LOOK, UNDERSTAND and PLAN before your LEAP!

Last year one of my close friend, Mr. Shashi had invested in a food-technology startup as an early stage investor. Mr. Shashi as I know him is a successful lawyer and has built his esteemed law firm over the last 2 decades milestone by milestone. I was surprised on knowing that he had invested in a “tech company”, as I was well aware of his reluctance to even learn the smartphone, let aside the ‘technology’ world. On further inquiring, he mentioned to me that now-a-days everyone is running with truck-loads of their money into the ‘food-tech’ sector and that he feels that this investment is his blue-eyed boy who will be a sure shot money spinner. He said that he expects good gains when this startup lists itself in the next 2-3 years. I was happy for Mr. Shashi, but as an expert in the field of investments and finance I couldn’t help myself from asking him about his knowledge of the sector and how did he choose to invest in. I was dumbfounded when he told me, “Ajay’ji, everyone is investing in the food-tech now. Don’t worry about my zero knowledge of technology, yeh IIT ke bacche hain aur pakka IPO karenge. If you want to invest too, I can help you out.” I said thank you and politely rejected the offer saying that my investment strategy is investing in sectors that I have complete knowledge and understanding of. He smirked and said that I was missing out on a big opportunity.

Just a few days back, I met Sashi at a family event and I could help myself from inquiring about how his startup was doing. He replied bluntly, “Ajay’ji, you were right. I just got blinded by the herd mentality.” His investee startup had closed within a few months of operations. He further added, “The cost to acquire and retain customers was so high that the founders were looking to raise the next round at astronomical valuations. And they failed miserably at it. Period!”

In today’s time, it is very essential to have a strategy for investing. Be it investing in an early-stage startup OR investing in Mutual Funds OR investing in the Equity markets (Stock markets) OR any other investing opportunity. And the key to successful investing is knowing WHAT you are investing in.

The WHAT of the business –

(a)   The Industry/Sector: Know the industry of your company whose stock you are investing in. If you know the industry, you can foresee the future of the sector and decide if the company initiatives are in alignment with the changing times. Domain knowledge if very important before investing in a particular sector. Based on the stage of the industry, you can classify the industry as nascent, fast-growing, stable, mature etc. and also identify the risk profile associated with the stage of industry. Sectors such as Fast Moving Consumer Goods (FMCG), banking, personal care, automobile, hospitality etc. have a good potential given that they have a significant domestic demand and growth story to take them forward in the coming years and decades.

(b) The Business Model: Knowing the business model is very crucial as it helps you understand the crux of the company. Depending on the nature of the industry, one can understand the strength of the business model. For a more established industry, the strength of the business model can be easily gauged by matching it to those of the performing peers. But one has to answer the question that whether this business model is sustainable in the future. A company can choose to have multiple business models. For e.g., let us take the case of Oracle, a global technology products company. Its business model can be broken into the following streams –

Every company will have multiple business models to ensure various revenue streams. This also helps us understand how efficiently the company has captured the consumption touch-points in the life-cycle of the customer.

(c)   Smart Thumb-rules: There is no strict formula or method to accomplish this. If I did have such a methodology, I would be a zillionaire by now. This also requires one to take risks, have patience to invest for long term and have conviction in the business potential. If things go wrong despite all efforts, one must try to book losses and readjust their portfolio accordingly. There are a few pointers which can help you pick businesses with good potential:-

• Try to select industries or sectors that are fairly well established
• Select a few leaders from an industry or industry segments (e.g. Hindustan Unilever, Nestle in FMCG)
• Avoid small, new or unknown players
• Observe the growth and past trends and performance of the company over market cycles
• Assess the future potential and sustainability (will the company survive in the next decade?) Can it adapt to new changes in technology, regulations, market conditions, etc.

(d)  Common sense and Experience-based knowledge: One must surely use rational common sense and experience in addition to the financial data and historical prices readily available. One needs to know if his/her invested company can be impacted by the BREXIT or TRUMP immigration ban. A company’s exposure to international market obviously implies impact on its revenue streams due to any global changes. There are some industries that thrive irrespective of economic conditions – e.g. toothpastes, medicines, food, consumer goods, personal care products, etc. Moreover all segments within an industry will not be affected equally – for example a slowdown in jobs may lead to slowing of car sales, but two-wheeler sales may remain stable.

Let me conclude with a simple analogy. Let’s say you have Rs.1 lakh to invest. You can invest it in a bank or you can lend the money to Mr. Sharma who wants to start a restaurant business. The bank offers 9% interest p.a. whereas Mr. Khanna offers 18% per annum. Obviously, the bank is safer because you know what the bank does with your money – it basically lends to individuals or companies at a higher rate of interest to earn and pay your interest. Similarly, established companies with proven business models have a systematic way to generate huge cash flows that are sufficient to run the business and provide stable return on equity. Know the business you are investing in, as understanding the fundamentals of a company will provide you a better insight into their profit pattern and helps you in making a better investment decision.