Equity Investing – getting the basics in place

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Out of all asset classes, Equities (stocks) are unfortunately the most misunderstood. My mom thinks it’s gambling, my friends think it’s something which lets you make money without working hard and unfortunately many of them who did try their hand at equities lost money and have vowed never to get back into this again. The grapples are many..

On the other side, you will see a lot financial advisors and mutual funds coming up with ads showing “equities have been the best asset over long term”, “they have given around 15%” blah blah..

So what is the truth ? Who is right ?

Now before we start analysing the past returns and the veracity of the statements surrounding equities, let’s take some time to understand what “equity investing” really means.

Equity investing essentially means “You become a partial owner in a business”. Period !

If you don’t intuitively understand this, you will most likely end up having a poor experience investing in equities.

Let’s understand this with an example. Assume you are running a restaurant business. You need Rs 50 lakhs to expand the business. But you have managed to save only Rs 25 lakhs. You need Rs 25 lakhs more. I have a spare of Rs 25 lakhs which I am looking to invest. Now you have three options

1) Borrow from me and promise to repay me back the entire amount in 5 years and pay a 12% interest every year

2) You borrow it from a bank at 14% interest rate while I invest my money in bank F.D for 8% (this is similar to the 1st transaction except for the fact that now you have an intermediary called the bank !!)

3) You sell a part of your company ownership to me in exchange of Rs 25 lakhs (lets say 25% assuming both of us agree that your company is valued at Rs 1 cr). The interesting part in this deal is that I will have no say in the day-to-day operation or the management of the company. You will be free to operate the company and you don’t need to pay me a salary or a part of profits (sometimes you and me can get paid through dividends).

But hang on..there are some issues with this arrangement.

One, you may find it difficult to find someone like me to provide you with the entire Rs 25 lakhs for 25% of your business. Two, I too have a problem. While I own 25% of the business I don’t get to participate in the management and don’t get an interest or salary. Dividends are provided by some companies but are generally too low. So the only way I make money is to sell my stake in the business after some years (inherent assumption being that the company’s value would have increased). So assuming the overall business value improves whom do I sell the 25% and get the corresponding higher value. So this makes me like the venture capitalist or the angel investor who will have to wait for a long time and needs to have the resources to find a suitable investor to exit from the investments.

So how do we solve this ??

Stock markets to the rescue !!

Instead of trying to sell the entire 25% for Rs 25 lakhs in one shot, you can split your entire company’s worth i.e 1 cr into 10 lakh shares worth Rs 10 each. Now you can retain 7.5 lakh shares with you i.e 75% of company’s ownership. And the remaining 2.5 lakh shares can be issued for Rs 10 to many people. This is called an IPO (Initial public offer). So someone might just buy 1 share for Rs 10 while someone else might buy 100 shares for Rs 1000. Now all of them are owners of the company (technically referred to as shareholders). So you end up getting the same Rs 25 lakhs in exchange of the shares (read as part ownership) to several shareholders. The ownership share is therefore proportional to the no of shares that someone owns. So this essentially solves your problem of raising money for your business. But the ones who bought your company’s share still have the issue of “how do I sell my ownership stake when the time is right”. So a market place is created (read as BSE and NSE) where the people who own the shares can offer to sell their shares to other people who would like to become a part owner of the company. The best part here is that you, as the company owner, need not return the Rs 25 lakhs, and can peacefully deploy it in business as you have already exchanged a part of your ownership in the company for the amount. So everyday there are different people who offer to buy and sell shares and based on the balance between the buyers and sellers the share price keeps fluctuating. Now while the price changes on a daily basis, there is no impact on the actual cash flow or the running of the business. However as the share price changes the value of shares owned by the owner and the shareholders also changes, implying that both the stock buyer and the owner’s incentives are aligned – to increase the overall value of the company

Now unfortunately what happens is that most people eventually forget all this and get anchored to only the prices. So they start understanding a company’s share price as a number which magically keeps moving up and down every day. Unfortunately, the basic fact that a share price reflects the market’s opinion on the value of the underlying business is conveniently forgotten.

So the gist is that when you buy a share, you basically become an owner of the business. Now if you buy Infosys for INR Rs 2000, both you and Mr Narayana Moorthy will see the same return % in the next 5 years. The only difference being that he holds a larger number of share. So if you are worried that Infosys shares might come down Mr Narayana Moorthy must be even more petrified given his huge exposure. Thus the first and most important step is to start viewing equity investing as a “proxy to entrepreneurship”. You get a chance to own a portion of a business.

So your participation in equities will depend on your belief that entrepreneurs will continue to make more money than an apartment, a gold jewellery or a loan given to entrepreneur for a fixed interest (read as F.D, Bonds or Fixed Income Mutual Funds).

Now till you start getting comfortable with the powerful concept that “stocks are essentially partial ownership in businesses” no amount of past return data can convince you to invest in shares.

For me personally, buying equities is the closest I will ever come to entrepreneurship. So I am personally significantly biased towards equities as I believe in humans – the ability to generate ideas, convert them into viable products/services, employ people, deploy land, borrow money and generate a higher return more than the input costs.

The most important thing to remember when you invest in stocks is :

Buying stocks = Partial ownership in a business

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Author: Arun

Hey! I'm Arun and I work for the research team of a boutique wealth management firm based out of Chennai. The idea behind this space is to share my learnings/mistakes and hopefully help people in making better investment decisions :)

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