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Sunday, April 5, 2009
Saturday, March 21, 2009
What is the right time to buy a stock?
How should an investor decide the right time to buy a stock? Many investors are interested in entering the stock market, but are not very sure about their timing.
Let’s try to work around this problem.
In the short term, nobody knows which direction a stock price is going to move in. It can go up or down depending on various factors including stock market sentiments, liquidity in the market, etc. However, if you have done a good amount of research on a stock and are convinced that the stock is undervalued presently and offers good margin of safety, you should go ahead and buy the stock. Here, I am assuming that you are not a short-term investor (that’s an oxymoron though- an investor can only be for long term. For short term, you have speculators) and you have sufficient patience to be able to reap the rewards of your efforts in future. If you keep holding the stock and your research on the stock was sound, the market will discover the true value of the stock and reward you with good return on your investment. The key here is to buy cheap and have patience.
If you are looking to make money in short term, there is no sure fire strategy. You can as well try your luck in a casino.
Many retail investors start thinking about entering the stock market when the market is in a bull phase. This is a general tendency of beginners as they see many people making profits (some realized and much unrealized!) on their stock market investments. During the peak of a bull phase, stock markets see entry of all kind of investors and speculators. At this stage, you will see that anybody and everybody, who doesn’t know anything about stocks, is talking about purchasing shares and giving tips on which stocks to buy. At such times, stock prices get very heated as there is huge demand for stocks and many stocks see unrealistically high prices that do not justify their underlying business valuation. You will still see promising companies but you will rarely see any stock that can be bought at a cheap price with a good margin of safety. In such times, you should not buy a stock or think about entering the stock market. In fact, this is the time to get out of the stock market, as a fall may not be far away.
A corollary of the above discussion is that a bear market is a good time to buy stocks for a long-term investor. You will find that many good businesses that are generating good returns consistently have come under the spell of bears. Fortunately or unfortunately, investors act in hordes. Even great businesses can be found trading at huge discounts in a bear market. As an investor, you should hunt for bargain stocks in a bear market. You will not be disappointed. The key again is to ensure that you are confident about the value of the stock and the business behind it.
Let’s try to work around this problem.
In the short term, nobody knows which direction a stock price is going to move in. It can go up or down depending on various factors including stock market sentiments, liquidity in the market, etc. However, if you have done a good amount of research on a stock and are convinced that the stock is undervalued presently and offers good margin of safety, you should go ahead and buy the stock. Here, I am assuming that you are not a short-term investor (that’s an oxymoron though- an investor can only be for long term. For short term, you have speculators) and you have sufficient patience to be able to reap the rewards of your efforts in future. If you keep holding the stock and your research on the stock was sound, the market will discover the true value of the stock and reward you with good return on your investment. The key here is to buy cheap and have patience.
If you are looking to make money in short term, there is no sure fire strategy. You can as well try your luck in a casino.
Many retail investors start thinking about entering the stock market when the market is in a bull phase. This is a general tendency of beginners as they see many people making profits (some realized and much unrealized!) on their stock market investments. During the peak of a bull phase, stock markets see entry of all kind of investors and speculators. At this stage, you will see that anybody and everybody, who doesn’t know anything about stocks, is talking about purchasing shares and giving tips on which stocks to buy. At such times, stock prices get very heated as there is huge demand for stocks and many stocks see unrealistically high prices that do not justify their underlying business valuation. You will still see promising companies but you will rarely see any stock that can be bought at a cheap price with a good margin of safety. In such times, you should not buy a stock or think about entering the stock market. In fact, this is the time to get out of the stock market, as a fall may not be far away.
A corollary of the above discussion is that a bear market is a good time to buy stocks for a long-term investor. You will find that many good businesses that are generating good returns consistently have come under the spell of bears. Fortunately or unfortunately, investors act in hordes. Even great businesses can be found trading at huge discounts in a bear market. As an investor, you should hunt for bargain stocks in a bear market. You will not be disappointed. The key again is to ensure that you are confident about the value of the stock and the business behind it.
Saturday, March 14, 2009
How to select a stock- Part VII- Finding the right price of a stock
In this post, we will learn about how to find the right price for a stock. Many people confuse good companies with a good stock. If they like a company’s business model, they purchase its stock without any consideration of the price it is trading at. What matters more in investment is that you have bought a stock at the right price. If you have bought stocks of a great company at a very high price level, it may not turn out to be a great investment. On the contrary, if you have bought stocks of a good company at a good price level (cheap), you may get good return on your investment. It’s important to buy cheap.
A stock price is supposedly an indicator of net present value of future earnings for the stock on per share basis. This is also called the intrinsic value of a stock. However, the problem with this concept is that one needs to predict the future to be able to arrive at the right stock price. Millions of people have tried predicting future in the past, but rarely have we seen anybody doing so accurately. This very concept leads to a lot of investing mistakes by millions of people. A lot of analysts get into the game of predicting future earnings through various esoteric mathematical formulae. Nobody gets it right!
A good approach for stock selection could be following what legendary Investment Guru Benjamin Graham advised- follow the principles of ‘margin of safety’ and ‘diversification’.
The margin of safety concept says what you are buying should be worth more than what you are paying by a wide margin. Such a simple thing, but it’s really difficult to act on it considering the problem in assessing the value of a stock. Graham says you shouldn’t get into the business of predicting the future; instead, use the past performance to assess the ability of the company to keep producing decent earnings in future. Hence, if the company has a current earning of about 12% of the stock price (i.e. a PE ratio of 8), and meets all our criteria of selection as mentioned in my previous posts, and risk free return (of a 10-year government bond) is 6%, you have a good margin of safety in the stock. There is no general formula for all industries. However, in most of the cases, the PE ratio should not go beyond 15. The higher the PE ratio, the more future growth dependent your return on the stock becomes. Never buy a stock if you believe it is fully priced even if it is of the best performing company.
Diversification is linked with the concept of margin of safety. Let me explain. If you are playing dart, and you are good at it; what are your chances of hitting bulls eye once if you have only once dart? What if you have ten darts? Of course, you will have much better chances of hitting Bull’s Eye at least once if you have ten darts. Do you understand the difference? If you have margin of safety in your favor, your chances of making good returns or at least not incurring loss in a portfolio of diversified stocks becomes pretty high. However, there is a caution here. Diversification will work to your favor if you have diversified in stocks with good margin of safety. It will hurt you badly if you have bought all losers. Diversification in overpriced stocks will ensure that you most likely incur loss on your investment. So, be careful. Don’t buy costly stocks. Always maintain a diversified portfolio of good stocks bought with a margin of safety.
With this, the series on ‘how to select stocks for investing’ ends. I hope I have been able to give you a few basic guidelines on how to go about picking stocks for investment. I must add that these are indicative guidelines and by no means exhaustive. You will do well if you use these guidelines along with your own research and experience backed by some sound reasoning.
A stock price is supposedly an indicator of net present value of future earnings for the stock on per share basis. This is also called the intrinsic value of a stock. However, the problem with this concept is that one needs to predict the future to be able to arrive at the right stock price. Millions of people have tried predicting future in the past, but rarely have we seen anybody doing so accurately. This very concept leads to a lot of investing mistakes by millions of people. A lot of analysts get into the game of predicting future earnings through various esoteric mathematical formulae. Nobody gets it right!
A good approach for stock selection could be following what legendary Investment Guru Benjamin Graham advised- follow the principles of ‘margin of safety’ and ‘diversification’.
The margin of safety concept says what you are buying should be worth more than what you are paying by a wide margin. Such a simple thing, but it’s really difficult to act on it considering the problem in assessing the value of a stock. Graham says you shouldn’t get into the business of predicting the future; instead, use the past performance to assess the ability of the company to keep producing decent earnings in future. Hence, if the company has a current earning of about 12% of the stock price (i.e. a PE ratio of 8), and meets all our criteria of selection as mentioned in my previous posts, and risk free return (of a 10-year government bond) is 6%, you have a good margin of safety in the stock. There is no general formula for all industries. However, in most of the cases, the PE ratio should not go beyond 15. The higher the PE ratio, the more future growth dependent your return on the stock becomes. Never buy a stock if you believe it is fully priced even if it is of the best performing company.
Diversification is linked with the concept of margin of safety. Let me explain. If you are playing dart, and you are good at it; what are your chances of hitting bulls eye once if you have only once dart? What if you have ten darts? Of course, you will have much better chances of hitting Bull’s Eye at least once if you have ten darts. Do you understand the difference? If you have margin of safety in your favor, your chances of making good returns or at least not incurring loss in a portfolio of diversified stocks becomes pretty high. However, there is a caution here. Diversification will work to your favor if you have diversified in stocks with good margin of safety. It will hurt you badly if you have bought all losers. Diversification in overpriced stocks will ensure that you most likely incur loss on your investment. So, be careful. Don’t buy costly stocks. Always maintain a diversified portfolio of good stocks bought with a margin of safety.
With this, the series on ‘how to select stocks for investing’ ends. I hope I have been able to give you a few basic guidelines on how to go about picking stocks for investment. I must add that these are indicative guidelines and by no means exhaustive. You will do well if you use these guidelines along with your own research and experience backed by some sound reasoning.
Sunday, March 8, 2009
How to Select a Stock- Part VI- Management Quality
While investing in stocks, one very important issue is that whether you can trust the management of the company for taking it to greater heights in future. If you can’t trust the management, you can’t trust the stock for giving you good returns. Let me explain. Imagine that you are going on a cruise, and, suddenly, you found out that the captain of the ship has been through three shipwrecks earlier; and on all three occasions he saved his life and left all passengers to die. What will you do? Of course, you will cancel your plans of going on that cruise. You got the point. Even if the business fundamentals are strong for a company, poor management can, and will, take it down.
There are a few things that you need to assess in the management of the company.
Focus: A sound management focuses on key issues that drive value for the business. If a management understands its role and the requirement of a business well, it will focus on taking actions that will drive growth and profitability of the business. However, if you notice that the management is focusing on unimportant or inexplicable issues, you should be wary of investing in such companies. If you notice that the management is not able to do justice to its current business and is trying to diversify into seemingly unrelated businesses, this could be an indication that the management is indulging in diversionary tactics to avoid attention to their non-performance in the existing line of business. A sound management knows its business well and focuses on building it by venturing into territories it can traverse well.
Past record & Consistency: Check out the past record of the management and see how they have grown business in the past. Go through past annual reports, dig into the management discussion and analysis section and see how they have been faring on their plans and promises on year-on-year basis. If you see lack of consistency on promises, plans, actions and results, there is a reason for you to investigate further.
If the management has been indulging more in media activities than on business, there might be a need to look into the capabilities of the management further. If there has been
a change in the top brass of the company recently, you need to check the past records of the recently joined management personnel.
Do look into the share buy-backs announced by the company. If the share buy back has happened at the time when the stock prices are down and below the ‘intrinsic value’, it’s a great thing for a stockholder. It will most probably result in increased value for shareholder in future. However, if the share buy-backs have been announced in a bull market when the prices are hyped and beyond the reasonable value of the stock, you should be careful.
Check out how the management has grown the company year on year. If the company has allocated its retained earnings well and increased its profit with better-than-usual market rate, it’s a sign of a good management. However, if the company has not been able to grow its profits on consistent basis, and has not shared its earnings with the shareholders in the form of dividend, you have a reason to question the ability of the management.
Integrity: Make sure that the company you are investing in has got a management with unquestionable integrity. With many corporate frauds being discovered in these days, you don’t want to get trapped in a company that has falsified its records or has got management that can go to any extent to hide their actual performance. A little bit of internet search on the names of the management along with key words like ‘fraud’, ‘court case’, ‘criminal case’, etc will unearth enough details for you to consider.
Instances of crises actually give you a very good understanding of the character of the management. If the management has been candid in accepting the issues, handled the situation with maturity, and proactively taken steps to overcome difficulties, you can rest assured about the quality of management.
You should also check out management rewards announced by the company. If there are instances of management rewarding itself with plump bonuses and obscene stock options without a credible link to growth in profits of the company, you have a reason to worry.
In conclusion, though judgment on the management quality of the company is based on many qualitative factors, you should do everything in your limits to understand this factor as it going to be the key factor that will decide the future earnings through your stock.
In the next post, which is going to be the last post in this series of ‘how to select a stock for investing’, I will explain a few basic things that will help you decide how you can identify a right price for a good stock.
There are a few things that you need to assess in the management of the company.
Focus: A sound management focuses on key issues that drive value for the business. If a management understands its role and the requirement of a business well, it will focus on taking actions that will drive growth and profitability of the business. However, if you notice that the management is focusing on unimportant or inexplicable issues, you should be wary of investing in such companies. If you notice that the management is not able to do justice to its current business and is trying to diversify into seemingly unrelated businesses, this could be an indication that the management is indulging in diversionary tactics to avoid attention to their non-performance in the existing line of business. A sound management knows its business well and focuses on building it by venturing into territories it can traverse well.
Past record & Consistency: Check out the past record of the management and see how they have grown business in the past. Go through past annual reports, dig into the management discussion and analysis section and see how they have been faring on their plans and promises on year-on-year basis. If you see lack of consistency on promises, plans, actions and results, there is a reason for you to investigate further.
If the management has been indulging more in media activities than on business, there might be a need to look into the capabilities of the management further. If there has been
a change in the top brass of the company recently, you need to check the past records of the recently joined management personnel.
Do look into the share buy-backs announced by the company. If the share buy back has happened at the time when the stock prices are down and below the ‘intrinsic value’, it’s a great thing for a stockholder. It will most probably result in increased value for shareholder in future. However, if the share buy-backs have been announced in a bull market when the prices are hyped and beyond the reasonable value of the stock, you should be careful.
Check out how the management has grown the company year on year. If the company has allocated its retained earnings well and increased its profit with better-than-usual market rate, it’s a sign of a good management. However, if the company has not been able to grow its profits on consistent basis, and has not shared its earnings with the shareholders in the form of dividend, you have a reason to question the ability of the management.
Integrity: Make sure that the company you are investing in has got a management with unquestionable integrity. With many corporate frauds being discovered in these days, you don’t want to get trapped in a company that has falsified its records or has got management that can go to any extent to hide their actual performance. A little bit of internet search on the names of the management along with key words like ‘fraud’, ‘court case’, ‘criminal case’, etc will unearth enough details for you to consider.
Instances of crises actually give you a very good understanding of the character of the management. If the management has been candid in accepting the issues, handled the situation with maturity, and proactively taken steps to overcome difficulties, you can rest assured about the quality of management.
You should also check out management rewards announced by the company. If there are instances of management rewarding itself with plump bonuses and obscene stock options without a credible link to growth in profits of the company, you have a reason to worry.
In conclusion, though judgment on the management quality of the company is based on many qualitative factors, you should do everything in your limits to understand this factor as it going to be the key factor that will decide the future earnings through your stock.
In the next post, which is going to be the last post in this series of ‘how to select a stock for investing’, I will explain a few basic things that will help you decide how you can identify a right price for a good stock.
Sunday, February 22, 2009
How to select a stock- Part V- Retained Earnings and Dividend Income
When you are thinking about investing in a company by owning its common stock, you need to see whether the company is using the profit generated in the best possible manner. There are two ways in which a company can make use of its earnings- return a part of the profits to its shareholders by paying dividend or use the earnings profitably to grow the earnings of the future.
Different companies use different ways of sharing wealth with their shareholders. One company might choose to pay a handsome dividend to their shareholders every year. Another company might decide to use the whole earning for investing in future growth and pay nothing to its shareholders. A third company may choose to pay a relatively small amount as dividend and invest the remaining amount in the business. Here, one could wonder how a beginner could decide which company is a better investment.
You should ask a question- if the company decides to keep the profits with itself, will it be able to generate a better rate of return on retained earnings than the return you would have got by investing it in some other opportunities available with you. If the company can do a better job with the retained earnings than you can in terms of generating a good rate of return, it should retain the earnings. Otherwise it should pay dividend to investors.
You can assess a company’s capability of generating superior returns by looking at the history of earning growth. If the growth in earnings in the past has been superior, you can trust the management with the retained earnings. If there is no history to look through, you should try to understand where the management is trying to invest in future. If you believe that the management is pursuing a worthwhile investment opportunity and can generate a good return reliably, you can trust the management with the retained earnings.
You should consider another factor in your analysis. If the company is giving you dividend, you have got money in your hands and you can earn real return on it by keeping in a safe investment opportunity. However, if you trust a company with retained earnings, there is a possibility that the company may not be able to give you superior returns in future. To compensate for this risk, ideally, the future earning prospects with retained earnings should far outweigh the earnings you can achieve yourself.
You will find that many companies pursuing growth opportunities are not paying dividends to shareholders. Similarly, many companies have matured in their earnings and are generating cash flow on consistent basis have been paying handsome dividends to their shareholders. These companies may not be having growth opportunities that can justify the use of earnings. Which companies you want to invest in depends on your personal judgment of the growth opportunities and your own ability to generate returns on dividend income. If you are in doubt, perhaps you should opt for the safety of dividend income rather than the probability of expected future earnings.
We have two more topics to cover in this series of ‘how to select a stock for investing’. Watch out for the next post in this series next week.
Different companies use different ways of sharing wealth with their shareholders. One company might choose to pay a handsome dividend to their shareholders every year. Another company might decide to use the whole earning for investing in future growth and pay nothing to its shareholders. A third company may choose to pay a relatively small amount as dividend and invest the remaining amount in the business. Here, one could wonder how a beginner could decide which company is a better investment.
You should ask a question- if the company decides to keep the profits with itself, will it be able to generate a better rate of return on retained earnings than the return you would have got by investing it in some other opportunities available with you. If the company can do a better job with the retained earnings than you can in terms of generating a good rate of return, it should retain the earnings. Otherwise it should pay dividend to investors.
You can assess a company’s capability of generating superior returns by looking at the history of earning growth. If the growth in earnings in the past has been superior, you can trust the management with the retained earnings. If there is no history to look through, you should try to understand where the management is trying to invest in future. If you believe that the management is pursuing a worthwhile investment opportunity and can generate a good return reliably, you can trust the management with the retained earnings.
You should consider another factor in your analysis. If the company is giving you dividend, you have got money in your hands and you can earn real return on it by keeping in a safe investment opportunity. However, if you trust a company with retained earnings, there is a possibility that the company may not be able to give you superior returns in future. To compensate for this risk, ideally, the future earning prospects with retained earnings should far outweigh the earnings you can achieve yourself.
You will find that many companies pursuing growth opportunities are not paying dividends to shareholders. Similarly, many companies have matured in their earnings and are generating cash flow on consistent basis have been paying handsome dividends to their shareholders. These companies may not be having growth opportunities that can justify the use of earnings. Which companies you want to invest in depends on your personal judgment of the growth opportunities and your own ability to generate returns on dividend income. If you are in doubt, perhaps you should opt for the safety of dividend income rather than the probability of expected future earnings.
We have two more topics to cover in this series of ‘how to select a stock for investing’. Watch out for the next post in this series next week.
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