3 Timeless Investment Principles

In his well known investment book "The Intelligent Investor", Benjamin Graham has explained several investment principles that have withstood the test of time.

If you haven't heard of Graham, he is considered the 'guru' of value investing and was a teacher of Warren Buffett. Graham's book is recommended reading for all small investors.

To appreciate and understand Graham's value investing principles, here are three time-tested ones:

1) Margin of Safety

It means buying a stock  at a price below its intrinsic value. What is intrinsic value? Investopedia.com defines it as the true value of a company's stock based on all aspects of the company's business, including qualitative and quantitative factors. That means putting a value to the company's reputation, business model, competitive advantage, as well as calculating its financial ratios to assess profitability, sustainability, financial prudence.

A DCF (Discounted Cash Flow) method that takes into account a company's free cash flow and weighted average cost of capital is often used to calculate intrinsic value. But even such a calculation is subjective, as it requires certain assumptions to be made about future earnings that may or may not turn out to be accurate.

Is there an easy way to figure out 'Margin of Safety'? One way is to compare the average 'earnings yield' of a company (inverse of the P/E ratio) over a period of 5 to 10 years with the fixed deposit rates of banks. If the average E/P is more than the current FD rate, you have some 'Margin of Safety'. (Otherwise, you may be better off investing in a bank FD.)

Note that higher E/P means lower P/E, which usually happens in bear markets or when a company is not performing well. A company with strong fundamentals in a bull market is likely to have a high P/E ratio and hence low E/P - not leaving much 'Margin of Safety'.

'Margin of Safety' can also be thought of as 'buy low and sell high'.

2) Profit from Volatility

A young investor had once asked John Pierpont Morgan, the famous American financier, banker and art collector, what the stock market will do on that particular day. Morgan had responded: It will fluctuate.

Warren Buffett had said: Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it.

Volatility is an integral part of stock market movements. Sometimes a market fluctuates so rapidly and wildly that it scares off most investors. But irrational market movements can be your friend, because it allows you to avail of sudden extremes of low or high prices.

If you are a long-term investor and not a day trader, there can be a couple of ways you can benefit from market fluctuations. First is 'Rupee Cost Averaging' (or, SIP), where you invest a fixed amount of money at regular intervals, which smooths out day-to-day fluctuations. Second is investing in a balanced fund, which has a mix of stocks and fixed income instruments; stock price fluctuations are 'balanced' by steady returns of fixed income instruments.

For novice investors, or, for those who don't have the time or inclination for detailed fundamental and technical analysis before buying a stock, regular investment of monthly savings in a good balanced fund is an excellent way to build wealth for the long-term without much effort.

3) Know Thyself

You know yourself better than anyone else. At least, you definitely should. Your investment style and strategy should depend on your personality. Otherwise your market returns will not be up to the mark.

Are you an active and enterprising investor, who loves nothing better than to dig out less-known small-cap or mid-cap companies and then do detailed analysis of their annual reports for selecting future multibaggers? Or, do you prefer to be a passive and defensive investor, who hates bothering about the economy, inflation rate, currency fluctuations, price chart patterns?

Do you enjoy the adrenaline rush of picking an unknown stock based on a friend's recommendation and seeing it rise into the stratosphere, or, would you rather make a detailed financial plan and asset allocation plan and then regularly invest according to your plans to achieve your investment goals?

Only you have answers to such questions. And there are no right or wrong answers. The bottomline is that your personality should match your investment strategy. 

However, remember that wealth can not be built by constant activity of buying and selling. It is built by buying with a 'Margin of Safety', using volatility to book part profits and re-entering at lower levels, and holding on for the long-term to get the benefit of dividends, rights issues, bonus issues and stock splits. 

Read more about the three timeless principles.

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Some strategies about selling stocks

Why discuss stock selling strategies just when the Sensex is showing some signs of life after an 8 months long corrective move? Isn’t this a good time to buy and make some money?

The answer depends on what type of investor you are. If you want to play the momentum in the short-term, by all means buy and book profits after a gain of 3 or 5 points. May be even 8 or 10 points. Which isn’t bad at all – if you are trading thousands of shares. Such a strategy can be followed at any time.

But many small investors don’t have big money at their disposal. They can buy 200 or 500 shares at a time (I’m not talking about penny stocks here). A 5 or 10 point gain is neither here nor there – compared to the risks involved. May be this isn’t such a great time to buy after all – since the index is just about 10% below its all-time high.

Instead of having an ad-hoc hit-and-miss strategy, have a plan. For buying, holding and selling. The ‘Margin of Safety’ concept works well for buying. P/E bands work well too – for buying, holding and selling. I prefer to use an asset allocation plan for timing buy-sell-hold decisions.

Today, I want to discuss a few selling strategies. Before you buy any stock, decide on a selling plan – based on your risk tolerance, time horizon and individual preference. As a long-term investor, I prefer to have a three years time horizon for any stock to perform. You can just as well choose a one year or two years time frame. Anything less than a year, and you will be treading the fine line between an investor and a speculator.

Once you decide on a time frame, pick a realistic price point. 100% gain in 1 year may happen once or twice, but is not a realistic goal. But a 50% gain in two years, or a 100% gain in three years may be more achievable. When the price target is reached, it is best to sell out entirely. But if you feel that more upside is left, book partial profits, and hold on to the rest with a trailing stop-loss. If the price target is not reached, don’t hold on with the hope that it will be reached ‘some day’. Just sell.

If by partial profit booking you have withdrawn your original investment, don’t ever think that the balance holding is ‘free’. It isn’t. It has an opportunity cost. If the market dives and your balance holdings drop by 50%, you have lost real money. A trailing stop-loss will save you from such a calamity.

Supposing you have a two years time frame with a 50% appreciation target. After six months, the stock suddenly starts to flare up and gains 50%. What should you do? Wait for your two years time frame, or sell now? Sudden flare-ups in stock prices occur for different reasons - insider buying, some company-specific news that you may not have heard yet, a fundamental change in the sector, a merger or acquisition.

Why bother with reasons? If your target is reached, sell – even if it means paying short-term capital gains tax. After all, tax is paid from profits – so you are still ahead.

So far, I have discussed selling strategies when your stock is in profit. What if you buy a stock and it keeps falling down? Have a strict selling strategy – a 3% or a 8% or a 15% stop-loss, depending on the type of stock and the planned period of holding. Have the discipline to sell as soon as the stop-loss is hit on a closing basis.

Learn to be unemotional and unexcited about your buy-sell-hold decisions. Treat them like any monetary transaction – like buying a cup of coffee or getting a hair-cut.

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How to reallocate your assets

What to do when stock prices fall?

Most small investors – particularly the recent entrants to the stock market – are ‘bulls’. That means, they buy a stock at a certain price and expect the price to quickly move higher so that they can sell and make a tidy profit without going through Step 1 (see below).

The idea is not entirely wrong. Being a bull is usually more ‘fun’. When you buy a stock and it starts to rise rapidly, you tend to feel elated and proud that you have made a smart choice. But it is no fun at all when the stock you have bought recently suddenly turns around for no rhyme or reason, and starts falling like a stone.

Your elation vanishes into thin air. Your pride takes a beating. You can’t confide to friends or family because they will either laugh at you or scold you for being a greedy gambler. You start losing sleep and look for ways to recover from the situation.

One of the worst things to do is to buy more as the stock price keeps falling. Your ‘average’ price goes down, but your losses keep on increasing. You eventually lose hope, and either sell when the stock price is near its bottom, or become a reluctant long-term investor.

So, what was wrong in being a bull? Forgetting that there is always another animal called a ‘bear’ in the stock market. While bulls are strong and can sweep aside all resistances when they are excited and charging, they are basically peaceful vegetarians.

Bears, on the other hand, are vicious and cunning meat-eating predators. In the stock market, a handful of professional bears make mincemeat out of the hordes of peaceful small investor bulls. What helps the bears is that they only need to pay a margin amount for shorting a stock which they may not even own. Then they square off the deal at a lower price and pocket the profit.

How do you avoid being decimated by bears? Follow three simple steps:

1. Do your homework before buying a stock. Is it fundamentally strong? Does the company have growth opportunities? Does the business model generate adequate cash from operations? What is the reputation and track record of the promoters?

Learn about some basic ratios like P/E, P/BV, Debt/Equity, Market Cap/Sales, Return on Assets. (Most of these concepts have been covered in different blog posts.)

2. Buy any stock with an adequate Margin of Safety

3. In spite of doing your home work and buying with a Margin of Safety, a stock’s price may start to fall after you buy it. Avoid a big loss by taking a small one. Learn how to set a stop-loss.

That was the long answer. The short answer is: Sell, and sit on the cash. Go to Step 1 above. Don’t go to Step 2 before becoming thoroughly conversant with Step 1.

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How to identify winning stocks – a guest post

The Sensex and Nifty have been quite volatile lately, jumping up and down like a kid on a trampoline. Small investors are not sure whether to buy or sell. At times like these, it may be better to sit back and do nothing.

Niteen has a better idea. Learn how to identify winning stocks using his 12 parameters. If you like his post, please write a comment or query. Your feedback may motivate him to contribute regularly.

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After 18 years in the stock market, I have observed that most small investors are only interested in tips for making quick money. But without exception, they end up losing money. Remember that the reverse of ‘TIP’ is ‘PIT’. ‘TIP’s can take you to the ‘PIT’s. There are no short cuts to making money. The stock market is a place that requires a highly disciplined approach. To make money, investing should be viewed as a long term process.

How to identify a winning stock without depending on tips? What are the parameters that help in choosing a winner?

The most important parameter is the ‘Margin of Safety’. The concept of margin of safety was first introduced by Benjamin Graham, author of investment classics like ‘The Intelligent Investor’ and ‘Security Analysis’.

Graham said: "Margin of Safety is always dependent on the price paid". One should buy a stock when it is worth more than its market price. This is the central thesis of the value investing philosophy, which emphasises preservation of capital. Graham looked at unpopular or neglected companies with low P/E and P/BV ratios.

If you feel that a stock is worth Rs 100, buying it at Rs 75 will give you a margin of safety. In case your analysis is incorrect and the stock is worth only Rs 90, the Margin of Safety provides a cushion against a possible loss. In India, markets tend to be volatile, so it becomes more important to look at each stock through the magnifying glass of Margin of Safety.

Very few stocks make it through the stringent screening process given below, and many potentially investment-worthy stocks can get excluded. If you come across any tips and get tempted to invest, at least you should screen those stocks through these parameters to ensure that you are not overpaying.

There are 12 parameters grouped under four heads.

(I)  Valuation & returns

• P/E ratio < 40% of highest average P/E ratio over previous 5 years: take the highest P/E ratio of each year for last 5 years and then take an average
• Earnings yield (E/P) > 2 x (RBI bond yield): RBI Bonds give a return of around 8%
• Dividend yield > 2/3 x (RBI bond yield): Dividend yield is calculated by dividing the last dividend paid by a company, by the current stock price. Some companies retain earnings and do not pay dividends to maintain growth. But most blue-chip companies that have grown from the time they were not blue-chip, have consistently paid dividends for many years

(II)  Balance Sheet related

• Current ratio > 2.0. This will give you a positive Net Current Asset Value (NCAV) number per share
• Stock price < 1.2 x (Book Value)
• Inventory trend: Inventory trend should reflect revenue numbers. Goods are produced to be sold, and not stored in a warehouse. If inventories increase faster than sales, a problem is brewing
• Minimum 12% Return on Invested Capital (ROIC)
• Debt/Profit =<5 and Debt/Equity ratio =<1.5: A company should pay its debt out of its profits, and not out of the equity base of the company. A ratio of 5 means that the debt can be paid out of 5 years profits

(III) Profit & Loss related

• Revenue and profit should preferably increase consistently during last 5 years. A drop in any one of the 5 years can be considered also
• Consistently paying dividends, bonuses: This is in line with (I) above

(IV) Governance

• Published Statements of previous 6 months/Management Discussion and Analysis (from Annual Report): If the management is over optimistic about future earnings, an investor should stay away. Infosys, which is well-known for its transparency, has always been cautious in projecting future earnings
• Shareholding pattern – Buying, selling or pledging: If management is selling/pledging their holdings, the stock should be avoided

The above parameters are available (or, can be calculated) free of cost from sites like: www.icicidirect.com, www.anagram.co.in or from economictimes.indiatimes.com.

There can be cases where you need to consider some additional parameters. The measurement of one parameter can be relaxed due to the strength of another parameter. This comes through experience and a new investor/analyst should avoid relaxing the parameters.

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(Niteen S Dharmawat is an MBA who has been working with Indian IT companies. A firm believer in long-term financial planning, and an 18 years veteran of the stock market, he likes to analyse the economy, and individual stocks. He also conducts investor education sessions.

Niteen blogs at http://dharmawat.blogspot.com.)

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The Interest Rate hike was expected – why did the market fall?

As expected, the RBI hiked the repo rate and reverse repo rates by 25 basis points. For the uninitiated, that means a 0.25% rise. The repo rate (the interest rate at which banks borrow short-term funds from the RBI) is now 6.5%, and the reverse repo rate (the interest rate that banks receive for parking short-term funds with the RBI) is now 5.5%. Two other rates – the CRR and SLR – have been left unchanged.

Why was the interest rate hike expected? Primarily because core inflation (non-food) has been rising and 6 rate hikes in 2010 had little effect in cooling off prices. Every one knows that food inflation has almost gone out of control, and the Indian housewife is at her wit’s end trying to put nutritious food on the table within the family budget.

If 6 previous rate hikes haven’t managed to cool off inflation, will the 7th (1st in 2011) fare any better? That is a good question, and the RBI Governor knows it. He took pains to explain to the media that his choices were limited. Inflation needs to be controlled, otherwise high prices of essential commodities will increase input costs for India, Inc. That would dent bottom lines and may slow down expansion and capital expenditure. The severe crack in Hindustan Unilever’s stock price today is a clear example of investor nervousness.

Raising interest costs too much at one go will increase borrowing costs and hurt the growth prospects of companies. The RBI has chosen the middle path of a gradual increase in interest rates. If inflation continues to rise, another round of rate hikes may be inevitable. Already, the RBI Governor has relaxed the target core inflation rate to 7% from the earlier 5.5%. There lies the first clue to the market’s fall today. So far, the RBI and finance ministry officials have been making positive noises about controlling inflation through monetary measures coupled with the ‘base effect’ of higher inflation in the year gone by. This was the first official admission that things haven’t worked as planned.

The second clue is the unambiguous message that the RBI Governor sent to the commercial banks: Curb lending and increase deposit rates. That may be music to the ears of retirees who stay far away from the stock market and depend on fixed income avenues. Fixed deposit rates at banks will hit the double-digit mark soon. What is meat for retirees is poison for stock market investors. The combination of higher interest rate with lending curbs will throw a spanner in the works of India’s growth story.

Rate-sensitive stocks took a beating today, and don’t be surprised if the stock market cracks further after the Republic Day holiday. As small investors, there are a couple of things we should do. One, don’t panic and sell off everything. But if you are in profit in second rung stocks, book some or all of it. Two, prepare for a bigger correction by making a list of fundamentally strong stocks that offer some Margin of Safety. Let the correction play out. The next positive trigger may come from the Budget. Buy then.

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Strategies for buying and selling stocks and mutual funds – analysis of last week’s exercise (Part I)

Last week’s reader exercise was a prelude to introducing certain strategies that can enhance the returns from stock market and mutual funds investment – particularly when the market is in a prolonged sideways consolidation.

Before I get into the analysis part, a big THANK YOU to all of you who participated. Except for questions 2 and 4, the answers to the other questions varied widely – as should be expected from investors with different experience and risk tolerances.

The Sensex has been trading in a broad band of about 2700 points – between 15300 and 18000 for almost 10 months. During this period, individual stocks have either hit the skids, or made new highs, or gone nowhere. Should you try to jump from stock to stock as one slides and another climbs? That would make the brokers rich.

At such times, stock picking skills come to the fore. Identify good funds or fundamentally strong stocks that still leave a ‘Margin of Safety’ and buy a small quantity. Where will the cash come from? If you had booked profits earlier and not redeployed the cash, then you have no problems. What if you are fully invested?

This is one reason why I recommend quarterly dividend option in bank fixed deposits (FD) and dividend options in mutual funds. That goes against the tenet of growth through compounding. But an investing strategy has to be flexible to factor in market vagaries.

The cash inflow through dividends and interests has several advantages. In funds, it works as automatic profit booking during bull phases. The dividend can either be reinvested in the same fund, or in a different fund, or to buy shares.

The interest from a fixed deposit can be invested in a recurring deposit, or for buying NSC certificates from the Post Office (which are not subject to the fluctuations of bank interest rates), or for buying funds through the SIP method. The principal should get reinvested in another FD – for a shorter period if rates are low. (An exception to this ‘rule’ will be covered in Part II next week.)

Question your own logic at all times, and try to avoid the ‘always growth option’ or ‘always through SIP’ strategies of investing. Suppose the market corrects viciously down to 12500 in the next 2 months. Unlikely, but possible. A year of gains will disappear from the growth option. SIP over 2 months of lower NAVs will not lower the holding cost of the previous 10 months by much.

Regarding gold, this what Warren Buffet has said: “Gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.”

I haven’t felt the need to buy gold. But if I did, it would probably be a gold ETF or a gold fund. Much more convenient from storage and transaction points of view.

This post has already become too long, and I haven’t even covered questions 4, 5 and 6. Guess you will have to wait till next week for my analysis – because 4 and 5 are a little tricky, and will need some explaining.

In the meantime, nods (and applause) for Rsuvarna, Joe and Ganesh for logical answers. A hat tip to Eswar for his elaborate thought processes which helped in writing this post.

Those whose names didn’t get mentioned, please don’t feel disheartened or slighted. None of the answers were ‘right’ or ‘wrong’. I was looking for the logic behind the choices.

About Growth Stocks and Value Stocks

Should the title of this post be changed to Growth stocks vs. Value stocks? So many dichotomies have become part of our everyday lives - like Good vs. Evil, Black vs. White, East vs. West, Fundamental analysis vs. Technical analysis - that we have come to believe them as truths.

The reality is different. By creating compartments and divisions through our imagination or dogma, we get into behavioural patterns that are detrimental to our emotional and financial well-being. Once we decide to cut the Gordian knot of needless differences, life and investments become so much simpler.

Enough philosophy for a short week of trading. Let us get down to the nitty-gritty.

What is a Growth stock?

These are stocks belonging to companies that have shown a consistent above-average growth in sales or earnings in the past, and are expected to maintain the rate of growth in future. One measure of growth is RoE (Return on Equity) above 15%.

To fuel such growth, cash is a major requirement. So companies often forego dividend payments to plow the earnings back into the business. When the earnings are inadequate to fund the growth, companies resort to share issues and debt.

Typically, these are high P/E stocks with volatile price movements that make them risky to own. Investors expect to make large capital gains and often get trapped by the 'greater fool theory'.

What is a Value stock?

These are stocks belonging to companies that are considered to be trading at a level lower than their intrinsic values, as determined by fundamental analysis of sales, earnings, dividend payments.

These stocks have low P/E or P/BV ratios and high dividend yields. Hence they have lower risk and a bigger 'Margin of Safety'. Value stocks tend to out-perform growth stocks during bear markets and under-perform in the later stages of bull markets.

Like in life, which has more shades of gray than black or white, there is no distinct dividing line between a Growth stock and a Value stock.

No company can have a high growth rate forever. Sooner or later, as its size increases, growth rate will begin to slow down. If it survives, it will become a stalwart and pay regular dividends and grow steadily.

The key phrase is: 'if it survives'. Taking on too much debt, or issuing too many shares in the singular pursuit of growth can weaken the balance sheet so badly that the company can collapse under the weight of its interest payments. Stocks from the retail and realty sectors come to mind.

Should investors choose Growth stocks or Value Stocks for their portfolios? It need not be an either/or situation. Why not choose Growth stocks and Value stocks?

How about using the 80-20 rule? Keep 80% of your portfolio in Value stocks, and 20% in Growth stocks. Remember that the best time to look for Value stocks is when the stock market is down, not when it is up 70% from its recent low. That doesn't mean that Value stocks are not available in bull markets. They are just very difficult to find.

(Do you have an opinion about any good growth or value stocks in the current market? Please share it here for the benefit of other readers.)

Stock Chart Pattern - 3i Infotech Ltd

The stock chart pattern of 3i Infotech Ltd looks a little different from other stocks that have been analysed recently. It made a high of 165 back in May '07 (actually 330, but adjusted for the subsequent 1:1 bonus). The bears attacked almost immediately, and the stock gradually slid down to 115 in Sep '08, before it fell off a cliff.

It finally bottomed at 25 in Mar '09 - dropping 85% from its peak. A swift 3 months rally took the stock to 95 in Jun '09 - an exact 50% Fibonacci retracement of the entire Rs 140 fall over 2 years. Thereafter, the stock has been in a consolidation phase within an 'ascending triangle'.

Let us have a look at the 1 year bar chart pattern of 3i Infotech Ltd:-

 

The RSI has moved above the 50% level. The MACD is positive, but marginally below the signal line. The slow stochastic is below the 50% level but the %K line has just crossed above the %D. All three are indicating mild bullishness. The OBV is providing the real clue to the underlying strength - the gradual rise indicates 'accumulation'.

3i Infotech is part-owned (39.5%) by ICICI Bank, and its revenues are a 50-50 split between software products and services. Its product portfolio - mainly targeted at banks and financial institutions - helps to generate a high net margin of close to 30%.

A low P/E of 6.25 means an earnings yield (E/P) of 16% - which is double the current fixed deposit rates in banks, leaving a good 'margin of safety'. Solid top and bottom line growth and strong cash flows from operations make this an ideal portfolio candidate.

Then why is the stock under-performing the Sensex (which has already retraced 70% of its bear market fall)? The company has been aggressively pursuing growth through the inorganic route. That means, it has been acquiring a number of software companies and businesses in India and overseas.

The danger of such a strategy - when leveraged through debt - is that the interest payments become due sooner than later, whether there is a global economic downturn or not.

3i Infotech is less reliant on clients in US and Europe (where the financial services outsourcing business has been hit the hardest) than most Indian software services companies. But the bears have mauled it just the same. And there lies an opportunity for smart investors.

Bottomline? The stock chart pattern of 3i Infotech is indicating that the smart money has been accumulating the stock, and an upward break from the ascending triangle may be imminent. Enter, or add more, on a close above 95. Keep a stop-loss at 70.

(Some questions: Why is the stop-loss set at 70? If you enter now, should you set a tighter stop-loss? At what price?)

How to buy a Great Business at a fair price

Before learning how to buy a great business at a fair price, we must be able to distinguish a great business from a mediocre one. But I'm getting a little ahead of myself, so let's start with some preliminaries.

When we buy a company's stock, we are not buying a piece of paper called a 'share certificate'. Nor are we buying an 'entry' in a dematerialised (a.k.a. demat) account statement.

What we buy is a minority share in a business. That is why they are called 'shares'. This is not a course in semantics. It is important to understand the difference.

A piece of paper, or a card, or a plastic chip can be used for gambling. But you will probably not gamble with part ownership of a factory, or a brand, or an export-import business. You are making an investment for future growth.

Before you buy a car, you go for a test drive, find out the fuel economy, maintenance costs, seating comfort, and then put your money down. Even for buying a less expensive item like a fridge or a TV, you probably check the products at a couple of showrooms and read reviews on the Internet before buying.

The same research and diligence, if not more, should be followed before you buy a share in a business - not after.

What are some of the traits of a great business?

• high net margin
• low debt
• positive cash flows from operation
• proven management with integrity
• high return on equity
• products or services with predictable earnings

What are the signs of a mediocre business?

• low net margins - which may be the result of creative accounting
• high debt
• negative or negligible cash flows from operations
• questionable management pedigree
• low return on equity
• products or services that keep changing, making earnings projections difficult

Buying a great business at a fair price is not easy, because great businesses usually sell at great prices. Occasionally, the market goes a bit crazy and great businesses and mediocre businesses sell at low or fair prices.

Once you have identified some great businesses, don't jump in to buy immediately. Wait patiently for an opportunity to buy at a fair price. If that means waiting for 2 or 3 years, so be it. Till then, keep your money in a bank fixed deposit and earn interest on it.

The worst mistake that an investor can make is to buy on a hunch or an impulse. That usually means buying a mediocre business at a great price - a ticket to financial ruin. A mediocre business bought at a fair price may also cause losses.

It is your money. Make it grow by buying great businesses at fair prices. It means, growing rich slowly. Isn't that better than getting poor quickly?

Related post

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

BSE Sensex Index Chart Pattern - Aug 14, '09

Last week, some bearish possibilities were observed in the BSE Sensex chart pattern. The weakness in the index chart remains, despite the sudden 500 point jump on Thursday, Aug 13, '09. The volumes were lower than on the previous day, which was a 'down day'.

FIIs were net sellers on 4 of the 5 trading days last week. The only day that they were net buyers - which was also the day when the proposed tax reforms bill was made public - the BSE Sensex index jumped up.

Some observations made last week about a 'broadening top' formation, may be worth revisiting:-

'Such a formation is a distribution pattern, where the 'smart money' gets out and the 'weaker hands' (typically MFs and retail investors) jump in, trying not to miss the bus. Volumes tend to be uncertain, and price swings can be quite unpredictable.'

This week, let us look at the 3 months bar chart pattern of the BSE Sensex index that shows the entire post-budget trading:-

The trading pattern of the last 3 months has been confined within a broad range of 13200 to 16000. This consolidation, after a spectacular rise from the bottom of 8000 in Mar '09, has gone on long enough. A break out, either up or down, could happen in the near future.

The broadening top and sudden swings in levels and volumes indicates a possible break down wards. But a flood of liquidity from the FIIs can change the direction of the market and make it move up at least by 4-5%. That will take it to the resistance zone at the 61.8% Fibonacci retracement level of the entire bear market fall.

A small bit of trivia. The current Sensex level is the same as that in July '07 and Aug '08. In between, the index made an all time peak at 21200, and a bottom at 7700. For all the gyrations of the BSE Sensex, and the zillions of words written and uttered on business media, we have made zero progress in 2 years!

This is as good an example as any, that investors should concentrate more on individual stock movements and worry less about the index directions. Over the longer term, all that will count for wealth creation is how well you have selected individual stocks based on fundamental analysis, using Graham's concept of 'Margin of Safety'.

Finally, a look at the technical indicators. The 20 day EMA was broken briefly. The index took support at the 50 day EMA before jumping up above the 20 day EMA, which has flattened. So, the short term trend is neutral; the medium and long term trends remain up.

The RSI is at the 50% level. Likewise for the slow stochastic, but the %K line is below the %D. The MACD is positive, but is below its signal line and moving down. The MFI is below the 50% level and also heading down.

The strong grip of the bulls seems to be slipping. The below average monsoon isn't helping the situation. The bears are fighting hard, yet haven't quite regained control.

Bottomline? The BSE Sensex chart pattern is not inspiring the confidence required for a full-fledged bull market, in spite of the 100% rise from the bottom. Keep booking profits wherever available. Avoid entering questionable or high beta stocks.

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