The Art of Picking Stocks is another fictional conversation about how to select stocks.
Suresh Natarajan decided he was out of his depth. Either this stock market business was too complicated, or he was doing something horribly wrong. He did the obligatory social media status update (“The stock market is a gambling den!”) and got 60 friends saying they agreed, and one – Atul Balaram Kasbekar, or Abacus – saying, “Call me, SN.”
Why not, he thought. He dialed the number.
“Abacus, it’s me, SN. How are you? Tell me what stocks to buy – the last five tips I got were utterly useless.”
Abacus replied, “Great, SN. But before I start, why don’t you tell me what you’ve done?”
“I started thinking last year that I have some surplus cash lying around, and I should invest it in the stock market. My insurance advisor suggested a person who had excellent inside knowledge of the market, for just five hundred rupees a month, and gave me a list of calls that had done very well. So I bought in.
“The first month it seemed very good – I got 30 tips and about 5 of them did really well. I broke even or lost some money on the remaining, and I followed the service diligently. When I checked my account at the end of the month, I realized that net of brokerage costs I had lost money. They advertised only their good trades!
“So I moved on to some tips provided by my broker, and the problems were similar; and they wanted me to trade 10 times a day, which I don’t have time for. Research reports always tell you when to buy, but hardly ever tell you how much to buy, when to sell, or how their own performance has been. Plus, I can never seem to get in at their purchase prices.
“I looked at a few internet sites, but they all talk about complicated concepts like revenue growth, EPS and head-and-shoulders patterns and all that. I don’t have the time to go through all of that for the 1000 companies that trade every day!”
Abacus said, “True. It might not seem easy to pick stocks. There is no ‘formula’ for investing – if it existed, everyone would be using it. Using stock tips or research reports is useful as an initial filter, since you don’t have the time to run through all the market stocks. How about using your knowledge and the internet to further gain confidence about a stock?”
Suresh found this interesting, but then what use was his knowledge here? “Abacus, how do you pick stocks? I might find it easier if I learnt from you, instead of asking you what to buy.”
Abacus paused. No doubt SN was aware of the generic gyan that littered the world of investment advice. He had to qualify what he said.
“SN, you might find that I do things differently from others, so work with your level of comfort. What I usually do is first identify a trigger. A trigger is when a stock comes to my notice. It could be that a friend mentions it, or that I read about it in a paper, or simply that I bought some of their products, liked them and found out they are listed.
“Once I know the company name, I usually check on the National Stock Exchange or the Bombay Stock Exchange for details of the stock. I check the financial history of the company (e.g. Infosys), specifically the Earnings Per Share (EPS), and how that number has been growing. The Price to Earnings ratio, or the P/E is simply the share price divided by the EPS. I like stocks with a 20 P/E, but a 30% growth in EPS in each of the last three years – basically a P/E lower than the growth I see in the EPS.
“I might also look at prospects of the sector itself. If I’m very positive on middle-class households buying kitchen-ware, there are stocks of pressure cooker companies that will be very attractive.
“And I choose stocks on price action. A stock that makes a new all-time high is always worth scrutinizing, in my experience. Sometimes the reasons are apparent after the price moves, and it’s useful to keep a note of stocks at or close to their historic highs. Regardless, the price move in a stock should be strong in its recent price chart– the stock should be moving up, and there needs to be strong volume on a daily basis.
“Now to scrutinize the stock. I check the shareholding pattern (e.g. for IndiaBulls). I look closely at who the promoters are, have they or the company seen any recent adverse news – a cursory check on an internet search. Given their larger resources, institutions are likely to have discovered a stock before me, so that’s another positive. Companies have to announce when their management buys or sells stock – I like stocks in which insiders are buying.
“Two things to note here – there are great stocks at not-so-great prices, and just like you will not pay Rs. 1,000 for a movie, I don’t like to overpay for a stock. I need to see that the company can grow its EPS faster than the Price to Earnings I pay. Secondly, I don’t expect every stock to be a winner, but I will only invest when it is enormously attractive. Basically, I don’t invest because I have to do so – only if there are fabulous opportunities.”
Suresh asked, “That’s great. Now you have a stock. How much do you put in each stock?”
“This is as important as what to buy and when. I personally allocate between 5% and 10% of my total portfolio per stock. That way I only have to manage 10 to 20 stocks any time. Even when I find a stock, I will invest only a part of the money allocated – say half of it – in the first go. I keep on adding to it as the stock goes up.”
“Not when the stock goes down? But they say you should average your holding price.”
“That’s a little like catching a falling knife. I buy a stock because it’s supposed to go up. If it loses value, it’s going against my theory; so I wait until my theory works and then buy. If a stock loses 20% from my buy price, I sell, regardless of what my analysis is. I can’t know everything!”
“But why sell at 20% loss? And why not sell at 20% profit also?”
“My experience is that when these stocks go up they go a lot higher than 20%. Sometimes as high as 500%. By limiting my downside to 20% and keeping my upside open, I make the probabilities and returns work for me – even if I am wrong as many times as I’m right, I will make a positive return.
“When I get out of stocks at a ‘stop-loss’ of 20%, it opens up capital that I can invest in a different stock I have identified. Eventually the stronger stocks stay, and the weaker ones are pushed out.
“I’m not in the camp that says hold your stocks forever. The current US markets are at the same level as they were 10 years ago, and the Japanese stock markets are still only a quarter of their value 20 years back. While stocks fall a lot, I don’t get married to such investments – even if they are good companies, there may be a better time to buy them.”
Suresh was startled. “But this is hardly what they suggest in books and on TV, Abacus. They tell you to buy and hold that investment until you need money. Though I guess that didn’t work very well for those American and Japanese investors.”
“It might work for a subset of people who don’t have the inclination or the time to learn about the markets. A passive way of investing is to simply buy broadly diversified mutual funds and allocate money appropriately between stocks and fixed income. That way you don’t have to think too hard. But I try to spend some more time with my investments; after I retire, the money will be my friend.”
Suresh smiled. “Very true, Abacus. I got into the markets because of the thrill in the game. But I can get my thrills at a casino. Like you’ve just said, stock market investing requires some discipline and work. How much time do you put in it, though?”
“A few hours every weekend for investigation, and I watch prices every few days for my ‘stop loss’. A small price to keep a friend.”