Sensex, Nifty charts (Feb 22, 2019): sideways consolidations continue

FIIs were net sellers of equity on Mon. and Tue. (Feb 18 and 19) but turned net buyers on the last three days. Their total net buying was worth Rs 50.3 Billion. DIIs were net buyers of equity on all five trading days. Their total net buying was worth Rs 46.5 Billion, as per provisional figures.

On Fri. Feb 22, net buying by FIIs exceeded Rs 63 Billion, which turned them into net buyers month-to-date. A bulk deal in Kotak Mahindra Bank (ING sold its residual 3% holding) was the probable reason.

Nifty's EPS for Q3 (Dec '18) hit an 11-quarter low of Rs 96.50. This is the first instance since Q1 (Jun '16) when the EPS slipped below Rs 100. It was also the 4th consecutive quarter of lower-than-estimated earnings for the Nifty 50 companies.

BSE Sensex index chart pattern

The daily bar chart pattern of Sensex closed below the 200 day EMA on Mon. and Tue. (Feb 18 and 19) after 2 months - thanks mainly to FII selling.

Just when it seemed bears were getting the upper hand, the index pulled back above its 200 day EMA towards the Fibonacci resistance zone (between 36140 and 36810).

Despite strong combined buying by FIIs and DIIs, resistances from the merging 20 day and 50 day EMAs capped the pullback rally. 

The index closed above its 200 day EMA in bull territory, but eight straight days of lower closes and the Valentine's Day massacre at Pulwama has dented bullish sentiments.

Daily technical indicators are looking bearish. MACD is moving sideways below its falling signal line in neutral zone. ROC is moving up towards its falling 10 day MA in bearish zone. RSI is sliding down towards its oversold zone. Slow stochastic has emerged from its oversold zone.

The government has been announcing several sops for various sections of citizens in a belated effort to curry favour with voters before the general election. The stock market has so far reacted with indifference.

With no visible bullish triggers on the horizon - monsoon is too far away and Q4 (Mar '19) results of India Inc. are unlikely to be any better - there is a distinct possibility that Sensex may succumb to gravity.

NSE Nifty index chart pattern

The weekly bar chart pattern of Nifty formed a 'reversal' bar (lower low, higher close) for the 6th time in the past thirteen weeks. Bulls need not expect a strong pullback rally. 

The index closed above its 50 week EMA but faced strong resistance from its 20 week EMA. FII buying can cause some more upside, but is unlikely to propel the index above the Fibonacci resistance zone (between 10880 and 11090). 

Weekly technical indicators are looking neutral to bearish. MACD, ROC and RSI are moving sideways in neutral zone. Slow stochastic is falling towards its 50% level. 

Nifty's TTM P/E has moved down to 26.32, but remains well above its long-term average in overbought zone. The breadth indicator NSE TRIN (not shown) has fallen into its overbought zone, and can limit near-term index upside.

Bottomline? For more than 3 months, Sensex and Nifty charts have been consolidating sideways after sharp corrections during Sep-Oct '18. Both indices managed to close above their long-term moving averages in bull territories, but are unlikely to cross above Fibonacci resistance zones. The consolidations may continue with a downward bias.

Q1 (June 2018) Earnings Review of Nifty Stocks

If not for a loss by India’s largest lender State Bank of India, Nifty 50 companies would have met the average estimate in the quarter ended June.

The combined earnings per share of the benchmark index constituents missed the consensus by 7 percent, according to BloombergQuint’s calculations. That’s when three-fourths of the 50 companies either surpassed or met forecasts—the highest in at least three quarters.

Read more at:

https://www.bloombergquint.com/quarterly-earnings/2018/08/16/q1-earnings-review-sbi-dampens-nifty-50s-best-earnings-season-in-three-quarters#gs.9VAHDF4

How to use the PEG ratio to evaluate companies

It is that time of the year when annual reports start arriving in mailboxes. With the stock market at a new high, it is becoming increasingly difficult to find stocks available at reasonable valuations.

All the more reason to take some time in going through annual reports in detail to find out which stocks to hold, which stocks to sell and which stocks to add more of.

The Price-to-earnings ratio (i.e. CMP/EPS) is commonly used to evaluate whether a company is fairly priced or over/under-valued. What the ratio doesn't reflect is whether earnings are growing or not.

The Price-to-earnings growth ratio (PEG = PE ratio/Annual EPS growth %) can provide a more realistic valuation metric.

Let us look at the ratios of two FMCG companies - HUL (MNC) and Marico (Indian):

HUL - EPS for FY17: 20.75; for FY16: 19.12; EPS Growth: 8.5%; P/E: 52.8;
Therefore, PEG = 52.8/8.5 = 6.2

Marico -  EPS for FY17: 6.53;  for FY16: 5.36; EPS Growth: 21.8%; P/E: 48.6;   
Therefore, PEG = 48.6/21.8 = 2.2

The P/E ratios of both companies seem high. But Marico's PEG is much lower, making it a better value than HUL (at Jun 1 '17 closing prices).

Read more here.
  

Stock Buybacks: A Good Thing or Not?

There are many ways in which a company rewards its shareholders. The most common methods are bonus issues, rights issues, dividends, stock splits and share buybacks.

Bonus issues increase the equity capital. The market price of equity shares gets adjusted according to the issue ratio. So, in theory, there is no gain for shareholders. The company can benefit because the higher capital enables them to borrow more. 

In reality, share price often rises following a bonus issue - particularly for established and financially strong companies - as the lower bonus-adjusted price attracts buyers.

Rights issues increase the equity capital, and sometimes also the reserves if the rights issue is offered at a premium to face value. If the issue price is lower than the market price, shareholders benefit through capital appreciation, even though the market price gets adjusted in the same ratio as the rights issue.

Dividends benefit shareholders, because it is tax-free cash in their hands. For companies, the cash outgo indicates that the company does have sufficient resources to pay dividends. 

If the company has to resort to debt in order to pay dividend (or tax), then it is a 'red flag'. This is why studying the Cash Flow statement in Annual Reports is so important. It gives a clear view of a company's cash position.

Stock splits do not increase the share capital of a company. The face value of equity shares get reduced and the number of shares increase proportionately. Again, in theory, there is no benefit for shareholders.

However, the increased number of shares in demat accounts usually leads to near-term selling. Eventually the selling subsides. The lower market price of the split shares attracts buyers, pushing up the market price. 

Here is an example of how bonus and splits can enhance value for long-term shareholders.

Back in 2002, ITC shares of Rs 10 face value were trading at around Rs 600 or so. If someone had bought 100 shares, his investment would be worth Rs 60000 - not a small sum 14 years ago. 

If s/he had the foresight to hold on till today, the holding would have increased to 3000 shares of Rs 1 face value - thanks to two bonus issues (1:2 and 1:1) and a stock split (10:1).

At the current (corrected) market price of Rs 300, the shareholding would be worth Rs 9 Lakhs - a 15-fold increase, not counting the substantial dividends paid each year.

Share buybacks - sometimes at a premium to market price - reduce the equity capital to the extent of number of shares bought back. The bought-back shares are extinguished. Shareholders get an exit opportunity at a profit.

In case they hold on, the market price tends to rise after the buyback (due to higher EPS and lower P/E) - providing capital appreciation.

Read more about pros and cons of share buybacks in this article.

Understanding Earnings – a dummies’ guide

In the middle of results season, several companies are announcing their quarterly and annual results every day. Financial terms like operating income, EBITDA, EPS, cash flow are being used to explain company performance.

Such terms may be familiar to CAs and commerce graduates but may sound like gobbledygook to those who have a background in science or humanities. In a recent article at morningstar.com, financial terms related to earnings announcements by companies have been explained.

Here is an excerpt:

“Revenue: Quite simply, this is the amount of money the company has brought in for goods and services provided over the given time period. Revenue growth, in particular, is a statistic to watch because it may indicate whether the company's business is growing or declining.

Gross profit: The amount of company revenues left over after subtracting the cost of producing the goods and/or services it has sold. These include costs such as raw materials, salaries of the workers who make the products or deliver the services, and other production-related expenses.”

Read the rest of the article here.

Is the Sensex valuation signalling a ‘buy’?

Given below is a chart that appeared in the Economic Times a couple of days ago. For those who are not familiar with, or feel shy about, graphs and charts – a brief explanation may be necessary.

What is PE (Price to Earnings ratio)? It is a common valuation metric that is calculated by dividing a stock’s current market price by its TTM (trailing 12 months) EPS:

In other words, PE of a company = CMP (Current market price) / TTM EPS

EPS (or, earnings per share) is calculated by dividing the net profit by the total number of shares outstanding (i.e. shares authorised, issued and owned by investors, including company promoters).

Net profit is declared along with quarterly results of a company. Quarterly EPS can be calculated by dividing the quarterly net profit by the number of shares outstanding. To calculate the full year’s EPS, the quarterly EPS of three previous quarters is added to the EPS of the current quarter (i.e. TTM EPS).

The Sensex is an index of 30 stocks. The ‘price behaviour’ of the index is supposed to represent the ‘price behaviour’ of the entire stock market. Does the Sensex have a PE, and can it be calculated. The answer is ‘Yes’. How?

By performing a simple arithmetic trick to make the calculation easier. For each of the Sensex constituent companies, CMP and TTM EPS are respectively multiplied by number of shares outstanding:

• CMP x number of shares outstanding = Market Capitalisation;
• TTM EPS x number of shares outstanding = TTM Net profit.

So,  PE of a company = Market Capitalisation / TTM Net Profit.

Now, calculate the market capitalisation of the 30 Sensex stocks; then add the 30 market capitalisation numbers (in Crores) to get the total Sensex market capitalisation. Next, add the TTM net profits of the 30 Sensex stocks (in Crores) to get the total Sensex TTM net profit. Dividing the total Sensex market capitalisation by the total Sensex TTM net profit gives us the Sensex PE. Voila!

Why is the PE ratio important? Because it is a commonly used valuation ratio. A PE of 15 means the market is ready to pay Rs 15 for each Re 1 in earnings of a company. A lower PE means the stock is a more attractive purchase. A higher PE means the stock is on the expensive side. Note that PE ratio should not be the only criteria to value a stock. Other metrics like Price to Book Value, Return on Capital Employed, cash flows from operations, etc. should also be looked at.

The chart above plots the Sensex PE from end 1998 to Jul 12 ‘13 (in red), with the average PE during the entire period of 18.34 (in blue). How to use the chart? Below the blue line is the ‘buy’ zone and above the blue line is the ‘sell’ zone. On Jul 12 ‘13, Sensex PE was at 17.65 – below the average level of 18.34. In fact, Sensex PE has been below the average level for the past several months. Now you know why investors were being implored to buy in various posts on this blog over the past few months.

Don’t worry too much about the gloomy economic scenario. The government is taking belated steps to allay the situation. The stock market cycle is usually a few steps ahead of the economic cycle. By the time the economy improves, it will be time to sell.

Related Post

Using Earnings Yield to time your Investments

Notes from the USA – a guest post

Many investors – specially new entrants to the stock market – get caught up in the exciting but vicious cycle of daily market movements, quarterly results, lure of quick profits, and chasing mythical small and mid-cap multibaggers. They look at a few trees, and think they know all about forests.

For successful wealth-building over the long-term, investors not only need knowledge, patience and discipline, they also need to be aware of the macro trends that are likely to shape the growth of global economies and stock markets. In this month’s guest post, KKP – a successful long-term investor – points out some macro trends that many are aware of but choose to ignore in their rush for short-term profits.

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Build a Portfolio to Capture the Rise of Asia

Investors all over the world are getting tons of unsolicited and solicited input (a.k.a advice) to get in and out of positions. It is a self-fulfilling prophecy that we are dealing with today, since the more people trade, the more it proves to be the right thing to do. The few long-term investors that are left who like to observe ocean-like macro waves of the market, economic weather patterns of planet earth, and review management styles to invest, are starting to question themselves.

Now recall Y2K…..Did we all not get sucked into the markets thinking that investments in information and related technologies are all going to the sky? We moved in with the herd, and what happened then? We all got crushed with this thinking that trees rise to the sky and markets are going to Dow 36000 and Sensex 25000 (at that time in year 2000). Yet, it did not happen. Once everyone is on one side of the thought process, markets prove the ‘majority’ wrong.

So, are we wrong about the short-term trading mentality that has set into most of us? With computers taking over to do the trading for us, are we setting ourselves up for the doom and gloom that can happen with one ‘error trade’, or a group of computers thinking alike and giving out massive buy signals or sell signals?

Looking at the macro trends for a moment, which is clearly the camp I belong to, I see the following unfolding (source Boston Consulting Group). If 3500 more “billion dollar” companies are coming up in 2020, then think where mid-cap mutual funds will trade by that time, even with all of the short-term selling/trading/buying. Earnings (a.k.a making money) always win when it comes to any business environment, and stock markets are primarily driven by EPS growth.

With 670 Mn working class people under age 30 entering the job market, this is going to give a tremendous boost to productivity, consumption, technology demand, and therefore GDP. These are the people that will power the companies forward and make them the billion dollar enterprises within the next 5-7 years (2020 is NOT that far away). Imagine everything that today’s 30 year old lower, lower-middle, middle and upper-middle income earner buys - from food, technology, mobility, housing, consumables, and capital goods. If the world GDP can sustain, and give this group of working class folks a job, then we know they will need all of the above to operate their lives. And, that is just going to happen……Therefore, here comes Sensex 45000 as predicted by some. It might take us until 2021-2025 but even those dates are not too far away from today.

Investing in ‘this’ macro trend is where the money will be made by patient investors. Sure, when people see stocks plummeting, it is tough not to feel discouraged and bearish, but that is the right time to buy with a view of 2020. Suzlon, BHEL, HDIL, Jain Irrign, RelCap, Opto Circ, DLF and many others have been crushed from their 2008 highs, but we should be careful about what we buy when the overall market PE is hanging above 20, and there is a bull-mania in progress. The key trends identified by Boston Consulting Group will unfold for India, China, Brazil, Russia, Africa, and some of the Frontier Markets.

I am sure none of my readers were exempt from getting sucked into the bull-mania in some way, shape or form, but those are life-long learning lessons from which we become better investors. So, right now, keep your powder dry, do not rush out to sell, and hold on for the bumpy ride. If and when the market corrects further, pounce on some of the good mid-cap buys and hold on for a while. Buy in SIP mode, and sell some to feel good when it doubles, but then hold on the majority for a long time.

That is what I am going to do, and I am definitely putting my money where my mouth is and waiting for the next bull run to begin. Pre-election years are good years for investors, and this year might be no different, unless we get hit with a macro event from EU or NA (North America). Stay focussed and keep your eye on the 2020 ball…

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KKP (Kiran Patel) is a long time investor in the US, investing in US, Indian and Chinese markets for the last 25 years. Investing is a passion, and most recently he has ventured into real estate in the US and also a bit in India. Running user groups, teaching kids at local high school, moderating a group in the US and running Investment Clubs are his current hobbies. He also works full time for a Fortune 100 corporation.

Why did Reliance announce a share buyback?

Regular readers of this blog know that I am biased against any company that has ‘Reliance’ in its name. So it should not come as a surprise that all actions by the Ambani brothers are viewed through a lens of strong suspicion by me.

If you are a dyed-in-the-wool Reliance investor, please don’t take umbrage at my tirade. Just ignore it. If you are considering an entry into this erstwhile darling of the Indian stock market, please read through and then decide.

The performance of Reliance companies have been less than stellar during the past couple of years. The stock market has punished all the group company stocks, including those of the big daddy of them all, RIL. The Ambani brothers have become wealthy beyond belief and have acquired notoriety by using various dubious means to circumvent the rules and accumulate the shares of their own companies. The hammering of Reliance group stock prices has dented their considerable personal wealth.

What better way to make a little extra cash than to announce a buyback before announcing Q3 results? RIL’s Q3 results – to be announced on Jan 20 ‘12 – is not expected to be great. That may lead to further selling of a stock that has already lost more than a third from its 2009 peak. The buyback announcement caused a price spurt – providing a nice opportunity to make a few extra bucks.

What will happen to small investors holding the stock? Not much – unless they use the current price spurt to book profits. Buybacks are a method used by companies ostensibly to ‘reward’ shareholders. How? Usually, the bought back shares are extinguished – which means they cease to exist. So, the equity capital of the company gets reduced and correspondingly, the EPS increases. The P/E ratio becomes lower, making the stock look more attractive valuation-wise.

But it all depends on how much of the equity capital gets bought back and extinguished. A similar buyback was announced six years back, but only a small percentage of the total equity capital was bought back. If it is a tiny percentage this time as well, it will have little or no effect on the EPS or P/E. RIL is likely to buy the shares from the open market – which means small investors will get no particular benefit.

A share buyback can be an indication that the management thinks that the shares are undervalued. It can also mean that the company is bereft of ideas about what to do with their money to enhance growth. More likely the latter, based on the totally unrelated ‘di’worse’ifications that the elder Ambani has undertaken of late – into sectors like retail, telecom, media.

Make no mistakes. The refinery business has been – and continues to be - a cash cow. But refinery margins are coming down and the gas business has been mired in controversies. None of the unrelated businesses have performed well so far. Technically, the chart looks weak and the stock price can fall to its 2009 low.

Related Posts

Why rely on Reliance?

1:1 Bonus announcement by Reliance Industries - is it good news for investors?

Use a Stock Screener to make a ‘buy’ list

The down trends in the Sensex and Nifty index charts have completed nine months, and are showing no signs of reversals. In fact, relentless selling by the FIIs in August ‘11 has turned a bad situation (from the bullish point of view) even worse.

Any sensible investor would stay far away from buying in a stock market that is showing all the signs of a full-fledged bear market. So, why a post about making a ‘buy’ list? If you have participated in the Boy Scout movement, then you wouldn’t need an explanation. The motto of the Boy Scouts is: ‘Be Prepared’.

Just as all good things must come to an end – like the heady bull run from the Mar ‘09 low did when it peaked out in Nov ‘10, bad times don’t last forever. In the not too distant future, inflation rates will start to moderate and interest rates will be lowered. The stock market will ‘discount’ the good news in advance and start to rise much earlier. That would be a good time to buy – provided you are ready with a ‘buy’ list.

Small investors face a big problem. With thousands of company stocks traded in the stock market, how does one begin to make a short-list of stocks for more detailed research? This is where a Stock Screener can come in handy. What is a Stock Screener? It is a software that allows you to use certain fundamental criteria to make a short-list of stocks that meet those criteria.

Which Stock Screener should you use? Every financial site probably has one, so there is a lot of choice. You have to do a bit of trial and error to find out one that works well for your style of investing. You can start with the Stock Scanner available at the BSE web site:

http://www.bseindia.com/stockscanner/stockscanner.aspx

It is quite rudimentary, and has only four fundamental criteria that you can use: Last traded price (LTP), Market Capitalisation, EPS and P/E. Each of the four criteria has a range of values to further fine tune your search. Try out with different permutations and combinations to arrive at a short-list from all the stocks traded on the BSE.

Edelweiss has a Stock Screener (as do many other such sites):

http://www.edelweiss.in/Tools/screener.aspx#

This also has four fundamental criteria, with Dividend Yield in place of LTP. An additional feature is you can short-list by specific sectors. If you don’t mind registering at the site (it is free, but you will get periodic mailers), then you can add more criteria for your short-listing.

Let me add here that I’m not a great fan of Stock Screeners – mainly because the criteria I use for short-listing are not available in most of the free software. In any case, you have to do a detailed study of each short-listed stock to find out if it merits a place on your ‘buy’ list.

A Stock Screener can be a good first step for short-listing stocks for making a ‘buy’ list. Be sceptical of unknown stocks that get short-listed. Don’t think that you have ‘discovered’ a hidden gem that the whole world has missed. If you keep trying different combinations, you may get lucky and stumble upon an undervalued stock.

Happy hunting!

The curious case of Crompton Greaves

This is not a post about a court-room thriller, even though the title may sound like one of Erle Stanley Gardner’s page turners. That doesn’t mean that the process of discovery of the real cause behind the serious hammering of the stock price of Crompton Greaves may not be an exciting one.

First, the facts. A less than stellar Q1 result due to significant reduction in the consumer business (mainly electrical appliances) was a shock. That was followed by the revelation that the erstwhile CEO had dumped his entire stock holdings of 180000 shares earlier in the month.

The former CEO took pains to explain that:

(a) he doesn’t like to invest in the stock market but had received the shares as part of his compensation some 11 years back; at that time he had resolved to sell the shares immediately after retirement

(b) he retired on June 1, 2011 and sold the shares within a month of retirement after following due process of informing SEBI and the stock exchanges.

Doubts remained in the minds of investors because of three reasons:

1. Insider selling of large quantity of shares is considered a warning sign

2. Though he retired on June 1, 2011 Mr Trehan is still associated with the company though he doesn’t draw a salary. That means, he had insider’s knowledge about the poor Q1 performance of the company

3. The timing of the sale seemed a bit fortuitous. What if the stock market was in a deeper correction? Would he have sold his shares at lower prices? Alternatively, if the market was in the midst of a strong bull run, would he have waited a little longer to sell at a higher price?

Only Mr Trehan can answer those questions. Bottom line is that a lot of small investors were shaken by the severity of the stock price crash. Since such a crash didn’t occur when the ex-CEO actually sold his shares three weeks back, fingers are being pointed towards a bear cartel that used the fact of the insider sale as an excuse to hammer down the stock price. A fit case for SEBI to look into.

The Joint Managing Director of Havell’s – a competitor of Crompton in the consumer appliances space – does not believe that there is any cause of worry. Retail prices were hiked some time back due to increase in input costs. That may have led to consumers delaying their buying decisions. Another explanation is that distributors picked up more inventory in Q4 to avail of the then lower prices. That is why they lifted less inventory in Q1.

What should small investors do? On a TTM EPS of 10.61, the P/E at today’s closing price of 182.55 is 17.2. Not mouth-watering valuation by any means, but not hugely expensive either. If you are planning to enter, you may want to wait for Q2 results and then decide.

If you are holding the stock and are in profits, use the short-covering bounce up to book a part of it, and hold on to the rest. Remember the old stock market adage: When in doubt, stay out.

How to read an Annual Report

It is that time of the year when Annual Reports start hitting the mailboxes of investors. There are three things you can do with the Annual Reports you receive:

1. Toss it into the recycling pile with the old newspapers and beer bottles without even opening the envelope

2. Check the Profit & Loss statement and the dividend amount before tossing it into the recycling pile

3. Actually take the trouble of going through the Annual Report in detail to find out whether the company whose stocks you are holding is growing, stagnating or flying kites.

In the wild west days in the USA, there used to be a saying: The only good Indian is a dead Indian. Of course they didn’t mean people from India (though Columbus thought he had reached the East Indies – the islands of South East Asia - when he landed up on the shores of the Bahamas).

If you believe that the only good Annual Report is the one lying ‘dead’ in the recycling pile, then this post isn’t for you. If you think otherwise, please read on.

First, go to the Cash Flow Statement to find out if the company is generating enough cash from its business to finance part or most of its expenditure for growth. If you don’t know how to read a Cash Flow Statement, please read my posts of  Mar 22 2011, Mar 24 2011, Mar 29 2011 and Apr 5 2011.

Next, check out the Profit & Loss statement and the Balance Sheet. Of particular interest should be inventory and accounts receivable (if percentage increases are more than the sales percentage increase, they are warning signs); increase in equity capital and loans (not a good sign if these increase frequently); cash in hand/banks should tally with the figure in the Cash Flow Statement (so that a Satyam-like situation doesn’t recur).

Next comes the Directors’ Report and Management Discussion and Analysis. Read through these even though there will be hardly any negative feedback in them. They will give an idea about the industry and the company’s growth plans and (rosy) prospects.

Last, but not the least, are the Notes on Accounts. However boring these notes may seem – particularly to non-accountants like me – they contain a wealth of information that usually have adverse implications on profits. If a company suddenly announces a surprising turnaround or spectacular recovery in results, chance are that they have ‘cooked their books’ (a Punj Lloyd speciality). Look for changes in depreciation calculation and inventory valuation, which can significantly alter profits without an actual improvement in performance.

Also look at the court cases – usually with various tax authorities regarding disputed demands. Prudent managements will make at least part provisions against likely future liabilities. For companies that provide stock options to their employees, use the diluted EPS to calculate P/E ratios. For companies that have several subsidiaries – listed or otherwise – use the consolidated results for analysis.

There are many other things to look for in an Annual Report – but these are the broad areas for a first-cut analysis to ensure that business and growth are on track.

(Note: Thanks to reader Jalal for suggesting this topic.)

What exactly is the Margin of Safety?

The heading of Chapter 20 of Benjamin Graham's 'The Intelligent Investor' (4th edition) reads: "Margin of Safety" as the Central Concept of Investment.

What is the Margin of Safety as applicable to stock investments? It is the amount by which a stock's price is lower than the intrinsic, or underlying, value of the stock.

There are several methods by which one can arrive at the intrinsic value of a company's stock - and I plan to write a post about it in future. Suffice it to say that none of these methods can give an exact value. At best it will be a reasonably close approximation.

Here is a definition from the master:

'Over a ten-year period the typical excess of stock earning power over bond interest may aggregate 50% of the price paid. The figure is sufficient to provide a very real margin of safety - which, under favorable conditions, will prevent or minimize a loss. If such a margin is present in each of a diversified list of twenty or more stocks, the probability of a favorable result under "fairly normal conditions" becomes very large.'

Some terms may require a bit more explanation. By 'bond interest', Graham means yield from strong corporate bonds. Since the bond market in India is underdeveloped, we will use Fixed Deposit(FD) interest in a public sector bank as an equivalent guideline. 'Stock earning power' is the same as earnings yield, which is the inverse of the P/E ratio.

Enough talk. Time for some concrete examples.

(a) Company XYZ has declared its results and has an EPS (i.e. earnings per share, calculated by dividing the net profit by the number of equity shares) of 10. The recent market rally has taken the stock's price to 150. That gives a P/E ratio of 15.

The earnings yield is E/P= 1/15= 6.7%. This is lower than the current FD interest rate of 8%. The Margin of Safety is a negative 1.3% (=6.7-8). What does it mean? The current yield from the stock is less than that from a risk free FD.

(b) Company PQR also has an EPS of 10. But its price hasn't moved up as much as XYZ, and is currently trading at 100. The P/E is 10 and the earnings yield= E/P= 10%. The Margin of Safety is 2%. That gives an excess of only 20% over the FD interest, which doesn't meet Graham's criterion of 50% excess over a 10 year period.

(c) Company ABC has a lower EPS of 9, and its price is also lower at 63. The P/E is 7; earnings yield= E/P= 14%; Margin of Safety is 6%. This meets Graham's criteria, because the excess of stock earning power over FD yield is 60% over 10 years. The greater risk of owning the stock is adequately covered by the margin of safety.

Does it mean that you rush out to buy Company ABC? Not yet. You still have to perform a detailed fundamental analysis using Graham's criteria mentioned in my earlier blog post about stock picking (link given below).

These examples have been simplified by excluding the effects of inflation and any tax incidence. But the 'Central Concept of Investment' is de-risking your portfolio by maintaining adequate margin of safety for each stock that you select.

Even by using the Margin of Safety method, you may pick a stock or two that go down. That is why Graham has mentioned owning about 20 stocks, so that in aggregate, the portfolio will gain over the long term.

Graham passed away in 1976. How relevant are these figures and methods in today's environment? Apparently, they work just as well, as John Reese has mentioned in his book, The Guru Investor.

Individual investors can tweak the figures to suit their investment style and risk tolerance. Remember that it is just as important to protect the downside of your portfolio while you try to build long term wealth through stock investments.

For those readers, who are beginning to get a little tired of my exhortations towards the slow but steady value investing concept of wealth building, I have some good news.

By keeping a higher margin of safety, even fundamentally weak stocks can be bought when they sink to abysmal depths during bear markets. Just look at the prices of Satyam, Suzlon, Unitech when they hit their recent bottoms, and compare with current prices. But that would be succumbing to the 'greater fool' theory!

Related posts

How to pick Stocks for Investment - Part III

How to build wealth using a buy and hold strategy