Indian Ticker : Choose Right Stocks that Ticks Money

Secret #9: Become a conscious investor

The Famous graphic artist M.C. Escher said that “most of the time we are meekly sleepwalking on a treadmill.” In other words we are acting in an unconscious way and making little progress. This certainly applies to investing. Most of the time decisions are made based on either hope and wishful thinking or on abstract academic theories.

Fortunately investing is an area that responds well to becoming more conscious of what we are doing and why. “Risk comes from not knowing what you are doing,” Buffett said.

The whole direction of Conscious Investor is to place your investing, and hence your financial future, on a firm basis of sensible and knowledgeable investing. Yet there is another part of being a conscious investor and this is to invest in companies with products and services that you support and believe in. When you
become conscious of why you want to invest in a particular company, then risk can be substantially reduced. Investing this way helps to eliminate many of the unknowns whether psychological, emotional or material.

As those who have been to an annual meeting of Berkshire Hathaway will know, Buffett gets great pleasure from using and talking about the products and services of the companies that he invests in or owns.

When you do this investing becomes easier and more fun. You don’t have the worry of having your money tied up with enterprises that you know little about. Also you will become a more astute investor since you are picking up signals about the economics of companies long before they show up in its financial
statements.

Secret #8: Remove the weeds and water the flowers — not the other way around

For many it is worse than having a tooth pulled to sell a stock for a price lower than what they paid for it. If you buy a stock for Rs.20 and it drops to Rs.10, so long as you don’t sell, then it can be referred to as an unrealized loss. In this case you can say to your spouse, “Don’t worry, dear. It’s going to come back.”

Similarly, many can’t wait to sell as soon as they can see daylight between the purchase price and the current price. If the price has gone up be a few dollars, they want to sell and “lock in the profit”.

Peter Lynch and later Warren Buffett referred to this as watering the weeds and pulling up the flowers. They are examples of what I call investor diseases. The disease of holding on to your losers I call get-evenitis. The disease of selling winners I call consolidatus profitus. Just how wide-spread these diseases are follows from a large-scale study carried out by Terrance Odean of the University of California in Davis. His study also showed just how expensive they are, being paid for in investors’ profits.

Reporting in the Journal of Finance, 1998, he found that people tended to trade out of winners into stocks that performed less well. In the opposite direction, the study showed that the losers in their portfolio tended to continue to underperform. It was really the case that once a loser, always a loser.

Overall he found that people would have been better to sell their losers and keep their winners. Instead, they did the opposite, namely keep their losers and sell their winners. Suppose two simple changes were made: the investors sold their losers and held on to their winners. On average, the study showed that their average annual performance would have gone up by almost five percent per year.

The difference between the two strategies is even more marked when taxes are taken into account. When you claim a loss you are getting a tax rebate and so you want this as early as possible. In contrast, with a profit you are paying tax so you want to delay this as long as possible. But, as we just learned, the average
investor tends to take profits early and losses late ending up on the wrong side of the taxman.

This gives us confirmation of secret number eight: Remove the weeds and water the flowers — not the other way around Of course, this is an oversimplification. There are times when it is better to keep a stock when the price has gone down. In fact, it may well make sense to buy more. At other times, it is better to sell a stock after it has gone up. Each case has to be treated on its own merits.

This leads to the question. Just when should you sell? A large survey carried out by the Australian Stock Exchange showed that investors found it much harder to know when to sell than when to buy. Similar results were found in a survey of nearly 300 investors that I carried out. Almost 50 percent said that they either regularly worry or constantly worry about when to sell their stocks.

The general rule which is full of common sense is: Sell only when you can be very confident that you can do significantly better with your money in another stock. The problem is to be able to determine when this is the case.

Secret #7: Calculate how much money you will make, not whether the stock is undervalued or overvalued according to some academic model.

As an investor what is the right question to ask? Most ask whether the stock is undervalued or overvalued. The problem with this is that there is no way of properly determining whether a stock is, in fact, undervalued or overvalued.

There are various academic models for calculating what is called the intrinsic value of a stock. From my extensive experience as a research mathematician all these models, referred to as discount cash flow models, are fatally flawed. There are four areas that bring them down. They are theoretical, contradictory, unstable and untestable.

These problems are a rather technical to explain fully so I will only give the general ideas behind them. Just because some theoretical formula labels a stock as undervalued does not mean that you are going to make money from it.

For example, perhaps the price will stay at that level. The models are contradictory since different values are obtained depending on which of the many variations of the models that you use.

They are unstable since insignificantly small changes in the input variables lead to changes of 100 percent or more in the intrinsic value. This means that in instead of the models being objective, they can lead to almost any output that is desired. And finally the models are impractical because they are untestable.

Some of the input variables require verification over an infinite number of years. For example, forecasts of growth rates have to be made over not just five or ten years, but extending out forever.

Secret #6: Know what a fat pitch is and what to do with it

WARREN BUFFETT likes to use examples from sport to outline his investment ideas. He particularly likes to use baseball with references to Ted Williams, the former record holder for the Boston Red Sox. A few years ago Buffett said “We try to exert a Ted Williams kind of discipline. In his book The Science of Hitting, Ted explains that he carved the strike zone into 77 cells, each the size of a baseball. Swinging only at balls in his “best” cell, he knew would allow him to bat .400; reaching for balls in his “worst” spot, the low outside corner of the strike zone, would reduce him to .230. In other words, waiting for the fat pitch would mean a trip to the Hall of Fame; swinging indiscriminately would mean a ticket to the minors.”

When we apply this to investing the message is clear. Wait until everything is in your favour. Nothing makes you buy any particular stock at any particular time. As investors we have the luxury of waiting for the “fat pitch.” But there are problems. To be able to do this effectively we need to master three steps. Before outlining these steps, to keep Buffett’s analogy running, let’s describe what we are trying to do as looking for home-run stocks. These are the stocks with the highest chance of being successful and making you money year after year.

The first step to master is to be able to recognize a home-run stock. As we have seen, they are not glitter stocks that have appeared on the front cover of an investment magazine or recommended by a popular share market commentator.Nor are they stocks that have a trader price pattern of breakouts, double bottoms, or candle-stick trend reversals.

The second is to know what to do when a home-run stock comes along. Buffett has said when everything meets your criteria of it being a great business at a fair price, then buy a “meaningful amount of the stock.” Of cource, this means that you can only hold a small number of companies in your portfolio. The extreme
exponent of only holding a small number of stocks was Phil Fisher. For Fisher, anything over six was too many. The more stocks you hold, the more likely your returns will be average and the more time you will have to spend keeping track of the stocks in your portfolio. You also add considerable risk because you can’t study them properly.

The third step concerns knowledge and confidence. You need the knowledge to know approximately how often a home run stock comes along. You won’t make the investors Hall of Fame if your criteria are set so high that you only get to swing every other decade. On the other hand, if they are set too low then, well,

they are unlikely to give you the outcome that you desire. You also need to have the confidence to wait. Our aspiring Hall of Famer has to resist being suckered in to swinging at pitches that don’t meet the criteria.

Secret #5: Stay away from “glitter” stocks

There are many thousands of stocks to choose from: in the USA over 10,000 stocks, in Canada over 3000 and in Australia over 1,500. Faced with these massive numbers and the associated deluge of information, investors get drawn to what I call glitter stocks. These are stocks that have some attention grabbing activity such as high trading volume, extreme movements in the price whether up or down, or when the stocks are in the news.

Even with the best of intentions, it is hard to look at these stocks in a clear and objective manner compared to the remaining stocks. Warren Buffett was so aware of this that he moved from New York back to his home town, Omaha, Nebraska. Regarding the benefits of living in Omaha, he said, “I think it’s a saner existence here. I used to feel, when I worked back in New York, that there were more stimuli just hitting me all the time… It may lead to crazy behavior after a while.” He ended by stating that it is much easier to think in Omaha.

A research study by Brad Barber and Terrence Odean of the University of California demonstrates very clearly the penalty to be paid by getting drawn into glitter stocks. They found that, on average, individual investors tended to invest in glitter stocks more than professionals. Secondly, they found that by doing this they underperformed the market by anything from around 2.8 percent to 7.8 percent per annum.

Buffett has long understood this. For example, back in 1985 he said, “Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can’t buy what is popular and do well.”

Secret #4: Calculate how well management is using the money they have

Home buyers understand about equity. It is the value of the home less the amount owed to the bank. The same is true of a business. Its equity is the total assets minus all the liabilities. You can think of this as the money locked up in the business. It is a measure of how much money management has to run the business.

Another measure of the money available to management is the capital of the business. This is its equity plus the long-term debt of the company. Clearly the success of any business is going to depend on how well management uses its equity and its capital. This is commonly measured by two ratios called return on equity and return on capital. Putting it simply, these are defined as the earnings of the company divided by equity and by capital. Their abbreviations are ROE and ROC.

Many companies consistently lose money year after year. So they do not even have an ROE or ROC. Others have very low values for these ratios. In other words, management is struggling to make a profitable use of what it has. Clearly, these are not the sort of companies that we should think of as quality investments. If management is only making a few percent on the money that it has, then over time this is all you can expect to make if you purchase shares in the company. After all, money can’t come from nowhere.

Every year, Warren Buffett writes in the annual report of Berkshire Hathaway that he is eager to hear about businesses that, amongst other things, are earning“good returns on equity while employing little or no debt.” This means that ROE and ROC are essentially the same.

It makes sense. If you want a healthy return on any shares that you purchase, at the very least you need to select companies with management that is making a healthy return on the money that they have.

Secret #2: Don’t invest for ten minutes if you’re not prepared to invest for ten years

When we look at the share price of a company we usually see a wildly fluctuating graph with mighty hills and plunging chasms.

This brings us to what Warren Buffett said a few years back, “If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes.”

He continued, “Put together a portfolio of companies whose aggregate earnings march upwards over the years, and so will the portfolio’s market value.”

In other words, as investors we focus on the medium to long term business characteristics of companies. It is these that drive the share price. Focusing on the short-term aspects of a company including both business and price fluctuations is foolish as Buffett has said. “Most of our large stock positions are going to be held for many years, and the scorecard on our investment decisions will be provided by business results over that period, not by prices on any given day.”

Even though we focus on the long-term, the investment is even more profitable if we purchase the stock during one of its drops. Buffett has said that even for the best of companies, you can still pay too much.

Secret #3: Scan thousands of stocks looking for screaming bargains

Only a handful of outsiders have been permitted to enter the inner sanctum of the Berkshire Hathaway offices in Kiewit Plaza, Omaha. When Chris Stavrou, the founder of the New York asset management firm, Stavrou Partners, visited the offices he reported seeing hundreds of file drawers full of reports on thousands of companies.

Two things stand out. Firstly, Buffett said that the reports were mainly annual and quarterly reports. In other words, material that is available to everyone. Secondly, he declares that he does not use a computer. Not even a calculator. He is able to do without these standard aids since, as many people have attested, he has a prodigious memory. There are numerous examples of him being able to recall obscure facts about the companies that he has investigated, and their competitors, many years later. It seems that he has read, and memorized, a huge amount of the material in the filing cabinets.

This means that, when he is looking for quality investments satisfying his stringent criteria, he can scan through his own memory and couple the results with current prices. In the end, he is not looking for investments that are, with a little luck, likely to be slightly better than average. He wants them to be great
investments by a large margin. “If (the investment) doesn’t scream at you,” he once said, “it’s too close.”

Summarizing this, we arrive at Secret #3: Scan thousands of stocks looking for screaming bargains.”
Few people have a memory to match Buffett’s. Even fewer have the resources to collect and index tens of thousands of documents on thousands of companies.

Secret #1: Invest in quality businesses, not stock symbols
For most people, investing in a stock is little more than watching the
trail left by the stock symbol as its price wanders along some drunken path.
They know that the symbol is associated with a company while not being too
sure what is expected of this company to ensure that its share price will rise. It is
a case of let’s sit back and hope for the best.

Then there are others who deliberately do not want to know anything about the
activities of the company. They want to study the “pure” movement of the stock
price with the belief that they can use this information to make forecasts about
the future movements of the price. Warren Buffett refers to this as trying to play
bridge without looking at the cards.
It just makes no sense to ignore the fact that the stock symbol is attached to a
company. And it makes no sense not to apply sound business principles to
analyze these companies. The more we know about the company, then the more
confident we can be about the price of the stock. Not on a day to day basis, but
over time.
“When I buy a stock,” Warren Buffett said, “I think of it in terms of buying a
whole company, just as if I were buying a store down the street.” If you were
buying a store you would want to know all about it. What were its products?
How consistent are the sales? Do they keep trying new products or do their
products stay fairly constant? What competitors does the store have and what
distinguishes it from them? What would be the most worrying thing about
owning such a store?
This leads to the idea of looking for companies that have a strong and durable
economic moat. Just as castles have moats to protect them from invaders, so
companies can have economic moats to protect them from challenges of
competitors and changes in consumer preferences. The moat can be made up of
attributes such as brand name, geographical position or patents and licences.
All these principles about purchasing businesses are equally applicable to
purchasing shares. It becomes one of the most enjoyable parts of investing to
look into the “business” aspects of any company that you are considering adding
to your portfolio.

Advantages Of Delivery Based Trading

In delivery based trading, you can always hold a stock till it reaches the expected price.

The long term investment can always get you dividend.

You can also benefit from split shares, bonus stocks and other benefits that the company announces.

Disadvantage Of Delivery Based Trading

In delivery trading you pay higher brokerage.

Your investment is always susceptible to market crashes, business cycles and other factors.

You need to analyze for better future companies.