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.