Some strategies about buying stocks

In a post last week, I had discussed strategies for selling stocks. Most small investors know how to buy stocks, but they rarely have proper strategies for selling. So why am I writing about buying strategies?

From the spate of questions I have recently received about when and how much to buy, it seems that discussing some buying strategies may be useful after all. I had mentioned about using the ‘Margin of Safety’ concept and P/E bands to decide entry points in last week’s post.

The importance of those two concepts can’t be over-emphasised. Too many young investors follow the wild west policy of ‘Shoot first, and ask questions later’. Just switch on any business TV channel (just for entertainment) during the day when they take reader queries. 99% of the questions are: ‘I have bought thus and such stock at this price; should I hold or sell.’

It is apparent from the questions that the stock was bought near a top, and the investor is already sitting on a loss. The question – or rather, a plea – is to find out if the TV expert knows some magical formula by which the loss can be quickly turned into a profit, or, at worst, break-even with no loss.

All one has to do before placing a buy order, is to first check whether the current E/P (i.e. inverse of the P/E ratio) is higher than the long-term bank fixed deposit rate, leaving a ‘Margin of Safety’ . Also check that the debt/equity ratio is less than 1, and that the cash flow from operating activities is positive for 4 of the last 5 years.

If E/P is lower than the bank FD rate, then check the P/E band within which the stock normally trades, and buy only if it is available near the middle of the P/E band or lower. These are basic precautions, and will help prevent losses – even if you don’t have the time or inclination to do a detailed fundamental analysis.

If you are like most small investors, the stock price will fall just after you’ve bought it (and, it rises soon after you sell)!! What should you do? Do not, repeat, do not average down. That is the single cause for turning a small loss into a much bigger one. Instead, keep a stop-loss – and sell if the stop-loss is hit on a closing basis (i.e. take intra-day movements out of the equation).

You will make much more money by averaging up. When should you do that? Buy 20-25% of your intended quantity at the beginning. Add more every time the stock dips or corrects on the way up. Follow a ‘pyramid’ strategy – i.e. buy less and less quantity on the dips as a stock keeps moving up in price – till you acquire your intended quantity.

Such a strategy will prevent impulsive buying of 2000 or 5000 shares in one go, in the hope of becoming a Warren Buffett within a month. Talking of Buffett, I love his quote: ‘You can’t make a baby in one month by getting nine women pregnant!’

Wealth-building takes time. If you hone your buying and selling strategies, you have a chance of becoming wealthy in 15-20 years – but not in 15-20 months.

Why small investors should avoid ‘cheap’ stocks

There are several reasons why small investors should avoid ‘cheap’ stocks, and I will take them up one by one. Before that, one must understand what is meant by ‘cheap’ stock.

Investopedia.com has the following definition:

“The illegal practice of issuing stock options at artificially low prices shortly before an initial public offering. Often underwriters will require a company to have more qualified management before they can go public. They attract these qualified individuals by giving options with a low exercise price.”

This was a practice which was prevalent prior to and during the dot.com boom in the USA, and is not unheard of in India. While it can lead to significant profits, the average small investor won’t be able to participate - unless his uncle or friend’s father was the promoter of the company. If a company is trying to sell its stock through bulk SMS and email messages at a lower price than its forthcoming IPO price, chances are that it is a ‘dud’ company and best avoided.

Then there are those companies that were the apple of investor’s eyes during the previous bull market, and reached stratospheric levels just before the crash in Jan 2008. Real estate stocks were at the forefront, followed by the stocks with the word ‘infrastructure’ in their name. Most of these apples had rotten cores. They have not only become cheap stocks, but continue to get cheaper by the day. Don’t go anywhere near them.

There are cheap stocks which are also called ‘penny stocks’ because they trade below Rs 10. Most of them are unknown, fraud companies who have no business and no intention of doing any business. Occasionally they boost up their share price from Rs 3 to Rs 8 by planting fake stories in the media about the great opportunity for investors once they dismantle the fourth rate defunct plant that they have bought in Uzbekistan or Burkina Faso and reinstall the plant in Jhumri Tilaiya. Avoid such stocks like the plague.

Some cheap stocks may appear cheap, but are not. A Re 1 face-value stock trading at Rs 15 is equivalent to a Rs 10 stock trading at Rs 150. A Rs 10 face-value stock trading at Rs 15 may not be cheap either, if it belongs to a loss-making company, or one that is trading at a P/E of 80 or 100. Stay away from such stocks.

What about stocks that appear relatively cheap with P/E ratios below 15 that generate strong cash flows from operations, have low debt/equity ratio and double-digit profit margins? Ah-ha, now we are talking. I just love to dig and find such stocks. They are the ones that will give a nice boost to your stock portfolio’s performance.

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.

Related Posts

How to lose more money and become a better investor

What exactly is the Margin of Safety?

What is the Return on Assets (RoA) ratio?

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.)

Related Post

What exactly is the Margin of Safety?

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.)