Amazon deals

Thursday, July 7, 2011

Some strategies about buying stocks

In a post last week, I had discussed strategies for selling stocks. Most small investors know how to buy stocks, but they rarely have proper strategies for selling. So why am I writing about buying strategies?

From the spate of questions I have recently received about when and how much to buy, it seems that discussing some buying strategies may be useful after all. I had mentioned about using the ‘Margin of Safety’ concept and P/E bands to decide entry points in last week’s post.

The importance of those two concepts can’t be over-emphasised. Too many young investors follow the wild west policy of ‘Shoot first, and ask questions later’. Just switch on any business TV channel (just for entertainment) during the day when they take reader queries. 99% of the questions are: ‘I have bought thus and such stock at this price; should I hold or sell.’

It is apparent from the questions that the stock was bought near a top, and the investor is already sitting on a loss. The question – or rather, a plea – is to find out if the TV expert knows some magical formula by which the loss can be quickly turned into a profit, or, at worst, break-even with no loss.

All one has to do before placing a buy order, is to first check whether the current E/P (i.e. inverse of the P/E ratio) is higher than the long-term bank fixed deposit rate, leaving a ‘Margin of Safety’ . Also check that the debt/equity ratio is less than 1, and that the cash flow from operating activities is positive for 4 of the last 5 years.

If E/P is lower than the bank FD rate, then check the P/E band within which the stock normally trades, and buy only if it is available near the middle of the P/E band or lower. These are basic precautions, and will help prevent losses – even if you don’t have the time or inclination to do a detailed fundamental analysis.

If you are like most small investors, the stock price will fall just after you’ve bought it (and, it rises soon after you sell)!! What should you do? Do not, repeat, do not average down. That is the single cause for turning a small loss into a much bigger one. Instead, keep a stop-loss – and sell if the stop-loss is hit on a closing basis (i.e. take intra-day movements out of the equation).

You will make much more money by averaging up. When should you do that? Buy 20-25% of your intended quantity at the beginning. Add more every time the stock dips or corrects on the way up. Follow a ‘pyramid’ strategy – i.e. buy less and less quantity on the dips as a stock keeps moving up in price – till you acquire your intended quantity.

Such a strategy will prevent impulsive buying of 2000 or 5000 shares in one go, in the hope of becoming a Warren Buffett within a month. Talking of Buffett, I love his quote: ‘You can’t make a baby in one month by getting nine women pregnant!’

Wealth-building takes time. If you hone your buying and selling strategies, you have a chance of becoming wealthy in 15-20 years – but not in 15-20 months.

4 comments:

Bharath said...

Hi Dada,
I have been searching for answer for the question "Where can I find historical P/E for a specific stock ?". I do have links for getting P/E for index, but not able to find stock specific historical P/E ratios.

Next things, I doubt the quote "You can’t make a baby in one month by getting nine women pregnant!" by Warren Buffett. Anyways, this quote not only applies to Stock markets,in S/w industry too.Here my client too asks us to take 8 resources(developers) to finish developing in a week, when we give estimate of 2 developers for 1 month time. :-)

Subhankar said...

Hi Bharath

I'm not aware of a site where you can find historical P/E data of individual stocks. But the data can be derived from historical prices from the NSE or BSE sites. Then find the EPS data from Annual Reports (which provide 10 years data some times) or from moneycontrol.com.

In 'The Mythical Man-month', Fred Brooks wrote some thing like: "It takes 9 months to create a child, regardless of the number of women involved." Buffett paraphrased that in his own inimitable style.

Ajay said...

Dear Sir,

What about if you are buying a solid bluechip stock like say Infosys or tata steel, even then you recommend to apply the stop loss rule? In my experience, 50% of the time I buy a stock it is easily down by 15 - 20% but have bounced back and given profits, e.g airtel, as it went down from 450 levels to 265, i went buying it and at 265 i purchased most and the average stock price was brought to 300 (i purchased less at top and more at bottom). Now it is in decent profit level and everyone says thats the best stock to buy now. May be waht u say is correct for small and mid caps.

Subhankar said...

Thanks for your comments, Ajay.

Whether to use a stop-loss or not is entirely up to an individual investor. But I'm not aware of any other way to limit losses. It is a trading discipline, and has nothing to do with large-cap or small-cap.

What you have done with Airtel is called 'averaging down' - and such a strategy has caused huge losses to a lot of investors - in stocks like JP Associates, Suzlon, Punj Lloyd, Bartronics - when the stocks never bounced above their average price.

If you had followed the same strategy with Rel. Comm., your results would have been quite different.

A better strategy may have been to exit Airtel when it dropped below 400, and then start buying it when it crossed above 275 nine months later.