Hello friends, in today’s blog, we see Investment strategy from the book Stocks to riches chapter 2, this book was written by value investor Parag Parikh. so in this chapter 2, we see investment strategy and the difference between investment and speculation. so let’s see one by one strategy.
Investment Strategy: Investment and Speculation
In this chapter, the author explains investment strategy and the difference between investment and speculation.
the author says, ” Investment strategy is the first issue that investors should consider. Investing is an act of faith, a willingness to postpone present consumption to save for the future, thus investing for the long term is central to the achievement of optimum returns for the investor.
there are two sources of returns in the stock markets:-
- Fundamentals are represented by earnings and dividends.
- Speculation is represented by the market’s valuation of these fundamentals.
then the author ( Parag Parikh) explains in detail above two sources of return.
the author says,” the first is reliable and sustainable over the long run; the second is dangerous and risky. these lessons of history are central to the understanding of investing. these two sources of return could be further classified into cash flow and capital gains.”
After this, the author explains what is Cash flow and how we have to consider ourselves.
Cash Flow concept:-Investment strategy:- Stocks to Riches Chapter 2
the author says, ” When one believes in the fundamentals of investing, one is looking at the dividend payout of the company. these arise from the company’s earning potential, and are possible, only when the company has a positive cash flow. this cash flow is a product of the fundamentals or inherent strength, of the company, the sustainability of the business, and the robustness of the business model.
along with that, there are other variables such as the quality of the management, competitive market position, core competencies, etc. Investing in such companies enables the investor to earn a regular income over many years.”
then, the author explains investment value.
the author says, ” the investment value of a stock is the present worth of all the dividends to be paid upon it. this is best explained by John Burr Williams, ” A stock is worth only what you get out of it. A stock derives its value from its dividends, A cow for her milk, a hen for her eggs, bees for their honey, and stocks for their dividends.”
then the author explain capital appreciation,
the author says, ” the capital appreciation that takes place is seen primarily from the angle of bonus and right shares, which in turn increase the shareholding leading to higher dividends. As a result, the shareholding cash flow is augmented.
The rise in stock price is secondary as there is no intention of selling for capital gain. It is only satisfying to know that one can cash in on such a huge appreciation in times of need.
When investors follow this cash flow model of fundamental Investing. it is always based on the premise that over a long period, the stock markets will go up irrespective of the turbulence.
For them, the bull and bear markets are part of the investment process. on the contrary, they wait for a bear market, as they are able to get bargains there is also a strong belief that equity investments are the best hedge against inflation.” (Investment strategy:- Stocks to Riches Chapter 2)
You all know, nowadays, there is huge inflation, so if you want to beat inflation, then equity investment is best.
then the author talks about the Capital Gain concepts, and what is the benefit of that, and how can we use them for our purpose or goal in life?
Capital Gains Concept:-
The author says, ” When a stock goes up in value and one sells it at a profit, that gain is known as a capital gain. When people buy stocks in the belief that the prices will go up and they will be able to make a profit, it is known as speculation.
the price of a stock listed on the stock markets reflects the value of the fundamental. Speculators bet on the market value of the fundamentals. Now there are traders and speculators who buy and sell stocks according to their perception of the correct price of the stock based on the fundamentals. Say a company like Colgate is quoted at a price of Rs. 145.
A trader may feel that according to the fundamentals of the company Rs. 145 is a low price and that the stock could go up so he would buy that stock at Rs. 145. when it goes up he makes a profit, which is his capital gain, if it goes down he makes a loss.
Stock price movements take place for a variety of reasons and the investor is vulnerable to a host of uncertainties yet he is willing to take the risk. Here people are not looking at the fundamentals of a company.
they are looking at the stock price going up because of probable factors, Such as the fortunes of the company changing, expectations of higher profits a technological breakthrough, etc. they buy and sell stocks on information or an opinion or a rumor. the idea is to benefit from a price movement.
the inherent gambling instinct in a human being is responsible for the huge turnover in this kind of speculation.
speculation perse is gambling. In the stock markets, the other name for speculation is trading. it gives some credibility to the process and also has a different tax treatment ( the basic difference between speculation and trading is that in the former no delivery of the stocks is taken and in trading, the delivery is effected.
The capital gains model is based on the premise that stock markets always witness bull and bear phases; one follows the other. For speculators and traders, the trick is to take advantage of the ups and downs of the market,
Volatile stock price movements excite them, they follow the short-term approach. They strongly believe that since markets always fluctuate, a long-term strategy is useless. In fact, during the tech boom, I interacted with some experts and fund managers who held the firm view that the old ways of investing were out as the rules of the game had changed. (Investment strategy:- Stocks to Riches Chapter 2)
To buttress their claim they cited the example of how warren Buffett missed the tech boom. today I know for sure that all of them are nursing their wounds, this is what short-term success does.”
then the author explains why warren Buffett missed the tech boom, and why they are so successful.
the author says, ” Warren Buffett’s success till date is due to the fact that he would refrain from buying business he did not understand. He would buy stocks that were quoting a discount to their intrinsic value, and he would buy businesses from which he could visualize sustainable earnings over the long term. As the tech stocks did not fit in with these conditions he stayed away from them.”
Then the author gives the case study of Infosys companies.
I think you should read this case study, by buying this book from the following link
then the author says ” let’s sum up, let’s take the example of a cattle farm and a dairy farm. In a cattle form, the asset is the cattle, cattle are bred and reared to yield good value when they are sold to the slaughterhouse. this is what is speculation and trading. You buy on the asset, wait till the price, Increase, then sell it off in the market for a profit. this is how capital gains investing works.
on the other hand in a dairy farm, the asset is also cattle, here too the cattle are bred and reared but they are not sold to the slaughterhouse. the cattle have long-term use, they are used to obtain a regular supply of milk.
In both cases, the asset is the same but it is used differently one for meat and the other for milk. similarly, in the investment world, some people used stocks for capital gains by trading while others use them. Stocks for cash flow by investing long term.”
then the author explains the law of the Farm
The Law of the Farm:-
Then the author explains how to make money in the stock market, by applying the simple law of the farm.
the author says, ” Stock market investing is all about managing the rewards associated with the risks undertaken. without risk, there is no return. Invest you must but before that, you must bear in mind the law of the farm. You reap what you sow but the crop is also subjected to the changing seasons. the seeds have to endure summer, rain, winter, and spring before it turns into full-blown tree. Stock market investments also work that way. there are no shortcuts if we invest in the right stocks with the right business model and fundamentals, over the long run we are assured of optimum returns. However, to do this requires patience and we have to go through the ups and downs but it is important to stay the course. (Investment strategy:- Stocks to Riches Chapter 2)
Getting carried away y the greed of quick returns ultimately destroys wealth as it does not conform to the law of nature. Many of us forget that nature and society are one.”
then the author gives the best strategy of investment.
The Best Investment Strategy:-
the author says, ” There is nothing wrong with speculation as such on the contrary it is beneficial in two ways, Firstly without speculation untested new companies like Infosys, Satyam, and in earlier times companies like Reliance, would never have been able to raise the necessary capital for expansion.
the tempting chance of a huge gain is the grease that lubricates the machinery of innovation.
Secondly, the risk is exchanged every time the stock is sold and bought, but it is never eliminated. when the buyer buys a stock. He takes the primary risk that the stock will go down.
However, speculating can go wrong if people.
- Do not understand the difference between investing and speculating.
- Speculate without the right knowledge and skill.
- Speculate beyond their capacity to take a loss ( that is called margin trading.)
- The Greatest problem today is that most investors are acquiring speculative habits believing that they are investing.
- The Attraction of quick money and the advent of the futures market have lured them to margin trading. for a number of people, this has become a full-time occupation due to the advent of the internet and online trading. This could be bad news especially when they are dealing with their life savings. “
then the author explains the risk Reward ratios.
the author says, ” the important thing to remember is that investing is all about risk and Reward and vice versa.
the investor needs, to select the right balance when choosing investment vehicles and the strategy.
During the IT sector boom, the stock prices of IT companies were going up by leaps and bounds and people were buying such stocks at any price thinking that the price would go up. There was no rationality as to the value and the price. People were thus only buying risk, there was no effort to balance the risk-reward ratio. (Investment strategy:- Stocks to Riches Chapter 2)
We all know the fate of various IT Investors when the markets crashed. In March 2003, when the Iraq war was on, the markets were vert down and some of the stocks were available at ridiculously low valuations. the dividend yield was also very high. the price to earnings (P/E) ratios was attractive. This was the time to invest in Good Stocks as one would be only buying reward and the risk would be minimal. The risk-reward ratio would be in the investors favor.”
so this is all about how much you take risks with companies fundamentals, not speculative manner, that gives the high rewards.
then the author explains long-term investment.
the author says, ” Here are certain facts which prove the point that long-term investment is very rewarding and that patience is a virtue in equity markets. Three companies ( and there are several others), that have given excellent long-term returns to investors who bought stocks over a decade ago and held on to them, are Hindustan lever, hero honda, and Infosys.
The Hindustan lever has given a compounded annual growth rate ( CAGR) of 21 percent in returns for the last 13 years, whereas hero honda, has given 41 percent CAGR to shareholders on their investments during the same period. Infosys has delivered an astounding 79 percent annual return to shareholders since its listing 11 years ago. All these figures include dividends. as we can see this is higher than the returns available in any other investment avenue like bonds or bank deposits. (Investment strategy:- Stocks to Riches Chapter 2)
However, this does not mean that these stocks have only gone one way that is upwards.
They have had pretty serious declines at various points in time but despite that, the long-term result from owning them has been impressive.
The Hindustan lever has been falling for the last two years, Infosys had a very sharp decline after the bursting of the bubble in technology stocks and Hero honda also fell significantly in early 2003 when its quarterly sales slowed down.
Short-Term investment can also be rewarding for the speculator who is able to take risks and time the markets. Take the case of a speculator who had bought Infosys, at Rs. 2000 when the market started moving up and sold it when it went to is 13,800 within a year and a half. He made tremendous gains and he laughed at the investor who hold on to the stock since the beginning and got a return of 79 percent CAGR.
a Speculator could have short sold Hindustan lever at Rs. 210 in November 2003 and recovered it at 4,120 in august 2004 making a return that even a long-term investor in Hindustan lever would envy.
Speculators do make a killing, as some would have definitely done during the various periods of the boom and the bust cycles. the only rider is, can they do it consistently over time! A lot of speculators could have made more money than the long-term investor on the above stocks.
So it is different to say which strategy is good and which is bad. It depends upon the individual’s mental attitude, discipline, risk-taking ability, and patience.
from the above paragraph, some points conclusively prove
- Long-term investing can be very rewarding if you buy the right company at the right price.
- a stock can decline significantly in the short run and yet give a decent long-term return.
- Short-term investing ( speculating) can also be very rewarding if you are able to time the markets and take advantage of short-term volatility.
As we can be seen from the above table even though the net profit of Infosys has grown it 43 percent CAGR, 2000-2004 the market capitalization has fallen by 14 percent CAGR in the same period.
This is the impact on investors when a good business is bought at irrational prices. the P/E ratio has continuously declined. (Investment strategy:- Stocks to Riches Chapter 2)
So if one had bought the stock at a higher price in 2000 he would be losing money in spite of the company showing improved performance, this is the risk one takes when one is speculating.
Most of the IT experts and fund managers ignored Benjamin graham’s words of warning. ” Obvious prospects for physical growth in a business do not translate into obvious profits for investors.
In today’s changing times there is so much uncertainty that looking at the long-term approach seems unviable. Hence the stock markets have become the bedrock of brute speculation.
this is the reason for so much volatility. It is also turning long-term investors into short-term punters. this is how the investment world works today. If you want to be a successful investor there are three ways of investing Chapter 3 looks at the best way to invest.
so this is all about chapter 2 from the book Stocks to riches by Parag Parikh
If you want to earn a lot of money in the stock market, you must read this book. This is only of my favorite book, so when I was looking I am away from my value investing strategy, then I read this book, and again set my mindset as a value investor.
this book explains wonderful investment strategies, be read continuously.