Losing some money is an inevitable part of investing. In fact, there is nothing you can do to
prevent it.
But to be a sensible and intelligent investor, you must take responsibility for ensuring that you
never lose most or all of your money.
Using the margin of safety concept, and by refusing to pay too much for an investment, you
minimise the chances that your wealth will ever disappear or suddenly be destroyed.
To conclude, as Graham reminds us, the intelligent investor must focus not just on getting the
analysis right. He must also insure against loss if his analysis turns out to be wrong – as even
the best analyses will be at least some of the time.
So that was about margin of safety. You now know its relevance, right?
In the next (tenth) lesson, we will talk about a weird creature called Mr. Market, who with his
ever-changing moods, lures investors to make big investing mistakes.
But there is a way you as an investor can protect yourself from the whims of Mr. Market. We’ll
find ‘how’ in the next lesson. So stay tuned.
Lesson #10: The curious case of Mr. Market
Imagine yourself as a businessman, working in partnership with your friend. This friend of yours
is a strange fellow, but you have him as a partner just because of some old family ties.
His behaviour gets so worse that every day he appears in the office asking you to either sell the
entire business to him. Or buy the entire business from him. On both such occasions, he also
quotes a price at which he’ll buy or sell the business.
Another strange habit of your friend is that the prices he quotes for buying or selling the
business change each day.
The day he is very optimistic about the future of this business, he will quote a very high price to
buy or sell the business. On such days, he is ready to buy your share at a very high price
because he sees very bright prospects for the business. Alternatively, he is ready to sell his
share of the business only at a high price.
Then there are days when he feels very depressed. On such days, he sees nothing but trouble
ahead for both business and the world. These are the occasions when he would name a very low
price, as he is terrified that if he does not do so, you would burden him (sell him) with your
share in the business.
In both such cases, what would you do assuming that you aren’t as strange as your friend?
If you were a sensible businessman, you would not let his daily moods and prices determine
your view of the value of your interest in the business. You may be happy to sell out to him
when he quotes you a ridiculously high price, and equally happy to buy from him when his price
is low.
But at the rest of the time, you would be wise enough to form your own ideas of the value of
your share in the business.
Now replace your share in your own business with your share in someone else’s business that
you own through stocks. And replace your neurotic partner with the ‘stock markets’ that offers
you a different price daily for your stocks.
Call this friend as Mr. Market.
How much influence will Mr. Market have on your own independent view of the stock you own?

Using the above example, Mr. Market’s ever-changing moods and ever-changing prices must not
force you into changing your view of the business. And this must be true of your stocks as well.
The above story is created using the parable of Mr. Market that was first told by Benjamin
Graham in 1934 in his ‘The Intelligent Investor’. Even after almost eight decades of being first
introduced, Mr. Market remains a manic figure.
And just like when he was introduced, the prices quoted by Mr. Market seem reasonable, but
often they are ridiculous.
As an investor, you are free to either agree with his quoted price and trade with him, or to
ignore him completely. Mr. Market won’t mind this. Instead, he will be back the following day to
quote another price.
The point is that you should not regard the whims of Mr. Market as determining the value of the
shares that you own. Instead, as Graham suggests, you should profit from market folly rather
than participate in it.
You will be better off concentrating on the real life performance of the companies whose stocks
you own, rather than being too concerned with Mr. Market’s often irrational behaviour.
Lesson #11: Hey, mind your behaviour!
Were you ever punished in school for not behaving properly in the class?
If you are like me, you must have experienced the happiness (mixed with some embarrassment)
of being ‘out-standing’ on a regular basis! But then, you must have behaved well after that
Sometimes I wonder if we as adults were always guided and punished by our teachers for all our
mistakes and mindless behaviour. Growing up and moving out of school gives us a lot of
freedom to behave the way we want to. But then, for some of us, it becomes a license to behave
any which way…even at the cost of our own peace, and money.
Talking about stock markets, the pundits will tell you that to learn to invest, you need to read
the theory books. You need to understand complex accounting. You need to know the jargons,
the P/E, the EV/EBDITA, the SOTP.
What these pundits however fail to tell you is that before you get to all that investing theory,
you need to work on the practical. You need to study ‘yourself’…your behaviour.
We are who we are…
…but our behaviour shapes us. And as human research suggests, 70% of our behaviour is
shaped by our experiences (the remaining 30% by our genes).
This implies that whatever we have learnt about saving and investing from our parents doesn’t
matter that much. What matters is what we have experienced ourselves in our lives and
The brain is a leaking boat
We call ourselves rational beings. The truth is that we aren’t rational but rationalising beings.
The brain that sits on the top of our head isn’t a flawless machine. Yes, it is powerful. But it has
its weaknesses. In everyday terms, we call such weaknesses as ‘biases’.
The good part is that while we cannot exchange our brains with other people nor can we
upgrade it at a hardware shop, we can avoid mistakes that our biases cause by just taking
notice of them.

It’s just like getting into a boat. Before getting in, you would want to know about any holes in it
before you start paddling. Right?
Biases are such holes in our brain’s reasoning abilities. And these biases can damage our
decision making.
Here are five most common biases that we carry with us, and which can really have a negative
impact on our decision making capabilities, including the way we invest in stocks.
1. Overconfidence
Answer this simple question – “Which is the world’s only officially Hindu country?” India? Sure?
Confident? Over-confident? Sorry, but you are wrong! It’s Nepal.
Now tell me – “Are you sure the stock you just bought will go up?” See, you are again getting
2. Confirmation bias
You can call it ‘wishful thinking’. Confirmation bias appears when you see what you want to see.
It’s a bias that makes you notice and look for information that confirms your existing beliefs,
whilst ignoring anything that contradicts those beliefs.
3. Availability bias
More people are killed every year from attacks by donkeys and by drowning in swimming pools
than those who die in car accidents or plane crashes! But just after a plane crash, we give more
prominence to those killers than anything else. So what is the reason for that? The answer lies in
‘availability bias’, which is a phenomenon in which people predict the frequency of an event
based on how easily an example can be brought to mind.
Hey, did you hear about that company that is coming out with India’s biggest IPO? They’re all
around the media. I’m buying their stock!
4. Framing
You may think it’s fine to eat a burger that is 90% fat-free. But when you turn it around and
think of it as a burger that’s 10% fat, you may think twice about eating it. That’s what ‘framing’
does to you – how you say and hear things makes a good impact on how you respond or act. In
investing, a 50% loss hurts more than the pleasure from a 50% gain.
5. Herding
When in doubt, follow! This is what the herding bias tells us. We are programmed to feel that the
consensus view must be the correct one. This mistaken belief that ‘not everyone can be wrong’
has led to many a disastrous decision. The Great Depression of 1920-30s, the dotcom boom of
1999-2000, and the more recent financial crisis are the most famous examples of how investors
have lost big time by doing what everyone else was doing.
So, which herd are you following?
Know the holes, and fill them
Simply noticing the holes in a boat won’t save you from drowning. A boat will fill with water
whether you are aware of a hole or not. But by being aware of the holes you can devise
methods to patch them up.
In the same way, if you know how your biases can hurt you, you will take precautionary action
to safeguard yourself from them.

So just be aware of yourself!
Lesson #12: Checklists, Checklists, Checklists
Imagine going to a doctor with a stomach pain after you have been operated upon. The doctor
asks you to get an x-ray done. The x-ray report shows a piece of sponge in your tummy.
Frightening, isn’t it? This could be life threatening.
As per a study done by the World Health Organisation, such medical mistakes result in around 7
million getting disabled every year. One reason this number is not higher is that doctors use
what is known as a checklist before and after every operation.
Medical treatments have become so complex that it is difficult for doctors to keep personal
check on each and every procedure. Mistakes still occur. But then the number of such mistakes
is greatly reduced due to the use of such checklists. So, checklists save lives.
The US Air Force introduced the concept of checklists decades ago. These have enabled pilots to
fly aircrafts at mind-boggling sophistication. Innovative checklists are now used in hospitals
around the world. These help doctors and nurses respond to everything from common cold to
epidemics. Even in the complex world of medical surgery, a simple 90-second checklist has cut
the rate of fatalities by more than a third.
A fair amount of research has been done in the past that suggest the immense value of
checklists. Checklists are valuable as these help short circuit the human brain in a way that it
wants to work against us.
We generally are overconfident of our capabilities. A checklist can remind us that we are not
infallible, that we do make mistakes, and not to be too sure about our decisions.
Investing in stocks is not as complex as doing a medical surgery or flying an airplane. But
checklists play a very important role when it comes to investing in stock markets.
Charlie Munger, Warren Buffett’s partner at Berkshire Hathaway, can be credited of first
introducing the checklists in investing. Munger talked about these in his book – Poor Charlie’s
Here is a checklist I have prepared from my study of Munger’s checklists and that of other great
investors like Warren Buffett and Philip Fisher.
The Investing Checklist
Step 1: Do the initial groundwork
1. Read about the company – Company website, Google search, BSE announcements,
Newspaper clippings
2. Read about the competitors – Same sources as above
Step 2: Read past 5-10 years’ annual reports of the company
1. Read the financial statements – Income statement, Balance Sheet, Cash Flow Statement
2. Notes and Schedules at the end of financial statements
3. Management discussion & analysis
4. Management’s compensation – See for red flags like higher compensation as compared to
industry, excessive bonus or commissions

5. Promoter stake – Check shareholding over the past few years
6. Read annual reports of the closest competitors and see for differences in tone and
industry outlook
Step 3: Ratio analysis – Calculate the following ratios and the trend in the past
1. Net-net working capital
2. Free cash flow to EPS growth
3. Free cash flow to sales
4. Return on equity
5. Return on invested capital (ROIC)
6. Earnings yield (inverse of Price to earnings ratio)
7. Inventory turnover and Receivables turnover
8. Debt to equity
9. FCF to debt
10.Valuations – DCF, EPV
Step 4: Emotional Check
1. Write down how you are feeling
2. Write down the biggest reason you want to buy the stock
3. Beware of wanting to just buy and study later
4. See if you are being overconfident in your analysis
5. Are you buying just due to amount of research you’ve put into the stock?
6. Are you reluctant to accept differing opinions?
7. Beware of buying just because others are buying the same stock
8. Get away from the excitement and noise. If necessary, take a break and clear your mind.
Step 5: Final Evaluation
1. What can go wrong?
2. What will be you reaction if things really go wrong?
3. What are the risks? How likely are the risks? How big are the risks?
4. How attractive is this idea compared to the other holdings? Is that stock you already hold,
better than this stock?
5. What is your expected holding time frame?
6. What price will you sell?
So here was the checklist that you must run through before making any investment decisions.

And if you do your homework on this properly, you can rest assured that the stocks that pass
this checklist will give you great return in the long run.

But there’s a caveat here – even if a stock passes this checklist and you go ahead and buy it, it
is important that you run this checklist on that stock ever year to see if things have changed.
That will keep you on your toes in case any adversity was to hit your stocks.

Lesson #13: Know when to sell
Most value investing discussions revolve around when to buy a stock. “Which stock should I
buy?” is the first question that comes to your mind when you think about your investment. But
equally important is the question – “Which of my stocks should I sell?” Well, the answer to this
question is often as difficult and individual as deciding when to buy a stock.
Philip Fisher, in his seminal book ‘Common Stocks and Uncommon Profits’ writes, “If the job has
been correctly done when a common stock is purchased, the time to sell it is – almost never.”
But then, there are times when the job is not done correctly and we realise later that the stock
purchase was a mistake. It is then that a stock must be sold.
Anyways, Fisher suggests three reasons a stock must be sold. Let’s discuss them now.
# 1 Reason to Sell A Stock – When A Mistake Has Been Made
This is the most obvious reason to sell a stock – when you realise that it was a mistake to buy it
in the first place. When you realise that the actual background (business, performance) of the
company is less favourable by a significant margin than what you had thought when you had
bought the stock, it makes utmost senses to sell it.
Also, while an investor must sell his stock if he realise that a mistake has been made, the losses
from that sales must never cause self-disgust. And neither should these losses be passed over
lightly. You need to review these losses as that you learn a lesson out of the same, and do not
repeat the same mistake in the future.
# 2 Reason to Sell A Stock – When A Stock Does not Qualify To Be Held Anymore
While this reason might sound similar to the first reason to sell a stock, it isn’t.
Instead, here we are talking about the good stocks in your portfolio. You must sell such stocks
when, because of passage of time and due to fundamental changes in the companies, these
stocks no longer qualify to be held anymore. That is the reason you must run your investment
checklist on your stock portfolio after a certain interval, say six months or a year.
If you realise that a company’s business has changed for the worse, like on any of the following
factors, you must sell its stock.
1. The company is facing increased competition and has thus lowered the prices of its
products or services;
2. The company is seeing a deterioration in its profit margins and/or cash flows;
3. The management has made a wrong decision – like entering an unrelated business – that
will could negatively impact the company in the future;
There could be other reasons to sell a stock, but these are the most common and obvious ones.
If you find any of your stocks to be facing any of these situations, it will always pay to get out of
the same.
# 3 Reason to Sell A Stock – When A Better Opportunity is Identified
If you have made the right decisions while buying your stocks, this reason for selling stocks does
not arise often. But in case you were to find a better opportunity in another stock than you find
in any of your holdings, and you don’t have additional funds to deploy, it is a good idea to sell
some of your existing stocks to reinvest in that better opportunity.
The stocks that you might decide to sell might still be good. But then the newly identified stock
might be even better. It’s like selling a stock where you expect annual average returns of 15%
(which is good in absolute terms) to buy a stock where expected returns are around 20%. But

when you are looking to switch to a better company, return must be just one of your criteria.
The new company must also pass your investment checklist.

Never sell your stocks just because…

You think a big stock market correction is round the corner, and that you must book
profits on your stocks before the correction takes place. This is ridiculous. Like purchase
of good quality stocks must not depend on what the general markets are going to do
next, the decision to sell bad stocks must not be driven by this reason as well.

The stock has become expensive. Well, this seems a logical reason on the face of it. But
wait before you make any hasty conclusions.
First answer, what is ‘overpriced’ or ‘expensive’? Won’t a good stock almost always sell at
higher P/E valuations than a stock that has stable earnings that are not expanding?
We hear the talking heads on business channel reciting their predictions for a company’s
earnings for two years hence. And the confidence in their voice suggests that they are
sure that their predictions will come true. But this is the case till the next quarter comes,
and the earnings projections are revised, either up or down. And the same cycle of
predictions begins.
If the company has the potential to grow strongly that its earnings quadruple in another
ten or twenty years, is it really of such great concern whether the stock is currently selling
30-35% overpriced?

The stock has moved up sharply and that it cannot go up much further up. This reasoning
seems right unless of course you are talking about an Infosys. Anyone who bought
Infosys’s stock in 1993 and sold it after it doubled or tripled, must be ruing now. This is
because the stock has multiplied almost 3,500 times (yes, that’s the right number!) since
its listing. See, it’s difficult to predict which stocks will go up ten-fold or twenty-fold. So it
is good to stick with good stocks as long as the story is intact.

To repeat Fisher’s words, “If the job has been correctly done when a common stock is purchased,
the time to sell it is – almost never.”
Lesson #14: Monitor the Behaviour of Management
In the original version of The Intelligent Investor, Ben Graham began his discussion of a chapter
on “The Investor as Business Owner” by pointing out that, in theory, “…the stockholders as a
class are king. Acting as a majority they can hire and fire managements and bend them
completely to their will.”
But he changed this part in the subsequent editions of the book.
In practice, says Graham, “…the shareholders are a complete washout. As a class they show
neither intelligence nor alertness. They vote in sheeplike fashion for whatever the management
recommends and no matter how poor the management’s record of accomplishment may be.
“The only way to inspire the average American shareholder to take any independently
intelligent action would be by exploding a firecracker under him.”
This is a fact that is true for not just American shareholders, but all shareholders.
Ask yourself these two questions if you have been an investor in stocks in the past –

1. How many times have I disliked what the management of a company was doing?
2. How many times have I communicated my dislike to the company’s management?
For most investors, the answer to the first question will be ‘never’. And that will automatically
make the answer to the second question ‘never’ as well.
What’re your answers?
You’ve ‘bought’ the stock. But do you ‘own’ it?
You buy a house, and you own it. It’s your private property.
The same goes with anything else you buy – car, television, timeshare holidays etc. You buy
them, and you own them.
But when it comes to stocks, do you really ‘own’ the stocks you hold in your portfolio?
Ownership means that we don’t allow anyone else to do anything with what we own without our
Ownership means keeping a keen eye on things happening around what we own.
Ownership means if someone is acting smart to play around with what you own, you have all the
right to chide him away.
And if that is what ownership of a stock means, you must know that…
1. The company’s managers, all the way up to the CEO, work for you.
2. The company’s board of directors must answer to you.
3. The company’s cash belongs to you.
4. The company’s businesses are your property.
5. If you don’t like how the company is being managed, you have the right to demand that
the managers be fired, the directors be changed, or the property be sold.
But for that, you need to know that you ‘own’ the company via its stock. And if not, you should
wake up and know your rights as a shareholder.
As Graham suggests, “There is just as much reason to exercise care and judgment in being as in
becoming a stockholder.” This suggestion is something very basic but incredibly important.
How to ‘own’ your stock?
Just be aware of your rights as a shareholder, raise your voice if you find something fishy…and
you’ll know that you own the stock.
Graham suggests that there just two basic questions to which shareholders should turn their
1. Is the management reasonably efficient?
2. Are the interests of the average outside shareholder receiving proper recognition?
The first question can be answered by the company’s past financial performance.
1. Has the company grown its sales at a steady pace in the past?
2. Has it earned good profitability in the past?

3. Has it shared profits with shareholders in the form of dividends?
4. Has it been able to earn return on capital over and above its cost of capital?
5. Has it gotten too aggressive in past to make faulty acquisitions by taking high debt and
thereby risking the quality of the balance sheet?
‘Yes’ to the first four questions and ‘No’ to the last question would mean that the management
has been reasonably efficient in running the company.
And if the answer is ‘No’ to most or all of the first four questions and/or ‘Yes’ to the last
question, you will know that the management has been inefficient.
So what can an investor do if the management has been inefficient?
The answer is two pronged:
1. If you own a major stake in the company, you can call for a change in the management.
2. If you just own a few shares in the company (and thus a minority shareholder), the best
option you have is to sell your stock immediately.
But remember this – you can take either of these decisions only if you know how the company
and its management have done in the past. And you can know that only if you have read its
annual reports.
So, read! Read the annual reports of the company you ‘own’.

Read its director’s report to know his vision.

Read the management discussion on the annual performance and the risks it foresees in
the future.

Read to find out of the management is taking the blame of a year of poor performance.
Or whether it is laying the blame of everything else – like a global crisis, or a domestic

Read the financial statements to find out big changes over the previous year.

Read the schedules and notes after the financial statements to really understand what
the company is up to.

Read the qualifications and background of the independent directors – you don’t want
mute spectators as people approving all management decisions.

In short, be open-minded and read diligently about the company you own.
If you do that, you’ll be better than 99% of shareholders who don’t read the annual report at all.
This will help you become intelligent, cautious, and thereby truly successful as an investor.

Lesson #15: Five Habits of Highly Successful Investors
We are nearing the end of our value investing course – Value Investing for Smart People. At this
juncture, let’s spend some time on understanding the five habits that you as an investor can
practice to become better at investing in the stock markets.
Let’s start right here.

Habit #1: Set a goal, and work towards it
You would vouch for the fact that the core reason you are an investor is because you want to
create wealth for yourself and your family. And you would also agree that there are some
reasons you want to create this wealth.
The reason might be to:
1. Create a nest egg for a post retirement life.
2. Plan for the education and marriage of children.
3. Accumulate money to go on a world tour.
4. Create wealth to meet all these wants, wishes, and obligations.
So, it is important that you have some financial goals in mind for which you are working
(investing) to create that kind of a resource pool. But then, you might be one of those majority
investors who do not have any goal for which they invest. Ask them why they invest in stocks,
and the plain answer – “To make money!”
Of course the idea is to make money. But the bigger idea here is to have a future goal for which
to make money by investing in stocks. So, if you haven’t yet set yourself such a goal, do it now.
But just remember one thing – the goals you set are not static and are very much subject to
change. So, be realistic and flexible. Revisit your goals whenever there has been a major change
in your life, such as marriage, child birth, or the purchase of a home.
Habit #2: Know basic accounting
Not complex accounting that companies use to manipulate their earnings! But you need to
understand the basic accounting concepts before you even become an investor. After all,
accounting is the language of business. And just like you learned the basic grammar in school to
be able to speak and write now, you need to understand basic accounting to identify good
companies from the bad ones based on their past financial performance.
Sincerely, if you cannot tell the difference between something like a current asset and a fixed
asset, you have no right to invest in the stock markets.
Habit #3: Read…read…read
That’s the best habit that to can have as an investor. Successful investors will tell you that if you
just read a company’s annual report, you will be better read than 90% of all investors. And if you
read the footnotes (explanations) after the financial statements in an annual report, you’ll be
better than 99% of all investors.
Warren Buffett’s business partner Charlie Munger once said, “In my whole life, I have known no
wise people over a broad subject matter area who didn’t read all the time – none, zero.”
Buffett and Munger are both well-known for the incredible amount of reading they do. And you
can follow their footsteps by starting with reading a lot.
Read books on value investing. Read books on human behaviour. Read books on the financial
history of the world. You never know when you’ll find a brilliant idea to add to your repertoire.
Read the daily newspapers, read the annual reports, read the biographies of successful
Knowledge is power, and there is no shortcut to success. Not even in investing!
Habit #4: Mind your behaviour
As you must have read in lesson 13, minding your own behaviour plays a critical role in your

acts as an investor. We humans are not hard-wired to be rational beings despite the fact that we
clam this honour. The truth is that we are rationalising beings. We make emotional decisions and
then try to rationalise the same with logic.
Sensible investing however requires that we notice where our emotions are guiding us to, and
then take preventive measures to fall in emotional traps. Traps like:

Being overconfident – We know all the right answers!

Wishful thinking – Hearing from others what we believe to be true.

Availability bias – Believing the news that’s readily available.

Framing – Going by how words are framed and not the rationale behind the same.

Following the herd – My truth, your truth, ‘the’ truth!

Habit #5: Understand risk
This is the hardest habit to form, simply because most of us investors never count risk as part of
the equation. And those who do, have a fuzzy idea of what ‘risk’ really means.
In general terms, investing risk refers to the uncertainty of the occurrence of a certain event
that can affect future returns. But ask Buffett, and he would go a step further. Buffett defines
risk as ‘permanent loss of capital’.
As per this definition, risk is to lose whatever you’ve invested and not have any chance to get it
back. Short term fluctuations in the stock prices, therefore, don’t equate with ‘risk’, as is
generally considered in the investing circles.
So the good idea for you to become a smart investor is to understand what risks you are taking
while investing in stocks.
Before buying a stock, try to answer this question – “Can this stock cause a permanent loss of
capital to me?”
If your answer is ‘yes’, or even ‘maybe’, you better stay away from that stock. Buying it despite
knowing that it would involve risk-taking would be foolish.
Of course we can never eliminate risks from stock market investing, but we surely can minimise
the chances of the same.
Lesson#16: Why Your Stocks Will Never Make You Rich
Every money-making opportunity comes with its share of myths and fallacies. Stock market
investing is no different. In fact, I believe this industry is the biggest game for the myth creators.
The stock market landscape is dotted with shaky principles. Time and again, the average
investor gets caught wrong-footed by this shadiness.
These myths not only cause heavy losses to investors, they also lead to opportunity losses that
block investors’ path towards true riches from stocks.
Here are what I believe the top five stock market myths, which if side-stepped, can lead to big
success and wealth through investing.
Myth #1: Investing is too risky
Really? If investing is too risky, so is swimming, crossing the road, riding a bike, and driving a
car. With proper training and guidance from your parents, you had learnt to do these things
fairly early in your life. But the sad part is that, parents rarely teach their children how to treat

the money – how to save and how to invest. And that is what makes the grown-up children
believe that ‘invest is too risky’!
The truth is – investing isn’t risky. It’s made out to be risky by the number-crunching, jargonfilled analysts, fund managers, and other stock markets experts. After all, if they do make you
think that investing is risky, how will they ever be able to sell you their wares – stock
recommendation tips, mutual funds, etc.?
I am ‘not’ saying that investing is not risky. It is! But only if you are ignorant about the subject
and still try your hands at it. If you do not understand it, or if you aren’t properly educated on
the risks involved, investing can be incredibly dangerous. Just ask someone who lost a lot of
money during the previous stock market crash what he knew about investing in the stock
markets except that he was acting on free and hyped-up stock tips received from friends,
relatives, business channel experts, and their brokers.
Warren Buffett once said – “Risk comes from not knowing what you’re doing.” By educating
yourself in investing, you will know what you’re doing. And that will take away a lot of risk from
your investment decisions.
Investing in stocks isn’t risky if you know how to do it the right way. Instead, not investing is the
biggest risk of all.
Myth #2: Only experts can make money from stocks
Most large business houses in India were started by people who had little or no education. They
were not glorified MBAs who used complex strategies to growth their businesses. Despite this
handicap (of less or no formal education), they made some remarkable investments that have
brought them such grand legacies. You as an investor can take a leaf out of their books.
This myth that you need to be an ‘expert’ to make money from stocks follows from the first
myth discussed above. If only you know what the experts were prescribing at the start of 2008
(when they were all bullish) and at the start of 2009 (when they were all bearish), you will know
why ‘being an expert to make money’ is a big myth. Of course, you need to be educated and
aware about what you are investing into (some basic accounting and awareness about your own
behaviour are necessary), but that’s akin to a high school education, not a PhD!
The irony is that the entire financial services industry has conspired to make you believe that
investing is tough and it’s better to leave the game to the experts. After all, if they do not do so
and instead spread the belief that you can make your own profitable investing decisions, how
would they earn their billions from selling worthless advice, and commissions every time you
trade in stocks?
The reality is that you do not need more than these free (or very cheap) resources to become a
successful investor yourself:
Brain (we rarely use it when it comes to investing, but it’s still the most precious of our
Time (this is precious, but you do not need to spend more than 30-40 minutes of it each week
towards enhancing your investing knowledge)
Willingness (you need to put in some of your own effort for sure!)
Annual reports of companies (for studying which companies are doing well, and which aren’t)
An internet connection (apart from getting investing ideas, you need this to read everything
else on a company that its annual reports do not provide – like about its competitors)
Myth #3: If you can’t beat it, stay out

Leaving aside the efficient market theory, I believe that ‘beating the markets’ is just a whim.
The reality is that your core goal must not be to beat the markets, but to meet your financial
goals with comfort. And for that, whether you earn same as the markets, or 1-2% here or there
than the markets, makes no sense.
It’s true that majority of all mutual fund managers have not been able to beat the market in the
last 20 years, but then you are not a fund manager and your investing performance won’t be
judged by whether you beat the market. Instead, it will be judged by whether you and your
spouse are living comfortably after your retire from work.
I remember a joke that will make this fallacy about ‘beating the markets’ clearer for you.
Once upon a time, two guys were hiking through the jungle when they spotted a seemingly
hungry tiger. One of the guys reached into his pack and pulled out a pair of sports shoes.
His friend looked at him in fear, and asked, “Do you really think those shoes are going to make
you run faster than that tiger?”
The second replied, “I don’t have to run faster than that tiger. I just have to run faster than
Similarly, the idea is that your stocks don’t need to earn you more than the markets (or your
friend, relative, or the fund manager). Your stocks just need to earn you enough to live happily
in your life in your golden days. Every other idea is superfluous!
Myth #4: High risk-high returns
Do you think you were a safe driver when you last drove your car to your office or somewhere
else? I mean, safe for others walking and driving around you? If you are like 90% of the
respondents, your answer will be ‘yes’.
Now imagine if your ten year old son or daughter is behind the steering wheel the last time you
travel by your car. Will your journey be still safe? I mean, you will still travel in the safety of your
car, and you will possibly take the same route. But still, will your journey be safe?
See, my point is that when we put someone in the driver’s seat who doesn’t know how to drive,
a relatively safe trip becomes an incredibly risky trip.
Exactly the same thing holds true for investing in the stock markets. If you don’t know what
you’re doing, your journey is going to be either very slow or very dangerous. Not knowing what
you are doing, as we discussed in the first myth on investing, is what risk is all about. And
considering this, if you take a high risk (you known nothing at all about the stock markets), you
won’t be getting high rewards anyways.
The concept of high risk-high rewards is possibly true when you get paid a bounty for working in
the middle of the Atlantic Ocean as an oil driller. You might never come back from there. But if
you do come back, your family will reap the rewards.
But when it comes to investing in the stock markets, high risk mostly does not equate with a
high reward until and unless you know the insider, or are one of them. And mind you, I am
talking about ‘investing’ here, not speculation.
You might earn high rewards with high risks when you speculate. But the biggest problem with
this is that you need to repeat this cycle over and over again. This is because after every period
of high rewards, you will face a period of big losses that will wipe out your previous gains.
In investing, you get high rewards only when you take low risks. Investing in quality companies
selling at cheap prices is a good way to get there. The whole idea is to keep a good margin of
safety to nullify the impact of potential losses in the future. And when you do that – buy a good

company at cheap valuations – you aren’t taking a high risk, right? You are indeed lowering your
risk of going wrong.
So, when it comes to investing, low risk = high rewards.
Myth #5: This time it’s different
“This time it’s different!”
How many times have you heard this from a stock market expert or from your friend who has
made big money from stocks in a short time? These words are commonly used in the stock
markets to explain that stock prices can touch the sky, or touch the earth’s crust depending on
if they are rising or falling.
But if you were to listen to the legendary Sir John Templeton, these are four most dangerous
words in investing – “This time it’s different.”
History repeats, and it repeats itself many times over when it comes to the stock markets. That
is what causes booms and busts, after booms and busts.

Lesson #17: The Fallacy of Asset Allocation
A time-honored investment rule is that your asset allocation should mirror your age. So, you
should allocate your money into stocks and bonds in a ratio of 60:40 at age 40, 40:60 at 60 and
so on.
Ask any stock market expert or financial advisor for a proper allocation of your money, and he
will tell you that you must simply subtract your age from 100 and invest that must proportion of
money into stocks, and the rest into bonds or other safe instruments.
So if you are 25, you are advised to invest 75% (100-25) of your money into stocks. And as you
age, your stock allocation must come down while that of safe investments like bonds must rise.
On the face of it, this logic of increasing an allocation to less-risky, less-volatile bonds as one
gets older seems convincing.
As investors approach and enter retirement, their ability to earn their way out of a stock-market
plunge evaporates. So does their ability to outlive a market decline.
So what is wrong with the allocation rule and the advice based on it?
Plenty! Like many investment rules, this one strikes me as grossly simplistic at best, and
dangerous at worst.
Why Benjamin Graham mocked such an allocation
The most striking thing about the father of value investing Ben Graham’s discussion of how to
allocate your assets between stocks and bonds is that he never mentions the word ‘age’.
This is what sets his advice firmly against the winds of conventional wisdom – which holds that
how much investing risk you ought to take depends mainly on how old you are.
Unless you’ve allowed the proponents of this advice to subtract 100 from your IQ, you should be
able to tell that something is wrong here.
Why should your age determine how much risk you can take?

A 90-year-old with Rs 10 crore in his bank account, a big enough house, and a gaggle of
grandchildren would be foolish to move most of his money into bonds. He already has plenty of
income, and his grandchildren (who will eventually inherit his stocks) have decades of investing
ahead of them.
On the other hand, a 25-year-old who is saving for his higher education and a house down
payment would be out of his mind to put all his money in stocks. If the stock market takes a
nose dive, he will have no bond income to cover his downside – or his backside.
What’s more, no matter how young you are, you might suddenly need to move your money out
of stocks not 40 years from now, but 40 minutes from now.
Without any warning, you could face troubles in your life – like losing your job, getting divorced,
becoming disabled, or suffering who knows what other kind of surprise.
The unexpected can strike anyone, at any age.
As such, everyone must keep some assets in the riskless haven of cash.
Also, as I’ve seen over the past many years, many people stop investing just because the stock
market goes down.
When stocks are going up 30% or 40% a year, as they did between 2003 and 2008, it’s easy to
imagine that you and your stocks are married for life.
But when you watch every rupee you invested getting crushed, it’s hard to resist moving into
the ‘safety’ of bonds and cash.
Because so few investors have the guts to cling to stocks in a falling market, Graham insists that
everyone should keep a minimum of 25% in bonds (or other similar safer instruments).
He argues that such a cushion will give you the courage to keep the rest of your money in
stocks even when they are sinking.

Lesson #18: The Art of Forecasting Stock Prices
…is not really an art!
It’s like shooting an arrow in the dark. If you hit the bull’s eye, you’re lucky. And if you don’t,
you’re a majority.
Those who have read the history of stock markets must have come across this famous
prediction that went horribly wrong – “Stocks have reached what looks like a permanently high
These were the words of one of the most respected economists of his time, Irving Fisher, in
1929. Just a week after Fisher made this glamorous statement, the US stock markets crashed
and the US economy went into what we now know as the Great Depression.
Look no further. Before the latest crisis hit home in January 2008, you must have heard several
market pundits (those who fill the slots in business channels and newspapers) gloating about
how they thought the BSE-Sensex was on its journey to the 25,000 mark.
What happened later is not a secret anymore.
Here’s what Warren Buffett has to say on the futility of forecasting the direction of stock markets
and stock prices.
“We have long felt that the only value of stock forecasters is to make fortune-tellers look good.
Even now, (Berkshire Hathaway vice chairman) Charlie (Munger) and I continue to believe that
short-term market forecasts are poison and should be kept locked up in a safe place, away from
children and also from grown-ups who behave in the market like children.”
Despite this, most stock markets investors crave to know the future direction of stock price.
In fact, if there was ever a ranking of the most used statements in India, after “What’s the
(cricket) score?” would come “Where is the Sensex headed?”
Everyone wants to know the future before it happens. Of course this is good in terms or
positioning your portfolio to take advantage of what might come, the issue is that future stock
market predictions have seldom been true.
And the irony is that this doesn’t stop brokers, analysts and fund managers to keep crystal
gazing into the future. And they make their forecasts sound like a gospel truth, as if whatever
they are predicting will definitely happen. Only that this truth changes at the next market surge
or crash.
But the most interesting part is that despite finding that none (or majority) of their predictions
come out to be incorrect, they spout out even newer predictions each passing day.
You can validate this fact by switching on to a business channel right away. One or the other
‘stock market fortune teller’ will be there…live…making some predictions about the future of
stock prices.
Or if you are away from the television, pick up any business newspaper and you will find a flurry
of such ‘free’ recommendations everywhere.
The biggest problem with such ‘free’ and ‘widely available’ predictions is that they cost the
small investors heavy.
If you have been investing in the stock markets for the past 2-3 years, you already understand
what I’m trying to tell you.

Forecasting earnings, stock prices, or direction of the stock markets with precision is as hopeless
as expecting a politician to be honest.
Smart investors don’t believe in such forecasts. They do their own homework, and take their
own decisions.
And I know you are a smart investor.

Lesson #19: Three Investing Legends and Their Three Big Ideas
“If at all I have been able to see any further, it is because I have stood on the shoulders of
giants,” said Sir Isaac Newton. He was spot on given that most of the big things we do in our
lives are generally inspired by someone else – someone we idolize, or someone who trains us.
In my career and life of the past eight years, I have come across several giants – people who
have lent their helping hands in training me in investing and stock market research.
But my best teachers all these years have been three people, whom I have never met
personally, but have seen them through books written by/on them.
These teachers are – Benjamin Graham, Philip Fisher, and Warren Buffett – the legends in the
field of value investing. While Graham and Fisher are no longer alive, Buffett continues to amaze
me with his wit and wisdom on investing and how he handles his investments.
This lesson is a dedication to these three legends. It also discusses briefly the one big idea
(each) that has come to be the hallmark of their investing philosophies.
Benjamin Graham (1894-1976)
The legend: Graham is also known as the father of value investing. His biggest contribution to
the investing world has been his two books that were published almost eight decades ago. The
first – Security Analysis – was published in 1934.
As the name suggests, it was meant for people who wanted to understand the quantitative
analysis part of buying an investment, whether a stock or a bond.
Graham’s second book – The Intelligent Investor – came out in 1949. Now this is the most widely
acclaimed book on value investing and has been described by Warren Buffett as ‘by far the best
book on investing ever written’.
Graham wrote this in extremely simple manner, so that the man on the street can understand it,
and incorporate the learning in his investing.
Graham’s big idea: The investing world sums up in three simple words – margin of safety.
These are also the three most important words for an investor. We studied the concept of
margin of safety in lesson eight of this series on Value Investing for Smart Investors. So I won’t
go in much detail again.
But in simple terms, margin of safety is the difference between the intrinsic value of a stock and
its market price. It is like paying Rs 50 for a stock that is worth Rs 100, so that even if the actual
worth is Rs 80, your buying price of Rs 50 is still much less and won’t lead into trouble if the
stock were to fall.
Anyways, margin of safety was not the only big idea that came from Graham. He is inarguably
called the father of vale investing. And just like any devoted father, this man has contributed a
lot the founding and development of this field of sensible investing.

And you can grasp all his learning by just reading The Intelligent Investor, and also by following
Safal Niveshak where we will discuss a lot about the man, and his ideas.
Let’s now turn to another doyen of the value investing field, Philip Fisher.
Philip Fisher (1907-2004)
The legend: Though not as widely known as Graham, Fisher has also contributed remarkably
towards the development of value investing. He is best known for dispelling his learning through
his famous book – Common Stocks and Uncommon Profits – that is a must-read for all value
investors and those who are trying to learn the art.
While Graham was more of a quantitative investors – deeply analyzing the numbers before
buying his stocks – Fisher add the tinge of qualitative aspects to the field. Graham, for instance
won’t buy a stock trading at a P/E higher than 15 times, no matter what the quality of the
company was.
Fisher, on the other hand, was all for paying a higher price (though not very high!) for a quality
Fisher’s big idea: He called it ‘scuttlebutt’. Simply explained, it means keeping your mind,
eyes, an ears open while studying a company. This involves meeting the company’s
management, its competitors, buyers and suppliers to take an all-round view of the company.
Warren Buffett (1930)
The legend: Buffett is inarguably the best practitioner of the value investing ideas laid out by
Graham and Fisher. He in fact calls himself ‘85% Graham and 15% Fisher’! While not much
information is available regarding the investment returns and wealth of Graham and Fisher,
Buffett’s story is an open book.
Adhering to the value investing principles that he learnt from these two masters, Buffett has
grown his wealth at an average annual rate of over 20% during the past 45 years. While this
number might not mean much at first, it is enough to grow every Rs 100 invested into Rs 3.6 lac
over a 45 year period. This is unmatched by any other investor, living or dead.
Buffett’s big idea: While most of Buffett’s ideas are what he learnt from Graham and Fisher,
the simplicity with which he has passed on these ideas to generations of investors is what is his
biggest idea. Buffett’s annual letter to the shareholders of his company Berkshire Hathaway are
considered a must read for any investor, analyst, or fund manager just starting out.
These letters that come out at the end of February each year, contain a wealth of investing
ideas and how Buffett practices them to invest his company’s money. These letters are the
ultimate epitome of selflessness from the man who has been the most generous in passing over
his legacy to the investing world.
With this, we come to the end of this educational series on value investing. I hope ‘Value
Investing for Smart Investors’ has really made a worthwhile and easy reading for you.

Value investing is a very vast field and I will not claim to have covered all aspects of it through
this series.
But it has been my sincere effort to include all the major ideas from the field that can be part of
every sensible investor’s toolkit.

Lesson #20: Investment Owner’s Oath
This investment oath was first published in Graham’s The Intelligent Investor. I have modified it
to suit an Indian investor’s requirements.
Fill it, print it, stick it in front of your work desk, and read it every day.

Investment Owner’s Oath
I, _____________ ___________________, hereby state that I am an investor who is seeking to
accumulate wealth for many years into the future. I know that there will be many times when I
will be tempted to invest in stocks because they have gone (or “are going”) up in price, and
other times when I will be tempted to sell my stocks because they have gone (or “are going”)
I hereby declare my refusal to let a herd of strangers make my financial decisions for me. I
further make a solemn commitment never to invest because the stock market has gone up, and
never to sell because it has gone down.
I will invest with discipline – month after month – and into businesses that I understand and
stocks that I find are trading with a good margin of safety as compared to their intrinsic values.
I hereby declare that I will hold each of these investments continually through at least the
following date (which must be a minimum of 10 years after the date of this contact):
_________________ _____, 20__.
The only exceptions allowed under the terms of this contract are a sudden, pressing need for
cash, like a health-care emergency or the loss of my job, or a planned expenditure like a housing
down payment or my children’s education bill.
I am, by signing below, stating my intention not only to abide by the terms of this contract, but
to re-read this document whenever I am tempted to sell any of my investments.
This contract is valid only when signed by at least one witness, and must be kept in a safe place
that is easily accessible for future reference.
Signed: ________________________
Date: __________
1. ______________________
2. ______________________

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