How to lose less with a Stop-Loss

"More money has probably been lost by investors holding a stock they really did not want until they could 'at least come out even' than from any other single reason", Philip A. Fisher.

You should re-read the quote above. If you have been investing in the stock market for any length of time, you have surely succumbed to the 'coming out even' fallacy at least once. If you are like me, you've probably done it more than once!

Truth is, Mr. Market does not know at what price you bought a stock or fund. Nor does he care. But you do, and that is the root of the problem.

I'm presuming that you performed due diligence in selecting a particular stock or a fund - carefully studying past performance, dividend records, peer comparisons. And yet, in spite of your best efforts, you pick a loser. It happens. All a part of the game.

This is when your investing mettle will be tested. Will you swallow your pride and get out? Will you soldier on, 'knowing' that you've picked a winner that will surely make you rich soon? Or will you become a 'long term investor' simply because your short term plans have got nixed?

A neat little device, called a 'Stop-Loss' level, may save you the blushes. How does it work? Before you buy a stock or a fund, you should decide how much loss you'll be able to tolerate. For an expensive stock, your loss tolerance may be less. For a cheaper fund it may be more.

As a conservative, long term investor, I like to set a stop-loss level of between 15% and 30% of the buy price.

Let us say I'm planning to buy a stock for Rs. 100, and set the stop-loss at 20%. If the stock falls to Rs. 80 or below, I'll not wait and sell immediately - thus stopping my loss at Rs. 20 per share.

What if the stock price rises to Rs. 120? Do I have a huge grin on my face and brag about my stock-picking skills to all and sundry? I'll be lying if I said, 'No'. But what I also do, is set a 'trailing stop-loss'.

What's that? It means increasing the original stop loss level by the same percentage as the rise in the stock's or fund's price. In our example, we will raise the stop-loss level to Rs. (120 - 24 =) 96.

If the stock moves up to Rs.200 (this happens usually in bull markets - but also some times in sharp bear market rallies), the stop-loss level will now be Rs.160.

Stop-loss levels not only help you to limit your losses, but a trailing stop-loss will protect your profits as well. Should the stock price suddenly fall to Rs. 150, your stop-loss level will be 'triggered' and you will sell off, pocketing the Rs. 50 per share (that you bought originally at Rs. 100).

The foregoing discussion has been written from the point-of-view of a conservative long-term investor. I have nothing against those who trade stocks on a daily basis, but I do not recommend trading to new investors.

But if trading is what gets you excited, you may want to read this article that provides more information and strategies for setting 'tighter' stop-losses for trading.

In the current bear market, the Sensex fell more than 60% from its January 2008 top of 21200. But many small investors are facing much bigger losses because of their penchant for buying smaller and cheaper stocks and funds.

The two lessons from such a traumatic experience are:

(1) most stocks or funds that seem a bargain are not; better stick to proven performers and market leaders;

(2) even if you've chosen the wrong stock or fund, applying a disciplined stop-loss mechanism will limit the losses.

A rectangular Sensex chart pattern

In a prior post on July 13, 2008 I had discussed about identifying stock market trends using moving averages. It is time to take a re-look at the current market trend.

After the prolonged bull market that started in May 2003 at about 2900 and took the Sensex all the way up to 21200 in Jan 2008, a  bear market reversal pulled the Sensex down to 7700 in Oct 2008.

We had a clear up trend for close to 5 years - interspersed with several bull market reactions, followed by a sharp down trend for 10 months - with a few bear market rallies.

After the Oct 2008 low of 7700, a swift rally took the Sensex to 10950. Thereafter, the Sensex seems to be meandering sideways with apparently no clearly visible up or down trend.

Let us take a look at the Sensex chart of the past 3 months.

The 200 day EMA is still moving down. The 50 day EMA and the Sensex are well below the 200 day EMA. So we are still firmly in a bear market.

But the Sensex is bouncing along sideways within a rectangular band between 7700 and 10950. Volume of transactions - given in the lower chart - are low. What does this indicate?

A rectangular chart pattern is a period of consolidation before the market makes up its mind where it wants to go. Such indecision amongst bulls and bears typically happens after a sharp move up or down.

A market consolidation - represented by a sideways rectangular chart pattern - can be of three types: accumulation, distribution or continuation.

At market tops the 'smart money', i.e. institutional and high net worth investors, sell. The 'weaker hands', i.e. retail investors and funds, buy. Shares are 'distributed' from stronger to weaker players.

At market bottoms, the opposite happens. The stronger hands 'accumulate' the shares from the weaker investors, who get tired of waiting for the market to move up.

In the middle of a clear up (or down) trend, a consolidation period is called a 'continuation', as the market pauses for breath before continuing the up ward (or down ward) journey.

Since we are not at a market top, this is not a distribution pattern. Is it then a period of accumulation at a market bottom or continuation for a further fall? There lies the conundrum.

The short answer is: we don't know. When and how will we know? Only when the market makes up its mind and decides to either move above 10950 or break below 7700.

Fundamentally, the macro economic situation is showing improvement. Inflation, as indicated by the WPI (Wholesale Price Index) is moving down. Oil prices have fallen drastically in the international market. Interest rates are also coming down.

We are now in the midst of the results season with companies declaring their Q3 or Q4 results for the period Sep to Dec 2008. Consensus amongst the experts is that most companies will declare awful results.

But the market is already expecting (i.e. 'discounting') that and unless there are more Satyam-like skeletons, it is unlikely that there will be a big fall below 7700.

On the day the Satyam scam broke, the volumes were very high and the market dropped 750 points but remained well within the rectangular pattern. The following two trading days also saw high volumes but much smaller falls. These are positives.

So, the scales look slightly tipped towards this pattern being an accumulation rather than a continuation. Why slightly? Because on some of the recent up days, the volume of transactions has been less than on down days. This goes against conventional wisdom of higher volume on up days and lower volume on down days.

If you are a patient investor, wait out this consolidation period. Such patterns can continue for a very long time - months, may be even years.

If you are itching for some action, start putting in small amounts of money in Nifty BeES or any good index fund. I would not rely on stock-picking skills at such a time.

Lessons from the Satyam scam

What started out as an aborted acquisition deal among family members has turned out to be the worst scam in the history of corporate India.

It is no wonder that Buffett said: 'You only find out who is swimming naked when the tide goes out.' Economic and stock market downturns have a habit of revealing the naked swimmers.

Yes, the plural is intended. Satyam is unlikely to be the only one. Many companies which have been declaring bumper profits quarter on quarter during the bull run have probably been 'cooking' their accounts as well.

I would be particularly sceptical about the infrastructure and realty companies - specially those with negative operational cash flows. As the bear phase meanders along, be prepared for more skeletons tumbling out of different cupboards.

Here are a few lessons that not only need to be learned, but internalised as well, so that we can benefit from similar occurences in future.

1. "There is never just one cockroach in the kitchen". This stock market adage has been proven once again by Satyam. Management trickery is never a one-off deal. Satyam had been involved in several questionable deals over the years. The latest scam is the culmination of past transgressions. Once corporate integrity is in doubt, avoid that particular stock.

(In this blog post I had mentioned that Jagran Prakashan was my favourite among the newspaper stocks. I removed it from my 'buy' list when I found out that they had recently appointed several sons/nephews of the promoter group to top positions on fat salaries.)

2. Just because a stock looks cheap (because it has fallen a lot from its recent high) doesn't mean it can't get any cheaper. Satyam has dropped from above 400 to 180 to 40 and now 20. Quite a few small investors got excited and bought the stock when it dropped to 100 and then 40. That's throwing good money after bad.

3. Markets usually 'discount' good news and bad news in advance but have little clue about what Nassim Nicholas Taleb calls 'black swan events'. These are unexpected events that seem to happen out of the blue. But more so during distressed times. 9/11 was one such event - soon after the dot.com bust.

A good way to take advantage of such situations is to strictly follow an asset allocation discipline (discussed in this blog post).

4. As a small investor, stick to industry leaders. If you are interested in FMCG, don't look beyond HUL, ITC. If you like metals, TISCO, Hindalco should suffice. In financials, choose HDFC, SBI. Alternatively, invest in index funds. There is no point in chasing the no. 4 (like Satyam) or the no.20 in the hope of making a killing.

Why rely on Reliance?

The proposed Satyam-Maytas take over deal had recently brought the issue of corporate governance to the forefront. Shareholder resistance eventually aborted the deal. Otherwise a huge amount of cash from Satyam's coffer would have been transferred to the two debt-ridden Maytas companies, headed by the sons of Satyam Chairman Ramalinga Raju.

But Raju is a minor leaguer compared to the biggest flouter of all corporate governance norms - the Ambanis.  Many may think that I am a heretic, trying to run down the group that practically invented equity consciousness among Indian investors by selling company shares to the public at large.

Don't get me wrong. I have the greatest admiration for the late Dhirubhai - for his grand vision, foresight and sheer chutzpah that has made Reliance Industries the largest Indian private sector company by market capitalisation.

What a way to do it though! I won't get into how Dhirubhai learned the ropes of the synthetic yarn and petrochemicals businesses during his sojourn in Aden, and turned a textile trading business into the huge conglomerate that the Reliance group has become.

Neither do I want to discuss the veracity of the way he bent all the rules in the book by getting licences and clearances from various ministries through bribery and coercion that benefited the Reliance group at the cost of competitors.

But I still vividly remember the twin share issues of Reliance Polyethylene and Reliance Polypropylene back in the early 1990s. Huge snaking lines stretching for several hundred metres formed in front of banks accepting the IPO applications.

The prospectus had mentioned that neither company had acquired even the land for the projects, let alone any plant and machinery. Needless to say, a few years later both companies 'disappeared', sorry, merged with the parent group. Probably after all the tax breaks that could possibly be claimed had been claimed. To read more about how Companies Act rules were bent, read page 9 of this link.

Then there was the famous UTI deal. After alloting to themselves debentures convertible to shares at around Rs 150 per share - in a highly irregular deal - the Ambanis allotted the same debentures to UTI at convertible price of Rs 400 per share.

This deal caused huge controversy and eventually led to the ouster of UTI's chairman Mr Pherwani and the collapse of the first and most popular mutual fund of India, the US 64 scheme, that caused large losses to small investors. More details are available here and in this Sucheta Dalal column.

Worst of all is the case of Reliance Petroleum. Shares were first issued in 1993 with a promise of project completion within 36 months. The project was completed in 36 months - but in 1999. Absolutely nothing was done between 1993 and 1996 - other than enjoy the shareholders' cash! Two years later, RPL was merged with RIL after promising that the two companies will remain separate. Read why here.

Fast forward to 2006. There was another Reliance Petroleum share issue! How SEBI permitted this is beyond me. Read what the Hindu Business Line wrote about it here.

Now that the RPL Part II saga is coming to an end, is everything hunky-dory again for RIL? Isn't the current price attractive for entering this counter?

Far from it. Read this article in DNA Money. The next financial year, i.e. 2009-10 will be much worse for RIL. So, if I were you, I would stay away from any investment in RIL.

Personally, I stay away from any stock which has the word 'Reliance' in it. The Ambanis are just not trustworthy enough - not for my money any way.