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5-step guide to locating a ‘wealth creator’

Posted by Sathyamurthy www.sathyamurthy.com on December 16, 2007

The first rule to investing is ‘Don’t lose money’. The second rule to investing is ‘Don’t forget rule no. 1’! It is essential to stick to these rules when it comes to investing, in order to avoid the possibility of capital erosion.

 

To apply these rules successfully and to create wealth through equity investing, Raamdeo Agrawal, Director & Co-founder, Motilal Oswal Financial Services identifies five parameters that you must evaluate. They are:

 

1. Assess the entry barriers created by a company

 

Entry barrier should be preferably intellectual in character

 

Remember, a stock is nothing but a stake in the company’s business. So, observe the company’s business and the entry barriers created by it. The entry barrier should be more ‘intellectual’ in character rather than ‘physical’. This is because while it is next to impossible to compete with a strong brand (an intellectual barrier), competitive advantage associated with a piece of land (a physical barrier) disappears when a competitor acquires one as well.

 

Strong brands such as ‘Thums-Up’, ‘Parle-G’, etc. have enabled their companies to retain the top spot. However, at times, there could be exceptions. For instance, the entry barrier associated with TISCO would be its large base of iron ore and coal, which allows it to lower its raw material cost drastically vis-à-vis its competitors for long time to come.

 

Entry barrier should be long-lasting

 

An entry barrier should not only be strong, but also long lasting. Such companies will keep making money because their entry barriers keep working for them. For instance, Britannia may not be the best managed company but its strong brand continuously earns money for it.

 

Buy into such companies at the earliest

 

As an investor, buy into such businesses ahead of the crowd. If an entry barrier has been established very recently, it may not yet be exploited by the business. Accordingly, the market would not have valued it in the company’s share price.

 

For instance, when Financial Technologies (promoters of MCX) got its commodity exchange license and launched it, the popular opinion held was that it would be unable to execute the business well. But, today, it has emerged as a premier commodity exchange. Investing in such companies before the market sees their potential delivers best appreciation.

 

“Though difficult to practice, think ahead of the crowd”

 

2. Management should be competent and passionate

 

Choose companies that are led by a team and are competent and passionate. Both these attributes are equally important. Competence or passion alone will not work. An individual with a local degree combined with passion would have greater growth prospects than one who has a Harvard degree but no passion. A company like Pantaloon Retail is a shining example of how passion can create wealth.

 

“The definition of a great company is one that will remain great for many years”

 

3. Management should have integrity

 

Integrity is the most crucial quality that a company’s management must have. Such companies not only run their businesses in an honest manner, but, are honest to all their stakeholders, whether they are employees, the government or the shareholders. 

 

If honesty is part of a company’s DNA, it will be fair to its smallest stakeholders – the minority retail shareholders. Companies such as Tata and Infosys have this quality, which has added to their growth and market attractiveness immensely.

 

“Without management integrity, no margin of safety can be high enough”

 

The above-mentioned three characteristics (long lasting intellectual entry barrier, competent and passionate management and integrity) must all be simultaneously present in a company that you choose to invest in.

 

4. Buy low

 

The price that you pay for a stock determines your rate of return. So, it is essential that you get your purchase price right. While some companies come out on top with respect to all the first three parameters, the returns falter when it comes to the purchase price.

 

For instance, HLL comes on top with respect to all the first three parameters but has not delivered as much as far as its stock goes. Its stock delivered a CAGR of approximately just 3 per cent over the last 5 years, when the market delivered a CAGR of approximately 44 per cent over the same period.

 

The quote – “In the bible it is said that love takes care of a lot of sins. In investments, purchase price takes care of a lot of mistakes” – is very apt. You can make mistakes on assessing the first three parameters, since they are subjective in nature, but getting the right purchase price covers up for all your mistakes. Hence, estimate the expected value / intrinsic value of the company and keep an adequate margin of safety in the purchase price.

 

“It is much more important to buy cheap than to sell dear”

 

5. Have patience

 

When you buy a house you don’t expect it to appreciate overnight. You look at its appreciation over a long period. The same goes with equity. After having bought a company that conforms to all the above four criteria, you need to have patience. Investing in equities is often driven by two emotions – greed and fear. And patience is the mantra that helps overcome these emotions. Patience makes the difference between investing and speculation. It’s like a fertiliser to the investment process.

 

“In reality, patience is crucial, but it is a rare commodity”

 

End note

 

Investing is laying out today’s money for more in the future. Its about performance of the underlying assets. Success in investing is the outcome of a disciplined approach.

 

Happy Investing !

 

Raamdeo Agrawal, Director & co-Founder, Motilal Oswal Financial Services

Credits: http://www.economictimes.com

 

 

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