Fundamental Investing: 3 Golden Rules that I inherited and swear by

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Introduction

Are you curious to discover the key principles that have steered my financial journey towards success? In this blog post, I’m not here to offer advice, but rather to share three golden rules that have personally guided my investments and contributed to my financial well-being. These rules have stood the test of time and have proven effective for me. I’m excited to share them with you, so you can incorporate them into your own investment strategy, keeping things straightforward and appealing.

1. Rule of Profit Potential

Have you ever wondered what lies at the heart of every successful business venture? Well, it’s not magic, but a powerful equation that can transform your understanding of profit generation. Let’s delve into the Profit Equation. It’s a key piece of knowledge that every business owner should have in their toolkit.

P = Q * (S-C) —- (Profit Equation)

Now, let’s break it down. P represents the profit in any given year, Q is the number of units of products sold, S stands for the selling price of those products, and C represents the cost at which the products were acquired or made by the company. In simple terms, this equation tells the story of how your business can turn a profit.

Imagine you’re in the business of selling apples. If you buy apples for 50 Rs each, sell them at 100 Rs each, and manage to sell 20 apples in a year, your profit can be calculated as follows: Profit = 20 * (100 – 50) = 1000 Rs for the year.

Here is a concise summary of the key factors that i consider in the context of the profit equation:

• Product Relevance: Ensure that the company’s products remain in demand and relevant for the long term, securing a steady/growing consumer base.
• Innovative Growth: Look for efforts to increase sales (Q) through product innovation / Quality and by adding unique value to the product, which can subsequently boost profits.
• Cost Optimization: Evaluate the company’s strategies for reducing production or purchase costs (C) through wise capital allocation in to efficient machines , adapting supply chains, Training the labor etc.
• Pricing Power: Assess the company’s ability to adjust selling prices (S) when production or purchase costs (C) rise. This demonstrates pricing power and a potential competitive advantage in the market.

Thanks to my Grandfather who thought me this !

2. Rule of Credibility

One of my uncles started a clothing shop when I was 13-14 years old, and I asked him how he measured the success of his business. The answer he gave me has had a profound influence on me to this day, and I am confident it will serve as a guiding light for me and future generations. He said, ‘I will buy clothes worth 10 lakh rupees and I am certain I can make a monthly profit of 8,300 rupees, thus generating around 10% return on my investment. If I start making less, there’s no point in continuing because I could simply place that money in the bank as Fixed Deposit (FD), which would pay me 8% interest anyway. So, all he was concerned about was the right allocation of capital and targeting returns on his equity.”

ROE = LR * ATR * NPM —– (Return on Equity)

Although this equation may appear complex at first glance, it is relatively straightforward. A business can achieve a higher Return on Equity (ROE) by employing one or a combination of the following strategies:

1. LR – Leverage Ratio: This involves taking on leverage and using it wisely, often referred to as ‘good debt.’ For example, if my uncle’s shop is successful, even if he doesn’t have the necessary capital, banks would likely be willing to lend him 10 lakhs, which he could borrow at a 9% interest rate to establish a new shop in a neighboring town. If he can generate a 10% return from it, pay 9% to the bank, and enjoy the 1% difference as additional profits.

2. ATR – Asset Turnover Ratio: My uncle doesn’t need to utilize all his capital to achieve a 10k monthly profit. He can optimize his inventory over time by learning about customer tastes, preferences, and seasonal trends. By keeping only 4-5 lakhs worth of clothing in stock at any given time and investing the rest in fixed deposits (FDs) at the bank, he can generate additional returns. This, of course, requires time and market insight to achieve.

3. NPM – Net Profit Margin: This can be a bit challenging to achieve. Instead of buying clothing from the same vendor, my uncle can explore alternative suppliers who offer a limited range at a lower cost. However, he must tread carefully, as this could potentially impact sales if customers seek a wider variety or the latest fashion trends. Alternatively, he might consider increasing the selling price, but this would require a unique selling proposition or a near-monopoly in the town.”

After witnessing my uncle’s success over the years, I couldn’t help but contemplate suggesting an alternative to borrowing money from the bank. Why not use my 10 lakhs to start another shop in a new town, with the aim of enjoying returns higher than what traditional FDs could offer? However, before making such a decision, I considered several factors carefully:

• Town Selection: Is he choosing a town with significant potential for sales and growth?
• Trustworthiness: Can I trust my uncle’s commitment to the business, especially in light of his past borrowing and repayment history with other individuals?
• Equity Fairness: Is he treating me fairly as a minority shareholder in his business, ensuring that he doesn’t allocate excessive expenses for his personal gain, thus diminishing my returns?

These considerations mirror the questions we must ask ourselves before investing in a company in the stock market. Trust, potential for growth, and fairness are crucial aspects in both scenarios.

Thanks to my Uncle who thought me this !

3. Rule of Risk-Adjusted Returns

Although I understood how a business is created and executed, I did not have the right method for valuation. In fact, I didn’t even know what valuation was until I started investing in the stock market and buying shares in businesses.

Thanks to Ben Graham, Uncle Warren, and Aswath Damodaran, they have made a deep impact on my thinking when it comes to valuations. Ben Graham taught me what a margin of safety is, Uncle Warren taught me how to understand it along with the economy, and Aswath Damodaran taught me a whole host of things, including discounted cash flow, which is one of the primary tools I use today.

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I promise to write a dedicated blog on valuation , describing it here will take a lot of space and doesn’t make the blog a pleasure to read

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Disclaimer: This blog post is intended for informational purposes only and should not be considered as financial advice. Always conduct thorough research and consult with a qualified financial professional before making investment decision.