Module 3 Fundamental Analysis PDF

Module 3 Fundamental Analysis  Module 3 — Fundamental Analysis Chapter 1 Introduction to Fundamental Analysis 83 1.1 – Overview Fundamental Analysis (FA) is a holistic approach...

Module 3 Fundamental Analysis  Module 3 — Fundamental Analysis Chapter 1 Introduction to Fundamental Analysis 83 1.1 – Overview Fundamental Analysis (FA) is a holistic approach to study a business. When an investor wishes to invest in a business for the long term (say 3 – 5 years) it becomes extremely essential to understand the business from various perspectives. It is critical for an investor to separate the daily short term noise in the stock prices and concentrate on the underlying business performance. Over the long term, the stock prices of a fundamentally strong company tend to appreciate, thereby creating wealth for its investors. We have many such examples in the Indian market. To name a few, one can think of companies such as Infosys Limited, TCS Limited, Page Industries, Eicher Motors, Bosch India, Nestle India, TTK Prestige etc. Each of these companies have delivered on an average over 20% compounded annual growth return (CAGR) year on year for over 10 years. To give you a perspective, at a 20% CAGR the investor would double his money in roughly about 3.5 years. Higher the CAGR faster is the wealth creation process. Some companies such as Bosch India Limited have delivered close to 30% CAGR. Therefore, you can imagine the magnitude, and the speed at which wealth is created if one would invest in fundamentally strong companies. 1 Here are long term charts of Bosch India, Eicher Motors, and TCS Limited that can set you thinking about long term wealth creation. Do remember these are just 3 examples amongst the many that you may find in Indian markets. At this point you may be of the opinion that I am biased as I am selectively posting charts that look impressive. You may wonder how the long term charts of companies such as Suzlon Energy, Reliance Power, and Sterling Biotech may look? Well here are the long term charts of these companies: 2 These are just 3 examples of the wealth destructors amongst the many you may find in the Indian Markets. The trick has always been to separate the investment grade companies which create wealth from the companies that destroy wealth. All investment grade companies 3  have a few common attributes that sets them apart. Likewise all wealth destructors have a few common traits which is clearly visible to an astute investor. Fundamental Analysis is the technique that gives you the conviction to invest for a long term by helping you identify these attributes of wealth creating companies. 1.2 – Can I be a fundamental analyst? Of course you can be. It is a common misconception that only chartered accountants and professionals from a commerce background can be good fundamental analysts. This is not true at all. A fundamental analyst just adds 2 and 2 to ensure it sums up to 4. To become a fundamental analyst you will need few basic skills: 1. Understanding the basic financial statements 2. Understand businesses with respect to the industry in which it operates 3. Basic arithmetic operations such as addition, subtraction, division, and multiplication The objective of this module on Fundamental Analysis is to ensure that you gain the first two skill sets. 1.3 – I’m happy with Technical Analysis, so why bother about Fundamental Analysis? Technical Analysis (TA) helps you garner quick short term returns. It helps you time the market for a better entry and exit. However TA is not an effective approach to create wealth. Wealth is created only by making intelligent long term investments. However, both TA & FA must coexist in your market strategy. To give you a perspective, let me reproduce the chart of Eicher Motors: 4  Let us say a market participant identifies Eicher motors as a fundamentally strong stock to invest, and therefore invests his money in the stock in the year 2006. As you can see the stock made a relatively negligible move between 2006 and 2010. The real move in Eicher Motors started only from 2010. This also means FA based investment in Eicher Motors did not give the investor any meaningful return between 2006 and 2010. The market participant would have been better off taking short term trades during this time. Technical Analysis helps the investor in taking short term trading bets. Hence both TA & FA should coexist as a part of your market strategy. In fact, this leads us to an important capital allocation strategy called “The Core Satellite Strategy”. Let us say, a market participant has a corpus of Rs.500,000/-. This corpus can be split into two unequal portions, for example the split can be 60 – 40. The 60% of capital which is Rs.300,000/- can be invested for a long term period in fundamentally strong companies. This 60% of the investment makes up the core of the portfolio. One can expect the core portfolio to grow at a rate of at least 12% to 15% CAGR year on year basis. The balance 40% of the amount, which is Rs.200,000/- can be utilized for active short term trading using Technical Analysis technique on equity, futures, and options. The Satellite portfolio can be expected to yield at least 10% to 12% absolute return on a yearly basis. 1.4 – Tools of FA The tools required for fundamental analysis are extremely basic, most of which are available for free. Specifically you would need the following: 1. Annual report of the company – All the information that you need for FA is available in the annual report. You can download the annual report from the company’s website for free 5 2. Industry related data – You will need industry data to see how the company under consideration is performing with respect to the industry. Basic data is available for free, and is usually published in the industry’s association website 3. Access to news – Daily News helps you stay updated on latest developments happening both in the industry and the company you are interested in. A good business news paper or services such as Google Alert can help you stay abreast of the latest news 4. MS Excel – Although not free, MS Excel can be extremely helpful in fundamental calculations With just these four tools, one can develop fundamental analysis that can rival institutional research. You can believe me when I say that you don’t need any other tool to do good fundamental research. In fact even at the institutional level the objective is to keep the research simple and logical. Key takeaways from this chapter 1. Fundamental Analysis is used to make long term investments 2. Investment in a company with good fundamentals creates wealth 3. Using Fundamental Analysis one can separate out an investment grade company from a junk company 4. All investment grade companies exhibit few common traits. Likewise all junk companies exhibit common traits 5. Fundamental analysis helps the analysts identify these traits 6. Both Technical analysis and fundamental analysis should coexist as a part of your market strategy 7. To become a fundamental analyst, one does not require any special skill. Common sense, basic mathematics, and a bit of business sense is all that is required 8. A core satellite approach to the capital allocation is a prudent market strategy 9. The tools required for FA are generally very basic, most of these tools are available for free. 6  Module 3 — Fundamental Analysis Chapter 2 Mindset of an Investor 45 2.1– Speculator Vs Trader Vs Investor Depending on how you would like to participate in the market, you can choose to speculate, trade or invest. All the three types of participation are different from one another. One has to take a stance on the type of market participant he would like to be. Having clarity on this can have a huge impact on his Profit & Loss account. To help you get this clarity, let us consider a market scenario and identify how each one of the market participants (speculator, trader, and investor) would react to it. SCENARIO RBI in the next two days is expected to convene to announce their latest stance on the monetary policy. Owing to the high and sticky inflation, RBI has hiked the interest rates during the previous 4 monetary policy reviews. Increase in interest rates, as we know means tougher growth prospects for Corporate India – hence corporate earnings would take a hit. Assume there are three market participants – Sunil, Tarun, and Girish. Each of them view the above scenario differently, and hence would take different actions in the market. Let us go through their thought process. (Please note: I will briefly speak about option contracts here, this is only for illustration purpose. We will understand more about derivatives in the subsequent modules) 7  Sunil: He thinks through the situation and his thought process is as follows: o He feels the interest rate are at an unsustainably high level o High interest rates hampers the growth of corporate India o He also believes that RBI has hiked the interest rates to a record high level and it would be really tough for RBI to hike the rate again o He looks at what the popular analysts on TV are opinionating about the situation, and he is happy to note that his thoughts and the analyst thoughts are similar o He concludes that RBI is likely to cut the rates if not for keeping the interest rates flat o As an outcome, he expects the market to go up To put his thoughts into action, he buys call options of State Bank of India. Tarun: He has a slightly different opinion about the situation. His thought process is as below: o He feels expecting RBI to cut the rates is wishful thinking. In fact he is of the opinion that nobody can clearly predict what RBI is likely to do o He also identifies that the volatility in the markets is high, hence he believes that option contracts are trading at very high premiums o He knows from his previous experience (via back testing) that the volatility is likely to drop drastically just after RBI makes its announcement To put his thoughts into action, he sells 5 lots of Nifty Call options and expects to square off the position just around the announcement time. Girish: He has a portfolio of 12 stocks which he has been holding for over 2 years. Though he is a keen observer of the economy, he has no view on what RBI is likely to do. He is also not worried about the outcome of the policy as he anyway plans to hold on to his shares for a long period of time. Hence with this perspective he feels the monetary policy is yet another short term passing tide in the market and will not have a major impact on his portfolio. Even if it does, he has both the time and patience to hold on to his shares. However, Girish plans to buy more of his portfolio shares if the market overreacts to the RBI news and his portfolio stocks falls steeply after the announcement is made. 8 Now, what RBI will eventually decide and who makes money is not our concern. The point is to identify who is a speculator, a trader, and an investor based on their thought process. All the three men seem to have logic based on which they have taken a market action. Please note, Girish’s decision to do nothing itself is a market action. Sunil seems to be highly certain on what RBI is likely to do and therefore his market actions are oriented towards a rate cut. In reality it is quite impossible to call a shot on what RBI (or for that matter any regulator) will do. These are complex matters and not straightforward to analyze. Betting on blind faith, without a rational reasoning backing ones decision is speculation. Sunil seems to have done just that. Tarun has arrived at what needs to be done based on a plan. If you are familiar with options, he is simply setting up a trade to take advantage of the high options premium. He is clearly not speculating on what RBI is likely to do as it does not matter to him. His view is simple – volatility is high; hence the premiums are attractive for an options seller. He is expecting the volatility to drop just prior to RBI decision. Is he speculating on the fact that the volatility will drop? Not really, because he seems to have back tested his strategy for similar scenarios in the past. A trader designs all his trades and not just speculates on an outcome. Girish, the investor on the other hand seems to be least bit worked up on what RBI is expected to do. He sees this as a short term market noise which may not have any major impact on his portfolio. Even if it did have an impact, he is of the opinion that his portfolio will eventually recover from it. Time is the only luxury markets offer, and Girish is keen on leveraging this luxury to the maximum. In fact he is even prepared to buy more of his portfolio stocks in case the market overreacts. His idea is to hold on to his positions for a long period of time and not get swayed by short term market movements. All the three of them have different mindsets which leads them to react differently to the same situation. The focus of this chapter is to understand why Girish, the investor has a long term perspective and not really bothered about short term movements in the market. 2.2 – The compounding effect To appreciate why Girish decided to stay invested and not really react to short term market movement, one has to understand how money compounds. Compounding in simple terms is the ability of money to grow when the gains of year 1 is reinvested for year 2. 9