Sensex, Nifty charts (Oct 18, 2019): down trend lines breached; new highs on the cards?

FIIs were net buyers of equity on all five trading days. Their total net buying was worth Rs 32.1 Billion. DIIs were net sellers of equity on Mon. and Thu. (Oct 14 and 17), but net buyers on the other three days of the week. Their total net buying was worth Rs 21.8 Billion, as per provisional figures.

According to a Nielsen report, India's FMCG market clocked a value growth of 7.3% during Q2 (Sep '19) - down from 16.2% during Q2 (Sep '18) - as rural growth dropped below urban growth for the first time in 7 years.  

The IMF has supported India's monetary policy stimulus and recent reduction in corporate income tax, which are expected to help revive investment. However, India should address continued fiscal consolidation and the NBFC issues.

BSE Sensex index chart pattern

The daily bar chart pattern of Sensex got a sharp bullish boost as FIIs turned buyers during the week. The index breached the (blue) down trend line that has dominated the chart for the past four months.

The breakout hasn't been a technically convincing one yet, because accompanying volumes (not shown) were not significantly higher during the trend line breach. That can change if FIIs continue to buy, and small investors decide to join the bandwagon. 

Daily technical indicators are looking bullish. MACD is moving above its signal line in bullish zone. ROC is poised to enter its overbought zone. RSI is above its 50% level. Slow stochastic has entered its overbought zone. More near-term index upside is possible, but some consolidation or correction may follow.

All three EMAs are rising, and the index is trading well above them in a bull market. If FIIs continue their buying spree, the market may celebrate a new index high by Diwali.

Just a handful of large-cap stocks - like RIL, HUL, HDFC Bank - are leading the rally. Small investors who are itching to jump into the market should follow a SIP mode when buying stocks. Avoid lump sum buying in beaten down small-cap stocks.

The stock market provides opportunities during bull and bear phases. However, buying near an all-time index high is not a great idea. 

NSE Nifty index chart pattern

The weekly bar chart pattern of Nifty rallied to breach the (blue) down trend line, thanks to strong buying by FIIs. The break out has not been a convincing one yet, but that can change if FIIs continue buying.

Weekly technical indicators are looking neutral to bullish. MACD and RSI are at their respective neutral zones, but showing upward momentum. ROC has risen to the edge of its overbought zone. Slow stochastic is rising above its 50% level. Some more near-term index upside is possible.

Nifty's TTM P/E has moved up to 26.94 - which is well above its long-term average inside overbought zone. The breadth indicator NSE TRIN (not shown) is falling in neutral zone, and can limit near-term index upside. 

Bottomline? Sensex and Nifty charts have breached their 4 months old down trend lines. A cut in corporate taxes, followed by FII buying have boosted bullish sentiments. Both indices might try to touch new highs by Diwali.

Technical updates – Colgate and HUL

Why do I like FMCG stocks? Predictability of earnings. Plus the fact that most companies are almost debt free, generate huge cash flows, pay regular dividends and grow steadily whether it is a bull or a bear cycle in the market.

But aren't they expensive? Sure they are. So are BMW cars and Harley Davidson motorcycles. Just as you can (and probably do) buy expensive vehicles using EMIs, you can buy expensive FMCG stocks using SIPs.

Colgate and HUL - two of the better known stocks in the FMCG sector - gave very little capital gains for nearly 18 of the previous 24 months. But they have 'caught fire' during the past 6 months - thanks to demonetisation and GST. 

The balance of power is shifting from the unorganised to the organised sector. The FMCG sector will be one of the biggest gainers of this shift. If you have avoided the sector because it is 'too expensive', it is time for a rethink.

Colgate

Colgate's stock has tested the patience of long-term investors. But long-term investors know the benefit of patience.

After moving sideways in a broad range of about 200 points - giving longer term trading opportunities, the stock has rallied sharply to close at a high of 1128 on Jul 3 '17.

Overbought technical indicators that showed negative divergences by failing to touch new highs with the stock have triggered some profit booking. The dip is providing an entry opportunity.

HUL

HUL's stock moved sideways within a 160 points range - testing the patience of long-term investors. But their patience has been well rewarded. 

The stock rose sharply to close at a high of 1124 on Jun 21 '17. But all four daily technical indicators touched lower tops. The combined negative divergences led to a correction down to its 20 day EMA, which has provided good support.

The stock can correct/consolidate a bit more. 

The best way to accumulate HUL is to spare 10K or 20K from your monthly savings and just go on buying for the next 5 years. (I can assure you that it is better than paying EMIs on a BMW or a Harley - both of which are depreciating assets.)

Is BrExit offering a good stock-picking opportunity? - a guest post

The BrExit referendum was expected to be a close contest between those who wanted the UK to 'remain' within the Eurozone and those who wanted the UK to 'exit'. The actual result was unexpected. 

Actually, UK was never a fully integrated part of the Eurozone - as they maintained their own currency and visa system. A large number of those who voted for BrExit may have been duped by politicians into thinking that the 'leave' vote was an 'anti-immigration' vote.

The legal negotiations between UK and the Eurozone will start now to make the referendum a reality. That will take till the end of calendar year 2017. Nothing has actually changed on the ground yet. Still, stock markets over-reacted on the downside.

And therein may lie an opportunity. In this month's guest post, Nishit identifies some industry sectors that are unlikely to be affected whether UK eventually leaves the Eurozone or not.   

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BREXIT has happened and the world is behaving as if it is about to end. The stock markets are correcting and this is a time to add several good stocks.

What is BREXIT? It is simply the UK leaving the European Union. All trade agreements made with the EU will not be valid after 2 years (from the date when the UK triggers the Exit clause). Fresh trade agreements will have to be put in place with the UK.

Now, there are several sectors which could be affected, viz. the IT sector as also export dependent sectors like pharma, textiles and auto-ancilliaries. What will happen is that the currency market will be in a state of flux. The Pound will get weaker and the US Dollar will get stronger with safe haven demand. The US will try to devalue the Dollar for its exports to remain competitive.

International Trade will face some hiccoughs. At the same time, there are several sectors which are not dependent on exports. They are purely domestic consumption stories. These are Sugar, FMCG, Packaging and sectors whose products are mainly consumed in India.

A safe bet during these turbulent times would be to focus on sectors which have less exposure to exports and are more focused on the domestic markets. India’s growing middle class will continue to consume, and there will always be demand for soap, hair oil, cooking oil, toothpaste, biscuits, cigarettes, liquor.

Also, with news of a good monsoon, rural demand will pick up. Two wheeler and tractor manufacturers will be in demand. Last 2 years have been drought years so many farmers have not changed their equipment for a substantial time now. A good harvest can led to increase in rural demand.

The Power Sector also is not dependent on external factors ever since Coal India made plentiful coal available. When the markets fall, everything falls and this is a good opportunity to focus on such stories which are not affected by BREXIT.

Such falls give the best buying opportunities. Remember the 'GrExit' drama in August 2013 when the Nifty hit 5118. Those who bought then doubled or tripled their money.

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(Nishit Vadhavkar is a Quality Manager working at an IT MNC. Deciphering economics, equity markets and piercing the jargon to make it understandable to all is his passion. "We work hard for our money, our money should work even harder for us" is his motto.

Nishit blogs at Money Manthan. You can reach him at nish.stockid@gmail.com)

Top-down Analysis: Finding the Right Sectors and Stocks

The stock market seems to be recovering from a year-long correction. Experts and analysts are suggesting that the next leg of a long-term bull market is about to unfold.

This is a good time for new investors to start building an investment portfolio. Note that I haven't mentioned anything about buying stocks just yet. 

Building an investment portfolio that will generate inflation-beating returns for many years requires careful planning and analysis. So, how should you begin the process?

Ideally, you should get in touch with a financial planner who will hand-hold you through the process of preparing a financial plan based on your current and future earnings and financial commitments.

Another option is to spend some time on research about how to prepare a financial plan, and do it yourself. It is not rocket science. Basic math skills and accounting knowledge is good enough.

Next, properly assess your risk tolerance. There are tools available to do such an assessment.

Based on your financial plan and risk tolerance, an asset allocation plan should be prepared. What is the necessity of an asset allocation plan? 

It diversifies your investments among different asset classes - like equity, mutual funds, fixed income instruments, gold - to enable better returns under different market conditions.

Now you are ready to build your investment portfolio according to your financial plan, risk tolerance and asset allocation plan.

To beat inflation, you have to invest in equity shares. It is not just about opening trading and demat accounts. You need to know which stocks to buy. 

For that, you need to go through another process, called Top-down Analysis - where you figure out how the economy is doing and which sectors are likely to perform better during the next leg of the bull market.

It helps to have some knowledge of the business processes in the identified sectors. 

If you have identified FMCG sector as a potential money-spinner due to the thrust on rural income by the government, you need to know that companies in the sector typically have huge advertisement costs, strong cash flows, low capex, well-known brands, high P/E, low growth, good dividend payouts.

You can choose the top two or three companies based on their rural distribution reach. Repeat the exercise for three or four more sectors to get adequate diversification. 

Now you have 10-12 stocks from three-four sectors for the equity part of your portfolio.

Read more about Top-down Analysis here.

Related Post

How to Pick Stocks for Investment - Part II

Spotting Cash Cows

Before you can spot cash cows, you must understand the true nature of the beast. The good news(?) is that cash cows will never get banned from slaughter. That means, bears can pounce on them at any time. They may get badly hurt, but hardly ever get killed.

A cash cow is a company that generates a lot of free cash flow. That means the cash it generates from its operations comfortably exceeds all its expenses. The actual formula for calculating free cash flow is:

Cash flow from operations – Capital expenditure = Free cash flow

The two items on the left side of the equation can be found from the Cash Flow Statement in Annual Reports. (If you haven’t yet learned how to read the Cash Flow Statement, click on the links at the bottom of this post.)

The lower the capital expenditure, the greater will be the free cash flow. Isn’t capital expenditure necessary for growth? Definitely yes for early-stage companies, which need to chase growth for survival and establish market leadership.

For more mature, stable companies that are sector leaders, high growth may no longer be feasible. They can rely on their existing assets to keep generating profits. Typically, FMCG companies fall in this category.

Aren’t FMCG companies boring and highly priced? Yes to both. But there is a reason for their high price. Due to their large free cash flows, they are usually low-debt or debt-free companies and are able to withstand economic (and market) downturns much better.

Why? Because you will still need to brush your teeth and wash your clothes regardless of the state of the economy and the market.

Read more about how to spot cash cows in this recent article in investopedia.com – and learn whether all cash cows are investment-worthy.

Related Posts

How to read the Cash Flow Statement – Part 1

How to read the Cash Flow Statement – Part 2

A Simple Exercise on Cash Flows

A Solution to the Exercise on Cash Flows

Stock Chart Pattern - Marico Ltd (An Update)

The previous update to the technical chart pattern of Marico Ltd was posted on Mar 23 ‘11 when the stock had closed at 129.45 (marked by grey vertical line on chart below). Earlier, after touching an intra-day top of 153 in Oct ‘10, the stock had started correcting a little ahead of the broader market. On Feb 9 ‘11, the intermediate correction had ended with a high volume ‘reversal day’ pattern as the stock touched an intra-day low of 112.10 – well below its 200 day EMA.

The 20 day EMA had briefly fallen below the 200 day EMA, but the 50 day EMA did not do so. That was an indication that the bull market was intact and the dip was a buying opportunity. The concluding comments in the previous post are worth repeating: “Small investors should add such stocks to their portfolios for steady gains and downside protection, instead of running after mythical multibaggers. Existing holders can top up their holdings. New entrants should wait for a convincing break above 136 to buy.”

The daily bar chart pattern of Marico Ltd clearly shows that investors would have benefitted by following the recommendation to buy:

Shortly after the previous post, the stock price rose to test the support-resistance level of 136 and crossed above. A few days of sideways consolidation in Apr ‘11 was followed by a sharp rise to 150 – an unsuccessful test of the Oct ‘10 peak of 153. The stock price dropped down below its 20 day and 50 day EMAs in May ‘11, but found good support from the rising 200 day EMA.

Another test of its previous top stopped short at 151.80 on May 31 ‘11. This time, the correction received combined support from the 50 day EMA and the 136 level. The subsequent up move comfortably crossed the previous top of 153 and touched a new high of 172.70 on Jul 27 ‘11 – a respectable 33% gain in 4 months.

For the next 6 months, the stock was in a period of consolidation during which the 200 day EMA provided good support – except for a few days in Dec ‘11, when it dropped below its long-term moving average and the 136 level. Dec ‘11 had marked the 52 week low on the Nifty and Sensex charts, while Marico’s stock touched a higher bottom.

The entire 6 months long consolidation formed the ‘cup’ of a ‘cup and handle’ bullish continuation pattern. The ‘handle’ formation took about a month – from early Feb to early Mar ‘12 – with the stock price getting support from the rising 50 day EMA. The next leg of the up move reached a new high of 184.40 on Apr 25 ‘12.

Before touching the new high, the stock started consolidating within a rectangular pattern between 176 and 184 and broke down from the pattern on May 14 ‘12. A drop to the rising 200 day EMA (at about 160) is a possibility, which may provide an opportunity to add/enter.

The technical indicators are quite bearish and pointing to a deeper correction. The MACD is below its signal line and has dropped inside negative territory. The ROC is negative and below its falling 10 day MA. The RSI has bounced up from the edge of its oversold zone. The slow stochastic is inside the oversold zone.

Bottomline? The stock chart pattern of Marico Ltd is undergoing a bull market correction and providing an entry opportunity. At the risk of sounding like a broken record (or a scratched CD), investors should seriously consider adding FMCG stocks like Marico to their portfolios. The high P/E ratios of FMCG stocks should not be a deterrent. Good things are never cheap!

Why do small investors get ‘cheated’?

The cynical answer to the question is: Because they deserve it. The cynicism can be explained by a recent incident during my last visit to the local market.

I was buying half a kilo of Kashmiri apples – the small, roundish kind with alternate patches of bright red and light green colours. They have a crisp, lightly sweet and fresh taste that takes me back on waves of nostalgia to my only trip to Kashmir more than 50 years ago. A place of such pristine and gorgeous beauty I have rarely ever seen again. But I digress.

As is my habit, I asked the rate per kilo, and was told by the young fruit vendor that it was Rs 80. As the young fellow was weighing the fruits, a middle-aged gentleman came by. He wanted to buy half a kilo of the Kashmiri apples as well, and proffered a Rs 50 note with this comment: “It is Rs 100 a kilo, isn’t it?”

The fruit seller glanced at me quickly, and observing my blank expression, simply nodded his head and promptly took the Rs 50 note. Now, being overcharged Rs 10 for half a kilo of apples may not seem like a big deal. The point is, the buyer unnecessarily tried to show-off that he was a knowledgeable buyer, and allowed himself to be ‘cheated’.

Should I have pointed out the correct price to the buyer and saved him Rs 10? That would have broken the mutual trust that has developed between the young fruit vendor and me over the past several years. I pay him whatever rate he asks, and he always gives me the best fruits from his pile.

What does all this have to do with investments? Change the ‘half a kilo’ to ‘500 shares’; ‘Kashmiri apples’ to ‘Dabur India’ (say); and ‘young fruit vendor’ to ‘Rakesh Jhunjhunwala’ (or, Ramesh Damani). A small investor could have bought Dabur shares for Rs 80 a few months back, but may choose to buy them at Rs 100 now. Due to the bear phase, the stock goes nowhere. After a couple of months, the stock’s price may drop to Rs 90, and the investor will probably exit in a hurry with a Rs 10 loss. Except that the loss is not Rs 10, but Rs 5000 – since the original quantity bought was 500 shares.

The investor feels ‘cheated’ because he bought a well-known FMCG stock, and still lost a decent amount of money. The fact that he made a couple of serious mistakes - buying at a higher price, and then selling at a loss because of a short-term mentality – may not dawn on him. A few more similar experiences may keep the investor permanently away from the stock market – with the feeling that the market is ‘manipulated by operators’ to ‘cheat’ innocent investors.

The moral of the story? Don’t allow yourself to be cheated. Do some prior preparation and planning. Talk to veterans of the market. Read a few books. Understand how the game is played. Opening a demat account and a trading account is a necessary formality but not adequate preparation for buying stocks.

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.)

A Solution to the Exercise on Cash Flows

Last week’s exercise on Cash Flows drew a large number of readers, but, disappointingly, only 6 responses. That could be because of three reasons: (a) most readers did not understand the concept of cash flow; (b) readers felt shy about making an incorrect response in an open forum; (c) readers did not feel that cash flow is an important enough concept to break their heads over.

Now that the Sensex is on the upswing again after nearly 5 months of correction, the participation in various investment groups and chat boards have increased significantly. Many of the topics are nothing but a succession of ‘buy’ calls on stocks of various pedigree, mostly questionable, with a stop-loss 2 points below the ‘buy’ price and targets of 3 points and 5 points above the ‘buy’ price. Gleeful announcements follow that the first target has been hit and one should book 50% of profits!

If more young investors learned the basics – and let me emphasise that cash flow is one of the most important concepts any investor should learn – they would know how to make really big money, instead of being happy with a 3 point or 5 point profit in 2 days (which they don’t forget to annualise into huge percentage gains to ‘prove’ their stock-picking prowess).

Pardon the rant. Now a turn to acknowledge the 6 readers who had the interest and intelligence to read and understand the concept of cash flow, and the guts to attempt answers to the exercise. Well done. All of you are winners, because you can consider yourself a few cuts above ordinary investors, who jump into the market with no idea of what they are doing.

There were no ‘right’ or ‘wrong’ answers, because stock picking depends on individual preferences and risk tolerance levels. But a distinction needs to be made on the process one follows to take a decision about a particular stock. A special hat-tip to reader ‘TK’ for the most logical way of arriving at his decision. My anonymous subscriber’s response was the next best.

Just to recap the concept of cash flow, a positive number is an inflow and a negative number is an outflow. In cash flow from operating activities, a positive number is preferred. A business should not just generate profits, it must generate cash – not as an amount to be received at some future date (which is represented by a negative cash flow). Often, the profit figure is an accounting sleight of hand. So the negative cash flow never turns positive. On this aspect alone, Company ‘A’ beats ‘B’ and ‘C’ hands down. (Cash flow can be fudged also – but will show up in the Balance Sheet. This is what Ramalinga Raju did at Satyam, and his auditors ignored or overlooked it.)

‘A’ has also been investing regularly in expanding its activities, as can be seen from the negative cash flow from investing activities. Negative cash flow here is actually good for the business. However, if the cash generated from operating activities is insufficient – as was the case in ‘06, ‘07 and ‘09 – there is no option but to resort to borrowing. Note that the cash flow from financing activities were large positive amounts. In the two years (‘08 and ‘10) that substantial cash was generated from operations, the company paid back some of its debts – as can be seen from the negative cash flow from financing activities. A sign of financial prudence.

What can’t be made out from the abridged cash flow statements is the total debt burden and interest payments. If the debt/equity ratio (which is calculated from the Balance Sheet) is more than 1, then the company may get into a debt trap after one or two bad years. Another metric to check is whether interest payment exceeds net profit (which can be observed from the P&L statement). If it does, then the banks are benefitting more than investors.

As far as ‘B’ and ‘C’ are concerned, both fail the test because I only consider companies suitable for investment if they have positive cash flow from operating activities in at least 4 of the past 5 years. Of the two, ‘B’ is better because it has achieved higher profits on lower levels of debt (as can be seen from the cash flow from financing activities). Also, its profits are growing, whereas profits of ‘C’ are stagnating.

Please appreciate that this particular analysis is a bit simplistic because the cash flow statements are abridged. However, it provides a good overall picture for short-listing potential companies to invest in. A more detailed analysis of the Balance Sheet and P&L statement should be conducted before taking a ‘buy’ decision.

Ideally, a company should not only have positive cash flow from operating activities, but also positive free cash flow. That means, cash flow from operating activities should be more than enough to fund any capital expenditure. Such is the case with many FMCG companies. One reason why FMCG is my favourite sector.

(Note: Company ‘A’ – Aurobindo Pharma; Company ‘B’ – IVRCL Infra.; Company ‘C’ – Pantaloon Retail. No particular reason for picking these three – other than the fact that they can be ranked based on their cash flow statement.)

How to read the Cash Flow Statement – Part 2

In last Tuesday’s post, I had covered the first part of the Cash Flow Statement – Cash Flow from Operating Activities. The next two parts will be discussed in this post.

Part 2: Cash Flow from Investing Activities 

To remain in business over the long haul, a company needs to grow. Without growth, a business will stagnate and eventually die or get acquired. But growth has a price. Cash has to be spent to buy land, machinery and related equipment, build factories and offices, acquire other companies, start subsidiaries or joint ventures, and make appropriate investments.

All of the above comes under Cash Flow from Investing Activities. You don’t have to be a genius to guess that this figure will be a (negative) one for most companies. Many mature companies, particularly those in the FMCG sector, don’t have much need for Capital Expenditure (i.e. spending cash on factories and equipment) because their rate of growth has slowed down.

Ideally, the depreciation amount in the Profit and Loss statement should be less than or equal to the amount of cash being spent in investing activities – because depreciation is meant to cover the notional loss due to wear and tear of the existing plant and machinery. If a company does not continuously spend on upgrading and modernising its facilities, it will not be able to compete with newer entrants who may have the latest technology and equipment.

The definition of Free Cash Flow is:

Cash Flow from Operating Activities – Capital Expenditure

This is a (negative) number for companies in their early growth stage, when cash generated from core operations may be insufficient to cover the cost of capital expenditure. But for well-established companies, positive Free Cash Flow is an indication of financial health. The more positive Free Cash Flow a company can generate, the easier it is for them to expand, acquire, pay dividend or buy back shares, and pay off loans.

Part 3: Cash Flow from Financing Activities 

What if a company has (negative) Free Cash Flow, or still worse, has (negative) Cash Flow from Operating Activities? Where will they get the cash to pay their suppliers, interest to banks for any loans taken, and for growing the business?

They can either resort to more borrowings, and/or issue more shares. If such companies are showing a net profit, then they are also expected to pay dividends to their shareholders. All inflows and outflows of cash due to loans, share issues, share buybacks, dividend payments come within Cash Flow from Financing Activities.

Financial prudence should dictate a company’s growth plans. As a thumb rule for selecting good stocks, about 60-70% of the Cash Flow from Investing Activities (Part 2) should be funded by positive Cash Flow from Operating Activities (Part 1); the balance 30-40% should come from Cash Flow from Financing Activities (Part 3).

Many companies forget the simple adage that one should cut one’s coat according to the cloth. They may even have positive Cash Flow from Operating Activities, but their ambitious growth plans require far more cash than they can afford. They resort to frequent borrowings and share issues in the hope of reaching the top quickly. One or two bad years can bring such companies down to their knees. Pantaloon and Suzlon come to mind.

(Note: The financial health of banks and financial institutions can’t be judged by analysing the Cash Flow Statement alone – because they need to borrow cash to give loans, and invariably have negative Cash Flow from Operating Activities. Price to Book Value and Return on Assets are better measures for such companies.)

Related Post

What is the Return on Assets (RoA) ratio?

Stock Chart Pattern - Marico Ltd (An Update)

The previous update on the stock chart pattern of Marico Ltd was in May ‘10. The stock had just hit an intra-day low below 100, and the technical indicators as well as volume spikes on down days were pointing to further downside.

But the stock took support from its rising 200 day EMA, and embarked on the next leg of the rally, hitting a new intra-day high of 136 on Jun 30 ‘10. When I wrote the original post back in Jul ‘09, the stock had moved above its Jan ‘08 bull market peak and was looking overbought at 90. Reader Sumit disagreed, and suggested a target of 160 within 2 years. I am not ashamed to admit that Sumit was right – as the one year bar chart pattern of Marico Ltd will reveal:

The stock price corrected from 136 down below the 50 day EMA to 116 on Aug 12 ‘10 – which happened to be a high volume ‘reversal day’ (lower low, higher close). The next rally ended with a sharp intra-day spike to 153 on Oct 25 ‘10 – nearly meeting Sumit’s target.

The stock continued to move higher on a closing basis for a few more days, but the down trend had begun. Note the negative divergences in the technical indicators (marked with blue arrows) – they touched lower tops as the stock reached a higher top.

The down trend appears to have ended with another very high volume ‘reversal day’ pattern on Feb 9 ‘11. The subsequent rally first broke the down trend line on Mar 7 ‘11, followed by a breach of the support/resistance level of 136 on Mar 16 ‘11.

A pullback to the down trend line is in progress. Twin supports from the rising 50 day EMA and the down trend line should make this a possible entry point. Despite the stock spending several trading sessions below the 200 day EMA and correcting more than 25% from its Oct ‘10 peak, a bear market didn’t get confirmed because the 50 day EMA never crossed below the 200 day EMA (‘death cross’).

Both the 50 day and 200 day EMAs are rising again with the stock trading above them, signifying a bull market. The technical indicators are showing some weakness – thanks to the pullback. The MACD is positive but has slipped below its signal line. The ROC has dropped below its 10 day MA into negative territory. Both the RSI and slow stochastic are falling towards their 50% levels after visiting their overbought zones. The stock may consolidate a bit between the down trend line and the 136 level.

Marico Ltd is fundamentally strong, though margins are under pressure. A TTM P/E of more than 32 doesn’t leave any ‘Margin of Safety’. Still, the stock has given more than 25% returns in 10 months – a good reason why small investors should take a serious look at this FMCG company.

Bottomline? The stock chart pattern of Marico Ltd is an example of why FMCG is my favourite sector. Small investors should add such stocks to their portfolios for steady gains and downside protection, instead of running after mythical multibaggers. Existing holders can top up their holdings. New entrants should wait for a convincing break above 136 to buy.

Stock Chart Pattern - Marico Ltd (An Update)

When I analysed the stock chart pattern of Marico Ltd in end-July '09, it had risen from a low of 47 to a high of 92 and was showing signs of being overbought. Brokerages were giving 'buy' calls but I expected a correction.

A growing, fundamentally strong FMCG company like Marico Ltd is just the kind of company that small investors should consider investing in - particularly during uncertain times. But one should always exercise caution near a chart top.

It is time to have a re-look at the one year bar chart pattern of Marico Ltd:

 

The stock corrected from 92 down to 78, where it received support from the rising 50 day MA. Now 14 points don't seem like much of a correction, does it? But for a Re 1/- face value stock that isn't a measly amount. In fact, it was a 31% retracement of the rise from the bear market low of 47 to 92, and a 15% correction from the high of 92.

The technical health of the stock got restored, and it rose steadily for the next 3 months to hit a new high of 113 in Nov '09. Thereafter, the stock got into a sideways consolidation phase that lasted almost 5 months.

A second bottom at 96 in late Feb '10 saw the stock moving up smartly, ending with a sharp upward breakout from the consolidation zone. The stock touched a high of 122 on Apr 5 '10 - but on low volumes. All three technical indicators made lower tops - indicating negative divergences.

The bears took the opportunity to go on the offensive. The stock hit a low of 105 earlier this month, then rallied to 118 before dropping to 100 in quick time. A bearish 'lower top - lower bottom' pattern has formed.

The stock is trading at an EPS of 28, which is higher than ITC's EPS of 25. Support levels at 96, 92, 87 and 78 have been marked on the chart. The 92-96 zone should provide strong support. The band between 78 and 87 could be a better entry opportunity.

The MACD is getting deeper into negative territory. The slow stochastic has entered the oversold zone. The RSI is showing positive divergence, by making a higher bottom as the stock made a lower one.

Bottomline? The stock chart pattern of Marico Ltd is hinting at more weakness. Prices neither rise nor fall in one go. So a bit of up move and consolidation can be expected. Further down side is indicated by the down day volume spikes, which are a sign of distribution.

What does the Debt/Equity ratio indicate?

An important measurement of a company's financial health is the Debt/Equity ratio. In an earlier article, I had discussed about assessing a company's financial health by calculating the 'Current ratio' and 'Quick ratio'.

The usually applicable definition of the Debt/Equity ratio is:

Debt/Equity ratio = Total debt / Shareholder's equity

Total debt includes both short term and long term debt, such as, secured and unsecured loans, mortgage payments. Shareholder's equity includes equity shares and reserves. (Preference shares can be a part of debt or of equity, depending on the terms of issue.)

Accountants some times use 'total liabilities' instead of 'total debt' in the Debt/Equity ratio to assess a company's true financial health. There is logic behind such a definition. But we will use the commonly accepted definition mentioned.

What does the Debt/Equity ratio indicate? It measures how much money a company can borrow over the long term without running into payment problems. When a company keeps borrowing, its fixed costs keep increasing due to the interest payments.

Is that a bad thing? Not necessarily. A newly formed company and/or one that is on a high-growth path may not be able to raise much equity capital because of lack of track record or the state of the stock market (or because it has already raised a lot of equity). Recourse to debt may be the only option for growth and survival.

As long as the interest and principal repayment costs can be covered by the cash generated from operations, there should be no problems at all. A company that can earn 17% on every Rupee invested and is able to borrow at 12%, will be foolish not to borrow when business is good. Every additional Rupee earned after fixed costs are covered, goes straight to profits.

Trouble starts when a company tries to grow too fast too soon and takes on too much debt. When the going is good, it can make bumper profits. During a business downturn, the high fixed costs can reduce the earnings drastically. And if a company has a long receivables cycle, or huge inventory (like in manufacturing and retail) then it may face difficulty in making payments, and to make matters even worse, need to borrow more (a la Pantaloon).

Ideally Debt/Equity ratio should be less than 1, and the lower the better. But this is a thumb-rule. For certain industries like auto manufacturing, the ratio can be 2 or more. One needs to make peer comparison in a sector or industry to arrive at typical ratios.

Bloated equity can obviously lower the Debt/Equity ratio. Is that good or bad? Given a choice, I'd prefer a company with high equity than one with high debt. Why? There are no fixed costs involved with equity shares. If business is good, more dividend payout may be involved. If business is bad, dividend payment can be slashed. Interest payments due to high debt will need to be paid regardless.

There are downsides to bloated equity. With too many shares available in the market, stock prices tend to stay depressed. Also, each individual shareholder may end up with a smaller percentage of the company's equity if shares are issued to FIIs and private equity investors. This should not affect small investors holding a couple of hundred shares.

Too small an equity capital restricts the ability of a company to borrow large sums of money. Most loans are sanctioned as a percentage of shareholder's equity. That is why you may find a huge bonus issue (like 5:1 or 10:1) preceding a company's intention to take on a big loan - for growth or an acquisition.

What about companies with Debt/Equity ratio close to zero? These are usually stalwart businesses that have been around for years and generate a huge amount of cash flow from operations. FMCG companies are a good example. Because they are in a mature sector, growth is typically in single digits. Taking on additional debt is meaningless, because internal accruals may be sufficient for any expansion.

Stock Chart Pattern - Hindustan Unilever

One look at the stock chart pattern of Hindustan Lever (sorry, Unilever - I'm just too comfortable with the older name) and you will know why it is my all-time favourite 'defensive' stock.

HUL is unlikely to give you multi-bagger returns. The days of super growth in the detergent-soap-toothpaste segment of the FMCG sector are over. That happened back in the 1970s and 80s.

If you want to preserve your capital during vicious bear attacks and like steady returns from tax-free dividends, there are very few stocks that can match HUL. This is not a stock for day traders. But there are plenty of opportunities for longer term trading.

Without further ado, let's take a look at the long term weekly closing chart pattern of Hindustan Unilever:-

  

(Please right-click on the chart; open it in a new tab or window for a better view.)

After making a low of 166 on Mar 7, '07 the stock entered a long term bull market of its own, trading within the up trend (green) channel that is not only intact but remained so right through the bear market from Jan '08 onwards.

A 'buy-and-hold' investor would have made a decent gain of 70% in a little less than two years, had he bought at 166 and sold at 267 in Dec '08 (including the dividends in between).

Also look at the trading opportunities for a more adventurous person. Every time the stock has come near the lower end of the channel it has jumped up.

The recent up trend in the Sensex from Mar '09 onwards has seen some selling in HUL and it has once again dropped down towards the lower end of the channel.

The RSI is about to enter the oversold region. The MACD and ROC are just below their zero lines. The slow stochastic is below the 50% line but still above the oversold zone. The stock may drift down a little more before it takes support at the lower trend line.

Bottomline? With the stock market undergoing a much needed correction, the HUL stock chart pattern looks poised for another rise within its bullish channel. Existing investors should hold on and await the dividend of Rs 4 per share announced recently. Bravehearts can enter now with a stop-loss at Rs 200.

Stock Market News, Financial News - Mar 6, 2009

Asia stocks slide as Wall Street hits 12-year low

By Eric Burroughs

HONG KONG (Reuters) - Asia stocks slid on Friday after a warning from General Motors' that it may need to file for bankruptcy drove Wall Street shares to 12-year lows and highlighted the severe troubles of major U.S. companies and banks.

World stocks struck a six-year low as Japan's Nikkei average fell about 3 percent in early trade, with shares in the country's big exporters and banks taking the biggest hit. (More...)

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Banks' retail lending model can't handle rate shocks, slump: IBA

By Financial Express Bureau

Retail lending model followed by Indian banks is either unsustainable or dependent on high economic growth. It was not designed to withstand interest rate shocks, or the slowdown in the country's economic growth rate.

A recent report released by Indian Banks' Association (IBA) titled 'Retail Lending Balancing Concerns in Difficult Times' has identified few weaknesses in the retail lending model of the Indian banking sector that need to be addressed. (More ... )

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Parsvnath launches affordable housing project in Lucknow

By Financial Express Bureau

In what can be termed as a major price correction, real estate player, Parsvnath Developers Ltd (PDL), which has is present across 50 cities and 17 states in India has launched an affordable housing scheme in Lucknow.

Branded Parsvnath Royale Floors, the project would be part of the group's integrated township called Parsvnath City and would target the economy-class buyers. (More ... )

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GSK to focus on RandD, new launches

By Kakoli Chatterjee, Indian Express Finance

GlaxoSmithKline Consumer Healthcare India is going ahead aggressively with its plans around development and launches of new products. In the next 12-18 months, the company will be launching new products in three categories in the health and nutrition segment, at an investment of Rs 10 crore upwards.

"In a couple of years' time, we are expecting the Horlicks brand to contribute around 15% of the topline of GlaxoSmithKline Consumer Healthcare", Shubhajit Sen, executive vice president GlaxoSmithKline Consumer Healthcare said. The company launched Horlicks nutribar about a week back in three flavours--cereal 'n' milk, choco crispy and nuts 'n' raisins. Priced at Rs 15, the nutribar is placed in the nutritional snack category and targets the 'on the go consumer' for out of home consumption. (More ... )

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Subhiksha to shut 20% of its outlets, enlarge board: MD

Indian Express Finance

Crisis-ridden retail chain Subhiksha said it will explore options to induct more independent directors into the company's board. It will also close down 20% of its outlets due to a liquidity crunch and will renegotiate with owners on rentals for another 30-35% of its stores. The retail chain, whose operations have come to a standstill in the wake of severe liquidity crunch, has already seen the exit of five board members in the last six months.

"The company is a board-managed one and will continue to be so. We will seek an even wider representation on the board so that we gain from the wisdom of all," Subhiksha Trading Services managing director R Subramanian told PTI. (More ... )

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Parle Agro, Dabur gear up to take on multinationals

By Lalitha Srinivasan, Indian Express Finance

In a bid to take on multinational giants, home-grown brands Parle Agro and Dabur India are drawing up aggressive growth plans to pump up volumes. Dabur India is entering into sub-contract manufacturing arrangement with local companies in order to increase its production capacity. "To counter the multinational competition, Dabur is gearing up to foray into the branded fruit drinks sector within a month," said Amit Burman, vice-chairman of Dabur India Ltd.

On the other hand, the Rs 950-crore Parle Agro Ltd is heavily investing on building up its retail visibility through various merchandise, to promote its water brand Bailley, which directly competes with Coke's Kinley and PepsiCo's Aquafina in the Indian market place. "Defying the economic slowdown, the Rs 85,000-crore Indian FMCG industry is steadily growing. With increasing competition between MNCs and swadeshi players, the sector will further grow this financial year," said an industry analyst based in Mumbai. (More ... )

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.

"Time in" vs. "Timing" the market

This is one of those investment debates that has been waged through the years, with no sign of a resolution in sight. With strong opinions on either side, it is quite likely that the controversy will endure for a long time.

The dilemma arises because of the way most experts and analysts define 'timing' - they mean selling out your equity portfolio completely at market tops, and buying the same portfolio back at market bottoms.

Common sense - which is not so common among the majority of investors - dictates that such a plan is doomed to failure. Why? Because consistently deciding when a market has reached a top or bottom over several economic and stock market cycles is pretty nigh impossible.

The stock market moves on its own logic, reflecting the collective sentiments of various market participants who have differing agenda. The hedge funds are in it for the short term (i.e. less than one year). Some of the Foreign Institutional Investors (FIIs) may invest for a longer term of 3-5 years. Pension funds tend to be real long term investors who stay in for 10 years or more.

As an individual investor it will be quite futile to try and outguess what these big boys are up to at any point of time. Chances are that they are better informed and have more research and financial resources. Therefore they can enter and leave the market in droves - driving up or smashing down prices before you can say 'Jack Robinson'.

Research has proven that those who stay invested for the long term perform much better than those who try to exit and enter the stock market frequently. No wonder most fund managers say that 'time in the market' is preferable to 'timing the market'.

While I can not disagree with such strong logic, backed by academic research, my investment experience has been otherwise. It arises from the basic definition of market timing.

For long term investment success it is imperative that you try and time the entry into and exit from individual stocks. But do not try to exit from your entire portfolio or try to buy the whole portfolio back.

If you've read my earlier post (Dec 1: Market cycles and Sectors), you will know that different sectors - and therefore, stocks from those sectors - get prominence depending on the state of the economic and market cycles.

Like now, when the Sensex is trying to find a bottom, FMCG stocks are hitting their 52 week highs whereas metal stocks are hitting their 52 week lows. So this is a good time to exit from FMCG stocks and enter metal stocks. (You don't have to sell your entire holding in a sector. Partial profit booking works pretty well.)

Now, experts and fund managers will tell you that FMCG is a good defensive sector to enter in a bear market and metals will face a lot of pain over the next couple of years. They will be quite correct from the short term view of the market. But a small investor with a long term outlook has to play contrarian. That is the only way to 'beat' the market.

While the 'time in' vs. 'timing' debate rages, my solution to the controversy is to replace the 'vs.' with 'and'; i.e. stay invested for the long term but time the entry into and exit from individual stocks.

In a future post, I will discuss about a technical indicator that helps lay investors to become master timers.

Which sectors should you invest in?

In an earlier post ("Market Cycles and Sectors") on Dec 1, 2008 the sectors that receive prominence during different stages of the economic and stock market cycles were discussed.

Does that mean that you, as a small investor, should look at investing in all those sectors? Probably not.

Fund managers, who are under pressure to perform in the short term, have no alternative but to move in and out of sectors depending on the particular stage of the stock market. They also have access to company managements and better research resources and larger funds than small investors.

With considerably less funds and little or no research capabilities, small investors like you and me are better off choosing only a handful of sectors to invest in.

Some industries are in an environment that helps to create substantial competitive advantage. It is easier for the companies in such industries to make money.

Four sectors that I like - based on their competitive advantage and cash generation capabilities - are :-

1.  FMCG: Strong brands built up over the years create huge competitive advantage. Companies tend to be solidly profitable, debt free and generate a ton of cash (which is distributed to investors through generous dividends). The market leaders have been around for many years, so they are slow but steady performers.

This sector is practically recession proof and should form a significant part of a small investor's core portfolio. Companies to look at are HUL, ITC, Colgate, Nestle, Brittania, Dabur, Marico.

2.  Pharmaceuticals: Like FMCG, Pharma companies are recession proof, have strong brands, are hugely profitable and good dividend payers, and long term growth is assured because of the large population. MNC Pharma companies have access to better product pipeline from their overseas parents. Domestic Pharma companies profit from generics and contract research and manufacturing.

This sector should also receive pride of place in your portfolio. Companies to look at are Glaxo Pharma, Aventis, Sun Pharma, Lupin, Glenmark.

3.  Financial Services: Banks pay less interest to depositors and lend the money at higher interests. For current account holders, banks pay nothing at all. Many make more money by selling other financial products to their customer base - such as insurance, demat accounts, credit cards, mutual funds, home loans. Home loan companies tend to be highly profitable with long term growth assured.

Companies to look at are State Bank of India, Bank of India, HDFC Bank, Axis Bank, HDFC, LIC Housing Finance, Sundaram Finance.

4.  Media: Many companies have competitive advantage through regional language and regional market domination. This sector also tends to be recession proof.

The dynamics of the media business was covered in an earlier blog post on Sept. 8, 2008.

Are these the only sectors that an investor should look at? Obviously not. But this should be a good starting point in building a long term portfolio.

Future posts will cover other sectors and criteria for individual stock selection.