The golden rules of stock investing
By Devangshu Datta November 2, 2006
When the Sensex hits an all-time high, even people who have never seen a stock ticker want to invest in shares. When they pluck up their courage and enter, they are promptly overwhelmed by an information overload. How do they sift through all the numbers, abbreviations, jargon and conflicting advice to pick the right stocks?
The best way is to develop a rational strategy that works over the long-term. Share prices fluctuate--but a long-term investor who ignores those fluctuations actually has a better chance of being on the right side of price movements than a trader punting on tips.
Ultimately, stocks represent shares of businesses. By deciphering how businesses work to create value, investors can make money. But they need to take the time and trouble to learn this. Investors generally come to this realisation the hard way after they have lost money speculating on tips. Even when they make money, it is more by chance than by following a considered strategy.
Eventually, regular investors figure out some system. All the investors we spoke to lost money before developing their strategies but were not sure if those strategies would always work. There are different styles of equity investment. Market legends such as Warren Buffett, the world's most successful investor, and Peter Lynch, the man who made Fidelity, have markedly different approaches.
But all successful investors follow rules-even if some of those rules differ. Some rules tend to be common to all successful investors since these work through every market phase. By learning some basic rules and applying them in a disciplined fashion, you will become rich- but not overnight. You will find stocks that tend to consistently beat the market in all its manicdepressive moods. Your long-term equity returns will very likely help to make you rich. Just as important, you will not suffer a catastrophic loss of the type that befalls the unwary and ignorant investor.
The bull run sweeping through the markets has created unprecedented wealth over the past three years. But all-time highs also mean more hazards. In the following pages, MONEY TODAY presents nine golden rules that could shorten an investor's journey to riches.
Golden Rule 1: Higher sales is a mustlook for 30% growth per year.
Because everything flows from the topline.
Before a company can even think about profits, it has to sell its products or services. No amount of brainstorming or fancy management theories can save a company- and its shares-from fading if the demand for its products is on the decline.
Enron Corporation is one example. It ran on empty and fooled its shareholders-for some time. Google did exactly the opposite. Long before it went public, its flagship product-the ubiquitou search engine-was dominant. TCS is an Indian example of a company that launched an IPO long after it had been a market leader.
Everything flows from the top line-that is so obvious, it is hardly an insight. Yet, even experienced investors under-rate high turnover growth. Surprisingly, none of the people we interviewed placed an emphasis on this fundamental aspect .
So what turnover growth rate would rate as excellent? The cut-off we recommend is 30% annual growth for the past three years. If that seems high, consider this: most profit-making companies have seen sales grow at 22-25% between 2003- 4 and 2005-6. The overall economy has grown by an average of 8% (post-inflation) during this period.Given the boom, there is no dearth of companies that have produced far higher levels of turnover growth than our cut-off. Suzlon Energy topped the list with sales growth at 120%. Even the last company in our list, Thermax, saw a vigorous salesgrowth of 61% between 2003-4 and 2005-6.
There should be a steady rise in the top line rather than sudden bursts in sales volumes. Consistency and predictability are useful factors, if only because they reduce investor stress.
There may be a sudden surge in demand for a product or a company may have undergone capacity expansions that cause a bulge in volumes. The company may or may not be able to sustain a sudden burst in sales driven by a chance spurt in demand for a product.
A key element in sustainable sales growth is the existence of the innovative streak-be it a new product, a new service model or out-of-thebox marketing.
Think of all the BPO firms that pioneered the outsourcing revolution some five years ago. Or the launch of contract research services in the pharma industry. Or ICICI Bank's drive to attract retail cuscustomers. Each initiative has delivered handsome returns.
Is the rule of 30% sales growth eternal? High sales growth is a must but the percentage may vary. The Nifty is our benchmark. A stock pick must have the potential to beat the Nifty - or else, you could invest in an index fund. Right now, the Nifty has over 25% sales growth so we have set 30% as our cut-off. If the Nifty's growth rate changes, we would review the 30% cutoff.
The easiest free access to a company's financials is often its own website. There are also many free-to-use financial portals. But the best are the stock exchange websites, http://www.bseindia.com/ and http://www.nseindia.com/.
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Golden Rule 2: Profits should have outspaced sales.
Profits after tax should have grown at over 30% every year for the past three years.
So your target businesses deliver on sales. Good. But sales growth must lead to higher profits. We are referring to profits after tax (PAT). Ideally, PAT should have outpaced the turnover growth through the past three years. If sales have grown at 30% or higher but PAT growth is slower, there is a problem with profit margins.
Extreme examples can be found in the refining sector. Due to rising crude costs, the refiners have seen high sales growth. But they are not allowed to pass on the entire cost escalation to consumers. So, PAT has dropped. For example, BPCL's sales grew 50% between 2003-4 and 2005-6 but its PAT dropped 23%.
Many companies have registered strong PAT growth since 2003-4. For instance, hospitality giant EIH has a stunning 158% rise in PAT. Others such as Suzlon, Reliance Capital, Varun Shipping and Eicher have also registered triple-digit PAT growth since 2003-4.
Since everybody tracks profits, "creative accounting" can give a misleading impression of PAT. Some typical situations:
PAT grows quickly but sales remain stagnant. Rising PAT may also be based on "other income", which is not generated from the core business.
PAT is low but there's high depreciation. Depreciation is cash retained out of pre-tax profits for the purpose of replacing assets. High depreciation is a positive.
Amortisation occurs when the company dips into reserves rather than cutting profits. It shows up on the balance sheet, not the profit and loss account.
Banks also make provisions against default and any company may make contingency provisions against legal claims it is disputing. Check for these factors when you're looking at PAT.
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Golden Rule 3: Making your money sweat.
Look for a return on net worth of 25% or more.
Sales growth and profitability are all very well. We also need to know if a company is using its funds efficiently. Does the company use enormous amounts of capital to generate sales?
It's normal to examine profits in relation to sales to arrive at profit margins or profits per unit of sales. But this doesn't tell us how much money has been invested in the business. Could that money haveearned a higher return invested elsewhere?
One way to judge capital efficiency is to compare profits with net worth. Net worth is the sum of the equity capital and retained profits. This is often shown as "reserves net of revaluation" in a company's accounts.
The percentage of PAT to net worth is referred to as the return on net worth (RNW), or the return on equity (RoE) by Americans.
RNW varies from sector to sector. Similar businesses should have similar RNW. It can often be a clear differentiator in judging peer companies. For example, Tata Steel's RNW is 42% while Sail has a RNW of 31.8%. Obviously, Tata Steel is better at managing its capital.If a company has generated consistently high RNW, it is capital-efficient. It generates high profits from a small capital base and uses those profits to generate even more profits. As a company gets bigger, a high RNW ratio is difficult to maintain since the net worth itself becomes quite large as profits accumulate.
The 50-company-Nifty, which can be used as our benchmark for comparison, has an average RNW of 22.75%. We suggest a cut-off of about 25% when making stock picks. Note that giants like TCS, Dabur and Hero Honda do generate over 50% RNW.
Warren Buffett, the most successful stock market investor of all time, uses RNW as the cornerstone of financial analysis. He will not invest in a stock without being assured of consistent, high RNW.
Another qualifier. A company with a high debt burden may have a deceptively good RNW. There are two common ways to control for high debt on the balance-sheet.
One is to calculate the profits as a percentage of total capital employed (capital employed = equity + reserves + long-term debt). This return on capital employed (RoCE) works similarly to RNW.
The other method is to compare the outstanding long-term debt to its equity. A low debt:equity ratio, ideally zero-debt, along with a high RNW is what the investor wants. IT businesses for example, tend to be zero-debt and high RNW.
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Golden Rule 4: Looking beyond price to find real value.
Use price to earnings ratios and dividend yields to buy cheap.
The price of a stock is not the same as the value of the business. We want to buy when the price is lower than the value.
The most common measure of valuation is the ratio of price to the earnings per share. This is the PE ratio. A PE of 10 means that the price of a share is 10 times the profits its earns. High-growth companies often have very high PE.
The PE tells us how low-priced stock may actually turn out to be expensive. For example, mid-cap company Polaris Software is trading at Rs 136 while Infosys is priced at Rs 2,090.
But with earnings per share of only Rs 2.33, Polaris has a PE of 58.5 while Infosys' PE is 23. Thus, in value terms, Infosys is cheaper than Polaris.
An entire sector may be overvalued. For example, during the IT boom of 1999-2000, Infosys, Wipro and other IT stocks were trading at PEs of 500-plus. These were great, high-growth businesses but the PEs were not justified. Ideally, compare the earnings growth rate to PE tosee if growth is fairly valued.
One thumb-rule: The PE divided by the EPS growth rate should not be greater than 1. This is the PEG ratio and if it's lower than 1, the valuation is sustainable. For example, Suzlon, with an EPS growth rate of 137% and a PE 45.6 can be considered cheap at PEG of 0.3.
A bank won't be valued at the same PE as an IT company. Always compare like to like. A sector's average PE can be used to benchmark only companies in that sector. A broader index like the Nifty can however, be used as a benchmark for gauging any listed company.
Right now, the Nifty is at PE 21 and its dividend yield is at 1.35%. If a stock has a much higher PE than the Nifty or its peers, there must be compelling reasons to buy , such as high EPS growth or a recent turnaround in profitability.
Other than PE, a more conservative measure of value is the dividend yield, which is dividend per share as a percentage of its market price. (Dividend is reported on face value-not the market value-of shares and therefore looks more impressive than the yield). Most companies offer dividends-this is how promoters reward themselves.
Nifty's dividend yields has fluctuated between 0.5 % and 3.2% since 2001. Dividends are tax-free. For a high tax-bracket, a dividend of 5% is equal to pre-tax interest income of 7.5% since the interest income is taxed at 32.5%.
If the price rises, so normally, will the PE ratio. The dividend yield will fall as price rises. It is interesting when price rises and the PE falls. This happens only if earnings rise faster than the stock price.
When PE and price move unexpectedly, we may receive a "green signal" to buy. One such green signal came between March 2002 and March 2003. The Nifty dipped 16% from 1120 to 940 and the PE dropped 41% from 18.7 to 10.9.
Earnings rose as prices dropped. Another green signal came at the peaks of January 2004 (Nifty at 1982) and May 2006 (Nifty at 3720) with the PEs of 21.9 and 21.1 respectively. Earnings rose quicker than price. Conversely, if PE rises while the price is stable, it's a "red" or sell signal. And if PEs rise faster than the price, then that's also a red signal.
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Golden Rule 5: Cheap stocks can be very expensive.
High-priced stocks may be better value.
This is a follow up to the previous rule about the differences between value and price. Penny stocks trading at very low prices are often very expensive.
They usually have dubious financials and make losses. Quite often, managements are dishonest- many don't even file financial reports.
The BSE's Z-category penny stocks are referred to as the "Dharavi" segment by politically incorrect traders. Most Z-category stocks have wiped out their net worth. Many exist only on paper.
Even well-run small businesses are vulnerable-a software service provider with one big client will crash if the client pulls out.
Speculators can charge in and out of low-priced stocks, causing huge swings in price and liquidity. If you're caught on the wrong side ofsuch moves, you may lose heavily. Or, you may gain big if you are on the right side.
Are you comfortable with this sort of roller-coaster? If you want stable returns, avoid small stocks. If you specialise in small caps, you accept huge risks.
Few institutions buy small caps because these stocks cannot absorb large sums. You are therefore also on your own in terms of research and analysis.
Of course, there is a counterargument in favour of small-cap investing. A small cap has more room to grow rapidly precisely due to its lack of size. It can double in size annually if the business is sound.
During bull markets, small caps can also yield higher returns. Small cap investing is therefore the classic high risk versus high reward game.
If you indulge, be prepared for occasional large losses.
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Golden Rule 6 : Heads you win...
Subscribe to IPOs only if you like betting on the toss of a coin.
There's an impression that an IPO allotment is like winning a lottery-it produces multiplied gains. Sure, many IPOs have created wealth,but in the end they are blind bets. Some IPOs will produce extraordinary gains. Others see listings lower than the offer price.
Some great investors, including Warren Buffett, will not touch IPOs. They want years of listing and financial compliance before buying a business. Benjamin Graham in the canonical The Intelligent Investor says that it is elementary for an intelligent investor to resist the temptation of IPOs. Some key IPO themes:
Far less is usually known about an IPO than about already-listed stocks. This raises the levels of risk for IPO investors.
When the business is wellknown, the price is often inflated. Look at Jet Airways. Jet's shares were offered at Rs 1,100 apiece. The stock listed at Rs 1,428 and trades at Rs 635, 18 months later.
If institutions are enthusiastic about it, the IPO is likelier to succeed. Study the institutional subscription on Day One before applying for shares on Day Two.
An IPO in a bear market may produce better long-term returns. One classic example was Infosys; the issue offered at Rs 110 and devolved to Rs 95 per share in April 1993 in the post-Harshad bear market.
Adjusting for bonuses, each original share of Rs 95 is worth over Rs 1.25 lakh today.We've attached a list of good and bad IPOs. Each of the winners had some factors in common.
The business, financials and promoters were well known in TCS, Maruti, IndiaBulls and IDFC. There was institutional over-subscription in each case. Retail investors knew the company brand even if they did not know the financials all that well.
The dangers are apparent when you look at bad IPOs. The losses can be massive.
Our attitude to IPOs is therefore, similar to our attitude to small caps: Don't invest unless you can live with the occasional massive loss.
If you do invest, and your allotment is listed at some gain to the issue price, you can consider taking a quick profit and running. This is known as going "stag".
The rationale is that your money is blocked for three weeks or so in an IPO. If you cash in a 5% profit at the end of that time, it annualises to a gain of about 85%.
If you can get an allotment every month and generate small profits on each, you could be a big winner. This is a trader's strategy rather than that of a long-term investor.
You can be a successful investor while ignoring IPOs as Graham and Buffett advise. Detailed IPO information is available from SEBI (http://www.sebi.gov.in/) as well as on stock exchange websites.
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Golden Rule 7 : Learn to cut your losses.
Don't get emotionally invested. Set loss limits and stick to them.
The worst losses occur when the investor takes a losing position and bleeds to death slowly. Ironically, this more often happens with good businesses than bad ones.
For example, in February 2000, Wipro traded at (the bonus-adjusted price) of Rs 1,500.
Six years later, it is some 65 per cent down from that high. It is a great company. But buying in February 2000 and hanging on would have grievously eroded your net worth.
Always set a personal loss-limit and sell if that limit is hit. It helps to translate the loss limit into the maximum-loss sessions.
In most stocks, the exchanges sets limits called "upper/lower circuits" to daily fluctuations. Use the circuit. For example, a loss limit of 20% translates to five maximumloss sessions with a 5% circuit.
Golden Rule 8 : Don't under or over diversify.
Three stocks may be too few, and thirty, too many.
Bill Gates made his fortune with one stock- that of his own company, Microsoft. Peter Lynch held up to 200 stocks at a time as a successful fund manager.
These are extreme examples of two types of investors if we stretch definitions slightly. Gates, of course, was actually an entrepreneur.
As a fund manager, Lynch deployed so much money he was forced to buy pretty much any profitable listing at reasonable price.
Most investors are more diversified than Gates and much less so than Lynch.
There are practical difficulties in tracking more than a few stocks. If you don't bother to keep track however, you may end up holding a huge portfolio before you realise it.
Let's start with the obvious. Any given stock can give returns from anywhere between 99% down to 10,000% up. Any randomly chosen set of 200 stocks is quite likely to deliver returns that are close to the market index.Lynch's track record is extraordinary because he managed to consistently beat Wall Street despite being forced to hold so many stocks.
At least two Nobel prizes have been won by economists specialising in portfolio theory. They used complicated mathematics to prove the following insight: If you buy very few stocks, your returns may fluctuate a lot.
If you buy too many, you may as well save yourself the bother and invest in an index fund instead since your return will be close to the index.
Portfolio theorists investigate stocks to discover how closely correlated the movements are with other stocks and with the indices.
A sophisticated trader can use these relationships to create a portfolio, which hedges against adverse events such as a currency crash or a jump in crude prices.
These are not primary concerns for retail investors. The key is to ensure that the portfolio is diversified enough to provide stability while not so diversified that the returns are average.
Also, make a call on the amount of time you can devote to tracking before you buy an entire dhobi-list.
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Golden Rule 9 : All things come to she who waits.
Returns rise if you hold for the long term.
In the short-term, the market is a polling booth, in the longterm it's a weighing machine. You've found a stock that conforms to your rules. You've set your stop losses and--nothing happens.
Your portfolio goes nowhere. Sit on your hands and wait. These rules yield results only in the long-term.
Don't expect investments to start generating returns within the hour or the week. As SEBI Chairman M. Damodaran says:"Investor shouldn't come as day traders. They shouldn't invest at 10 a.m. and check at 10.05 a.m. where the share price is.
Give some time depending on your liquidity requirements." You should not deploying either borrowed funds or even the housekeeping cash in stocks picked using these rules.
Take a look at the chart showing long-term Sensex returns (we used the Sensex because it offers a quarter-century of data). Assume that four different investors churns their respective portfolios every year, every two years, every three years and every five years.
That is, regardless of market movements, our hypothetical investors book profits or losses at the end of given time period. Every one of these long-term investors would be a major gainer. But guess who gets the highest average return and the safest one over 1980-2006?
That's right-it's the guy who holds longest. The five-year investor gets an average return ofover 30% per annum-and he loses money in just two trading periods out of 22.
The trend towards higher returns with greater safety is marked. The average annual return rises and the number of losing trading periods drops, as the holding period is extended.
If this doesn't convince you, think about brokerages and the Securities Transaction Tax. If you are a frequent trader, brokerage plus STT will hit your returns.
Traders often under-perform long-term investors due to brokerage costs. Cut your losses when you must but "let the losers go and let the winners run".
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THE WARREN BUFFETT WAY
The most famous "graduate" of the Benjamin Graham School of value investing, which looks for stocks with unjustifiably low prices in relation to their intrinsic worth.
Once Buffett determines the intrinsic value of the company, he compares it to its current market capitalisation - which is the current total price. If his measurement of intrinsic value is 25 per cent higher than the extant market capitalisation, Buffett sees value. Sounds easy, doesn't it?
Well, Buffett's success, depends on his unmatched skill in accurately determining this intrinsic value. While we can outline some of his criteria, we have no way of knowing exactly how he gained such precise mastery of calculating value.
Buffett is a focus-investor, preferring narrow portfolio with a high concentration of FMCG and consumer brands, along with interests in insurance.
His holding company, Berkshire Hathaway is the biggest insurer in the world. Buffett famously avoids technology stocks despite a personal regard for Bill Gates. He doesn't like IPOs either.
1. How long has the company been listed?
2. Is the stock selling at 25% discount to intrinsic real value?
3. Are profit margins high? Are they increasing?
4. Has the company minimised debt?
5. Has the company consistently delivered high return on equity?
THE TEMPLETON WAY
A value-oriented contrarian with a global perspective, John Templeton stresses flexibility. He is against permanently adopting any asset or type of selection.
In a sense this is understandable given that his investing style is comparison-shopping (always be ready to ditch one stock for a better one), and the confidence engendered by a wealth of knowledge.
He was the pioneer in the global search for value and the founder of Templeton Group. Given his global bargain-hunting style, he looks for open economies with low socialistic tendencies and pro-investment policies.
It is interesting to note how he determines value.To him, a hundred or so factors can be considered in making an appraisal, but most of these are industry-specific; four are always present: The four key factors to consider in fundamental analysis of any company are:
1. The p/e ratio in relation to comparable companies
2. Operating profit margins; see if they are rising
3. Liquidation value, which means the price at sell off
4. The average earning growth rate, and consistency of growth. Avoid companies where earnings slip two years in a row. Also steer clear of those growing too fast.
THE PETER LYNCH WAY
Peter Lynch's mantra: Average investors can become experts in their own field and can pick winning stocks as effectively as professionals by doing just a little research. Investment opportunities abound for the layperson.
By simply observing business developments and taking notice of your immediate world - from the mall to the workplace - you can discover potentially successful companies before professional analysts do.
Gaining this edge on the experts is what produces 'tenbaggers'; stocks that appreciate tenfold or more and thus turn an average portfolio into one that's a star performer.
Investors who get in early, almost at the beginning, end up making boatloads of dough.
In the 13 years Lynch ran the Magellan fund from Fidelity, he outperformed the S&P 500 stock index no less than 11 times.
Lynch promises that if you ignore the ups and downs of the market and the endless speculation about interest rates, in the long-term (anywhere from five to fifteen years) your portfolio will reward you.
Lynch loved growth stocks and had his biggest gains when he invested in stocks of companies that were hot at the time. As they ascended into the highest arc of their growth phase, their share prices sizzled and he cashed in.
1. Has the company avoided excess debt?
2. Are profit margins high and increasing?
3. Is the stock selling at a discount to its real value?
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PLAYING BY THE RULES
A portfolio of stocks that make the grade.
There are over 6,000 stocks listed on Indian exchanges. If we apply the above rules and filter for liquidity, size and institutional coverage, the interesting set shrinks to a couple of hundred stocks.
But you can generate a huge number of different portfolios by various permutation and combinations of that set of 200-odd stocks. That's what fund managers do.
We've picked a set that fit our specifications with a little subjective tweaking. You will notice that these stocks don't all necessarily appear right at the top of the lists on any given rule.
But all of them do appear high up on at least one or the other of our lists. Some like Suzlon are high up on several. So why choose this particular set?
Each company in our list outscores the Nifty on several or most benchmarks. There are compelling reasons to award grace marks in the cases where the numbers don't quite measure up to the benchmark index.
For instance, in the cases of Ultratech Cement and Dabur, the low sales growth is deceptive because of demergers and restructuring that make the sale comparisons less useful than normal.
Ultratech has started a turnaround, which has already led to dramatic improvement in its (still sub-par) return on net worth.
Cement is a growth sector and our reasoning is that Ultratech easily has the scope to double in price if its RNW improves to approach that of its parent, Grasim.
EIH also barely makes the grade in terms of sales growth and return on net worth but there has been a big improvement in the prospects of the hospitality sector. That shows up in startling profit growth in this stock and we are hoping sales will also rise strongly in 2006-7, given the improvement in occupancy rates across the entire hotel industry.
Each of these companies has been listed long enough for us to trust the promoters. There's plenty of institutional holding and coverage of each of these stocks. The chances of being fooled by creative accounting is therefore, less.
Each of these businesses can be understood by applying common sense and the concerned sectors are all doing well.
There is a small question mark about the strength of the global shipping cycle but Varun Shipping has strong financials and a terrifc dividend yield of 6%.
The market capitalisation is on the high side in most of our chosen stocks and, in terms of valuations, several are also high PE. But in terms of PEG, most are either moderate or downright cheap.
Of course, the decisive subjective factor is our belief that the growth prospects of each of these businesses will remain good through the long-term.
These businesses are therefore, individually and collectively likely to produce higher long-term returns than the Nifty.
Once again, the index is our benchmark. There is no point in buying stocks or creating a portfolio that doesn't give some assurance of beating the index.
The past is no guarantee of the future and it is incumbent on every investor to do in-depth research before buying anything. All we'd suggest is that you look carefully at this set.
Of course, you can generate hundreds of similar dhobi lists using the above rules or some variation of these. If you work in a specific industry, you may find picks there long before the fund managers.
So long as you apply logic and think long-term,your chances of beating the Nifty are good. Apply yourself to understanding and following the rules.
Good luck and happy investing!
(With Narayan Krishnamurthy and Sudhir Gore)