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Of Potato Shopping and Stock Picking

Feb 18, 2016

In this issue:
» Jack Bogle's winning formula
» Pay hikes by Indian companies this year
0.00
Rahul Shah, Co-Head of Research

She yelled at him, rage in her eyes.

I stood there in amazement. I couldn't believe what I was witnessing.

At this busy vegetable market, an old lady was fuming at what looked like an innocent potato seller. His crime? The lady was upset with him because he had 1kg packets of potatoes priced at Rs 20 and 2kg packs priced at Rs 40.

'How can you sell one pack so much more expensive than another?' she protested. Strangely enough, the fact that the second pack had twice the quantity of potatoes was lost upon her. She just couldn't get her head around that!

From one market to another

If you think this is just too silly a scene even for a vegetable market, you're right. I made it up.

But here's something even more amazing: A similar scene often takes place in what most consider to be a significantly more sophisticated market - the stock market. Many investors unfamiliar with the territory have the same fallacious reasoning as my fictional woman. They think a stock selling for Rs 1,000 a piece is much more 'expensive' than another selling for Rs 10.

Delve just a little deeper, and one realises that it hardly works that way.

Shares of different companies represent packets of different sizes. Except that, instead of potatoes, the packets represent the company's profits and assets. A share may represent Rs 5 of profits for one company or Rs 50 of profits in another company. Naturally, the 'packet' sizes being different, a direct comparison of share prices is meaningless. And akin to the old lady shopping for potatoes.

So how does one compare the share prices of two companies?

Stock market jargon - simpler than you think

Do what you would when shopping for potatoes. You ask for the rate per kilogram. So if one guy is selling you at Rs 20 per kg, and other at Rs 25 per kg, you know the second guy's potatoes are more expensive.

In the case of stocks, this equates to the rate per rupee of profits earned by the company, or the rate per rupee of networth of the company. So if one stock is selling for Rs 20 per rupee of profit, and another for Rs 25, you know the second company's stock is more expensive.

Analysts call this ratio the PE ratio, or price-to-earnings ratio. In the case of networth, it's the PBV ratio, or price-to-book value ratio.

And as you can imagine, there will be cases where you won't mind paying more for the second company. Because just like potatoes, the quality of companies could differ. But at least you are measuring 'expensive' the right way.

Don't let the financial experts ever fool you. A lot of stock market jargon floating around is much simpler than you think. And intelligent investing is often only about understanding the basics really well.

The rest is just a matter of common sense.

Do you think stock market jargon is actually much simpler than it sounds? Let us know your comments or share your views in the Equitymaster Club.


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2.45 Chart of the day

Two back-to-back droughts had already dimmed hopes of a recovery in consumption demand in the rural areas. And with the business environment yet to improve, there were worries that urban consumption demand could also be affected as companies could dole out lower pay hikes. However, firms in the consumption space can take heart from today's chart of the day as far as the urban demand is concerned.

As the chart highlights, the average pay hikes to be offered by Indian companies this year at 10.3% will only be marginally lower than 2015. Therefore, while business sentiment has dipped, the pay hikes haven't been affected drastically. The hike does pale in comparison to the hike doled out in 2012, the biggest in the last six years.

Important to add that amongst sectors, e-commerce and technology driven start-ups are likely to offer the best average salary hike while financial institutions may offer the lowest. Life sciences and media are also amongst the sectors offering the best pay hikes in the current year.

Pay Hike By India Inc. Nearly Same As Last Year

3.50

The volatility in the stock markets currently can induce fear in the minds of even the most seasoned investors. Not Jack Bogle though. The Vanguard Group founder whose books even Warren Buffett recommends, has asked for investors to not flee the market when it is down, pointing out how that has been his winning strategy. What else does his winning formula contain? Well, an allocation of 60:40 between stocks and bonds with a higher weightage to stocks if one is young and lower if one is old.

He is of the view that far too many investors waste time and energy, trying to find out whether the markets have hit a bottom. And this is hugely counterproductive as per him. The plan should be to stay the course as over the long term, stocks have beaten bonds hands down.

Well, if you are finding echoes of Warren Buffett in what John Bogle has said, you are absolutely correct. Buffett also agrees that time to be fearful in the stock markets is not when everyone else is fearful. In fact, when everyone else is fearful, one should turn greedy. It is in this environment that stocks are available at hugely marked down prices. Well, we couldn't agree more with both Buffett as well as Bogle.

4.40

The Indian stock markets were trading strong today on the back of buying activity across most index heavyweights. At the time of writing, the BSE-Sensex was trading higher by around 250 points. Gains were largely seen in pharma and telecom stocks.

4.55 Today's investment mantra

"It is mere common sense to abstain from buying securities at around 100 if long experience indicates that they can probably be bought at 70 or less in the next weak market." - Benjamin Graham

This edition of The 5 Minute WrapUp is authored by Rahul Shah (Research Analyst).

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2 Responses to "Of Potato Shopping and Stock Picking"

Subir K Ghosh

Feb 19, 2016

PE ratio is understood. However, how about explaining all the other jargon that we keep reading about. PE by itself is not sufficient or is it?

Like 

Rajeev Arora

Feb 18, 2016

Let's end the day on a positive note - IMD has predicted a normal monsoon in 2016 :)

Like 
  
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