Stock trading? What are your rules?- PROCESS IN INVESTING

(This appeared in the Deccan Chronicle- July 20th, 2015)

Many of us buy shares without having a ‘goal’ in mind. Do we invest because we like the company and want to own the shares as long as possible, participating in the company’s growth? Or do we own the shares, watching the price every day, hoping to make a quick buck? Nothing wrong with either so long as we know what our reasons for buying are.

The second type of buying, where we hope to make a quick buck, often does not work out the way we thought it would. When we are a short term buyer and seller of shares, we do not give too much thought to the company, its fundamentals or its prospects. More often than not, this kind of buying is based on our pet theories or from newsletters or tipsheets etc. Or it could be because we heard a one minute talk on the television set and decided to buy.

It is important to have a process when we indulge in short term trading.  The process should answer the following questions:

i)              Why have I bought this share?

ii)             What do I expect? What is the price target?

iii)           How long do I have to wait for this?

iv)           If the price falls, what do I do?

v)             What if the price does not move and my time of holding is coming to an end?

vi)           Do I buy my entire allocation for the stock in one lot? If not, then do I buy more if it falls? Do I buy more if it rises?

vii)          Can I sell the quantity I buy without moving the price much? In other words, what is the trading volumes?

Often, I have seen people buying for a quick churn and becoming long term investors even as the share price keeps dropping over years. This is real erosion of wealth.

It is useful to have a set of rules before we execute our short term trade ideas. A simple framework could have rules like these:

a)    My total corpus kept aside for short term trading is , Rs.__ lakh;

b)   Of this, the maximum in a single scrip will not be more than Rs.__;

c)    My maximum holding period is ___ days;

d)   My aim is to get a 20% return in this trade;

e)    I WILL sell earlier if the price either rises by ___ or falls by ____;

f)     I will NOT have more than five positions outstanding at any one time:

g)    I may buy half my limit in one go;

h)   I will NOT fall in love or attachment with any stock from this basket;

i)     I DO NOT need the money allocated to this activity;

j)     I do not hurt if I lose money.

You can keep adding or subtracting from those rules. The idea is that short term speculation should not be a random activity. Have a process. It is likely that you may lose most of your money over time. Or you may get lucky and make some money. The idea behind having a process is to help you be aware of the situation and not go in to panic or worry.

Also, keep a track of why you bought each share, on whose reco, whether you did any additional work to confirm etc.  Of course, I do not have anything to say to those who follow technical analyses or charts, since they have their own process to follow. But they too could do well to have a system and process in place.

I do not expect you to make a big fortune out of this. The probability is that half the trades could go wrong. The idea behind a system and a compulsory exit is to ensure that you do not keep ‘averaging’ or ‘chasing’  and get shut out.  The key is to analyse each mistake and learn from them. Respect the process and it will reward you in more ways than one.

R Balakrishnan

(balakrishnanr@gmail.com)

DC- July 14^th, 2015

SIP in Mutual Funds- Choose well- A case for Index investing(Th

People write in to ask whether it is better to opt for mutual fund route or direct equities route. To me, it is clear that a portfolio of well chosen direct equities will do better than a mutual fund portfolio.

As mutual funds grow larger in size, it becomes difficult for them to beat the benchmark indexes. This is because of our market structure. We do not have many large ‘market capitalisation’ companies. If a fund manager has a Rs.5000 cr portfolio, he would ideally like to put a minimum of Rs.50 to 100 crore in a single stock. So, he would look for companies that have a minimum market cap upwards of Rs.5000 crore, so that a Rs.50 cr investment in a company does not become a very large stake in the company. Here, the invesment of Rs.50 cr becomes a one percent stake in the investee company!

There are only around fifty companies that have a market capitalisation of over Rs.40,000 crores! So, if an FII were to want to put $ 10 million in a single stock, they would like to look at a company of at least a billion dollars in market capitalisation.  So, as investment vehicles become bigger and bigger, there is a compulsion to invest in the biggest companies and most large mutual funds start looking like each other. And they cannot ignore any stock in the index, for fear of not conforming to the herd.

Due to this lack of depth and breadth in the market, a highly focused quality portfolio of five to ten companies can do better than the NIFTY or Sensex. 

However, not all of us can spend time. Apart from this, there is another big handicap when we want to invest in direct equities. For example, if we were to pick a high quality portfolio of ten stocks, we may need a minimum monthly investment of around Rs.50,000 and upwards as a SIP commitment for ten years. Not all can afford this. So, the choice of direct equities through an SIP route, is closed if we cannot write this size of a cheque every month. And we need to have five to ten stocks rather than pick just one or two stocks. A minimum diversification is needed to insulate the shock of a single company investment going under for unforseen reasons or through a structured fraud.

A mutual fund route is good for those whose investment sizes are small to moderate.  Choosing a mutual fund thus becomes more important, though everyone says they have the same benchmark, they seem to invest in similar or same stocks.

A five year return (as of 20^th June 2015) on an annualised basis is given below:

1.     MFs that invest in Large Caps- Best return was 15% and the worst was 7.5%;

2.     MFs that invest in Multi Caps- Best was 20% and worst was 9%;

3.     Banking sector funds- The best was 17% and the worst was MINUS 1%.

4.     The NIFTY/Sensex return was around 9%.

5.     The Liquid Funds returned around 8.5% !

This clearly shows that there is a huge disparity in performance between professional money managers who are paid to manage money on a full time basis.  You could trust any one of them, but the returns are not going to be predictable at all. The disparity is surprising given that all of them have expertise in investment management and have equal access to information and research. We do get a lot of statistical tabulations on mutual fund performance and there is no assurance that if someone topped the charts in the past, he will do it in future. There is unpredicability of performance going forward, irrespective of what measures we use.  So, it becomes important to diversify amongts mutual funds, in order to hedge ourselves agains weaknesses of the investment managers. Portfolio diversion does not happen since most mutual funds look like each other in terms of top holdings etc.

Thus, mutual fund investment through SIP routes do not guarantee us market returns. Going by available data, there is a fifty percent chance that the fund we choose may do worse than the market. In such a case, if we want to be sure about being as close to the market returns, the best option is to choose an Exchange Traded Fund (ETF) on the Sensex or NIFTY.

To sum up, if you are not confident about picking stocks, it is best that you stick to the mutual fund route. And if market returns are what we are looking at, it is better to stick to an ETF.  I am not a big fan of sector funds and there is a lot of timing involved in picking those up. Maybe an FMCG sector fund or a MNC sector fund will always do well, but there are no guarantees.

 (This piece appeared in today's Deccan Chronicle)

The Greek Tragedy and the Nikkei ...

The Greek Tragedy unfolding is desperation gone berserk. Keeping the banks closed for a few days to deny the truth. Reminds me of the old days when the Nikkei used to start tanking after it touched a peak of near 40,000 (It is now at near 20,000!, after never having been near thirty or forty).
In those days, the Nikkei 30 Index computation was supposed to be hilarious. At the start of the day, the exchange officials would write down prices of the 30 stocks. The first trade in the stocks had to be at or above that price. And as prices were falling like nine-pins, the exchange authorities resorted to desperate measures.
Each day, they would write an artificially high price. As no trades would happen at that level, the stock/s would remain untraded through the day. The same price would be treated as the closing price for the day and index computed on that number. So, a false sense of the market was created. Finally....
So Greece is now trying that during the shut days of the bank, all will be forgiven and the world will come to a solution on terms suitable to Greece. And banks will reopen as if nothing had happened. Well, even Rip Van Winkle would have winked.

Compounding of Money, Rule of 72 and some basics that time forgot

(This piece appears in Deccan Chronicle)

Investing should not get complicated. You either love it or hate it.  Some of us like to spend time understanding stocks. Most of us do not want to know about its existence, but the noise bothers. We all think that either the stock market is one big scam designed to cheat us out of our savings or it is a casino where money doubles faster than we can fold a currency note.

We all need to ‘reformat’ our thinking when it comes to investing. Money is an important part of our existence ( hopefully not the sole purpose ). It is an aid to living and not an end in itself.

Let us understand that big wealth has been created mostly by owning businessess that do well. Very few people have created big wealth from stock markets alone. The fact that we find it dificult to recall more than a handful of names that made it big from investing, tells us all.

Stocks are perhaps the fastest way to growing wealth, IF risk is managed well and you have the right attitude. A bank account may give us, say nine percent annualised return. Stocks may give us around fourteen percent (a random number- assuming six percent inflation and eight percent GDP growth).  You may think that all I am losing is a five percent return for something unknown.

Unfortunately, due to our schooling system, innumeracy is rather high,.  Let me put across a table to you that shows the impact of Compound Interest:

	(Value of Rs.1000  at different rates / diff periods)
Rate	5 years	10 years	20 years	30 years
6%	1,338	1,791	3,207	5,743
8%	1,469	2,159	4,661	10,063
10%	1,611	2,594	6,727	17,449
12%	1,762	3,106	9,646	29,960
16%	2,100	4,411	19,461	85,850
20%	2,488	6,192	38,338	237,376

The first row is the rate of return at which a sum of ONE THOUSAND is ‘compounded’.  The next rows are the maturity amounts at the end of different time periods.  Thus, 1338 is the sum at the end of 5 years, at 6% Compounded. It is 5.743 at the end of 30 years,  Similarly, if we can get 12%, the amounts at the end of 5 years is Rs.1,762 or Rs.29,960 at the end of 30 years.  The difference between 6 and 12 is just 6 or it is double the rate. However, Compounding it, at the end of thirty years, 12% is 29,960 and 6% is 5,743.  Over five times!

It shows us the importance of fighting for that one or two percent return, on a longer time period.

This table also gives us another very important lesson. For example, if I were to start investing and get returns from, say age 40, at the end of 20 years, when I am 60, 1000/- would have become 6,727. If I had started just five years earlier, at age 60, I would have had  17,749!  Nearly three times. This is why everyone tells us to ‘start young’. Probably it is repeated so often, we think it is a cliched phrase and ignore it.  

You will become easy with it, once you understand something as simple as a ‘rule of 72”.  For example, you want to know how long it will take for your money to double, at , say 8%.  Simply divide 72 by 8 and the answer, 9, is the number of years it will take. Similarly, if someone promises to double your money in six years, just divide  72 by 6. The resulting number, 12, is the annual rate of interest on your money.  This is a very close approximation and not mathematically precise.  So do not let anyone fool you. Now you can easily work out the consequences of starting late in life, when it comes to savings.

Once you understand your compounding tables, you can decide when you want to save, how much etc. Of course, the table will not tell you about the risks  In fact, use the power of compounding to retire early by saving more in the earliest periods of your earning life. .

The purpose of introducing the above table was to demonstrate what it means to invest in stocks rather than keep money in the bank. I think it is feasible to look at a return of 12 to 14 percent compounded return from stocks, over the very long term. This is a conservative number. And you do not even have to choose which stock or which mutual fund. Buying the index, through a proxy, like the Nifty or Sensex ETF should be good. This will save you from the risk of having to choose a mutual fund scheme that may underperform the index.

Of stock market bubbles etc

(From "The Investmentsblog.blogspot.com)

History repeats frequently when it comes to financial euphoria. If the seemingly obvious lessons from these episodes going back almost 400 years haven't been learned yet, chances are it isn't going to be any different the next time.

Galbraith explains why these bubbles recur so often with what he calls "financial memory" (or the lack thereof). Basically every 20 years the new players involved in the financial system, the so-called smart money**, become convinced "it's different this time" because of some new innovation, financial or otherwise (ie. The Joint Stock Corporation in the 1700's, holding companies in the 1920's, junk bonds in the 1980's, internet stocks in the late 90's, derivatives like CDO, CDS etc more recently). Here are some relevant excerpts from John Kenneth Galbraith's book, A Short History of Financial Euphoria:

"The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version. All financial innovation involves, in one form or another, the creation of debt secured in greater or lesser adequacy by real assets." - John Kenneth Galbraith in A Short History of Financial Euphoria (Page 19)

"All [financial] crises have involved debt that, in one fashion or another, has become dangerously out of scale in relation to the underlying means of payment." - John Kenneth Galbraith in A Short History of Financial Euphoria (Page 20)

"Let it be emphasized once more, and especially to anyone inclined to a personally rewarding skepticism in these matters: for practical purposes, the financial memory should be assumed to last, at a maximum, no more than 20 years. This is normally the time it takes for the recollection of one disaster to be erased and for some variant on previous dementia to come forward to capture the financial mind. It is also the time generally required for a new generation to enter the scene, impressed, as had been its predecessors, with its own innovative genius." - John Kenneth Galbraith in A Short History of Financial Euphoria (Page 87)

One of the common elements in these episodes is the use of debt to finance speculation.

Historically, the so-called financial innovations from these episodes of euphoria have just been leverage in a different guise.

Patience- Find stocks at your price-

(My piece that appeared in Deccan Chronicle on 26 April, 2015)

The stock markets have been on a roll for the last one year. From April 2014 to March 2015, the index delivered a splendid return of 27 per cent, once again rewarding people who have faith in equities and the patience to wait. Of course, over the last few months, the stock markets seem to be clutching at straws to hold on to the highs that have been reached.

Of course, everyone tells us that we should hang in there and not panic. My advise to people is to ignore the noise So long as we are invested in stocks of companies that are doing well, do not worry. Similarly, if we are in to the SIP mode of investments, do not waver. Do not try to time the market.

The last one year has also demonstrated the damage inflicted to wealth by investing in real estate or gold etc. Alas, both are unavoidable in the Indian context (House to own and stay and gold for the daughters’ wedding) unless one is so enlightened that we understand that it is cheaper to rent a house and gold is of no practical use and not the most profitable of long term investments.

Why do I say that it is cheaper to rent? Given today’s prices, I will use an example from a locality named Besant Nagar, Chennai. A premium location. The cost of a 3-BHK, around 2,000 sq ft, is approximately Rs 4 crores. It can be had on rent at around Rs 50,000 to Rs 65,000 per month, with an annual escalation of five per cent. Now, if we keep the Rs 4 crore in fixed deposit, we would get around Rs 32 to Rs 36 lakh a year or Rs 2.6 lakh to Rs 3 lakh a month! That is if we are buying the flat for full cash. If we are buying it with housing loan, the annual costs would be far higher. The rent would be under Rs 8 lakh a year. So by postponing your buying by one year, you add around Rs 25 lakh to your kitty, as opposed to buying. Figure it out. And there are enough rentals available.

It would make sense to buy when rentals go so high that it crosses six to seven per cent of the capital cost of a house. This is my take.

The flip side of this is that it does not make sense to ‘invest’ in a second home, given the poor yield on the asset, even if one factors in an’appreciation’ in the capital value.

One more aspect to wealth creation is to preserve a decent chunk of your assets in cash or near cash form, even if it means that inflation keeps biting in to it.

We need to preserve some liquidity so that we can take advantage of any panic selling, which makes quality stocks sell at mouth watering prices.

I see this happens once in five to seven years, but can never predict when. And it need not be market conditions alone. It could be stock specific. Like for instance, there is a slow down in growth of the automotive industry. I would like to keep an eye on the price of a stock like Bajaj Auto, Hero, Maruti etc. Should there be a big sell-off, I would like to own some. Surely, it is not as if the companies are headed for a closure. Once the industry bounces back, these will once again be in demand. I am happy to buy some things at my price. For this, I need to keep some money handy.

Similarly, I will use sharp rallies in stock prices which take some stock I own to a very high price. A price at which I am never going to buy it. So, I will sell maybe a part of my holdings, to cash in.

Today, the markets are “nervous” and is easily spooked. Given the illiquid nature of most of the stocks on our markets, there is always hope that some good high quality stock may tank because of some temporary reason. That is when we should be buying. When I buy like that, I never do all my purchases in one go. I buy maybe one third or one half and then wait for a fortnight or so and then buy the rest. Why I do this is to take advantage of the market behaviour and also to give myself time to kick the tyres once again.

The writer is an independent analyst and can be contacted at balakrishnanr @gmail.com

STOCK VALUATION- AN APPROACH

WHAT IS A SHARE WORTH?

Most often, the dilemma we face is in understanding a company. We invest in a stock so that we get benefits or gains in two ways- One is from the dividend stream and the second is from a favourable change in the stock price. To make both happen, it is obvious that the company has to do well. Even if there is a slippage in performance, the dividend may still come to us, but we could be disappointed with a decline in stock price.

Temporarary declines in stock prices do happen. It is part of the volatility of stock prices and only the nerds on the TV channels can give reasons for a rise in price one day and a fall the very next day, and so on. Volatility has no explanation. One day there are more people feeling good about the company and drive up the prices. Another day, they are outnumbered by people who feel bad about the price and sell it. And these are most often not caused by any underlying change but by transient sentiments of buyers and sellers who throng the market place with changing views every nano second.

I like to look at most companies from two perspectives, with a view to deciding an approximate ‘value’:

THE FIRST is a ‘balance sheet’ view. This is useful in case of companies that are in business with no entry barriers, no significant technology changes over time and just economies of scale matter.  Most commodity companies would fall in to this category. For instance a Cement or a Steel company or even an automobile company. All of them have replicable plants and we can estimate a ‘replacement’ value for these kind of businesses. For instance, we could say that it costs around $130 per tonne (of installed capacity) to set up a cement plant.  Very unlikely that any one player has any significant advantage over the other, except for one growing faster and another growing slower. The time I would like to buy these companies is when the Enterprise Value (market capitalisation plus total debt minus cash ) per share is higher than the market price of the share. In other words, I am willing to give a fair value which would just be the replacement cost. I know that the product is cyclical and will rebound in the not to distant future. Thus, I will buy aggressively when there is a steep discount to the fair value as I estimate it. That is my ‘margin of safety’.  I am not bothered about the change in EPS etc since every player will be doing the same.  Balance Sheet based valuation is more useful to find stocks that are more short term opportunities than long term investment value.

THE SECOND is a ‘profit & loss’ view. Here, the company is asset light. Has turnover that is several times its fixed assets. Earns a superior ROE as compared to the Balance Sheet earning company. This company has brands, earns super normal margins and is one of the first three in the industry or segment. The company has built a ‘moat’ round itself by building market size, brand pull, scale economies etc over time, which will ensure its continued dominance in the near term. Here we will find companies predominantly in the FMCG, pharma space. These shares trade at several times the ‘book value’. However, their ROE is several times the commodity company. Most grow at healthy rates and the shares always trade at what we could term as ‘expensive’.  If we go by our above hypothesis for valuation, we will never own a single stock of this kind. Here, what I would do is to look at the average ROE over the last few years. And then relate it to the Book Value. If the ROE is 25%, then I do not mind paying three to four times book value. I would also use what is called as ‘historical P/E Band” ( the range of P/E at which the stock traded in the past ten years) and see the pattern. I am happier buying closer to the lower end of the P/E Bankd and selling at the higher end of the P/E Band. For instance, if I find out that HUL has historically traded in a band of 20 to 50 times EPS, I will buy the stock at closer to twenty rather than 50.

Of course there is another type of share which I cannot value. Companies in the emerging space that are allergic to profits and get valued higher if they lose higher moneys.