Why building a stock portfolio is like buying a car

One of the requests I receive most often from blog readers and newsletter subscribers is to help them in building a ‘good’ stock portfolio. Many think that this is a trivial task. All they need is a list of ‘good’ stocks to buy. It is not that simple. A portfolio is not a ‘T’ shirt with a ‘L’ written on its label that will fit 90% of investors. It needs to be custom-tailored for a near perfect fit, to suit each individual investor’s background, experience, financial commitments, risk tolerance, and future plans.

But the real problem lies elsewhere. Most young investors can spare Rs 1 - 2 lakhs. Some have recently started earning and can only spare Rs 3000 – 5000 per month. These are insufficient amounts for building a ‘good’ stock portfolio. So, I use the analogy of buying a car.

One doesn’t go out and buy a car – specially if they have just started earning. Some prior planning is required. (Car loans are readily available nowadays, but the EMIs can burn a big hole in your pocket.) A better option may be to buy a scooter or motor cycle for immediate transportation needs. Even then, you need to learn the rules of the road, and get a driver’s licence before you buy anything.

Unfortunately, there is no licence required to invest in the stock market. Most small investors jump into the market without any knowledge of the basic rules of investing. No wonder their stocks crash and they suffer heavy injuries (to their savings). Grow your capital by regularly investing in fixed deposits, recurring deposits, PO MIS, ETFs, mutual fund units till you have sufficient capital to buy a ‘good’ car.

Can’t you buy Rs 3000 – 5000 worth of stocks every month? Yes, but which stocks? You can’t even buy 10 shares of Tata Steel. So you’ll probably buy 100 shares of Suzlon instead, or worse still, 800 shares of Cranes Software! Your risk of loss will increase proportionately. You are far better off investing that amount of money every month in a ‘good’ fund like DSPBR Top 100 or HDFC Prudence. After 5 or 6 years of regular savings, you may have sufficient capital for a ‘good’ portfolio.

How much is sufficient capital? I suggest Rs 5 lakhs as a bare minimum. Rs 10 lakhs is a more reasonable figure. Can’t cars be bought for Rs 1 - 2 lakhs? Yes, they can. But they won’t be ‘good’ cars. How about a used car? That may work, but is likely to require regular trips to the service centre for repairs. And you really can’t be sure if a used car is really a ‘good’ car. The previous owner may not have driven or maintained it properly.

Even with Rs 5 lakhs, you will only be able to buy a decent entry-level car. But if you are ready to spend Rs 10 lakhs, then your choice of ‘good’ cars increases significantly. And if you own a Rs 10 lakh car, chances are that you will take good care of it by following scheduled maintenance procedures, getting repairs done promptly, adding accessories that will enhance your driving comfort and experience.

A ‘good’ stock portfolio needs sufficient capital, and has to be nurtured and maintained as well – by keeping track of market happenings, individual stock results, using opportunities to book part profits or add more on dips. The emphasis should be on safety, and not about driving/investing recklessly.

Stock Chart Pattern - Cranes Software (An Update)

The stock chart pattern of Cranes Software brings to mind a few stock market cliches:

1. Never try to catch a falling knife - you are supposed to wait for the knife to hit the table first, where it is likely to vibrate for a while; then it is safer to catch it. Question is: do you want to? (In the case of Cranes Software, some one seems to have removed the table which was covering a bottomless hole!)

2. Just because a stock is trading cheap, doesn't mean it can't trade cheaper.

3. Never average down in price; average up instead, because you don't know how low it can go.

The bar chart pattern of the Cranes Software stock from Mar '09 till date shows that ambition and the pursuit of growth needs to be tempered with financial prudence and patience - otherwise it may lead to annihilation:-

When I wrote about the stock back in July '09, it had made a double-bottom - 35 in Mar '09 and 34 in Jul '09 - and tried to move up. The resistance from the 50 day EMA proved too strong and the stock moved down again to 33.5 in Aug '09.

An up move on good volumes took the stock above the 50 day EMA, but a double-top at 48 proved to be its last hurrah. The stock dropped below the 50 day EMA in Oct '09 and has stayed below it till date.

A long-term support-resistance line has been drawn at 33. That level supported the stock's fall four times (marked by up arrows). This provides a classic example about support-resistance levels - which act more like a thin membrane than a spring. Each test of the support (or resistance) weakens it.

After three or four tests, the support (or resistance) tends to break. Thereafter, the support usually turns into a resistance, and a resistance turns into a support. Note that after the convincing break below the support of 33 in Dec '09, the level provided resistance in Jan '10 (marked by the down arrow), and then the bottom fell out of the stock.

The MACD has remained negative since Oct '09. The RSI and slow stochastic have once again entered oversold zones.

For those who did not read my earlier analysis in July '09, the concluding paragraph is quoted below:

"The stock chart pattern of Cranes Software is a reminder of what can happen if the pursuit of growth by acquisition leads to too much debt. Even good cash flows from operations may not be enough to survive. This is not for the faint-of-heart. Intrepid investors should maintain strict stop loss at Rs 33."

Technical analysis is not perfect. But if you don't know the basics, it can hurt you where it hurts the most in the stock market. Your wallet!

Bottomline? The stock chart pattern of Cranes Software shows that its glory days during the previous bull market are long gone, and now it is just a struggle for survival. If you own the stock, get out now. If you think it can't go lower, think again. It is game, set and match for the bears.

(Question for readers: what do you think the volume action may indicate?)

Related Post

About Support and Resistance levels in stock chart patterns

Do you invest with your head, or do you invest with your heart?

One of the building blocks - may be the most important one - of becoming a successful investor is to know yourself. To help you understand if you invest with your head or your heart, here are some practical situations that you are likely to face:-

1. March is usually the time for last-minute tax-saving investments. So you start looking at some ELSS funds. You hold the SBI Magnum Tax Gain fund since Mar '07. It was one of the best ELSS funds then and gave good dividends.

Your head tells you to sell it because of its recent under-performance and switch to Canara Robeco Tax Saver or DSPBR Tax Saver. Your heart urges you to stick with it as it will surely return to its earlier glory.

2. The Nifty is trading just short of its Jan '10 high for the past 6 trading sessions. Your head is saying 'be careful' because a previous top made some time ago can be a tough hurdle to cross. Your heart is saying 'a new high is imminent' and this is the time to jump in.

3. You had made a killing in the Bharti Airtel stock when you sold part of your holdings when it hit 1200 (pre-split) back in 2007. The rest of your holding effectively became 'free of cost'. Ever since, the stock has been sliding, but you held on because your holding cost was zero.

Your head is urging you to get rid of it, as the entire telecom services space has lost its pricing power with the entry of big global players. Your heart is forcing you to hold on because Bharti has proven management and the stock will definitely move above 500 soon.

4. Your decision to pick up OnMobile Global shares at 250 in Mar '09 turned out to be a really judicious move, as the stock zoomed to hit 700. Out of the blue, the bears attacked and the stock halved in value to 350.

Your head is accepting the fact that you got a lucky break initially, but you goofed by not booking profits at 700. Your heart is considering it as plain bad luck that your smart pick suddenly changed direction through no fault of yours.

5. You read my blog post about Indraprastha Gas back in July '09 when the stock was trading at 137. I had mentioned a possible target of 180. You decided to spend some time to research the stock thoroughly. But within a month, before you could gather sufficient details, the stock hit 180.

Your head told you to wait for better valuations. Your heart decided that you should buy before the stock runs away even higher.

6. Cranes Software was a hot stock in the previous bull market. It sold engineering software products to overseas clients and made huge profits. Because of the down turn, the stock hit the skids but at 45 it seemed like a screaming buy.

Your head warned you not to try and catch a falling knife. Your heart ignored the warning as the downside seemed very limited, and you bought a large chunk and then averaged down at 30.

If you are like most investors, you some times invest with your head and at other times invest with your heart. There are no guarantees which will be a better investor - your head or your heart. Logically, for long-term investors, the head should rule the heart. But stock markets can be illogical in the short-term.

Does economic growth lead to higher returns for stock market investors?

A recent article in Business India magazine warned that investors 'should be wary of relying on a link between overall growth of the economy and returns on specific company stocks'.

The article written by Hugh Sandeman, MD of Langham Capital, concludes with the following statement:

"...the macro-economic growth story is a cue for caution, not just celebration."

That sounds counter-intuitive, doesn't it? If the economy is growing, then more goods are being manufactured, roads and bridges are being built, every one has more disposable income, so more shares will be bought and their prices will go up. Right?

Not quite. In his book 'Stocks for the Long Run', Jeremy Siegel presents some interesting research data to show that 'economic growth has nowhere near as big an impact on stock returns as most investors believe'.

In one chart, percentage returns (in dollars) for 16 developed countries was plotted against each country's percentage real GDP growth from 1900 to 2006. Real GDP growth had a negative correlation with returns from the stock market. Higher the economic growth in individual countries, lower was the returns to equity investors.

A similar chart for 25 developing countries (including India and China) shows a similar negative correlation, in spite of the massive returns provided by the stock market indices of these countries in recent years. Are we missing some thing?

Turns out that the growth in aggregate earnings and dividends do increase along with GDP growth. But for investors the returns are based on earnings and dividends per share.

Economic growth is dependent on expenditure on R&D, technology upgradation, increase in manufacturing capacities, building new factories and offices. Such expenditure needs to be funded - either through loans, or through issuing new (or additional) equity shares, or both.

The interest burden and equity dilution leads to lower rate of growth in EPS and dividends per share. While internal accruals (read: positive cash flows from operations) can fund expenditure in the shorter time frame, Siegel's research shows that in the longer term a 10% increase in GDP requires a 10% increase in the equity capital.

The cautionary note in the article was directed particularly at asset heavy sectors like infrastructure, energy and shipbuilding. Investors in IVRCL Infrastructure may have noted the recent downgrade in its credit ratings due to a large debt burden.

Pantaloon and Cranes Software are other examples of how rapid growth funded through loans and equity can quickly lead to poor share holder returns.

Stock Chart Pattern - Cranes Software

Some readers may question why I am even bothering to look at the chart pattern of Cranes Software, and they may be amply justified in doing so.

Here are some of the reasons why I like the company. Not only is it a software products company - and the breed is rare in India - it is a leader in the profitable niche of scientific research and engineering design simulation. Cranes owns some of the better known brands internationally, most of which were added to their products portfolio through judicious acquisitions. It also has tie-ups with leading international companies.

Mar '09 top line was at Rs 530 Cr, with 450 Cr realised from exports. In spite of the economic down turn, Cranes Software was able to generate Rs 124 Cr in profits after tax. Increasing cash flows from operations and regular dividends are other positive features.

So why is the market shunning the stock? It is the Rs 800 Cr debt, hanging like the proverbial shining sword suspended from the ceiling by a single horse's hair above the neck of the sycophant Damocles. The company is trying to raise around Rs 300 Cr by selling stakes in two of its subsidiaries.

The one year bar chart pattern of Cranes Software doesn't instill too much confidence at all - and therein may lie the seed of opportunity:-

Ever since hitting a high of 174 (for this Rs 2 face-value stock) back in Dec '07, the stock has been sliding steadily down with very little sign of a bottom being in place. The recent low of 34, made on July 13, '09 is actually its 52 week low. Maybe, the double bottom formation will finally halt the long bear market phase.

The stock is well below its downward sloping 200 day EMA. The 50 day EMA is also quite a bit below the long-term average, and both EMAs are moving down. Last week's rally took the stock up to its medium-term average, where it faced resistance and moved down again.

The technical indicators are not encouraging. A volume spike on July 20, '09 took the stock to the 50 day EMA and the MFI to the overbought level. Subsequently volumes have come off somewhat. The RSI moved out of the oversold zone, but remains below 50% level. The slow stochastic shot up from its oversold zone and went above the 50% level, but the %K has now slipped below the %D line. The MACD is above its signal line but in negative territory.

Volumes have been sharply higher on recent up days - which hints at informed buying. There is good support at 39 and 34 levels. So watch out for any breach of these levels. If the company is able to raise the funds within the next 3 months or so, this stock could zoom. Should the stock manage an up move, resistance zones will be at 45-49 and 60-65.

Bottomline? The stock chart pattern of Cranes Software is a reminder of what can happen if the pursuit of growth by acquisition leads to too much debt. Even good cash flows from operations may not be enough to survive. This is not for the faint-of-heart. Intrepid investors should maintain strict stop loss at Rs 33.

(A question for readers: Why is the stop loss set at 33 and not at the 52 week low of 34?)