To invest means to commit. The basis of investment is logic and analysis. For an asset the logic for investment should be the analysis which says that the income that one would derive from asset would be greater than the payment for the asset. For assets which have defined income stream the analysis part seem simple. The only complication is that one is not sure about the kind of inflation that would happen. For small time periods reasonable estimate about inflation can be made. So it is quite easy to analyse whether one should buy a two year bond or not.

For stocks the analysis is rather complicated. We are not sure about how much dividends we will receive from a share. We are even less sure about how much the final price would be at which it would be sold. How do we analyse the stocks for investment? This problem can be overcome if we make conservative estimate of the earnings of the companies. If with the conservative estimate the analysis yields that one can earn more than one is paying for the stock then we could invest in it.

What if even the conservative estimate proves to be too high? Since, the company whose shares we have bought may face the worst economic conditions the earnings estimates may prove optimistic. To make up for this lack of clairvoyance one must include a “Margin of Safety”. This concept first proposed by Benjamin Graham is the bedrock upon which any successful investment strategy is built. Margin of safety means suppose you estimate that the net cash flow from the stock that you are buying is Rs 100 then you should buy it for more than say Rs 80 to Rs 50. The higher limit of your buy price would depend upon how sure you are about estimates. If you feel quite sure about your conservative estimates then may be you can pay up to Rs 80, however if you are not that sure your buying price should be closer to Rs 50. These limits are for illustration purpose. The Margin of Safety would be an informed estimate based on understanding of risks.

Now that we have an understanding about investment in stocks we will list few cases which cannot be basis of investments in stocks.

1. Buying a stock just because it has gone up in last few days with the hope that uptrend will be maintained.

2. Buying a stock because you have been tipped by someone else that it has a great prospect

3. Buying a stock which has fallen much below its higher level thinking that it will regain it higher level in future.

4. Buying a stock just because everybody else is buying it.

5. Buying stocks just because it is being offered in an IPO.

While investing in any company’s stock the following three factors are evaluated by Rational:

1. The economics of the business that company operates.

2. The honesty and competence of management of the company.

3. The price that one has to pay for the stock.

4. The level of taxation and inflation which would determine the purchasing power of returns.

The equity holders have the last claim on the revenue that is generated by the company. The company should have sustainable competitive advantages which contribute in increasing shareholders claim.

An honest and competent management would exploit the growth options and would also return capital to shareholders when it is in their best interest. Only a competent management can exploit the potential benefits of an opportunity. An honest management would be one that would channel the rewards from the business to shareholders rather than engaging siphoning it off for itself or towards some ego enhancing expansion. The management while investing shareholders money must ask whether every rupee invested generates at least a rupee worth of value for shareholders.

The price one has to pay to buy is another key factor. The value of the stock is the present value that you assign to all the future payment which the holder of the stock would get. Less one has to pay for the stock more could be one’s potential profit from the stock. Even a company stock whose business has good economics and is endowed with honest and competent management has a certain value. Only if the stock is available below this value will we buy it. Otherwise we will wait.

The shares should be sold only for two reasons. One, in case there are companies which provide better value for money. Two, in case the share price has become higher than the value. No other reason is valid. Just because share price has appreciated a lot is not a rational reason to sell a stock. If the appreciation of stock is because of higher operating profits which can continue to increase in future it should be retained.

There is nothing inherently risky in buying stocks. It is only when we give in to our fears and our greed while buying shares the risks manifest themselves. The first key to being successful in stock investment is being rational. Buy only if you have done the proper analysis. Otherwise stay away. The second key is being independent. In short run the stock market is a voting machine where any fool can vote but in long run it is a weighing machine that has to respond to financial results of companies. So, buy stocks of companies which can increase their stock earnings on a sustainable basis for a long time. Buy them at a reasonable price and hold them till you have one of the two reasons to sell.

Benjamin Graham introduced the concept of Mr. Market. We find this idea very useful while making stock market transactions. According to this concept stock market transactions are between you and a person called Mr. Market. Everyday Mr. Market comes with a buy price and a sell price of all the stocks that are listed. Mr. Market is a strange kind of person. Though businesses that are listed have stable economic characteristics the prices that Mr. Market gives for them are anything but stable. On some days Mr. Market can see nothing but good fortunes ahead. He increases his buy and sell prices so that nobody can buy from him and deny him the imminent gains. On other days Mr. Market can see nothing but dark clouds ahead. So he decreases his buy and sell prices because he fears that you will dump your holdings on him.

Mr. Market also does not mind being ignored. If the quotations that he gives to you are not interesting, he will come back tomorrow with a new one. The transactions that are done with Mr. Market are strictly by your choice. Under such scenario, the more mood swings he has, the better it is for you. One should note that Mr. Market is there to serve you rather than guide you. It is his buy sell quotation rather than his wisdom that you will find useful. If someday he shows up in a foolish mood you are free to take advantage of him or ignore him. However it would be disastrous in case he influences you. If you cannot value shares better than Mr. Market and independently of him than you should not be dealing with him.

The success of in purchase of stocks should be judged by the operating results of respective businesses. Price movement of stocks should not be a criterion for success. The market can ignore operating results for a while but would eventually confirm it. The speed at which the market recognizes the business’s operating success is not important as long as the intrinsic value of the company continues to increase at a satisfactory rate. In fact the delayed recognition could be an advantage as it gives us the chance to accumulate shares at an attractive price.