Stock Market — Avoid Loss and Earn Consistently

An attempt to save hard-earned money in equity investing

Investing in high-quality businesses (stock) at the right price and holding them for a reasonable period is the key to create wealth. Stock picking is considered one of the most complex subjects in the world.

Almost all billionaires in the world have created their fortune through the stock market, either directly or indirectly. “Directly” refers to direct stock investing and “Indirectly” refers to listing their companies on the stock market. Some of the world’s billionaires such as Warren Buffet, Rakesh Jhunjhunwala, Vijay Kedia have earned their entire wealth from direct stock investing.

Tip#1: Do not trust your broker blindly. Brokers earn money for every transaction you make, hence they encourage you to do frequent trading.

Tip#2: Intraday trading is almost guaranteed way to accumulate losses. You can make money once, twice or thrice but you’re bound to lose after that.

Tip#3: It is best to stay away from “loan against share” schemes. This loan can help increase gains during bullish markets but during bearish market, investors have to sell off their shares at loss to maintain the collateral against loan.

Tip#4: Trading in “Futures and Options” is the worst decision any retail investor can make. You can lose your entire life’s savings in F&O. F&O is meant for hedging and not full fledged trading.

Bank deposits do not offer a positive return. It is because of inflation and taxes. Inflation is the increase in price you pay for the same amount of good. If 2kg of rice costs Rs.100 today, then after one year you won’t be able to purchase the same quantity at Rs.100.

Rs.100 in bank will give turn to about Rs.107–108 in a year, but it will also cost 107–108 for the same daily expenses. The situation worsens if you consider the taxes. the interest of Rs.7–8 is fully taxable.

Any investment that doesn’t give you a min of 12% return is actually depreciating your money. Bank deposits offer a negative return considering inflation and tax. Equity investment is required to beat inflation+taxes.

Never judge a stock by profit and sales growth numbers. A company may report millions of profit with negative cash flow in the books. Profitable growth might be fuelled by external debt.

Sales growth doesn’t ensure shareholders’ profit. You can’t be sure how much sales is translating into cash and how much margin is added. At the end of the day, how much cash you retain matters the most.

We should first look at Return on Equity (ROE).

ROE tells how much profit a company generates from their shareholders’ money. ROE = Net Income/Shareholders’ Equity. Always prefer stocks with improving ROE or companies having an ROE of more than 20%.

Analyse debt position of a company. Debt is essential for a business to expand. But sometimes debt becomes disastrous. Consider a situation where you’re earning 10% profit margin but paying back 12% interest on the borrowed money. In such a case, higher sales will widen the loss because you are losing 2% on every sale.

Debt to Equity = Total Liabilities/Equity

DTE ratio tells how much of shareholders’ equity is used in debt.

Always check DTE ratio of previous 3 years. Stay away from companies that have 1+ (& increasing) DTE ratio.

In summary, if you find that the stock has ROE of less than 12% & DTE ratio or more than 1 (& increasing), then discard it.

Before investing in a stock, always check management’s credibility by looking at —

1. Shareholding Pattern
2. Dividend history & Tax Rate
3. ROE

Shareholding pattern of any listed company can be found on BSE website (www.bseindia.com).

ROE and tax rate are readily available on company’s financial statements and on many other financial websites.

Dividend history is readily available on BSE or NSE website.

Shareholding pattern is divided into 2 groups —

1. Promoters and promoter group, are the basic owners of the company
2. Public group, are shareholders other than promoters. FII, DII, banks, money managers, mutual funds, individuals all come under this group

Nobody knows a company better than it’s owners. Without high conviction, an owner would not purchase the shares of his own company from open market. So, promoters increasing stake via open market purchase is a positive signal.

Lower stake of promoters means low confidence in the company i.e. promoters are not optimistic about the prospects. So, try to avoid companies where promoters have small shareholdings or where they are consistently reducing their stake by a huge percentage.

However, sometimes promoters reducing their stake can give positive outcomes. For example, a promoter can sell some of his holdings to a big institutional investor which is the first sign of good times.

Promoters of banking and finance companies often dilute their stake for fundraising which is a positive sign in the banking business. The more money banks can have, the more they can lend and thus more profit, even though in such cases promoters holdings are reduced.

Institutional Investors buy large quantities of shares leaving a high impact on the stock movements. They are usually knowledgeable and experienced, so their footprints are followed by many retail investors.

There are 2 types of institutional investors: Foreign Institutional Investors (FII) & Domestic Institutional Investors (DII).

Higher FII stakes are considered positive. If FIIs offload massive quantities, then huge fall in stock price is witnessed.

You can create wonder if you can invest in a stock before it attracts investment from FIIs.

Pledging of shares is a process when the promoters keep the shares of the company that they own as collateral for the debt. Pledging of shares is done with banks or non-banking finance institutions.

Pledging is usually the last option for promoters to raise funds. It means that no one else is ready to provide a loan because wither the company’s future prospect is not bright.

Drop in share price leads to a decrease in collateral value. It means that the shares that were initially 100cr are now worth only 50cr. To protect the loan amount and limit the risk, the lender asks for more collateral, to which promoters are forced to pledge more shares. So, pledging can lead to promoters losing their stake in the company.

As an investor, always avoid companies where promoters pledge more than 30% of their holdings and are increasing their pledged shares.

Companies can either re-invest the entire profit into the business or it can distribute a portion of the profit to shareholders as dividend. If the dividend figure is increasing every year over the previous 5 years, then we can assume that the company is in “real” growth track.

If you purchase a quality product at an excessively high rate, do you find another buyer to take it at a even higher rate? Obviously, no! To become a successful investor, you have to buy a great company at an attractive price.

PE ratio = Current market price / Earnings per share (EPS)

PE ratio compares the current market price of the stock with its earnings per share. PE ratio in isolation has no significance. Compare a stock’s PE with its last 3 years or 5 years historical PE. If you find a fundamentally strong stock trading much below its historical average, then it might be a worthy investment.

When buying a stock, make sure PE ratio is not more than 2 times the average of last 3 years EPS. PE ratio ≤ 2 * avg(3 years EPS)

In short,

1. If current PE ratio is ≤ 3-5 years average and the current PE ratio is less than 2 times the last 3 years average EPS, then buying opportunity can be explored
2. If current PE ratio is in the highest band of previous 3–5 years average and PE ratio > 2 times last 3 years avg EPS, then explore selling options.

The above PE related valuation method only work when there is no change in the business prospects. If the prospects change drastically (like change of CEO), then past data hold no value anymore.

The valuation also doesn’t work for loss making companies, which should anyway be avoided by retail investors.

If you find a stock is trading at a much higher PE compared to its historical PE range with no drastic improvements in future prospects, then you can consider it as overvalued.

Immediately exit from a stock if your original purchase reason is no more valid. For eg., Deccan Chronicle Holdings was the owner of few popular newspapers and magazines. They were market leaders in their own niche. Later they spent 60cr to buy Odyssey, a retail bookstore. They also purchased the IPL team for $107m. At this juncture, anyone holding the stock just because of its market leadership in newspapers, should have immediately exited because the fundamentals changed and were no more intact.

Before investing, develop an exit strategy and strictly follow the same. Don’t put a second thought.

Suppose you bought a stock because of its 30% growth rate, you should sell it whenever the growth slows down.

In short, be clear about the purchase reason and write it down. Keep monitoring those purchase reasons and sell when the purchase reason alters.

Always diversify your portfolio across multiple sectors —

1. Banking (Private)
2. Banking (Public)
3. Pharma
4. IT
5. Automobiles
6. FMCG
7. Telephone
8. Oil and Gas
9. Infrastructure
10. Cements

Having stocks from different sectors ensure that your portfolio can affect less even in a downturn. It is unlikely that all ten sectors underperform at a single time.

Quality small cap and mid caps can offer more safety, better dividend yield and a better return than large caps.

Dangerous misconception — “Stocks that fall sharply must move sharply”. Avoid investing in stocks that suffered 60%+ correction from the recent peak.

In a minor stock market crash (when index falls 5%-30%) —

1. Don’t sell off your entire holdings to re-enter at a lower level. None can predict short-term market movement correctly. So, it may happen that after you sell off, the market takes a U-turn and you’re not able to invest at a lower level ever again
2. Accumulate high-quality stocks during such a correction
3. During a market crash, you may not have enough cash to re-invest in quality stocks. In such a situation, the best solution is to HOLD your current position. Don’t try to predict the bottom for investment. You can’t buy at the bottom and sell at the top every time

In a major market crash (index collapsing by 50% or more), it is impossible to earn a return as high as 20%–30%. The best swimmer in the world can’t survive during a Tsunami. The target in such times should be to generate at least a positive annualised return.

Last 30 year’s price trend suggests that gold and equity mostly move in the opposite direction. So, during a major market crash, shifting a portion of portfolio into Gold can be a prudent move.

Quick Formula First step —

1. Last 3 years average Return on Equity (ROE) and Return on Capital Employed (ROCE) are both greater than 20% and not on a continuous decline
2. Debt to Equity ratio is less than 1 (or heavily reducing for the last few years)
3. Promoters pledge less than 10% of their total shareholdings, or there is a clear sign that it will fall below 10% soon

Second step —

1. Valuation — Explore buying opportunity while PE ratio remains lower than the historical average or hover around that range, provided there are no changes in the business prospects
2. Stock Price movement — As a final step, conduct a price movement test. If you find that the stock has generated a negative return over the last 3 years, then avoid it.

Post Script

This book has been authored by Prasenjit Paul, a SEBI registered Research Analyst known for having a history of identifying several multi-bagger stocks.