Saturday, November 17, 2012

Chapter 5: When the going gets tough, do nothing

Edward Kennedy 'Duke' Ellington was a well-known jazz pianist who later became a famous composer and bandleader. Considered by many to be one of the foremost influences in jazz music, his complex compositions and arrangements brought jazz to the mainstream of American music.

Several of his compositions have become jazz 'standards' - recorded and performed by a whole host of singers and musicians through the years. Some, like 'Caravan', became so popular that even pop instrumentalists performed and recorded the song.

One of Duke's compositions - 'Do nothing till you hear from me' - has relevance to the current state of the Indian stock market, if you replace 'me' with 'Mr Market'!

With the market hitting new highs every day, many small investors are utterly perplexed about what to do. Some feel this is a great time to buy. Others had seen their portfolios erode away in the bear market and are waiting for the next big correction to enter again. The more adventurous ones are writing puts and calls and probably making their brokers rich! Risk-averse investors are looking at bank fixed deposits and company deposits. But the really smart ones are riding out the market turmoil by doing nothing.

An avid mountain climber once commented about his frequent attempts at climbing the Everest: “I try to climb the Everest because it is there!” Well, the stock market is very much there - and will be there for quite some time longer! Does that mean that you should always be buying and selling?

Remember, 'do nothing' does not mean 'remain completely inactive'. This is a great time to do fundamental analysis of companies. Find out which ones are offering greater value in terms of dividend yields, price to book value ratios, operating cash flows, profit margins.

Make a short list of such companies and track them on a daily basis. Then wait to hear from ‘Mr Market’. He will start giving you diverse and interesting clues - such as, changes in interest rates, a decrease in the advance-to-decline ratio, an aversion to discussion about the stock market among your market-savvy friends.

The cumulative effect of such clues will indicate that the correction may be around the corner. Till you hear from me (I mean, ‘Mr Market’), take your spouse out for a candlelit dinner, take that dream holiday to Mauritius or Machu Picchu but do nothing about buying or selling in the stock market. If you absolutely must buy or sell, at least wait for the quarterly results before doing so.

Sunday, January 15, 2012

Chapter 4: Don’t be a bull or bear in the Stock Market

The triangular headed South African python is a truly awe-inspiring reptile - massive in length and weight, immensely strong with an intricately patterned shining skin. The other day, on the National Geographic channel, the camera followed such a beauty as it slowly slithered through the bushes and weeds and glided into a watering hole.

There it hid with only its snout above the water - and waited patiently. Day followed night and night followed day - and still it waited. Animals big and small, frisky and sloth, came to the watering hole for a drink. The python didn't move.

Six days and nights passed - and no one except the camera-person knew that the python was lying in wait. On the seventh evening a herd of deer came for a drink. A younger member ventured a little further in from the water's edge - unaware of the peril.

Suddenly, the water hole exploded into action. With its immense muscle power, the python lunged out like greased lightning and in the blink of an eye had wrapped itself around its prey. The poor animal probably didn't even know what hit him.

The South African python is used to spending weeks and even months without feeding. Some times it eats the odd rodent or bird. But when it really wants to eat, it plans its every move and with infinite patience grabs a large meal so that it won't have to eat for a long time.

Like the python, a successful long-term investor does not need to 'feed' (i.e. trade) every day or every month. Once in a long while, the stock market provides an ideal opportunity to grab a few frontline stocks at mouth-watering prices. Back during the 2002-2003 bear market period, stocks like Tata Steel was available at 100, M&M at 90, ITC at 60 (actually 600 for a Rs 10 share). All three subsequently offered bonus shares at 1:2, 1:1 and 1:2 ratios respectively.

There were many other shares going for a song and which made a ton of money for savvy long-term investors. Since then, there was a one-way bull-market with V-shaped corrections in 2004 and 2006. But after 5 long years there was a full-fledged bear market from January 2008, which ended in March 2009.

For long-term investors, the period from January 2008 to March 2009 was the right time to behave like the python. Not to jump in, but to conserve their muscle power (i.e. cash), decide on a few target companies and wait patiently for the market to start rising.

Saturday, January 7, 2012

Chapter 3: What are your Future Options?

A British schoolboy cricketer had once approached Sir Geoff Boycott to learn how to play the hook shot. Boycott told him that the best way to play the hook shot was not to play it!

"But how do I score runs?", the boy had asked. Boycott's response was typical: "Don't get out! The runs will come.”

Futures and Options (F&O) trading by small investors are akin to a young cricketer playing the hook shot. The chances of losing money overshadow the probability of scoring big. It is far better and safer to buy quality stocks and wait for your wealth to grow.

Nowadays the lot sizes for F&O trading have been reduced, but the risks have not. Such trading is better left to professional and institutional investors who play for much bigger stakes and usually buy or sell in the cash market and hedge in the F&O market.

There is no harm in being aware of what F&O trading is all about, and some smart investors can get clues about the market levels from the open interest volumes and the difference between spot and future prices. But I get confused when I hear talk about 'covered calls', 'strangles' and 'naked futures' and have stayed far away from F&O trading.

Seems like I'm not in a minority of one. The legendary Peter Lynch has made the following comments in his book ‘One Up on Wall Street’:

"I've never bought a future nor an option in my entire investing career.... Reports out of Chicago and New York, the twin capitals of futures and options, suggest that between 80 and 95% of the amateur players lose. Those odds are worse than the worst odds at the casino or at the race-track, and yet the fiction persists that these are 'sensible investment alternatives'.... I know that the large potential return is attractive to small investors who are dissatisfied with getting rich slow. Instead they opt for getting poor quick.... Warren Buffet thinks that stock futures and options ought to be outlawed, and I agree with him.”

Monday, January 2, 2012

Chapter 2: How to lose less with a Stop-loss

"More money has probably been lost by investors holding a stock they really did not want until they could 'at least come out even' than from any other single reason" - Philip A. Fisher.

You should re-read the quote above. If you have been investing in the stock market for any length of time, you have surely succumbed to the 'coming out even' fallacy at least once.

Truth is, ‘Mr. Market’ does not know at what price you bought a stock or fund. Nor does he care. But you do, and that is the root of the problem.

I'm presuming that you performed due diligence in selecting a particular stock or a fund - carefully studying past performance, dividend records, peer comparisons. And yet, in spite of your best efforts, you pick a loser. It happens. All a part of the game.

This is when your investing mettle will be tested. Will you swallow your pride and get out? Will you soldier on, 'knowing' that you've picked a winner that will surely make you rich soon? Or will you become a 'long term investor' simply because your short-term plans have got nixed?

A neat little device, called a 'Stop-Loss' level, may save you the blushes. How does it work? Before you buy a stock or a fund, you should decide how much loss you will be able to tolerate. For an expensive stock, your loss tolerance may be less. For a cheaper fund it may be more.

As a conservative, long-term investor, I like to set a stop-loss level of between 15% and 30% of the buy price.

Let us say I'm planning to buy a stock for Rs. 100, and set the stop-loss at 20%. If the stock falls to Rs. 80 or below, I'll not wait and sell immediately - thus ‘stopping my loss’ at Rs. 20 per share.

What if the stock price rises to Rs. 120? Do I have a huge grin on my face and brag about my stock-picking skills to all and sundry? I'll be lying if I said, 'No'. But what I also do is set a 'trailing stop-loss'.

What's that? It means increasing the original stop-loss level by the same percentage as the rise in the stock's or fund's price. In our example, we will raise the stop-loss level to Rs. (120 - 24 =) 96.

If the stock moves up to Rs.200 (this happens usually in bull markets - but also some times in sharp bear market rallies), the stop-loss level will now be Rs.160.

Stop-loss levels not only help you to limit your losses, but a trailing stop-loss will protect your profits as well. Should the stock price suddenly fall to Rs.150, your stop-loss level will be 'triggered' and you will sell off, still making a profit of Rs. 50 per share (that you bought originally at Rs. 100).

The foregoing discussion has been written from the point-of-view of a conservative long-term investor. I have nothing against those who trade stocks on a daily basis, but I do not recommend trading to new or inexperienced investors. But if trading is what gets you excited, you may want to set 'tighter' stop-losses.

In the 2008 bear market, the Sensex fell more than 60% from its January 2008 top of 21200. But many small investors were facing much bigger losses because of their penchant for buying smaller and ‘cheaper’ stocks and funds.

The two lessons from such a traumatic experience are:

(1) most stocks or funds that seem a bargain are not; better stick to proven performers and market leaders;

(2) even if you've chosen the wrong stock or fund, applying a disciplined stop-loss mechanism will limit the losses.