Sunday, December 28, 2008

"Time in" vs. "Timing" the market

This is one of those investment debates that has been waged through the years, with no sign of a resolution in sight. With strong opinions on either side, it is quite likely that the controversy will endure for a long time.

The dilemma arises because of the way most experts and analysts define 'timing' - they mean selling out your equity portfolio completely at market tops, and buying the same portfolio back at market bottoms.

Common sense - which is not so common among the majority of investors - dictates that such a plan is doomed to failure. Why? Because consistently deciding when a market has reached a top or bottom over several economic and stock market cycles is pretty nigh impossible.

The stock market moves on its own logic, reflecting the collective sentiments of various market participants who have differing agenda. The hedge funds are in it for the short term (i.e. less than one year). Some of the Foreign Institutional Investors (FIIs) may invest for a longer term of 3-5 years. Pension funds tend to be real long term investors who stay in for 10 years or more.

As an individual investor it will be quite futile to try and outguess what these big boys are up to at any point of time. Chances are that they are better informed and have more research and financial resources. Therefore they can enter and leave the market in droves - driving up or smashing down prices before you can say 'Jack Robinson'.

Research has proven that those who stay invested for the long term perform much better than those who try to exit and enter the stock market frequently. No wonder most fund managers say that 'time in the market' is preferable to 'timing the market'.

While I can not disagree with such strong logic, backed by academic research, my investment experience has been otherwise. It arises from the basic definition of market timing.

For long term investment success it is imperative that you try and time the entry into and exit from individual stocks. But do not try to exit from your entire portfolio or try to buy the whole portfolio back.

If you've read my earlier post (Dec 1: Market cycles and Sectors), you will know that different sectors - and therefore, stocks from those sectors - get prominence depending on the state of the economic and market cycles.

Like now, when the Sensex is trying to find a bottom, FMCG stocks are hitting their 52 week highs whereas metal stocks are hitting their 52 week lows. So this is a good time to exit from FMCG stocks and enter metal stocks. (You don't have to sell your entire holding in a sector. Partial profit booking works pretty well.)

Now, experts and fund managers will tell you that FMCG is a good defensive sector to enter in a bear market and metals will face a lot of pain over the next couple of years. They will be quite correct from the short term view of the market. But a small investor with a long term outlook has to play contrarian. That is the only way to 'beat' the market.

While the 'time in' vs. 'timing' debate rages, my solution to the controversy is to replace the 'vs.' with 'and'; i.e. stay invested for the long term but time the entry into and exit from individual stocks.

In a future post, I will discuss about a technical indicator that helps lay investors to become master timers.

Sunday, December 21, 2008

Learn from my investment mistakes

When I look back on my track record of stock market investments over the past 20 plus years, I am amazed by the sheer number of downright idiotic mistakes that I have made.

Without trying to sound immodest, I consider myself of above-average intelligence. Most of my friends, and I dare say a few enemies, will probably corroborate that.

So how did I end up making so many mistakes in stock investing? And was I in a minority of one? Turns out that most amateur investors, and several professional and acknowledged experts, have made their share of similar mistakes.

Why do apparently intelligent and experienced people make ridiculous and stupid investing mistakes? The answer may lie in an area of study called 'behavioral finance', which studies the effect of human psychology on financial decision making.

Have you ever bought a share only to see its price going downwards? Or, decided not to buy a share (or bought only a small quantity) at a particular price, only to see the stock zoom up? This happens because the market has no idea - nor is it bothered - about your buy price. The market moves as per its own logic. But we tend to 'anchor' at a particular price.

If we buy at a higher price and the stock falls, our 'loss aversion' prevents us from selling it. Keeping a loss making stock in the portfolio does not seem like a real loss, whereas selling it would incur an actual cash loss. The way out is to have the discipline to stick to a 'stop loss' figure (it could be 5 or 10 or 25% below the buy price - depending on the stock's volatility and your risk tolerance), and sell as soon as the stop loss figure is hit.

What if the stock you buy starts zooming up, up and away (which usually happens in a bull market, but can also happen during sharp bear market rallies)? The smart investor's way is to keep moving the 'stop loss' figure upwards by the same percentage as the stock's price and ride the rally. During the next market dip, sell when the now much higher stop loss figure is reached.

One of the biggest mistake of all is to 'water the weeds and cut off the flowers'. This means selling off the good performing stocks too soon, and hanging on to the loss making stocks for long periods in the hope of a recovery.

This mistake is often compounded by another big mistake. That is over confidence in your stock picking skills. During bull markets, any stock that you touch seems to fly upwards and you start feeling that you are a genius at stock picking. When the market tanks, some of the high fliers - specially small and mid caps - lose as much as 80-90% of their peak value.

It is no wonder that Benjamin Graham in his 'The Intelligent Investor' has written: "The investor's chief problem - and even his worst enemy - is likely to be himself." (Haven't read Graham's book yet? Buy it tomorrow and then carefully read it, and then re-read it again and again.)

Sunday, December 14, 2008

Which sectors should you invest in?

In an earlier post ("Market Cycles and Sectors") on Dec 1, 2008 the sectors that receive prominence during different stages of the economic and stock market cycles were discussed.

Does that mean that you, as a small investor, should look at investing in all those sectors? Probably not.

Fund managers, who are under pressure to perform in the short term, have no alternative but to move in and out of sectors depending on the particular stage of the stock market. They also have access to company managements and better research resources and larger funds than small investors.

With considerably less funds and little or no research capabilities, small investors like you and me are better off choosing only a handful of sectors to invest in.

Some industries are in an environment that helps to create substantial competitive advantage. It is easier for the companies in such industries to make money.

Four sectors that I like - based on their competitive advantage and cash generation capabilities - are :-

1.  FMCG: Strong brands built up over the years create huge competitive advantage. Companies tend to be solidly profitable, debt free and generate a ton of cash (which is distributed to investors through generous dividends). The market leaders have been around for many years, so they are slow but steady performers.

This sector is practically recession proof and should form a significant part of a small investor's core portfolio. Companies to look at are HUL, ITC, Colgate, Nestle, Brittania, Dabur, Marico.

2.  Pharmaceuticals: Like FMCG, Pharma companies are recession proof, have strong brands, are hugely profitable and good dividend payers, and long term growth is assured because of the large population. MNC Pharma companies have access to better product pipeline from their overseas parents. Domestic Pharma companies profit from generics and contract research and manufacturing.

This sector should also receive pride of place in your portfolio. Companies to look at are Glaxo Pharma, Aventis, Sun Pharma, Lupin, Glenmark.

3.  Financial Services: Banks pay less interest to depositors and lend the money at higher interests. For current account holders, banks pay nothing at all. Many make more money by selling other financial products to their customer base - such as insurance, demat accounts, credit cards, mutual funds, home loans. Home loan companies tend to be highly profitable with long term growth assured.

Companies to look at are State Bank of India, Bank of India, HDFC Bank, Axis Bank, HDFC, LIC Housing Finance, Sundaram Finance.

4.  Media: Many companies have competitive advantage through regional language and regional market domination. This sector also tends to be recession proof.

The dynamics of the media business was covered in an earlier blog post on Sept. 8, 2008.

Are these the only sectors that an investor should look at? Obviously not. But this should be a good starting point in building a long term portfolio.

Future posts will cover other sectors and criteria for individual stock selection.

Monday, December 8, 2008

BeES in your bonnet?

After a steep fall and a short and sharp rally, the Sensex has been moving in a sideways consolidation phase for the past few weeks. At times like this, it becomes difficult for fundamental or technical analysis to provide clear indications of what is to follow next.

Reduction in the repo and reverse repo rates have probably been 'discounted' by the market already. The overhang of tensions following the Mumbai terror attack puts a spanner in the works of any quick recovery in the economy. And consolidation phases are notorious for doing exactly the opposite of what every one expects them to do.

Small investors have four choices.

For the adventurous who rely on their stock picking skills, this may be as good a time as any to start buying into frontline stocks at beaten down prices and build a good long term portfolio.

The less adventurous can select highly rated large cap diversified equity funds with good performance records over bull and bear cycles.

For conservative investors the above two choices may still seem risky because of the possibility of further downsides. Also, when the market does turn upwards (as it eventually will), there is no guarantee that the shares or funds selected will perform well.

Risk averse investors should then limit their choices to bank fixed deposits or index funds. Fixed deposits protect capital but are not tax efficient. At current interest rate of around 10%, the post-tax return at the highest tax bracket of 33% will provide a net return of 6.7% (which is lower than the current inflation rate).

Index mutual funds allow the investor to buy into a particular index - it could be the Sensex or Nifty. The underlying assets are the 30 Sensex or 50 Nifty stocks. There is no relying on a particular fund manager's skills or whims in stock selection. The returns will be almost the same as the Sensex or Nifty performance.

A good spin on an index fund is Benchmark Mutual Fund's Nifty BeES ETF (Exchange Traded Fund). An ETF is listed on a stock exchange and can be bought and sold at any time during the trading day through a broker by paying the Security Transactions Tax (STT). So for all intents and purposes, it is treated like a share. There are no separate entry/exit loads.

But while the underlying asset of a share is a single company, Nifty BeES' underlying asset is the entire Nifty 50 stock group. Which means that by buying a unit of Nifty BeES, whose NAV is 1/10th of the current Nifty level, you are effectively buying all 50 stocks that comprise the Nifty.

Why not just buy an index mutual fund? The major advantage of an ETF like Nifty BeES is being able to buy or sell any time during the day at the prevailing rate - whereas a mutual fund can only be bought or sold at the day's closing NAV value. During volatile trading days, this can be a real advantage.

The other unseen advantage, apart from there being no entry or exit loads, is that the fees charged by the fund is much less because an expert fund manager's stock picking skills are not required. So the disposable profits are higher.

If you are a risk averse investor with some spare cash, periodic investments in Nifty BeES can provide reasonable, if not spectacular, returns over the long term.

Monday, December 1, 2008

Market cycles and Sectors

The stock market rises and falls in a cyclical fashion that often 'leads' the economic cycle by several months. The signs of an economic down turn are quite visible now, but the stock market had started to 'discount' that fact back in Jan 08.

Now that we have been in a bear market phase for more than 10 months, many investors are struggling to understand what they should be looking for next.

Some who had purchased earlier when the market 'broke' Sensex levels of 12000 and 10000 are losing money and thinking about selling out at the next rise. Others may be resigned to the fact that they won't see any profits for several more months.

When all the fundamental and technical analysis still leaves common investors bewildered, a look at how different industry sectors have performed during previous market cycles may be enlightening.

The first signs of a stock market revival become visible when stocks from the financial sector like banks and NBFCs (Non-banking financial companies), retail and transportation sectors start to rise and consumer durables like home appliances, cars and trucks start showing improved sales. The economic story is nothing but bad news.

As the bull market begins to mature, and the economic cycle starts to improve, the sectors to watch will be technology, capital goods (like construction machinery) and construction materials (like cement and steel).

These will usually be followed by chemicals, paper, non-ferrous metals, petroleum - when the economy starts to gather momentum. Near the peak of the bull market, the real estate and energy sectors tend to dominate.

The FMCG and Healthcare sectors come to the forefront as the stock market begins its bear phase.  The economic cycle tends to be at or near its peak around this stage.

As the bear market matures, utilities and services sectors try to hold the fort. The economy is now well and truly in its downward cycle.

As the poet T. S. Eliot wrote in "Little Gidding":

What we call the beginning is often the end
And to make an end is to make a beginning.
The end is where we start from.

Wednesday, November 26, 2008

What is happening with the Sensex?

After Sensex hit the low of 7700 on Oct 27, we saw a sharp bear market rally that took the Sensex up to 10950 in 6 trading days. Thereafter the downward movement resumed again and we saw a higher low of around 8400 odd.

If we draw an upward sloping trend line connecting the two lows of 7700 and 8400, and a downward sloping trend line connecting 10950 with the next lower top of around 10500, we get a 'symmetrical triangle' pattern. Today's (Nov 26) trade penetrated this triangle's downward sloping trend line.

What does this imply? The bulls, grasping at straws, may think this is a sign of reversal and an up trend will follow. But the bears have several aspects on their side.

A triangle is a period of consolidation, caused by indecision amongst bulls and bears. It rarely indicates a reversal of trend. Also, the upward 'breakout' was on thin volumes (barely higher than Tuesday's low down day volumes). The advance-decline figure was negative. All these point to underlying weakness.

Since the previous trend leading into the triangle was down, the likely next movement will also be down. The up ward breakout looks like a 'false' move. After a few days, this rally ought to peter out. May be after Thursday's (Nov 27) settlement.

Technical analysis - as I keep harping - is an art and not a science. The same chart patterns are open to different interpretations, depending on the different methodologies used by the analyst. Ultimately, Mr Market knows best. We can only attempt to make some sense of his movements.

Sunday, November 23, 2008

Five more things to avoid in a Bear Market

A lot of investors who joined the party from 2004-2005 and haven't really experienced a bear market bought a lot of stocks during the current downturn - specially after the Sensex breached 12000 and then 10000. They are now realising that just because the market has fallen a lot from its peak it doesn't mean that it can't fall even more.

So here are five more things you should avoid doing in the current market situation.

6.  Don't be swayed by the occasional bullish news. They should be noted and filed in the memory, but no action should be taken yet. Instances include the US bail out, the Chinese bail out, reduction of CRR/SLR/repo rates, slowing of inflation. These may appear to be good news and the market usually reacts positively to them. But you must understand that most of these are actually measures to put some upward impetus to the crashing economy and markets.

7.  Don't blindly trust your stock picking skills. You may have picked some real winners during the bull run. So did every one else. Bull runs lift all stocks - good, bad or ugly - to stratospheric levels. Be very careful in preparing your buy list in a down market. Do some 'paper' trading to see if your chosen scripts are going up, down or remaining static during the brief rallies. After some time you will realise which stocks should remain in your buy list.

8.  Don't assume that past performance will get repeated in future.  Just because certain stocks did very well in the later stages of the bull market doesn't mean that they will do well again when the market turns. Realty and cement stocks come to mind.

9.  Don't confuse inflation and capital protection. At times like these, you may be better off locking your cash into a two year fixed deposit at 10.5% and opt for monthly or quarterly interest. You may think that tax adjusted return will be 7% which will be eaten away by inflation of 9%. But a year hence, the inflation rate may fall below 6% (mostly due to higher base effect) and you will actually gain. Plus your capital will be safe. The periodic cash flow from interest income can be used if some unbelievable buying opportunities come by (like TISCO falling to Rs 100 or Bharti going below Rs 400).

10. Don't do some thing silly on a hunch because you are getting bored. This is a great time to actively learn the importance of patience. If you have targeted some interesting stocks (I'm looking at Maharashtra Seamless and Yes Bank), buy a small quantity and keep actively tracking it. When it breaches a previous low, don't jump in. Wait to see how far down it'll go. When it goes lower, wait some more. Till you see volumes almost disappear. Then buy some more.

Sunday, November 16, 2008

The Investment World according to JP Morgan

Last Friday (Nov 14, '08) I attended an investor's meet arranged by HSBC at the Taj Bengal, Calcutta. The featured speaker, Harshad Patwardhan, Fund Manager of JP Morgan Asset Management, gave a slick presentation with lots of charts and graphs titled "Invest with Conviction".

Here is a gist of what he said.

* The worst is behind us; however, the pain is far from over

* Economies will contract world wide; there will be deceleration of growth

* Inflation is coming down; interest rates may come down also

* Indian GDP growth may moderate to 6.5 to 7%; China's GDP may be around 8 to 10%

* FII selling has been more intense in small and mid caps; likely reversal of FII flows in '09 with increased allocation to India and China

* Large part of the hedge funds' selling is over

* There seems to be a mood change in the market; 12 months down the line, things will look better

* This is once in a decade - if not once in a lifetime - opportunity; increase allocation to equities

* Invest in companies with 'robust' balance sheets and 'robust' business models

That was the good news. Now the bad - the floor was opened to Q&A.

* The Company Secretary of Exide said that he had visited three different banks including two private sector ones earlier that day. All had been very considerate and welcoming, only to quote terms that no self-respecting organisation could accept. So how can the worst be over? If this is happens to a company of the stature of Exide, what must be happening to smaller companies?

* An elderly investor said that he had listened to his funds advisor at HSBC and invested in JP Morgan's Equity Fund and JP Morgan's Opportunity Fund. Now that he is losing heavily in both and has no funds left, how can he invest more?

* A merchant exporter said that overseas buyers have stopped delivery of orders and there is hardly any movement of outward or inward cargo. So where is the mood change?

There were several other questions in a similar vein. Finally Mr Patwardhan had to accept that things were not quite 'hunky dory'; however prices of shares had reached 'mouthwatering' levels and investors should consider putting some money back into the market.

His plea would have been more credible if he had said that investors should protect their capital by putting their money in a 1 year FD and get back into the market when the first signs of a turnaround was visible.

As the Finance Director of Nicco Corp. quipped: Poor chap, he is only trying to earn his keep. If we don't start buying, he may lose his job!

Monday, November 10, 2008

Five things you should avoid in a bear market

Now that the last of the disbelievers has given up hope, we should have no further doubts that we are in the midst of a raging bear market. So what does a smart investor do in this situation? Avoid making a bad situation even worse.

1. Don't Panic: One can well understand that you may be losing sleep if you entered the market in late 2007 or early 2008. You must be facing serious losses. But do not panic. The world has not come to an end. Your loved ones still love you. And unless you are overleveraged, you will eventually get out of this tough  situation, and hopefully, learn from it.

2. Don't Average down: Just because you had bought stocks at higher prices, you may be tempted to lower your average price per share by buying at lower prices now. That will be like throwing good money after bad, as you may be turning a smaller loss into a much bigger one. No one knows how much lower the market or individual stocks may go, and how long they will stay there.

3. Don't Buy on rallies: Bear market rallies are usually sharp and swift. But bear markets do not provide great entry points, because it is difficult to call a bottom. (Bull market corrections provide better entry points.) You make money in a bear market by selling short. I'm not advocating short selling for small investors because it is a risky proposition for the inexperienced. But bear market rallies can, and should, be used for disposing off non-performing stocks.

4. Don't Buy second or third rung stocks: They may appear cheap and a bargain. But such stocks get even cheaper, that is, if they manage to survive at all. Remember, if you bought a stock that has fallen 50% and now looks cheap, it will need to rise 100% just to get back to its earlier price.  When the next bull market begins, the market leader stocks will be at the forefront of the up move.

5. Don't Trust the media: They broadcast or write what they think will 'sell', and therefore get market situations all wrong. If you have been hearing (or reading) of late that the market has capitulated and we are close to a bottom, chances are that the market will fall some more. Bear markets come to an end when every one has lost all interest in what is happening in the markets.

Wednesday, November 5, 2008

A Reversal Day

While the the whole world rejoiced at Barack Obama's victory as the first ever African-American President of the USA, the Sensex suffered a reversal day.

A reversal day is a 1-day price pattern usually signifying a short-term trend reversal. We had 5 days of a 'V' shaped move that propelled the Sensex up from the 3 years low of 7700 and was typical of a bear market rally.

Today, the day started at almost the 10950 level but ended at 10120. So, the high of the day was higher than yesterday's while the close was not only near the low of the day, but considerably lower than yesterday's closing level of 10630.

This indicates a strong reversal, which was confirmed by the higher volume of transactions on the BSE. I would avoid buying for the time being.

Sunday, November 2, 2008

What the CRR-SLR-Repo cuts mean for investors

Economics and monetary matters are not my strength areas, but a lot of investors must be wondering how all these different rate cuts may affect them. So here is a 'dummies guide' to the triple rate cut dose.

But first, some of the basics.

The Repo rate is the rate of interest charged by the Reserve Bank of India (RBI) to commercial banks who may need to borrow some short term funds against securities. (The Reverse Repo rate is the rate of interest paid by the RBI to the banks who may park short term funds with it. Usually the RBI pays a lower rate.)

The Cash Reserve Ratio (CRR) is a percentage of the total deposits with commercial banks that they need to keep with the RBI.

The Statutory Liquidity Ratio (SLR) is a percentage of deposits that commercial banks need to invest in government securities.

What purpose is served by such means? It is for the safety and security of the funds available in the banking system (which in turn helps investors like you and me). It is also for controlling the supply of money (or liquidity) in the country's financial system.

The Foreign Institutional Investors (FIIs) were lured by the growth prospects of the Indian economy and brought in huge funds (by Indian standards) to purchase shares of Indian companies. Indians working overseas also channeled money back to the country for investments because of the comparatively higher interest rates.

As demand for products and services kept rising, capacities got stretched, and prices were hiked. Industries went in for capacity expansion availing cheaper overseas funds. With higher production the GDP kept rising, attracting more foreign funds.

The increased liquidity - mainly from overseas - and higher prices caused inflation to rise. Initially the government kept ignoring the rising inflation rate till it hit double digits. To curtail inflation, the RBI squeezed the supply of money by gradually increasing the CRR, SLR and Repo rates.

Unfortunately, the sub-prime crisis in the USA hit the world's financial system like a whirlwind. Many of the FIIs who had lost heavily in the sub-prime derivatives markets, started to sell aggressively in the Indian share market.

The outflow of foreign money caused two problems. First, it caused a reduction in liquidity - which had already been tightened by RBI's policies. Second, it caused a fall in the value of the Rupee - which the RBI tried to stem by buying foreign currency, further reducing liquidity.

The banks started feeling the pinch and started offering higher interest rates for deposits and, therefore, charging higher interest rates to borrowers.  Industry found the easy-money taps getting closed - both in India and overseas, and started slowing down their growth plans.

Speculators who borrow money to invest felt the cost of doing business was too high and started selling off. This compounded the selling pressure already exerted by the FIIs. The downward spiral in the stock market got exacerbated when small investors also started selling off.

The several rate cuts over the past couple of months is the RBI's and governments rather belated effort to inject liquidity in the market so that banks can resume lending. Hopefully that will lead to rejuvenating the growth plans of industries and eventually lead to reduction of interest rates.

That would be the first indication that the stock markets are ready to stop falling and starting their next upward journey.

Sunday, October 26, 2008

How to reallocate your assets

An investor friend asked me a million dollar question last week: The stock market has collapsed and blue chips are available at attractive valuations, but where is the cash to buy them?

Many investors - yours truly included - have been taken by surprise by the severity of the market decline. Let alone think about buying, many are scrambling to save whatever little is left of their portfolio. The currently attractive fixed deposit (FD) rates have prompted some to sell even at a loss and move to fixed income.

This is as great a time as any to give some thought to asset reallocation. But to do that we have to start with asset allocation.

Let us say that you are 35 years old and an investor in the stock market. The thumb rule for percentage allocation to equity suggested by market experts is (100 - your age). In this case, it will be (100 - 35 =) 65%.

Now you may not feel comfortable with the associated risk of such an allocation to equity. No one is pointing a gun at your head. Choose whatever percentage makes sense to you. 40-50% if you are a conservative investor. 75% if you are aggressive about making high returns with high risk.

The younger you are the more should be your equity allocation. Why? Because equities tend to earn the best returns over the long term, and when you start young you have less responsibilities and hence can afford to take more risk.

The older and closer to retirement you are, the more should be your allocation to fixed income. Why? Because the stock market can be in doldrums just when you are about to retire - when your regular income source will dry up. The (100 - age) formula comes in handy after all.

For argument's sake, if you agree with the 65% equity allocation (this could mean shares or equity MFs or a combination), the balance 35% should be in fixed income, gold ETF and cash. A rough breakup can be 25% in bank FD or Post Office MIS or PPF, 5% in gold ETF and 5% in cash.

The gold ETF is a hedge against inflation, but low returns may not permit a higher allocation. The cash is necessary for unforeseen opportunities - like a rights issue, or additional purchase due to a bonus issue or divestment.

If you have Rs 20 lakhs as an investible surplus, this asset allocation formula means Rs 13 lakhs in equity/MF, Rs 5 lakhs in fixed income, and Rs 1 lakh each in gold ETF and cash.

Investment guru Benjamin Graham had advocated that on no account should you let your equity allocation go beyond 75% or go below 25%. If you follow this advice to the letter and spirit, it will enable you to reallocate almost without thinking.

How? Say the stock market moves up (not likely in the near future!), and the value of your equity portfolio becomes Rs 18 lakhs. Your total investment value now becomes Rs 25 lakhs (=18+5+1+1), and your equity percentage becomes 72% (=18/25).

This is still below Graham's limit of 75% but is 7% above your original plan of 65%. Prudence requires that you start booking profits partially. If you are aggressive, you can ride the bull market till your equity value goes up to Rs 21 lakhs. Now you've hit the 75% level (=21/28). No further waiting - start selling and invest the proceeds into fixed income and cash, to return to your original percentage allocation plan.

What happens in the process is you increase your wealth in real terms - not only on paper, because now your fixed income/cash amounts have increased. The actual figures are about Rs18 lakhs in equity, Rs 7 lakhs in fixed income and Rs 1.5 lakhs each in gold ETF and cash.

Thanks to the bear market, let us assume your equity value drops to Rs 10 lakhs. Your total investment value is now back to Rs 20 lakhs (=10+7+1.5+1.5) but your equity allocation is down to 50%.

Guess what? You now have some extra cash to deploy back into the market. And if you opt for Post Office MIS and/or monthly/quarterly interest from your FD in your fixed income allocation - then you will have even more cash without touching your FDs or gold ETFs.

No wonder Warren Buffett has said that knowledge of simple arithmetic is enough to be a smart investor! (In real life, the arithmetic may become a little more complicated - but an Excel spreadsheet should take care of that.)

Sunday, October 19, 2008

Three phases of a Bear Market

I have been receiving a number of queries and comments about what to do now, whether the bottom is near, and if this is a good time to start putting some money back into the markets. For many investors this may be the first real taste of a bear market, so these queries need addressing.

To get some idea of what to do next - and I've already voiced my opinion of the benefits of 'doing nothing till we hear from Mr Market' - one should be aware at which phase of the bear market we might be in.

There are three distinct phases in a bear market.  The first phase can be called a 'distribution' phase if you are an enlightened investor, or a 'denial' phase if you are a newbie. Smart investors start exiting the market, 'distributing' their stocks mostly to the late entrants who got caught up in the hype of the bull run.

The consequent fall in the index is looked upon as a bull market correction by the less informed investors, who follow their prior 'buy on dips' successes to buy some more. This in turn causes the first of the bear market rallies which is not supported by the smart investors. The rally peters out making a lower top.

When the second down phase starts, concerned investors begin to realise that this may be a bear market after all and start selling off. Buyers are few and far between. Volumes become lower and the market makes new lows every day.  A few disbelievers still hang in there and think that the market has bottomed.  There is usually a short upward rally which soon fizzles out and the market heads down again.

Now the fundamental news and company results start getting weaker and more negative. Every one becomes fully bearish and stocks are sold at any price leading to a complete 'capitulation' phase. Investors become risk averse and look for safe options like fixed deposits to protect their capital. The stage is now set for the recovery.

A fairly prolonged bottom formation happens now. Prices tend to drift sideways and then marginally down, but at a much slower speed than the earlier two phases. Finally the bear market ends when all the possible negative news gets discounted and smart investors begin to enter for the first or 'accumulation' phase of the new bull market.

So where are we now? We have definitely gone through the first two phases and are probably at the last stages of the final 'capitulation' phase. While no one can say where the final bottom will be, it looks like we are getting pretty close to it.

Is it a time to start buying? As a fairly conservative investor, my take is to wait till the first confirmation of an up move is received. That may mean waiting for 6-8 months more and buying at prices 10-20% higher than what they are now. If you are less conservative and wish to buy now, stick to large cap stocks and be prepared for a longish period of little or no returns.

Sunday, October 12, 2008

When the going gets tough, do nothing

Edward Kennedy 'Duke' Ellington was a well-known jazz pianist who later became a famous composer and band leader. Considered by many to be one of the foremost influences in jazz, his complex compositions and arrangements brought jazz to the mainstream of American music.

Many of his compositions have become jazz 'standards' - recorded and performed by a whole host of singers and musicians through the years. Some, like 'Caravan', became so popular that even pop instrumentalists performed and recorded the song.

One of Duke's compositions - 'Do nothing till you hear from me' - has relevance to the current state of the Indian stock market, if you replace 'me' with 'Mr Market'!

With the market hitting new lows every day, many small investors are utterly perplexed about what to do. Some feel this is a great time to buy. Others have seen their portfolios erode away and are thinking about selling and getting out. The more adventurous ones are writing puts and calls and probably making their brokers rich! Risk averse investors are looking at FDs and FMPs. But the really smart ones are riding out the market turmoil by doing nothing.

An avid mountain climber once commented about his frequent attempts at climbing the Everest: 'I try to climb the Everest because it is there!' Well, the stock market is very much there - and will be there for quite some time longer! Does that mean that you should always be buying and selling?

However, 'do nothing' does not mean 'remain completely inactive'. This is a great time to do fundamental analysis of companies - particularly the large cap ones. Find out which ones are offering greater value in terms of dividend yields, price to book value ratios, operating cash flows, profit margins.

Make a short list of such companies and track them on a daily basis. Then wait to hear from Mr Market. He will start giving you diverse and interesting clues - such as, lower interest rates, an increase in the advance-to-decline ratio, an aversion to discussion about the stock market among your market-savvy friends.

The cumulative effect of such clues will indicate that the worst may be over. Till you hear from me (I mean, Mr Market), take your spouse out for a candlelit dinner, take that dream holiday to Mauritius or Machu Picchu but do nothing about buying or selling in the stock market.

If you absolutely must buy or sell, at least wait for the Q2 results. Looks like this one is going to be a long bear market.

Sunday, October 5, 2008

Start your own risk free FMP

We have now spent 9 months in a bear market. For investors who had entered the markets in the last 5 years, this is the first experience of how a bear market can destroy wealth.

What we saw in 2004 and 2006 were just bear phases in a bull market, which provided opportunities to buy.  Many small investors jumped in to buy in March and July this year - only to see that there was no real recovery in the markets.

Experts have now started talking about a 4-digit Sensex, and investors who have been in denial for the past 9 months are now thinking and talking about how to protect capital and reduce losses.

The mutual fund industry has been promoting Fixed Maturity Plans (FMPs) of 12 months+ duration and trying to explain the benefits of lower tax against a bank fixed deposit. Of late, they have even started offering 1 month FMPs - and are not mentioning anything about tax benefits!

A small investor trying to protect his capital should start his own FMP and make it completely risk free. How? It is so simple, that it is almost a no-brainer.

Let us say you have some investable cash of Rs 2 lakhs. What are your options?

a) You can buy shares at low prices and watch them go lower;

b) You can buy MF units and watch their NAV drop

c) You can park it in a bank FD for 2 years and earn 10% interest

d) Start your own FMP - start with Option (c) above, but take monthly or quarterly simple interest. Depending on your risk tolerance, set up a recurring deposit (RD) account with 20% or 50% of your monthly/quarterly interest. The balance interest should stay parked in your savings account for periodic purchases of shares and/or MF units. 

After 2 years, when your FD matures your entire capital will be intact, the RD account would be intact as well, and the shares or MF units that you purchase should start showing some real gains, as this bear market should be history by then.

Simple, isn't it? But exciting? No. But who said building wealth is exciting? It is a slow and steady and disciplined process to be carried through for many years.

(I try to preach what I practice. In Oct '07, I had sold a percentage of my holdings in shares and MF units when the market looked overbought. With the proceeds, I opened a 3 years FD with a leading private bank. 20% of the quarterly interest earned is reinvested in a RD. The balance interest is accumulating in a savings account. I have slowly started to reinvest in shares and MF units.)

Sunday, September 28, 2008

What are your future options?

A British schoolboy cricketer had once approached Sir Geoff Boycott to learn how to play the hook shot, because he was frequently getting out trying to hit a hook. Boycott told him that the best way to play the hook shot was not to play it! "But how do I score runs?", the boy had asked. Boycott's response was typical: "Don't get out! The runs will come."

Futures and options trading by small investors is akin to a school boy playing the hook shot. The chances of losing money overshadows the probability of scoring big. It is far better to buy quality stocks and wait for your wealth to grow.

Nowadays the lot sizes for F&O trading have been reduced, but the risks have not. Such trading is better left to professional and institutional investors who play for much bigger stakes and usually buy or sell in the cash market and hedge in the futures.

There is no harm in being aware of what F&O trading is all about, and some smart investors can get clues about the market from the difference in spot and future prices and volumes. But I get  confused when I hear talk about 'covered calls',  'strangles' and 'naked futures' and have stayed far away from F&O trading.

Seems like I'm not in a minority of one. The legendary Peter Lynch has made the following comments in his book 'One Up on Wall Street':

"I've never bought a future nor an option in my entire investing career.... Reports out of Chicago and New York, the twin capitals of futures and options, suggest that between 80 and 95% of the amateur players lose. Those odds are worse than the worst odds at the casino or at the race track, and yet the fiction persists that these are 'sensible investment alternatives'.... I know that the large potential return is attractive to small investors who are dissatisfied with getting rich slow. Instead they opt for getting poor quick .... Warren Buffet thinks that stock futures and options ought to be outlawed, and I agree with him."

Sunday, September 21, 2008

Is this the time for Tisco?

During the glory days of the Bombay stock market - when there was no NSE, no Internet, no Reliance, no Bharti - the traders used to flock to Dalal Street to make their fortunes by trading Tisco (i.e. Tata Steel) shares.

It was the bellwether of the stock market till new age stocks like Reliance and Bharti pushed it to the background as a 'widows' stock. So it stayed in the background, while continuing to churn out excellent results by curtailing costs and judiciously expanding capacities.

Then Ratan Tata and his team decided enough was enough and it was time to look ahead and become a global player through acquisitions. Tisco made preliminary forays in South East Asia, buying plants in Thailand, China, Singapore, Vietnam. And then came the crowning glory - the Corus acquisition, that catapulted Tisco to the worldwide 6th position in the steel industry.

Historically, acquisitions have known to be value destructive for shareholders, and the jury is still out about the success of integrating Corus with Tisco. Already margins have been affected though turnover has risen manifold. Tisco management is working on that by trying to secure raw material sources globally, mainly for Corus that needs to buy its raw materials (and unlike Tisco which is an integrated plant).

However, the stock that had touched Rs 970 just a few months back, with no dearth of buyers, is now down to Rs 470 odd. That gives Tisco a Trailing Twelve Months (TTM) P/E of 6.7 and a P/BV of 1.6 as per June '08 results.

Technically also, the indicators are heavily oversold and ripe for an upward spurt. That does not mean Tisco can't go down to Rs 400 level. But for those who are trying to build a portfolio, this is a very appropriate time to enter.

An interesting bit of trivia for those who are still not convinced. The June '08 quarter's net profit of Rs 1686 Crores is just about Rs 130 Crores less than the net profit of ALL the listed cement companies (yes, that includes ACC, Ultra Tech, Ambuja, Prism, Birla Corp, JK, Sree, Madras, India, Chettinad, and the rest from north and south India).

So, the short answer to the question is 'yes'. This is a great time for Tisco (I mean Tata Steel - as a long time shareholder I just feel more comfortable with Tisco!).

Tuesday, September 16, 2008

A Sensex extra

Some interesting patterns happened in the Sensex on Monday, Sept 15, 2008 that prompted this extra edition to my weekly posts.

First, the EMAs. The 20 EMA had kept close contact with the 50 EMA while both averages were below the 200 EMA. Monday's price action has sent both the 20 EMA and 50 EMA downwards signalling the next (and last?) down wave of a 5 wave bear pattern.

Now the interesting part in the price action. The first up-wave of the three-wave bear market rally from the July '08 low of 12500 was resisted at 15100 or so. The second wave came down to 13700 and the third wave went up to about 15600. 

This was a lower top. The first down wave got supported at 14000. The next up-wave tried to cross the 15100 resistance twice and failed - thereby forming not only a double-top but a 'head-and-shoulders' pattern where the left and right shoulders are both near 15100, the head is at 15600 and the neckline is at a slight angle to the horizontal drawn through the 13700 and 14000 support points.

Last Friday, Sept 12 '08 the Sensex was tantalisingly perched near  the neckline at 14000. Monday's price action has decisively broken through the neckline, confirming the head-and-shoulders pattern.

So what happens next? This is where the true beauty of the art of technical analysis lies! The price implication of a head-and-shoulders pattern is that once the neckline is broken the Sensex will retrace at least the amount by which the 'head' is above the neckline.

The difference between the head and the neckline is around:

15600 -14000 = 1600 points.

The Sensex will, therefore, drop atleast 1600 points from the neckline; i.e. to:

14000 - 1600 = 12400.

This is close enough to where the last bottom of 12500 was made in July '08. So we are looking at a bottom testing situation as a first target. If 12500 does not hold, then we might see 10000 level.

A detailed reasoning for these levels were given in an earlier post. There is a possibility that the Sensex may not drop all the way down to 12500 or 10000 right away. Instead it may try to recover around 13100 levels and then meander along sideways for a while before testing or breaking the previous bottom.

The earlier advice of buying in small lots (either in 'A' group stocks or in diversified Equity funds) below the 13000 level is reiterated. In my next post, I plan to discuss if it is the time to Tisco!

Monday, September 15, 2008

How to exercise your rights

Several large rights issues from companies like Tata Motors, Hindalco, Tata Investment will be hitting the market in the near future. Recent entrants to the stock market, like my young friend Bala, may not have a clear idea about what to do with a rights issue.

Once you receive the rights issue application form and the offer booklet from the company, go through the details of the offer. Special attention should be given to the details about how much to pay, when to pay, where to pay and what to write on the cheque. Any mistakes can cause your application to be rejected.

Several options are available to the investor. These are listed below:

1.  Apply for your entire entitlement; e.g. if your entitlement is 42 shares, this figure will be clearly mentioned in the application form; just fill out the form and pay the application money for the 42 shares

2. You may apply for additional shares in the box provided in the form; e.g. apply for 8 additional shares and pay your application money for (42+8=) 50 shares; chances are you will get allotment for the 50 shares because the market is in a bear phase and many investors may not apply for additional shares. Don't get greedy and apply for 52 additional shares. You may then get an allotment of say 17 shares and be left with an odd number of 59 shares (which may be difficult to sell later in one lot)

3. You can apply for less shares than your entitlement; e.g. apply only for 25 shares and let the balance entitlement of 17 shares lapse

4. You may 'renounce' your entire entitlement in some one else's favour, like your broker or your friend. You will usually get a monetary consideration for your renouncement, say Rs 8 per share.

5. You can request the company for split forms, i.e. 25 shares in one and 17 shares in another. That way you can apply for 25 shares and 'renounce' the balance 17 for a consideration of say Rs 8 per share

6. You can decide not to do anything at all and let your entire entitlement lapse.

Why would you choose this last option? In a falling market the difference between the market price and the rights price may not be large enough. After the rights issue is over, the market price may even drop below the rights issue price. So you may be better off to buy the shares at market price after the rights issue is over if you feel the rights price is not leaving a large enough margin of safety.

Investors who participated in the recent rights issues of ICICI Bank and State Bank will know what I'm talking about.

There is a recent move by SEBI to make rights issues paperless, but as on date it remains a proposal only. If readers have any questions on rights issues, please send me an email with your specific query ( or leave a comment on the blog).

Monday, September 8, 2008

Are the media companies 'defensive'?

With the stock markets in a long-term bear phase, experts and analysts have been suggesting that investors look at 'defensive' sectors like FMCG, pharma and IT. The logic behind such suggestions is that whether the market is in a bull or bear phase soaps, toothpastes, medicines and IT services will get consumed.

By the same logic, people will listen to radio, read newspapers and magazines, watch TV and movies regardless of the gyrations of the Sensex.  So media companies should fall under the 'defensive sector' category.

Why aren't the analysts talking about them? Possibly because the different sub-groups of the media sector have different dynamics. Let us have a closer look.

Movies, books and CD/DVD businesses require upfront investments for every new 'product'. Actors, authors and musicians need to be paid beforehand. There are no guarantees that a particular movie or book or CD will sell.  If it sells well, there will be a lot of cash inflow. If not there will be a loss. One hit product may or may not make up for all the losses. Such uncertainty is what investors are wary about.

Radio and TV businesses are largely dependent on advertising. If a particular channel has national recognition - e.g. Radio Mirchi or Star Plus - it can charge a premium rate and advertisers will have no choice but to pay up. But during a downturn, advertising budgets do get cut. The fringe channels get hurt the most and are sometimes wiped out.

The magazine and newspaper businesses are the real 'defensive' ones. Magazines are subscription based and the money is collected in advance and the product is delivered over several months/years. No wonder magazine subscriptions always come with lots of 'free' offers.

The newspaper business is truly recession-proof. No matter what happens in the stock market or in the economy, no body stops reading a newspaper. With the advent of computers and the Internet, a newspaper can be published simultaneously from several locations. However, newspapers tend to have a monopoly in their particular region/location. Think of Times of India in Mumbai, Hindustan Times in Delhi, The Hindu in Chennai, The Telegraph in Kolkata, Deccan Chronicle in Hyderabad.

My favourite among the newspaper companies is Jagran Prakashan. Why? It's circulation is more than the combined circulation of all the well-known English dailies mentioned. Plus it has great cash flows.

Sunday, August 31, 2008

Sensex in a narrow band

For the past two weeks, the Sensex has moved sideways in a band between 14000 and 14700.  Friday's 500 point rally was 'resisted' by the 50 EMA. So what is interesting about this situation? It is another textbook example in technical analysis.

Those who understand and interpret Elliott Waves (and I'm no expert) may recognise that the fall from the top of 21000 in Jan '08 happened in 5 waves - three down and two up.  The Sensex then retraced to the 17500 level in 3 waves - two up and one down.

Again the Sensex dropped from 17500 to 12500 in 5 waves - three down and two up. This was followed by a 3 wave move up to 15500.  So from the Jan '08 top we had two down movements of 5 waves each and two up moves of 3 waves each.

Now we are into the 5th (and final?) down move from 15500. The drop from 15500 to 14000 is almost an exact 50% Fibonacci retracement of the last up move (i.e. 50% of 15500 - 12500).

The two weeks sideways movement indicates a pause or a consolidation before the next move. Such a sideways movement can be an 'accumulation' (stronger and smarter investors buying; weaker investors selling) or a 'distribution' (smarter investors selling and weaker investors buying) phase.

We won't know the outcome of this sideways phase till the Sensex breaks up above 14700 or down below 14000. But we can make some educated guesses based on the fundamental and technical scenario.

The macro scene isn't great. Inflation has dipped marginally but is still at 13 year highs. Oil prices have moderated, but this has been largely offset by the fall in the Rupee value. Interest rates continue to remain high. Falling industrial production figures don't provide much hope. On top of all this, a large number of rights issues and IPOs are waiting in the sidelines to hit the market. That will suck out a lot of liquidity - which is poor anyway.

To top it all, the technical indicators like the moving averages, MACD, stochastics are mostly bearish. So my educated guess is that the Sensex will break downwards from the sideways phase of the past two weeks and then test the previous low at 12500. It may even break 12500 and touch 10000 levels to complete the 5 wave down move from the Jan '08 top.

But the markets are known to do the exact opposite of what the 'experts' may interpret. Please keep an eye on the Sensex levels over the next week or two as the consolidation phase should come to an end within that period.

In the next few posts, I plan to short-list some stocks that can be put on a watch-list for buying. That means I will give adequate reasons why I like them - but you must do your own research if you do decide to buy.

Tuesday, August 26, 2008

Your portfolio of stocks and mutual funds - why you shouldn't diversify

Investment analysts and the pink papers cry themselves hoarse about why investors must diversify their portfolios to mitigate risk and enhance returns.

This is another one of those investment myths that need debunking. Peter Lynch coined the term di'worse'ify about companies who enter unrelated areas of activities. The term applies equally well  for investors.

50 stocks or 20 funds in the portfolio is a classic case of di'worse'ification. Individual investors should try not to have more than 10 stocks or 5 funds in their portfolio. Otherwise it takes too much time and energy to keep track of the performance of individual shares and funds.

The richest individuals in the world tend to have extremely concentrated portfolios. Think about Microsoft's Bill Gates, Oracle's Larry Ellison, Walmart's Sam Walton, Infosys' Narayanmurthy.

While the average investor like you or me can't be compared with the legends mentioned, we can reduce risk and enhance wealth by placing a few concentrated bets on outstanding stocks. The key word here is 'outstanding'.

If you prefer particular sectors, avoid sugar or cement or real estate that give you windfall profits one day and huge losses on another. Concentrate on defensive sectors like FMCG and Pharma. You'll get steady and regular returns through price appreciation and dividends. And the downside will be limited.

So here is a formula for investment success. Buy a few outstanding stocks from the FMCG and Pharma packs - like Colgate, Hind Lever, ITC, Nestle, Glaxo, Lupin, Sun Pharma. These will provide steady returns and limit your losses during bear markets.

Balance such a sector tilt with stalwarts like Reliance, L&T, Bharti, Tata Steel, M&M. For a little extra, albeit risky, return add the odd Maharashtra Seamless and Opto Circuit.

Mutual Fund investors can buy a couple of diversified equity funds (like HSBC Equity, DSPML Top 100, Sundaram Select Focus), a couple of Balanced Funds (like HDFC Prudence, DSPML Balance) and an ELSS fund (like Magnum Tax Gain or Sundaram Tax Saver).

If you feel that such a portfolio is boring or uninteresting, then that is a very good indicator that you will make very good returns! For excitement and adrenaline flow, you can always visit Las Vegas or the Mahalaxmi race course!

Sunday, August 17, 2008

Making sense of the Sensex

It is time to take another look at the Sensex technicals, as some interesting price movements happened last week. The sharp bear market rally seems to have come to a halt.

After a steep month-long rise from the low of 12500 made on July 16, the Sensex reacted from a level of 15600. This 3100 points up-move was almost an exact 61.8% Fibonacci retracement of the 5000 point fall from the previous top of 17500 (17500 - 12500 = 5000; 5000 x 0.618 = 3090; 12500 + 3090 = 15590; Q.E.D.).

Equally interesting is the behaviour of the 20 EMA and 50 EMA on the Sensex chart. The 20 EMA has moved up from below to touch the 50 EMA which has flattened out. The Sensex low for the week has touched the confluence point of the 20 EMA and 50 EMA.

Why is it interesting? This looks like an intermediate trend deciding situation. If the Sensex bounces up from the confluence point, then the 20 EMA will also penetrate the flattening 50 EMA. That will provide a short-term buy signal, which will be confirmed when both the 20 EMA and then the 50 EMA crosses the 200 EMA from below. 

What if the Sensex continues its downtrend? The 20 EMA will start moving down after touching the 50 EMA and both the 50 EMA and 200 EMA will continue downwards. All signals will be bearish again.

There are some more indicators in the chart which I will discuss on later posts. Both the Stochastics and MACD indicators are suggesting a downward movement. Last week's much higher inflation rate and depreciating Rupee may further aggravate the downtrend.

But Mr Market plays by its own rules. So watch the Sensex movements closely during the forthcoming weeks. If the Sensex moves below 13000, I am going to buy some more. Probably frontline Sensex stocks.

Saturday, August 9, 2008

If you must SIP, sip good Darjeeling tea

Edward Luce, the Financial Times correspondent who was stationed in Delhi and is now at Washington DC, has written an eminently readable book on the challenges faced by the growth story of modern India. Called "In Spite of the Gods", the book postulates that the reason for the success of a vibrant democracy is India's diversity.

This diversity can be exemplified by how tea is prepared in different parts of India. In the west, tea leaves, water, sugar and milk are brought to a boil in a pan. In the north, spices like cardamom or ginger or both are mixed with the tea to make 'masala chai'. In the south, coffee is the preferred drink, though a large quantity of tea is grown in the Nilgiris.

In the east, there is Assam tea - a strong rich brew prepared with milk and sugar. And then there is the queen of teas - Darjeeling - whose beautiful bouquet and light taste emerges only if it is brewed in a pre-warmed porcelain tea pot and sipped without adding milk.

That brings us to another SIP, or a Systematic Investment Plan (another of those investment myths!). A disciplined and conscientious investor should have no problems with saving a fixed amount of money every month or every quarter. But is it necessary to invest that sum every month or every quarter on a particular date?

The fund managers of most Mutual Funds will say a resounding "Yes".  They even provide examples on offer documents or on business channels to prove their point that investing a fixed amount on a particular day every month or every quarter is the way to untold riches.

Like a dummy, I listened to their collective advice and started a 12 months SIP in a well known diversified equity fund in the middle of 2004. By the time my 12 monthly installments were complete, I found to my horror that my average price per unit had continuously climbed up - along with the stock market. For my last monthly installment, units cost as much as 40% more than the units bought with the first monthly installment!

One lives and learns. The only people who get rich from your SIP is the fund manager. SIPs provide a steady monthly (or quarterly) revenue to the fund without the fund manager spending any time or effort in selling the fund.

In a trending market - whether it is moving up or down - a SIP will always make your average cost per unit much higher than the cost you will incur at the beginning of an up trend or the end of a down trend.

Is a SIP completely worthless? No, it works if a market is moving sideways - some times up and some times down within a range - without a clearly discernible up trend or down trend. How often do such sideways movements happen?

Not very often, and even when they do, they last for a short period of 3 weeks to 3 months - not long enough to benefit from the price averaging that a SIP will provide.

So heed a word of advice. Buy some good Darjeeling tea and learn how to prepare a proper brew. Savour the taste and flavour by taking small sips. And avoid SIPs.

(Note: No, I haven't joined a tea company. But I have alluded to another investment myth: Timing the market vs. Time in the market. That myth will get debunked in a future post.)

Saturday, August 2, 2008

Don't be a bull or a bear in the stock market, be an African python

The triangular headed South African python is a truly awe-inspiring reptile - massive in length and weight, immensely strong with an intricately patterned shining skin. The other day, on the National Geographic channel, the camera followed such a beauty as it slowly slithered through the bushes and weeds and glided into a watering hole.

There it hid with only its snout above the water - and waited patiently. Day followed night and night followed day - and still it waited. Animals big and small, arrogant and shy, came to the watering hole for a drink. The python didn't move.

Six days and nights passed - and no body except the camera-person knew that the python was lying in wait. On the 7th evening a herd of deer came for a drink. A younger and frisky member ventured a little further from the water's edge - unaware of the peril.

Suddenly, the water hole exploded into action. With its immense muscle power, the python lunged out like greased lightning and in the blink of an eye had wrapped itself around its prey. The poor animal probably didn't even know what hit him.

The South African python is used to spending weeks and even months without feeding. Some times it eats the odd rodent or bird. But when it really wants to eat, it plans its every move and with infinite patience grabs a large meal so that it won't have to eat for a long time.

Like the python, a successful long term investor does not need to 'feed' (i.e. trade) every day or every month. Once in a long while, the stock market provides an ideal opportunity to grab a few frontline stocks at mouth-watering prices. Back during the 2002-2003 bear market period, stocks like Tata Steel was available at 100, M&M at 90, ITC at 60 (actually 600 for a Rs 10 share). All three subsequently offered bonus shares at 1:2, 1:1 and 1:2 ratios respectively.

There were many other shares going for a song and which made a ton of money for savvy long term investors. Since then, we had a one-way bull-market with V-shaped corrections in 2004 and 2006. But after 5 long years we are now in a full-fledged bear market which seems to have completed its first leg at 12500.

For long term investors, this is the right time to behave like the python. Don't jump yet. Conserve your muscle power (i.e. cash), decide on a few target companies and wait patiently for the market to exhaust its second leg. This will possibly happen in the 15500-16500 range. (A few 'dud' shares in your portfolio can be sold in that range.)

The Q1 results declared so far show that top line growth has been satisfactory for most companies. But margins growth has been far lower and below expectations. With inflation rate still in double digits, interest rates are unlikely to come down any time soon. The lower oil prices and political stability are the silver linings.

The Q2 results are likely to be worse than Q1. The market will probably have a third leg down to test the 12500 bottom, and panic and doom will be all around. Time frame should be around October. That will be the right time to lunge.

Saturday, July 26, 2008

Now, learn stock portfolio selection from a tall ex-cricketer

During his playing days, former England & Sussex skipper Tony Greig literally towered over his opposition. His medium pace and offspin bowling and aggressive batting earned him the 'best England all-rounder' title till Ian Botham took over his mantle.

But he is best known for his controversial comments - used to intimidate and provoke the opposition. Many may remember his "I'll make them grovel" statement about the West Indies team that really stirred up a hornet's nest.

The comment I remember best is about which players to choose if he was the captain of a World XI. In typical Greig-like fashion he said that he would prefer to have a Geoff Boycott in his team over a Gary Sobers.

Now anyone who knows anything about cricket knows that Gary Sobers is the greatest all-rounder in the history of the game. Boycott is best known for his long, strokeless stints at the crease that frustrated opposition bowlers.

Greig's logic was simple - Sobers could, and often did, win a match single-handed with his flashy stroke play. But he was equally likely to score a zero. Boycott however could be relied upon to grind out scores of 30s and 40s in game after game.

That brings us to the biggest lesson in stock selection. Stock market success is all about staying power over the long haul. So you need stocks in your portfolio that have performed well - but may not be spectacularly - year after year after year, through bull and bear markets. Not only in terms of capital appreciation (often through attractive rights and bonus offers) but also regular income through steady or increasing dividends.

The Boycotts of the stock market are Hind Lever, ITC, Colgate, Reliance, Tata Steel, Tata Motors, Mahindra and Mahindra, Sesa Goa (you get the gist - this list is not meant to be exhaustive). The Rico Autos, Prajay Engineers, IVRCLs, Gujarat NRE Cokes shine for a year or two and then fade away.

Does it mean that your portfolio should only contain 'boring' stalwarts? Not really. But the high-fliers of the day should form only a small part. The formula that works for me is 8 to 10 stalwarts that form 90% of my 'core' stock portfolio. (And the best time to build such a 'core' portfolio is when the stock market is in a bear grip - like now!)

The balance 10% of my portfolio is made up of 6 to 8 mid-caps and small-caps with a potential to hit the big time. I'm mentally prepared to lose all the money allocated to this 10% 'speculative' part of my portfolio. You have to choose the percentage allocation that suits your risk profile. But a word of advice - don't let the 'speculative' part exceed 25% of your portfolio. If it does - and that is likely to happen near a market top - reallocate by booking partial profits.

If you prefer to invest in mutual funds - and most investors should, unless they have the time and interest to pursue the solid amount of research required to maintain a good stock portfolio - then the Boycott's are HDFC Equity, DSPML Equity, HSBC Equity, Magnum Contra, HDFC Prudence, Magnum Tax Gain (once again this list is not meant to be exhaustive). The 'speculative' portfolio can contain the ICICI Pru Infrastructures, Reliance Visions, DSPML T.I.G.E.R.s.

Saturday, July 19, 2008

How you can stay ahead by being interested in interest

After a couple of posts with strong technical overtones, it is time to clear the air that I am also interested in fundamentals.

Interest rates are a 'leading' indicator. That bit of profundity means that interest rates usually change direction before the stock market does. Some times this can happen several months ahead of time and some times it happens shortly before.

Back in 2002-03 (if you can remember that far back!) when the stock market was in the doldrums, the returns from debt mutual funds were so good - upwards of 15% - that a certain foreign bank's mutual fund division didn't even bother to have an equity fund in their portfolio!

Then the interest rates started falling and by the time they woke up to the fact that equities had started picking up, they were way behind in performance. They finally came out with some equity funds - one of which performed pretty well - but the bank's mutual funds division had to be sold off.

The situation had drastically changed by 2007 when interest rates started moving up again. Conservative Indian investors started moving money back into bank fixed deposits and inflation hadn't reared its ugly head. However, that was the first warning sign that the stock markets were going to be in trouble.

Why? Because most 'punters' (the gamblers who play with derivatives) bet with borrowed money - many a times loaned by their brokers. As interest rates move up, their cost of doing business goes up and makes the margin of profit minimal.

The higher interest rates also have a cascading effect on the economy - particularly in interest-rate sensitive sectors like banks, automobiles, real estate. The cost of doing business goes up for all of them. Less people take out loans at higher interest rates, so they hold back on their vehicle and apartment purchases.

To top it all, the huge run up in oil prices pushed inflation up - causing the Reserve Bank to raise interest rates even further to curb inflation! Then the FIIs started to depart. Talk about a 'perfect storm'!

So when will the nightmare end? A necessary - but not necessarily sufficient - condition is when interest rates start moving down again. That will be the first sign that the market may start to turn back up. It doesn't look like that is going to happen in a hurry - so be prepared for a long drawn out bear market - but keep your eyes and ears glued to the RBI pronouncements.

Just a positive note amongst all the gloom and doom. I tried to practice what I preach by going out and making small purchases in a leading Balanced fund and one of the top diversified equity funds on Thursday morning (the day after the market had made a 15 month low).

Does that mean that I think the market has touched bottom? Not really. No one knows that. But any time that the Sensex closes below 13000 provides opportunities to make small purchases.

Sunday, July 13, 2008

Why you need to follow the latest trends to become a better investor

There is an old market cliché: The trend is your friend. So how does one identify stock market trends?

The simple concept of a moving average gives a clear visual image of what the stock market has been doing and what it is likely to do next. A moving average is an average of the index level (or share price) over a specific number of days, updated daily by replacing the oldest day’s level with the most recent day’s level.

So for a 20 day (short term) moving average, the 21st day’s level replaces the 1st day’s level in the average; the 22nd day’s level replaces the 2nd day’s level, and so on. Likewise for a 50 day (medium term) or a 200 day (long term) moving average. An exponential moving average (EMA) provides more weightage to the recent prices/levels.

Why not a 13 day moving average or a 100 day moving average? No reason. You are free to choose which averages you wish to follow. Through trial and error, I found that the 20 EMA / 50 EMA / 200 EMA combination works best for me. Of the three, the 200 EMA is the most important average because it confirms transition from a bull to a bear market (and vice versa).

Now, do a little exercise to understand the power of moving averages. Open a new tab (assuming that you are familiar with tabbed browsing) or a new window on your browser.

Go to the Yahoo! Finance site ( which allows you to draw charts for the Sensex, Nifty and most shares listed on the two exchanges. Click on ‘BSE Sensex’ below the thumbnail chart. On the next page, under ‘Charts’ on the left panel, click on ‘Technical Analysis’. Now you’ll get to see the full 1 year chart of the Sensex. Click respectively on 200, 50 and 20 next to ‘EMA’. The three averages will get superimposed on the Sensex chart.

During Aug ’07 to Jan ’08 the last leg of the 5 year bull run played out. All three averages – 20 EMA / 50 EMA / 200 EMA moved up in tandem with the short term average on top and the long term average at the bottom. The last bull market correction happened in Aug ’07. The 20 EMA took support on the 50 EMA while the Sensex took support on the 200 EMA.

The wide gap of more than 2000 points between the 50 EMA and 200 EMA in Nov & Dec ’07 when the Sensex crossed 20000 was the first warning sign of a forthcoming correction. The 20 EMA dipped below the 50 EMA in Jan ’08 warning of trouble ahead. Both the Sensex and the 20 EMA went below the 200 EMA in Mar ’08 confirming that the market was changing trend from bull to bear.

After the bear market rally in Apr - May ’08 from 15000 to 18000 levels, the Sensex briefly nosed above the 200 EMA. All three averages bunched together - which is a sign of change. What followed thereafter was a confirmed bear market with all three averages moving down in unison – this time with the short term average at the bottom and the long term average on top.

Monday, July 7, 2008

What you can learn about contrarian investing from a great tennis player

While watching the epic Wimbledon final between Nadal and Federer on TV late Sunday night, I was disenchanted by the number of viewer polls popping up about “The King of Wimbledon” and “The Greatest tennis player”. None of these polls mentioned the name of arguably the best player ever – Rod Laver.

Sampras, McEnroe, Federer haven’t won at Roland Garros. Borg never won the US Open. Lendl and Rosewall never won Wimbledon. A handful of players have won all four majors in their career. Only two have won grand slams – all four majors in the same year – Budge and Laver. Only Laver has won the Grand Slam twice – once in 1962 in the amateur era and once in 1969 in the Open era. The defence rests.

So what does Laver have to do with investments? In his book, “The Education of a tennis player” Laver writes about his attitude at Wimbledon – a tournament frequently interrupted by rain and blustery winds. He used to put on his whitest and starched pair of shorts and shirt, was well-groomed and used to jump up and down with enthusiasm – as if the cold and rain was just the kind of weather he enjoyed. Far from it. It was specifically meant to demoralize the opponent, who was already feeling miserable in the inclement weather!

Contrarian investing is not about selling at the market top and buying at the bottom, nor is it about buying realty stocks when every one is dumping them. It is about developing a mindset that prevents you from getting swayed by what is happening in the market on a daily basis. It is about making an asset allocation plan and sticking to it. It is about ignoring all the buy calls given by so-called experts.

Most important of all, contrarian investing is about making an investment plan based on your knowledge and risk tolerance, and having the self-discipline to stay with the plan through the ups and downs of the market. But all this is common sense, isn’t it? You will be amazed how uncommon it is amongst the bulk of the investors!

In future posts, I will discuss about stock selection and making an asset allocation plan.

Monday, June 30, 2008

How low can the Sensex go?

That must be the question on the lips of every investor.

Inflation is going up, so are interest rates for borrowings. Pretty soon banks will be forced to raise interests for fixed deposits. Oil prices are at an all time high. The political situation is in turmoil with the Congress and the Left fighting harder than the bulls and bears!

So the fundamentals – at least in the near term – are looking bleak. That tells you the Sensex will go down further – but can’t tell you how far. Score one more point for the technical analysts over the fundamentalists.

Enter Fibonacci retracement levels. For some strange reason better known to smarter investors than me, the Sensex tends to reverse direction at levels of 38.2%, 50% and 61.8% of its previous move (up or down). Of these, the 61.8% appears to be the most significant.

If we take the entire 5 years bull run from 2900 in 2003 to 21200 in 2008, we had a total up move of (21200 – 2900 =) 18300 points. The respective Fibonacci retracements are:

(a) 38.2% of 18300 = 7000 points

(b) 50% of 18300 = 9150 points

(c) 61.8% of 18300 = 11300 points

So the retracement levels are:

(a) 21200 – 7000 = 14200

(b) 21200 – 9150 = 12050

(c) 21200 – 11300 = 9900

The 14000 level has been violated already. So the next stop is at 12000. If there is no retracement at 12000, then the Sensex can drop to 10000. (Now you know why these numbers are being talked about in the media!)

If the 10000 mark is violated also, then the Sensex may retrace the entire up move. This is a possibility but highly unlikely considering the current growth path of the Indian economy.

Let us, therefore, concentrate on the 12000 and 10000 levels. We seem to be in the grip of an 8 years time cycle. In 1992 and 2000 we had bear markets where the Sensex retraced between 50-60% of the up moves. As we are in the middle of a bear market again in 2008, my guess is that history will tend to repeat itself. (In 2004 and 2006 we had bull market corrections – but the long term up trend line was not broken; it has been broken conclusively in 2008.)

Chances are that the Sensex bottom will be somewhere between the 11000 and 12000 levels, and there will be some consolidation at that level before the market begins to turn back up again.

If you are a pessimist, wait for clear market up trend signals before entering. You may have to wait till the end of the year to do so. If you are an optimist, start nibbling at fundamentally strong ‘A’ group stocks once the 13000 level is broken.

Monday, June 23, 2008

Why Michael Ballack is a good role model for the better investor

There are two kinds of people in this world - those who are crazy about soccer and those who aren't.

For the latter, who are missing some of the most exciting midnight entertainment of sudden-death penalty shootouts and stunning extra-time goals, Michael Ballack is an outstanding German midfielder with a rocket right foot (and the Austrian team will vouch for that!).

So what does Ballack have to do with investments? It's his left foot (not to be confused with Daniel Day Lewis' Oscar winning performance), with which he can kick the soccer ball just as hard and with immense power.

Which brings us to the unresolved debate about fundamentalists (pun intended) and technical analysts. Fundamentalists don't understand technicals; technical analysts believe that all fundamentals are reflected in the price!

Just as an international soccer star needs to use both his feet, the better investor needs to learn about the fundamental analysis of companies as well as study the technicals of price charts. Why?

Fundamental analysis looks at an industry, whether it is a sunrise or a sunset one, and then identifies companies within that industry, their growth rates, future plans, profitability, management quality, competitive advantages.

After doing all that hard work for a particular industry - let us say for infrastructure, you make a short list of three companies: DLF, L&T and BHEL. All supposedly great companies. If you had bought them in December 2007, you are losing 50% of your investment.

Technical analysis of individual price charts or the Sensex (or Nifty) in December 2007 would have indicated a severely overbought status indicating an imminent fall. Exactly the time when you should not buy.

More on this debate in future posts - so stay tuned!

Tuesday, June 17, 2008

Now, become a better investor by reading the ‘scriptures’

If you are a student of the Hindu religion, then the three most important references will probably be the Bhagavad Gita, the Vedas and the Upanishads. But if you are studying Comparative religion, then you may also refer to the Quran, the Bible and the Talmud.

To become a better investor, study the following ‘scriptures’:

  1. One Up on Wall Street by Peter Lynch
  2. The Intelligent Investor by Benjamin Graham
  3. Common Stocks and Uncommon Profits by Philip Fisher
  4. The Five Rules for Successful Stock Investing by Pat Dorsey

Lynch’s book is the easiest read but contains all the guidelines for ‘fundamental analysis’ of companies. Graham’s book is an all-time classic, though a tougher read. Fisher’s book was used for the longest time as a text at Stanford University’s Graduate School of Business.

Dorsey has written a very practical book that uses real-life examples to explain fundamental concepts, and emphasizes the importance of the cash-flow statement to study the financial health of companies.

I think it was Lynch who humorously denigrated ‘technical analysis’ as “a science of wiggles”. Some of the books I found useful in understanding technical concepts are:

  1. Technical Analysis Explained by Martin Pring
  2. Timing the Market by Arnold and Rahfeldt (of Weiss Research)
  3. It’s when you Sell that Counts by Donald Cassidy

The saint Sri Ramakrishna Paramhansa had demonstrated that there are many ways and different religious beliefs that can be followed to attain the common goal of Nirvana. In a future post, I will discuss why both fundamental and technical analysis should be followed to attain the common goal of becoming a better investor.