In March 2002, Rakesh Jhunjhunwala, then still relatively young and fresh-faced, walked into our office with an article he had written on his decade long experience as a successful investor.

He was not a national name yet and he had still not made his big investments in companies like Titan, Star Health and Metro which would gain him national fame, but he was already making waves on the stock market with his ability to make big bets on undervalued stocks. In a market that was recovering from the scandals sparked by speculators like Harshad Mehta and Ketan Parikh, Jhunjhunwala wanted to disseminate the wisdom behind his way of picking stocks.

His theories were mostly based on what he had learnt from reading about, and observing his heroes like Warren Buffet and Peter Lynch.  And the piece was a combination of his journey as an investor and his learnings along the way, written in a style that was simple and lucid, targeted at the lay reader. And almost everything that he had to say are still valid lessons for investors who are starting out.

Here we reproduce the article in full.

An early start:

At a comparatively young age of 15, my father’s conversations with various people introduced me to the world of stocks and stock markets. I started reading the daily stock quotations in the newspapers and realised that stock values fluctuate. I found that fascinating. 

Driver by curiosity:

I was a curious child and was constantly quizzing my dad as to why these values fluctuate. He asked me to relate the fluctuations to the news items appearing in the newspapers, thus beginning the unending process of my education as an investor.

Scanning the horizon:

I was told that the Profit and Loss accounts and Balance Sheets play an important role in determining stock values, and thus I started reading every Annual Report that I could lay my hands on, and scanned the newspapers for news on company’s profits.

Learning the ropes:

In the meanwhile, I completed my graduation and started my Chartered Accountancy. I soon realised that companies having the highest quantum of profits, or highest reserves and surplus, or highest net worth need not necessarily have the highest stock price. I read somewhere that ‘A balance sheet is like a bikini – what it reveals is alluring, what it hides is vital’. I learnt that the saying is right. 

Differentiating quality from quantity:

On completion of my Chartered Accountancy in 1984, 1 took on the challenge of making a career by investing and trading in stocks. I started following stock markets very intensively. Stocks were now my livelihood, and I learnt that it’s not the sheer quantum of profits but the quality of profits that matters as much.

Differentiating ratios from rationale:

I was introduced to a simple mathematical equation: Earning per share (EPS) X Price earnings ratio (PER)= Price.

It was apparent that when both the variables determining price viz: EPS and PER gain, then stock prices explode.

Look for quality drivers:

I learnt that the EPS was very specific to each company while the PER was dependent on various factors, both internal and external to the company. We could not look only at the sheer EPS of a company, but there was a need to look at the quality of EPS. The quality depended mainly on three factors:

• Accounting policies followed;
• Cash profile of the profits;
• Return on capital employed, i.e., efficient use of capital.

The internal conditions that determine PER included the reward record of the company, predictability of earnings, risk model, perceived growth opportunity, and the perceived integrity of the management.

Look for value drivers:

I learnt that markets disproportionately reward companies that are leaders, innovators, and performers.

Future lies in realism:

We can predict future prices by predicting future EPS and PER, but to predict future profits, we need to understand the business itself.

Key success factors:

While predicting a company’s profit, I assess the following:

• The addressable external opportunity available to the company. The scope of demand for the product or service of the company determines its addressable external opportunity. To illustrate, the profitability of Infosys fluctuates primarily with global demand for software services; or Colgate India’s growth is dependent on the size and the growth of the toothpaste market in India.

• The competitive ability of the company. This means the ability to deliver quality products/services at the lowest price to the widest customer base.

• The effect of operating leverage on profits.

This article originally appeared in the April 2002 issue of MW magazine.

Lead Image: Getty Images/Umesh Goswami