How not to invest? (Value Investing and behavioral finance by Parag Parikh)

Being a successful investor has less to do
with a persons IQ which is how intelligent he is, and more to do with a persons EQ, which
is his emotional intelligence. A person that has emotional reaction to everything
that is said to him, can not control his emotions and thus can never control his money
I did not say that, that was actually said by warren buffet
Successful and rational investing is part valuing and understanding a business and part
chanellizing your emotions of greed and fear.

All the great investors you knew understood
their behaviour and themselves, much more than they understood the businesses. Business in general are a fragile framework
and is susceptible to many changes, primarily due to various factors such as, management,
economic environment, policies of the government etc. Most of these things are not in control of
an investor. But what surely is in control of an investor
is his behavior. In this book we will learn how our behaviour
and emotions affect our investment decisions and how can we work around them to emerge
out successful. This is the better investor helping you achieve
your financial goals and freedom, through organising your finance, stock market investing
and learning from billionaires and these are top five lessons from the book Value investing
and Behavioural Finance. Lesson number 1:
The Law of farm There are certain universal principles in
life which don t change even if people change, times change, technology changes, geography
changes. There is one thing, like the law of the farm. You cannot sow something today and reap tomorrow. Every seed which is sown will have to go through
different seasons. It will take time before the seed becomes
a fully grown tree and so is the case with value investing.

Same is true for businesses and investments. You cannot buy a stock today and expect it
to double your money the next day. Success in life and investing comes in understanding
that there are no shortcuts. Inspite of that, we keep checking the price
of our stock daily, giving us emotional dopamine, if the price is up by 10 percent in one day,
we become happy. When it goes down by five percent the next
day, we feel bad. Not understanding that the fluctuation of
the price is immaterial for a long term investor, what matters to him is the price he has got
at the end of his investment horizon.

Amazon scored its first profit after four
and half years after going public, just because Amazon did not make profit in the first year,
Jeff Bezoz did not sell off his company and run away. He knew sooner or later his investment and
hardwork would show up in operations of business A farmer does not sell off his farms and liquidate
his money if he has a couple of hot and humid months, he waits for the seasons patiently,
sometime he may have to wait for a longer in case of bad monsoon, but he sticks with
it, water it. But don t get me wrong, this does not mean,
to keep holding your stock even after you know that you have made a bad investment. According to the law of farm, It is pointless
for a farmer to expect to have apple and strawberries in Africa or sahara desert, no matter for
how much time he waits, he can never grow them there.

So just like farming in investing too, picking
up the right seed and sowing at the right time is important. Once the right stock has been picked up, All
you need to do is wait, and give its time to grow and not come onto premature conclusion
just looking at the price or hearing about a stock from the person around you
We can learn something similar from a famous value investor Guy spier. Every stock that he buys, he disciplines himself
to buy for atleast for three year. Any stock that he feels is not worthy enough
for a three year holding comfort, he doesnot buy them
This discipline allows him to stick with his winners and not sell them early just because
they appreciated in value quickly in first six months.

This also allows his stock investments to
get enough time for their situation to fan out. Once after waiting for three years, the value
of the stock has not appreciated, he digs onto find, if there is anything wrong with
his decision. This makes him have a long term outlook, and
not get excited or sad because of short term fluctuations. Three year is just his time frame, it could
be different for you, but the whole point is to discipline yourself to not get an emotional
reaction from everyday price fluctuations. No matter if the reaction is good or bad. Lesson number 2:
Good business vs Good investment One of the most common myth and jargon among
investors is that the path to wealth creation is to buy good quality businesses and hold
them for long term. This statement misses a very important factor
and that is price. Whether or not a business will be good investment
depends on what price is the business available for. There are many examples to prove that investors
have lost money investing in quality businesses because they were bought at an expensive price.

Castrol is a great brand of oil lubricants,
who does not know them. Sponsoring many formula 1 and moto GP races,
tying up with great celebrities to be their brand ambassador and a long experience. Castrol is nothing but a very high quality
business. In the end of year 2014:
It had posted its return on capital employed as 114% which is phenomenal for any company. A return on capital employed of 114% means. Company was doing their business in a way
that by investing a total of 100 rs say by buying assets, other companies, machinery
etc, the company was able to generate 114 rs in earnings.

And mind you this was not just a one of case. Since 2009, castrol was reporting return on
capital employed of more than 100%. To give you a comparison, even the most successful
companies today such as amazon, Netflix and google has return on capital employed close
to 17 to 20%. Return on capital employed more than 20% is
considered exceptional, so you can understand what a return on capital employed of more
than 100% means There was not debt on their balance sheet. The earnings were growing every year
Castrol was the darling of stock market and it was said to be the best stock to be in,
just like people tell you to buy Unilever or Amazon today. Another company in the same space was Tide
Water Oil, which many of use know today by their brand Veedol in lubricant space.

Its return on capital employed in 2014 was
28% And had been between 20 to 25 % in past five
years. Let us see what these two stocks have done
to their investors. Currently the return on capital employed of
castrol is still more than 50% consistently which is almost in top 5 % of the listed businesses. That of tide water oil has been just 23% , much
like before. Stock price of Castrol in the end of December
was 245rs , that of tide water oil was 4,501 rs
Stock price of Castrol today, after more than six years is Rs 140, a negative return of
-42% Stock price of tide water oil is 16,425 rs,
return of 264% To make you understand in absolute terms.

1000$ invested in castrol would be 580$ today
And 1000 $ invested in tidewater oil would be 3,640$ today. But why did this happen? A market leader of such high quality, one
of the most efficient businesses of the country and still you would have lost almost half
of your money investing with it and here is other business not so much heard of giving
such outsized returns. The answer lies in paying a higher price for
the high quality business while investing in Castrol. In Dec 2014 the PE of Castrol was 52 times
whereas that of tide water oil was just 20.

People investing in Castrol at 52 times price
to earning ratio were paying much higher price than that of tide water oil. People buying Castrol were buying a business
producing 1$ in profit every year for 52$, whereas the people buying tide water oil were
buying a business that produced 1$ in profit every year at 20$. You were definitely getting more for the money
you paid in tide water oil than in Castrol. Also Tide water oil just maintained its mediocre
performance whereas Castrol return on capital employed slowly decreased from north of 100%
to 50 %. Thus great businesses may be a bad investment
if not bought at the right price and valuation. And an average business may prove out to be
a good investment if bought at the right price. Today the PE of castrol is just 20 and that
of Tide Water oil is 40.

When tide water oil s return on capital employed
is much lesser than castrol. So what do you say, are people again doing
the same mistake with tide water oil, what they did with castrol around six and half
years back. Well time will tell us that. But remember as a value investor, don t be
blinded by someone telling you that so and so company is of exceptional quality. Quality is of only value to you if it is offered
at the right price. So patiently wait for such opportunities to
show up, than just hearing from some news channel or youtube video to put your money
in some company just because it is of good quality.

Lesson number 3:
The recency Bias: The financial memory of investors Is very
short. People always extrapolate things that happened
recently into the future and form their opinions. If the stock market give returns of 20% in
consecutive 3 years then people extrapolate this in the future and will put more money
in stock market thinking the same will continue. Investors in castrol extrapolated that it
will continue to earn return on capital employed of more than 100% just because it had done
so for its past decade. In the last five years from 2015 to 2020,
the fmcg stocks performed really well almost the big ones giving return of more than 20
to 25 % every year. Thise performance attracted more and more
fund managers and investors. Whereas the commodity stocks, such a cements,
sugars , automobiles gave negative returns in these five years. People extrapolated the same performance in
future and see what happens, From 2020-2021 in last one and half years,
the fmcg stocks have given almost zero returns wheras these commodity stocks have tripled
and quadrupled the money of their investors.

So when something happens for too long, be
sceptical to accept is as a trend and that it wil go on forever. More often than not, it will not continue
forever. Things revert to mean. Exceptional performance will come back to
median and poor performance will rise up to median. This is the only trend that is universal in
stock market. To cope with recency bias, never extrapolate
present performance into the future. Be conservative in your estimations. If in a coin flip, you get heads two times
consecutively, does not mean, you will get it continuously for next ten flips too. Remember that. Don t extrapolate. Lesson number 4:
Fundamental and speculative return. In investing we are told that the stock price
is a function of, the earnings that the company makes, however this is incomplete information. The returns that and investor gets from a
stock constitutes of fundamental returns, which is how much the profit of the company
has grown, and second the speculative return, which means what is the perception of the
people involved in market about the company, though this is a very subjective thing, however
the Price to Earning ratio is a good symbol of indicating markets confidence in the stock
price.

Higher the price to earning ratio at which
the stock is quoting at, more optimistic are the market participants about the company,
and more expensive the stock is said to be. The fact that people are buying the stock
being so expensive proves the fact that people are ready to pay high price for owning such
business. Like increase in profits is the fundamental
return, similarly, change in the Price to Earning ratio is Speculative return. Not always but more or less, Less price to
earning ratio with respect to a competitor means that the stock price is undervalued. If you are thinking what rocket science I
am talking about, you must go and checkout my last video on little book of valuation. The reason that the price to earning ratio
of a stock has increased signifies that people are buying it even the price of the stock
has increased much more in comparison to its earnings. Lets go back to our example of Castrol and
Tide Water oil that we took In 2014, the profit oof the comp-any were
475 crores and in 2021 they were 701 crore An increase of 6 percent per annum
These of tide water oil grew from 65 crore in 2014 to 141 crore in 2021
An increase of 11 percent per annum The PE ratio of castrol was 52 in 2014 and
is 20 in 2021 A decrease of -14 percent per annum
The PE ratio of tide water oil was 23 in 2014 and is 41 in 2021
An increase of 9 percent per annum.

So the total returns in castrol becomes 6
percent 11 percent, that is -5 percent per annum
And that of tide water oil becomes 11 percent plus 9 percent, that is 20 percent per annum So it is very clear that speculative returns
which depends on the confidence or psychology of investors or market participants about
a business plays a big role in generating return on your stock selection. Rise in profit is not enough to guarantee
a growth of your money in stock investment, not even the quality of a company.

A value investor only buys when the price
of a good business offered to him is significantly below its fair value, so that even if the
company is not able to generate profits as expected from it. The principal invested is safe. Thus buying in negative environment is one
of a process followed by many value investors. During pessimist time, the valuations are
cheap, stock is available at less PE ration, when the market outlook becomes better, not
only the earnings rise, giving us fundamental returns but the psychology of the investors
toward a particular industry becomes positive, making that stock sell at a higher PE ratio
and higher price. Lesson number five:
The IPO phenomenon. IPO s are known as a shortcut to riches, the
secret sauce to get rich overnight. Especially ehn the markets are at all time
high and it seems that nothing can go bad.

Companies come out with IPO. These IPO s are marketed very intelligently
and retail investors are sold a dream to make a quick buck, to invest in future, invest
in next generation business The herd mentality comes into play and these
IPO s are over subscribed by more than twenty times, the recent IPO of Zomato was oversubscribed
by 44 time by retail investors. This mismatch of demand and supply makes the
stock list on the stock market at a very high price.

Not only that some people who do not get allotment
in the IPO, buy the stock the very first day the stock gets listed, shooting the price
even higher. This looks so exciting, but as a value investors
we must understand that, most of the IPO s give negative return to their investors in
long run. To understand why, we must know the phenomenon
of an IPO Why does a company need to come with an IPO? There can be many reasons, to raise money
to return the debt. Or to raise fund to expand the business. But other than these the biggest reason why
companies come out with an IPO is because the promoters of the company or, the initial
investors of the company want to sell their stock at high price. When a company which is not listed in stock
market, wants money, they approach private investors and angel investors who take risk
and invest their money with them. Now when these people want to sell the stocks
of the company, the company comes out with an IPO to allow these investors to exit.

They want to sell their share of the company
at the highest price possible. For this reason most of these IPO s comes
in a bull market, when stock market are just hitting new highs, when everyone is optimistic,
when there is euphoria among people, when people are are okay buying at high valuations. You will hardly listen to any noble value
investor investing in the IPO, it is because they know that IPO s are over priced and overvalued. The people who are attracted toward IPO s
are punters, who form the part of the herd, who want to grab a piece of the pie. In bull market most of the IPO s list at more
than 30-40% gain from their initial offering primarily due to the supply demand mismatch
that is created due to the herd mentality. The researches clearly show that IPO s underperform
in long term, because people buy them into crazy valuations.

Yes there are businesses and managements that
genuinely come out with offering to pay debt and expand businesses, of the the likes of
DMART, Infosys etc. But more often than not. Purpose of IPO s is to provide an exit to
the promoter or initial investor of a business in as expensive way as possible. If the sole reason for IPO would have been
genuinely raising money and expanding, then IPO s would come in bear markets and bad economic
times, when the money is actually needed and is scarce. The fact that these come in the time, when
herd mentality, speculation and optimism is at its peak, only proves the point that promoters
and initial investors use it as a vehicle to cash out big from the company taking advantage
of the poor knowledge of the retail investor who does not have much knowledge of valuation. Not only that, investing in IPO can prove
to be risky too, as there is not much history of the company available, about its corporate
governance and relationship with shareholders. Stock market is a big sea of opportunities,
and it is not necessary to go to every party.

A value investor stays away from herd mentality
and rampant speculation If you remember the law of the farm, you would
stay away from such investment vehicles and get rich quick schemes. Lets have a quick recap:
1. Law of the farm states that you cannot sow
something today and reap tomorrow, it takes time for a seed to grow in a fully grown tree. Same is the case with value investing. Short term price fluctuations, quick gains
and fast losses must have no effect on a value investor.

It takes time for an investment decision to
play out. 2. A good business may not always be a good investment,
if the price paid for it is high. Be skeptical of people telling you that xyz
is a good quality business and will only go up. The most important factor for a value investor
is value that ones get for the price one pays 3. The financial memory of investors Is very
short. People always extrapolate things that happened
recently into the future and form their opinions. To avoid this, be conservative in your estimates
and expect reversion to mean. 4. The growth in the stock price is both the
function of growth in the earnings as well as change in investors psychology regarding
a business or industry.

Though subjective but most of the times P/E
ratio is a good indicator of this. Be skeptical of buying stocks about which
everyone is so optimistic about and the stock is already priced to perfection. 5. The companies need to come out with its ipo
to raise money to pay off debt or to expand the business, though very few companies genuinely
list the shares for this reason and most to take advantage of rampant speculation of herd
behavior during bull market. Value investors stay away from herd behavior. That s it guys, I hope you liked the video,
If you did Do like share and subscribe
You can check out my last video on the summary of the little book of valuation .
I will come again soon with summary of some other investing book soon, until then cheers
guys! https://sho.co/1ENX6.

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