Why you need the resilience and discipline of a door-to-door salesman to succeed in the stock market

If you are thinking: "What on earth is a door-to-door salesman?" then you probably belong to a generation that has never seen 3D picture discs in a View-Master or listened to a 78 rpm vinyl record on a gramophone. In which case, you have obviously never met a door-to-door salesman. 

There was a time in the not-so-distant past, when many retail products - particularly encyclopedias - were sold by salesmen who knocked on the doors of homes to demonstrate and sell their wares.

Just like the buggy whip and the hurricane lantern have almost disappeared with the onslaught of industrial and technological progress, so has the profession of door-to-door selling.

A few years ago, Forbes magazine had listed '10 Top Dead or Dying Career Paths'. Telemarketing and door-to-door selling was 7th on the list - just ahead of photo film processing.

Before the advent of the Internet and social media, the only way smaller manufacturers or dealers could mass-market their products was through door-to-door selling. 

Salesmen were paid a token salary - or none at all - and made money through sales commissions only if they met their monthly or quarterly targets. Each salesman was allocated a specified locality or territory - where they had to compete with other salesmen selling similar or different products.

Home owners were bothered and irritated by their door bells being rung by salesmen at all odd hours trying to sell them anything from incense sticks and toothpaste to books and vacuum cleaners.

Most slammed the door shut on the faces of the salesmen. A few who were kind enough to listen to a salesman's pitch probably didn't buy, giving some excuse like "I just bought a similar product" or "I don't have enough cash with me."

In other words, making a sale itself was a difficult task. Meeting stiff monthly sales quotas was nearly impossible. Still, the salesmen would go on their rounds come rain or shine - knocking on doors and getting them slammed in their faces.

You can just imagine the kind of resilience and discipline that was required to carry on - despite knowing that the chances of success were negligible. But when they did make a sale, good salesmen ensured that they sold their higher-valued products so that they could earn more commission.

Being able to handle repeated disappointments and having the mental wherewithal to bounce back and keep trying is just the kind of discipline one requires for success in the stock market.

A successful salesman eventually developed a winning strategy after repeated failures. So should a stock investor. 

If you have tasted some success by buying a stock without doing much research and then selling it at a profit, you are unlikely to be able to repeat your success.

Even after doing proper study of a company's annual report and its stock price chart, the stock you pick may not give you the returns you expect. 

Eventually, the resilient and disciplined investors will learn from their mistakes (or follow the advice of an experienced investor) and learn to follow a plan and a strategy that enable them to select winning stocks.

And once they have picked a winner, they buy a lot of it and hold on for the long-term to reap the benefits of dividends, rights, bonuses and buybacks.

Stock Buybacks: A Good Thing or Not?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Technical updates – DLF and Unitech

Real estate stocks were all the rage during the later stages of the previous bull market in 2007. The term ‘land bank’ entered the stock market jargon dictionary. Companies were falling over each other in trying to acquire land parcels at any price. Banks and NBFCs joined the race of lending money against ‘land banks’.

Stocks of companies in completely unrelated businesses – particularly older companies in the doldrums – were getting highly valued on the basis of their ‘land banks’. Small investors relished the idea of making quick money and jumped on to the real estate band wagon.

A real estate bubble had been created, and it burst with a loud ‘pop’. Paper wealth of small investors vanished into thin air. Two of the most popular and high fliers among the real estate stocks were DLF and Unitech – despite the reported poor quality of their construction and unfavourable agreement clauses with buyers.

Both stocks have been in long down trends for the past 6 years. The moral of the story? Buy real estate; shun real estate stocks.

DLF

DLF stock had gone past the 1200 mark in Jan ‘08 before the bottom fell out. In just over a year, it fell almost 90% from its peak. The subsequent rally saw the stock cross the 450 mark in Oct ‘09 – giving 3-bagger returns from its Feb ‘09 low, but failing to retrace even 50% of its huge fall. That kept the stock technically in a bear market.

That was a signal for bears to take charge. The stock price has formed a bearish pattern of lower tops and lower bottoms that dropped the price to 122 in Aug ‘13 – which was lower than its Feb ‘09 low. The rally to a high of 241 gave almost 100% gains from its Aug ‘13 low. The stock is undergoing a price consolidation, and may try to breach the resistance level of 241. Only a convincing move above the Mar ‘13 top of 285 will negate the ‘lower tops-lower bottoms pattern’.

Technical indicators have corrected overbought conditions and are in bullish zones. Another test, and possible breach of 241 is likely. The company is saddled with massive debt and valuations are sky high. Best to avoid.

Unitech

Unitech stock had touched headier heights in the 5-figure range in early 2006. A huge bonus and stock split brought the price down to more reasonable levels. The stock price continued to rally and tripled to cross the 600 mark in May ‘07. A 1:1 bonus could not stem the rush to buy and took the stock price up to the 550 level in Jan ‘08.

The crash was extraordinary, as the stock price dropped more than 95% to touch a low of 22 in Nov ‘08. The subsequent rally took the stock price to 118 in Sep ‘09 – more than 400% gain from its Nov ‘08 low – but retracing less than 20% of its massive bear market fall. It has been all down hill since then.

The stock touched a low of 11 on Mar 3 ‘14 – 50% lower than its Nov ‘08 low. The recent rally saw a sharp rise to 38 last month – 3-bagger returns in 3 months! Daily technical indicators had become extremely overbought. The stock price corrected below the support/resistance level of 30, and is struggling to move up again.

Interest expenses were more than twice the reported net profit last year and P/E ratio is 88. Don’t be swayed by budget sops. Avoid with a capital ‘A’.

Strategies for buying and selling stocks and mutual funds – analysis of readers' exercise (Part II)

Last week, I had analysed the first three questions of the readers' exercise about strategies for buying and selling. Today, the balance three questions are being addressed. To jog reader memories, and for the benefit of those who missed the earlier posts, here are the last three questions:

Q4. You had bought 500 shares of a small cap company about 2 months back. After stagnating for a while, the price recently shot up by 25%. Will you:

(a) sell all 500 shares and book short-term profits?

(b) sell 250 shares and reduce your holding cost on the balance shares?

(c) hold on for higher prices?

(d) buy another 200 shares at the 25% higher price?

Q5. You had bought 1000 shares of another small cap company about 6 months ago. The stock has been stagnating since then. A recent announcement of 20% dividend and a stock-split perked up the price by 10%. Will you:

(a) use the up-tick in price to sell out?

(b) wait for the dividend and stock split and then decide?

(c) buy another 250 shares at the 10% higher price?

Q6. You have been holding a well-managed mid cap MNC company's stock for a couple of years. The company recently announced delisting of its shares from the stock exchanges at a buy-back price that was 15% higher than market. Subsequently the price has spurted by 30%. Will you:

(a) hold on with the hope that the company may increase the buy-back price?

(b) sell your entire holding at the current market price?

(c) sell 80% of your holding now, but keep 20% aside in case the company increases the buy-back price?

(d) sell to the company at the announced buy-back price?

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Q4 and Q5 appear similar, but I would like to point out the differences. Small cap stocks are inherently risky because few analysts cover them and there is little information publicly available about their operations.

As small investors, it should be our primary goal to reduce the risk of losses. A spurt of 25% in 2 months is equivalent to an annual gain of 150%. The logical answers should be (a) or (b). Option (c) won't reduce the risk. Option (d) will increase the risk by buying more at a higher price.

If you have read my post about 'How to use Financial News', you will know that dividend and stock-split announcements can be classified as 'good news'. The effect of such news on the stock's price is temporary - lasting not more than 2-3 days - so it doesn't make much sense to trade on it. So, the logical answer should be (b).

A few words about stock-splits and bonus issues may be in order. In small caps, unscrupulous promoters often announce splits or bonus to jack up the stock's price through circular trading, only to cash out at the higher price and leave small investors in the lurch.

But reputed promoters either use stock splits to increase liquidity of high-priced stocks, or announce bonus shares to indicate that the company is in good enough financial health to shoulder the liability of the increased equity capital.

Theoretically, stock splits and bonus issues do not add to investor wealth because the stock's price gets adjusted after the split/bonus. But what actually happens in the market is beneficial for investors who hold for the longer-term.

Once the increased number of stocks following the split/bonus is credited to investor accounts, there is a tendency towards some selling, which reduces the split/bonus adjusted price some more. After a few months, the selling subsides and the stock price starts to move up again.

For well-managed companies, the price eventually surpasses the split/bonus adjusted price. Typically, a dividend paying company reduces the per-share dividend according to the split/bonus ratio, so that the dividend received by investors prior to the split/bonus remains the same.

Over the next few years, if the per-share dividend is increased (which is often the case), investors gain on both capital account and dividend account without investing a single paisa.

For the last question, option (b) should be the logical answer. Options (a) and (c) are speculation and not investment options. Option (d) leads to capital gains tax as per current rules, since selling to the company does not incur STT (securities transaction tax).

If the stock is infrequently traded, and an investor holds a large chunk, then option (b) may not be practical. Investors would have no choice but to sell the shares back to the company.

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A Clarification about subscribing to my Monthly Investment Newsletter

The recent announcement of re-opening of a limited number of subscriptions to my Monthly Investment Newsletter has received a very encouraging response from readers, several of whom have signed up already.

Some readers who received and read my FREE eBook: 'How to become a better Investor', may have assumed that the subscription to my Monthly Investment Newsletter was also free. It isn't. It is a pre-paid subscription. I do regret any confusion.

If you are interested in subscribing to the Monthly Investment Newsletter, send me an email at mobugobu@yahoo.com for details. But do so at the earliest. Subscriptions will close on July 21, 2010.

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

Reliance Industries made the bonus announcement after the Indian stock markets closed for trading on Oct 7 '09. Today (Oct 8 '09), the stock closed up by less than 1% at 2120 - still more than 15% below its high of 2490 on May 19 '09.

A 1:1 bonus - particularly when announced after 12 years in the midst of a strong bull rally - should have elicited joy and buying euphoria among market participants. Why? Because bonus shares are considered to be beneficial to shareholders. From Reliance, the 'gift' should have appeared an extra special one.

In reality, it should make no difference to a shareholder's wealth. No doubt bonus issues offer 'free' shares on which dividends are paid in the future. But the share price is adjusted downwards depending on the bonus ratio. In the case of a 1:1 bonus, 100 shares will become 200 shares, but the share price prevailing on the record date will get halved after the bonus issue.

A shareholder's wealth remains the same - double the shares at half the price. What can happen after the bonus issue? One year later, dividends are likely to be paid on the enhanced quantity of shares, but the dividend payout ratio is usually maintained by reducing the dividend percentage. The total dividend received by the shareholder remains the same.

There is a downside as well. After receiving the bonus shares, many shareholders sell the original quantity - specially if bought less than a year back - to book a short-term loss and get a tax break by adjusting the loss against short-term profits. This selling pressure pushes the stock price below the already halved ex-bonus price. So the actual wealth of shareholders, who do not avail the tax break, may go down after the bonus shares are issued.

But there are long term benefits if the company continues to perform well in the future - and Reliance should do so. (A bonus announcement is management's way of communicating a bright future to shareholders.) The dividend payments gradually increase, and the investor receives a higher amount each subsequent year.

Why the muted buying? Several reasons. The company's performance over the next few quarters are not likely to be exciting. The KG basin gas selling fiasco and the ongoing public feud amongst the Ambani siblings is creating negative ripples in Government circles, and uncertainty among large shareholders.

Reliance had out-performed the Sensex by gaining 167% from its Oct 27 '08 low of 930 to its May 19 high of 2490. Subsequently, the stock has under-performed by going through a 4 months long sideways consolidation.

If 'good news' doesn't move a stock up sufficiently, it is an indication that there is no longer enough buying interest in the stock. The fact that the Sensex is in some sort of a topping formation is also restricting the bulls at the Reliance counter.

Existing investors may continue to hold. New entrants can make a token purchase at current price, and buy more on dips. (I stay far away from any stock with the 'Reliance' name in it.)

Related post

Why rely on Reliance?

How to reallocate your assets

An investor friend asked me a million dollar question last week: The stock market has collapsed and blue chips are available at attractive valuations, but where is the cash to buy them?

Many investors - yours truly included - have been taken by surprise by the severity of the market decline. Let alone think about buying, many are scrambling to save whatever little is left of their portfolio. The currently attractive fixed deposit (FD) rates have prompted some to sell even at a loss and move to fixed income.

This is as great a time as any to give some thought to asset reallocation. But to do that we have to start with asset allocation.

Let us say that you are 35 years old and an investor in the stock market. The thumb rule for percentage allocation to equity suggested by market experts is (100 - your age). In this case, it will be (100 - 35 =) 65%.

Now you may not feel comfortable with the associated risk of such an allocation to equity. No one is pointing a gun at your head. Choose whatever percentage makes sense to you. 40-50% if you are a conservative investor. 75% if you are aggressive about making high returns with high risk.

The younger you are the more should be your equity allocation. Why? Because equities tend to earn the best returns over the long term, and when you start young you have less responsibilities and hence can afford to take more risk.

The older and closer to retirement you are, the more should be your allocation to fixed income. Why? Because the stock market can be in doldrums just when you are about to retire - when your regular income source will dry up. The (100 - age) formula comes in handy after all.

For argument's sake, if you agree with the 65% equity allocation (this could mean shares or equity MFs or a combination), the balance 35% should be in fixed income, gold ETF and cash. A rough breakup can be 25% in bank FD or Post Office MIS or PPF, 5% in gold ETF and 5% in cash.

The gold ETF is a hedge against inflation, but low returns may not permit a higher allocation. The cash is necessary for unforeseen opportunities - like a rights issue, or additional purchase due to a bonus issue or divestment.

If you have Rs 20 lakhs as an investible surplus, this asset allocation formula means Rs 13 lakhs in equity/MF, Rs 5 lakhs in fixed income, and Rs 1 lakh each in gold ETF and cash.

Investment guru Benjamin Graham had advocated that on no account should you let your equity allocation go beyond 75% or go below 25%. If you follow this advice to the letter and spirit, it will enable you to reallocate almost without thinking.

How? Say the stock market moves up (not likely in the near future!), and the value of your equity portfolio becomes Rs 18 lakhs. Your total investment value now becomes Rs 25 lakhs (=18+5+1+1), and your equity percentage becomes 72% (=18/25).

This is still below Graham's limit of 75% but is 7% above your original plan of 65%. Prudence requires that you start booking profits partially. If you are aggressive, you can ride the bull market till your equity value goes up to Rs 21 lakhs. Now you've hit the 75% level (=21/28). No further waiting - start selling and invest the proceeds into fixed income and cash, to return to your original percentage allocation plan.

What happens in the process is you increase your wealth in real terms - not only on paper, because now your fixed income/cash amounts have increased. The actual figures are about Rs18 lakhs in equity, Rs 7 lakhs in fixed income and Rs 1.5 lakhs each in gold ETF and cash.

Thanks to the bear market, let us assume your equity value drops to Rs 10 lakhs. Your total investment value is now back to Rs 20 lakhs (=10+7+1.5+1.5) but your equity allocation is down to 50%.

Guess what? You now have some extra cash to deploy back into the market. And if you opt for Post Office MIS and/or monthly/quarterly interest from your FD in your fixed income allocation - then you will have even more cash without touching your FDs or gold ETFs.

No wonder Warren Buffett has said that knowledge of simple arithmetic is enough to be a smart investor! (In real life, the arithmetic may become a little more complicated - but an Excel spreadsheet should take care of that.)