3 Things All Self-Directed Investors Should Know

There are two ways you can invest your monthly/quarterly/annual savings - the easy way and the hard way.

The easy way is to get hold of an experienced financial adviser and follow his investment advice. The hard way is to take charge of your own financial future and do the investing on your own.

Many small investors skip the easy way because they think that investing for the long term is a trivial activity, and not worth the fees a good financial adviser will charge. No wonder they end up with poor returns or losses.

Common sense suggests that you follow the easy way first. Learn the ropes and gain experience about which investment instruments carry what types of risks and give what kind of returns over different time frames.

Once you have followed the advice of a financial adviser you can trust and built up a decent investment portfolio, then you may start thinking about managing your portfolio on your own.

Before you decide to march to the steps of Tagore's well-known song "Ekla Chalo Rey" ("tread your own path"), there are three things you need to remember:

1. You can't be an expert at everything - invest in what you know, and gradually broaden your 'Circle of Competence'

2. Be patient and disciplined - Rome wasn't built in a day. A good investment portfolio requires canny selection, disciplined approach to regular investing and monitoring, and patience to hold for the long term

3. Control your emotions -  be dispassionate about the periodic ups and downs in the economy. Not investing when there is doom and gloom all around is just as bad as investing when there is euphoria and everyone is jumping into the stock market to buy.

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5 Must-Have Metrics For Value Investors

The investopedia.com web site is one of my favourites because they have such a wide variety of useful articles and tutorials aimed at small investors. Whether you are interested in learning about fundamental analysis or technical analysis, trading or investing, equity market or debt market – you will find something of interest.

For most small investors interested in the equity market, the place to start should be to learn as much as possible about the company whose stock you wish to buy. But the problem for many small investors is: which companies to choose from the thousands that are listed in the stock exchanges.

There are no formulas or rules that work for every one. The concept of “Circle of Competence” has been recommended by Warren Buffett. It means investing in the stocks of only those companies whose businesses you clearly understand. You should be able to assess with reasonable certainty their business model, competitive advantage, strengths and weaknesses, future growth possibilities.

What if your “Circle of Competence” is very limited? You are not in a minority of one. The “Circle of Competence” expands with experience. What to do till then? Stick to sectors that are known for consistent performance over many years. Such as? FMCG, Pharma, Financial Services. You don’t need to own stocks in 20 different sectors. Owning a couple of good companies in 3 or 4 sectors should be enough for a core portfolio.

Once you have decided on the sectors, you need to go through fundamental analysis to identify the better stocks from each sector. In a recent article by Jonas Elmerraji, 5 important metrics for value investors have been explained. Read the article at this link.

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How to choose stocks for trading

Regular readers of this blog need not feel let down by the subject of today’s post. I am a firm proponent of generating wealth through long-term investment by carefully choosing stocks, using both fundamental and technical analysis.

Though I occasionally indulge in longer-term trading in cyclical and FMCG stocks, intra-day or short-term trading remains a strict no-no. The odds for success are too low and the scales are heavily tipped towards the professional traders.

So, why write a post about how to choose stocks for trading? Last week, I had written a post explaining why good investment stocks may not be good trading stocks – and vice versa. The chart patterns of Titan and Reliance were used for comparison. The concluding statement in the post was: “Whether you are a trader, or investor, or both – it improves your chances of making big money if you do your homework in selecting stocks.”

I have already written a series of three posts on how to pick stocks for investment. If you haven’t read those posts, I would strongly recommend that you do so. But because of my antipathy towards trading, I had refrained from writing about choosing stocks for trading.

Why then the sudden change of heart? Let me explain. I have been working on this theory about suicides: If any one is hell-bent on committing it, it should be my duty to guide that person towards the least painful method.

If some one is planning to commit financial suicide (which I reckon a few readers may already have attempted), then it is also my duty to guide them towards the process that may be less painful.

Enough preamble. Now let us get down to brass tacks. Though any stock can be chosen for trading – regardless of its fundamentals – it helps to have a plan and some background knowledge.

High value stalwart stocks typically do not fall too much during down trends, neither do they rise much during up trends. That makes them good picks for stability in one’s long-term portfolio. Not so great for trading.

Penny stocks (i.e. those trading below Rs 10) tend to be irregularly and thinly traded most of the time. Only a few hundred shares being bought and sold can change the stock’s price by a significant amount. While that may appear attractive for trading, being able to buy or sell any decent quantity when you want to can pose a problem.

Mid-priced stocks – say those trading between Rs 30 – 80 – may be the best bets for trading success. Of course, such stocks should trade regularly and with decent volumes. Make a list of such stocks, and start studying their chart patterns. Short-list the ones that are most volatile (i.e. the ones that give big swings from high to low in short periods of time).

Even after going through the above exercise, you may have a short-list that is not so short. Checking the charts of more than 20 or 25 stocks on a regular basis can be a daunting task unless you are doing it full-time. Use the ‘Circle of Competence’ concept to drill down to about 20 stocks, and then spend a period of ‘paper trading’ to fine tune your short-list.

Drop the ones where your paper trades turn sour. Add a few more from the original short-list till you are comfortable with the final choice of the stocks you would like to trade.

Happy trading! (Don’t blame me if you get killed – you are the one attempting to commit financial suicide.)

How small investors can widen their Circle of Competence

Warren Buffett is a strong believer of the Circle of Competence concept. If a company or business doesn’t fall within his Circle of Competence, he won’t touch it. He famously avoided buying into any high-tech company in the 1990s – when every one and his brother-in-law were investing in dot.com companies. He didn’t understand how high-tech companies were making money, and whether they had sustainable businesses. He missed the boom – and the inevitable bust that followed.

Warren Buffett is one of a kind. You and I will never be able to match his skill and wisdom in investing. That doesn’t mean we shouldn’t follow some of his money-making principles. What if our Circle of Competence is too limited? Is there a way to widen the Circle?

Let me give you the bad news first. You can’t widen your Circle of Competence in a hurry. It is a process that will take a lot of time and effort. The good news is that the process is not difficult or complicated. It takes patience, perseverance, and a plan.

First make a short-list of all the knowledgeable people you know. The list isn’t likely to be a long one if you are looking for people with real knowledge. Not some one who knows how many hundreds Tendulkar scored before the age of 25, or the exact locations of the seven wonders of the world. But some one who knows about the economy, business and industry.

Next, figure out how you can meet such people without imposing too much on their time and patience. May be he is a friend’s father or your wife’s uncle. If you inform them in advance that you want to meet them, and the reasons for the meeting, knowledgeable people will be more than happy to share some of their experiences.

Don’t know anyone knowledgeable enough? Join discussion forums and investment groups. There are many in cyberspace. Each group or forum will have a few knowledgeable members. Try and pick their brains.

Going to a family wedding or a party? Don’t just waste your time eating and drinking and being merry. Introduce yourself to people you don’t know, and find out about what they do. If you show genuine interest in their activities, they will give you a lot of information that you won’t find in TV channels or pink papers.

Carry on this process for some time, and you will be amazed at how much wider your Circle of Competence can become. Then, have the discipline to stick to your Circle of Competence when choosing stocks to buy. That will prevent you from getting badly stuck in the shares of a company that you really know nothing about. Like Suzlon, or Punj Lloyd, or Bartronics.

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BSE Sensex Index Chart Pattern – Aug 06, '10

The chart pattern of the BSE Sensex index reminded me (again) about an old Herman’s Hermits pop-song where all the verses have the same words and tunes. The late Patrick Swayze’s ghost (not the real one, but the one in the movie ‘Ghost’) sang it to irritate Whoopi Goldberg into helping him contact his wife Demi Moore.

Who will help the bulls to take the Sensex out of the boring 11 months long trading range? The FIIs are net buyers, but they seem to have given up on most of the Sensex stocks, and are concentrating on mid-caps and small-caps. Many such stocks are shooting up like rockets on sharp volume spikes for no apparent rhyme or reason.

Some investors are sure that a big correction may be around the corner. They are selling at every opportunity and hoarding their cash to buy at lower levels. Others think that the Sensex will soon break out upwards and make new highs that are 5-10% higher than the current levels. They are holding on to squeeze out the last few paisas.

A few investors – mainly inexperienced – are feeling left out of this grinding up move, since they sold out much earlier and didn’t get a chance to get back in. If the Sensex does make new highs above its range, these left-out souls may get sucked in only to find that all escape hatches are closed.

Then there are those that have come to the end of their reasoning capabilities and have started looking heavenwards, with the hope that some kind of strange and magical astrological configuration of stars and planets can unlock the secret to untold riches!

The bar chart pattern of the BSE Sensex index since the bull rally started in Mar ‘09, is still stuck in the slightly upward sloping channel that I drew two weeks back:

For two months, the index has been moving up and getting good support from the 20 DMA. It reached the upper end of the trading range and has again dipped a bit. All three moving averages are rising with the Sensex above them – indicating that the bulls are controlling the market.

The Sensex made new intra-day and closing highs last week, but the technical indicators failed to follow suit – a negative divergence. The MACD is entangled with its signal line in positive territory, and made a lower top. The slow stochastic also made a slightly lower top but is above the 50% level. The RSI also made a clear lower top, but stayed above the 50% level.

Most of the Q1 results have been declared – except for the Tata biggies and a few others. Top lines have shown better growth than bottom lines. Raw material and other expenses have eaten into profits. The monsoon, which was deficient in Jun ‘10, fully revived in Jul ‘10 and caused floods in some parts of the country.

The interest rate hikes by the RBI may take some more time to cool down inflation. Any one doing grocery shopping knows that food prices remain expensive. Most of the good news has already been discounted in the stock market.

Even the slightest bad news could start a correction that every investor seems to be waiting for. The relentless FII buying has propped up the market and allowed the Sensex to defy gravity. There is no reason to believe they will suddenly turn sellers – unless some thing drastic happens in Europe or USA.

Bottomline? The chart pattern of the BSE Sensex index continues to trade in a range with the bulls calling the shots. Investors should remain cautious and need not go the whole hog either in their buying or profit booking. There are still value picks in this market – but they are not that easy to find. Stick to your ‘Circle of Competence’ and hold on to what you own.

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What is the Australian Mining tax and how is Gujarat NRE Coke affected by it?

During question hour in one of the popular business channels today, a viewer asked whether he should buy the Gujarat NRE Coke stock. One of the anchors enquired why he had chosen this particular stock. The answer was enlightening: "It is a good company".

Both the fundamental and technical analysts in the show seemed positive about the stock with a long-term view - more so because the dark cloud of the Australian Mining tax had apparently lifted. The stock had already perked-up on the news. (So did many global mining stocks today.)

Mining stocks are not within my 'Circle of Competence', and I have never invested in them. A friend had strongly recommended the Sesa Goa stock many years ago, and I would have become rich had I listened to his advice.

But I have learned from Warren Buffett - who studiously avoided tech stocks during the dot.com boom - that investors should only buy businesses that they know something about.

Anyway, I was intrigued and decided to do a little digging. This is what I discovered.

Kevin Rudd, the erstwhile Labour Party Prime Minister of Australia had announced last month that he proposed to introduce a Resource Super Profit Tax of 40% on mining companies. Why?

Thanks to the huge, unsatiated Chinese demand for commodities, top mining outfits like BHP Billiton (60% Aussie owned) and Rio Tinto (30% Aussie owned) were making bumper profits from their Australian mines. Australians were not benefitting much because these foreign-owned companies were repatriating their profits overseas.

'Super' profits meant any profits above the long-term Australian Government bond rate of 6%. So any excess profit above 6% was proposed to be taxed at the rate of 40%. Needless to say, the mining companies were up in arms and started lobbying against the tax and threatened to take their business elsewhere.

The adverse publicity and pressure forced Kevin Rudd to resign, as elections are around the corner. The new incumbent, Julia Gillard, is the first female prime Minister in Australia. She opened the door to negotiations with the mining companies without abolishing the proposed tax - which will come into effect from July 2012.

Whether the tax proposal is changed or remain unaltered, the balance sheets of mining companies will get affected only from 2013. There will be no effect for the next two years.

Does this 'positive' news for mining stocks worldwide and Gujarat NRE Coke in particular warrant today's price rise? There is no proposal to remove the tax - only an offer to negotiate, which could lead to a possible reduction in the rate.

Gujarat NRE Coke has a mining subsidiary listed in the Australian stock market. I am not sure how much profit it makes, or whether it makes any profits at all. The company itself can hardly be termed 'a good company'!

At today's closing price of Rs 65, the stock is trading at a P/E of 62.5! The company has bloated equity, debt of Rs 1328 Crores, debt/equity ratio of 1.12, negative cash flows from operations in three of the last five years, net margin and RoE in single digits.

Technically, the 50 day EMA is below the 200 day EMA and the stock is trading below both its medium-term and long-term moving averages. The stock is weak fundamentally and technically. Just the kind of stock from which small investors should stay miles away.

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About Active vs. Passive investment strategies

There are basically two kinds of investors - those who follow active investment strategies and those who follow passive investment strategies. (I am excluding those who trade on a daily basis, whether in the cash market or the F&O market.)

Some Active investment strategies

1. Looking for new stock ideas: constantly looking to buy stocks that are being overlooked by the market, or selling stocks that have started to drop off after a brief rise

2. Identifying sector rotation: try to outguess the market about which sector will be the next 'hot' one (in bull phases), or 'dumped' one (in bear phases) and try to buy or sell ahead of the market

3. Frequently booking small profits: every time a stock moves up or down by 10% or 20%, lock the profits and hunt for the next stock to repeat the process

4. Using a 'ladder' or 'pyramid' approach: keep buying more in stages as a stock moves up or selling more when a stock starts to fall; contrarian investors may do just the opposite

Some Passive investment strategies

1. Identifying fundamentally strong stocks: spending a lot of time in initial research to choose only those stocks that have performed well in the past through bull and bear markets, and are likely to continue to do well in future

2. Choosing sectors within 'Circle of Competence': selecting stocks from only those sectors about which the investor has in-depth knowledge about operations, competition and growth prospects

3. Booking partial profits: when markets reach near an intermediate top (or bottom), booking partial profits (or partially covering shorts)

4. Lump-sum buying or selling: buying large quantities in a few stocks near market bottoms, waiting patiently for the stocks to rise several-fold, then selling large quantities when valuations suggest a market top

Both strategies carry a certain amount of risk. An active investment strategy tries to exploit short-term market movements on a regular basis. This carries an extra risk of the stock or sector calls going wrong. There might be a tendency to become a long-term investor by default, to avoid immediate cash losses.

Passive investment strategies also carry the risk of investments not performing up to expectations even after holding for a longer period, and may have to be sold off at a meager profit or even a loss.

The kind of investing strategy you want to follow should depend on why you are investing in stocks. Saying 'to make money' is a cop-out. Every one has to make money to survive - whether he is a big-shot, or a clerk or a peon.

Stock market investing should be for long-term wealth building that complements regular income from a job or business. It is for individual investors to decide whether active investment strategies or passive investment strategies are more conducive to long-term wealth creation.

As in life, so in investing - it may be better to strike a balance between the two. As a conservative long-term investor, I prefer to follow passive investment strategies for my 'core portfolio' and active investment strategies for my 'mad money portfolio.

What do readers think? Is it better to be an active investor or a passive one?

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Are you an irrational investor?

When should you 'hold' and When should you 'fold' a stock?

There are four things you can do with a company's stock:-

1. Avoid it 2. Buy it 3. Hold it 4. Fold (or, sell) it.

In several blog posts, I have indicated the types of companies that an investor should avoid, and why. A quick recap may not be out of place here. Companies with

* questionable management
* negative cash flows from operations
* high debt and frequent share issues
* 'me-too' products with no competitive advantage
* low trading volumes
* high 'beta' (i.e. stock rises and falls more than the index)
* low growth in sectors that have seen better days, are the ones to pass on.

A series of articles have also been written about market cycles, sector selection, top-down and bottom-up methods for picking individual stocks, 'margin of safety' and 'circle of competence'. 'What to buy' should be supplemented with technical analysis to decide 'when to buy'.

Hopefully, readers have started absorbing some of the guidelines and are now sitting on (or in the process of building) a portfolio of well-chosen, fundamentally strong stocks, from sectors or industries that they can understand. That is only half the job done.

Buying a stock doesn't make any one any money. Holding it for a reasonable length of time, and then selling it at a profit completes the cycle.

How long should one hold a stock? Warren Buffett is ready to hold it forever. You may not have that long a time frame. But long term isn't one year. To get proper returns from a stock, you should hold it for at least 3 to 5 years. Like good wine, a stock should be given time to mature.

That doesn't mean you put it in a locker and forget about it. Industry and company developments should be regularly followed. (If you are unable, or unwilling, to track your portfolio - refrain from buying stocks. Invest in index funds/ETFs or balanced funds.) Irrational price movements - either up or down - should be used as opportunities to book partial profits or add to your portfolio.

When should you sell? That's the million dollar question. If you can learn the art of selling, you will be on the path to riches. Before we get to that, one must learn when NOT to sell. Do not sell a stock if

* the price has gone up from 41 to 48 in 15 days
* the quarterly results have been below expectations
* a temporary calamity has stalled production
* a big order has fallen through

There are only three reasons why a stock should be sold. By 'sold', I mean sold off completely from the portfolio.

1. You realise you've made a mistake in selecting the stock. Could be due to making incorrect assumptions, or, not researching the stock adequately.
2. The fundamentals of the company takes a turn for the worse. A failure of imported technology, fraud by top management, new and more nimble competitors changing the rules of the game, a big acquisition turning sour, could be some of the causes.
3. There is a sudden emergency or unforeseen requirement of money, for a medical condition or a job loss or a daughter getting admission in a foreign university or investment in an apartment.

I also use the 'sleeplessness indicator' - though it may not be universally reliable! If I'm unable to go to sleep at night because a stock investment isn't turning out the way it was supposed to, I sell it the next day.

(Readers may please share why they have sold stocks, if any mistakes were made and what lessons were learned.)

What is your Circle of Competence?

'You don't have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.' - Warren E. Buffett

If you are able to answer the question truthfully and without letting your ego come in the way, you will be well on your way to becoming a successful investor. Trouble is, even seasoned investors are some times unaware of how to answer the question.

So, here are some guidelines in helping you to find out.

Think about your family. Your parents, relatives, in-laws, cousins. What kinds of activities have they been associated with. A doctor in the family? She'll be able to help with pharmaceutical and medical devices companies. In the textiles business perhaps? He may help you understand all about synthetic and man-made fibres.

What about your education, training and work experience? A civil engineer? You will know about construction companies, cement companies, road projects. An electrical engineer? Power generation and distribution, electrical cables and meter companies, electrical appliances will be in your knowledge base.

Your upbringing, education, work experiences, financial stability will all influence your behaviour patterns, risk tolerance, ability to take independent decisions and awareness about what you can do, and what you can't.

That creates your Circle of Competence. Your knowledge base. It is entirely an individual's circle. Only you know what you know and how much you know. Never confuse familiarity with knowledge.

I may use a fancy Mach III Gillette razor every morning. But I have no idea how Gillette runs its business or if a hike in steel prices will dent its profits significantly or not.

You may be a Bharti Airtel customer for a number of years. You like their service and their all-India presence and fast growth. So you get excited by the announcement of a maiden dividend and stock split and pick up 200 shares. Then you hear about the MTN acquisition, which seems to be going nowhere. Is that good, or bad for Bharti shareholders? Should you sell, hold or buy more?

Before you buy a single share of a company, make sure you have a basic understanding of how that company operates. What do they sell? Who do they sell it to? Who are their competitors? Are they in a sector that is growing fast, or is it a cyclical business? If you don't have this knowledge, don't buy the share.

What if your Circle of Competence is very, very small? Say you have worked for 15 years in the software industry and really don't know much about anything else. You can still earn a fortune by buying and selling shares of Infosys, TCS, Wipro.

But that will be putting all your eggs in one basket. Better to have several baskets. How? By increasing your Circle of Competence. Meet people. Join investor groups. Learn about new businesses and industries. And read, read, then read some more. Books, magazines, web sites - information is all around you.

Be sensible in gathering information. Don't suddenly try to become an expert about the Shipping industry and the Baltic Dry index. First look at businesses for which you have developed software. Chances are, you have in-depth knowledge about their operations and processes already.

Just sticking to your Circle of Competence may be a good idea, because it takes out the guesswork from stock investments. But it is not enough. You still need to be able to identify good sectors and companies through fundamental analysis. Then use technical analysis to determine if this is a proper time to buy or sell.

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