Dear Reader,

In the stock market there is no rule without an exception, there are some principles that are tough to dispute. Here are 10 general principles to help investors get a better grasp of how to approach the market from a long-term view. Every point embodies some fundamental concept every investor should know.

1. Ride the winners not the losers

Time and time again, investors take profits by selling their appreciated investments, but they hold onto stocks that have declined in the hope of a rebound. If an investor doesn't know when it's time to let go of hopeless stocks, he or she can, in the worst-case scenario, see the stock sink to the point where it is almost worthless. Of course, the idea of holding onto high-quality investments while selling the poor ones is great in theory, but hard to put into practice. The following information might help:

Riding a Winner - The theory is that much of your overall success will be due to a small number of stocks in your portfolio that returned big. If you have a personal policy to sell after a stock has increased by a certain multiple - say three, for instance - you may never fully ride out a winner. No one in the history of investing with a "sell-after-I-have-tripled-my-money" mentality has ever had a tenbagger. Don't underestimate a stock that is performing well by sticking to some rigid personal rule - if you don't have a good understanding of the potential of your investments, your personal rules may end up being arbitrary and too limiting.

Selling a Loser - There is no guarantee that a stock will bounce back after a decline. While it's important not to underestimate good stocks, it's equally important to be realistic about investments that are performing badly. Recognizing your losers is hard because it's also an acknowledgment of your mistake. But it's important to be honest when you realize that a stock is not performing as well, as you expected it to. Don't be afraid to swallow your pride and move on before your losses become even greater.

In both cases, the point is to judge companies on their merits according to your research. In each situation, you still have to decide whether a price justifies future potential. Just remember not to let your fears limit your returns or inflate your losses.

2. Avoid chasing hot tips

Whether the tip comes from your brother, your cousin, your neighbour or even your broker, you shouldn't accept it as law. When you make an investment, it's important you know the reasons for doing so; get into the basics by doing research and analysis of any company before you even consider investing your hard-earned money. Relying on a tidbit of information from someone else is not only an attempt at taking the easy way out, it's also a type of gambling. Sure, with some luck, tips sometimes pan out but they will never make you an informed investor, which is what you need to be to be successful in the long run. Find out what you should pay attention to - and what you should ignore.

3. Don't sweat on the small stuff

As a long-term investor, you shouldn't panic when your investments experience short-term movements. When tracking the activities of your investments, you should look at the big picture. Remember to be confident in the quality of your investments rather than nervous about the inevitable volatility of the short term. Also, don't overemphasize the few bucks difference you might save from using a limit versus market order.

Active traders will use these day-to-day and even minute-to-minute fluctuations as a way to make gains. But the gains of a long-term investor come from a completely different market movement - the one that occurs over many years - so keep your focus on developing your overall investment philosophy by educating yourself.

4. Don't overemphasize the P/E ratio

Investors often place too much importance on the price-earnings ratio (P/E ratio). Because it is one key tool among many, using only this ratio to make buy or sell decisions is dangerous and ill-advised. The P/E ratio must be interpreted within a context, and it should be used in conjunction with other analytical processes. So, a low P/E ratio doesn't necessarily mean a security is undervalued, nor does a high P/E ratio necessarily mean a company is overvalued.  

5. Resist the lure of penny stocks

A common misconception is that there is less to lose in buying a low-priced stock. But whether you buy a Rs. 5 stock that plunges to Rs. 0 or a Rs. 75 stock that does the same, either way you've lost 100% of your initial investment. A lousy Rs. 5 company has just as much downside risk as a lousy Rs. 75 company. In fact, a penny stock is probably riskier than a company with a higher share price, which would have more regulations placed on it.

6. Pick a strategy and stick with it

Different people use different methods to pick stocks and fulfill investing goals. There are many ways to be successful and no one strategy is inherently better than any other. However, once you find your style, stick with it. An investor who flounders between different stock-picking strategies will probably experience the worst, rather than the best, of each. Constantly switching strategies effectively makes you a market timer, and this is definitely most investors should avoid. Take Warren Buffett's actions during the dotcom boom of the late '90s as an example. Buffett's value-oriented strategy had worked for him for decades, and - despite criticism from the media - it prevented him from getting sucked into tech startups that had no earnings and eventually crashed.

7. Focus on the future

The tough part about investing is that we are trying to make informed decisions based on things that have yet to happen. It's important to keep in mind that even though we use past data as an indication of things to come, it's what happens in the future that matters most.

A quote from Peter Lynch's book "One Up on Wall Street" (1990) about his experience with one of the stock he bought demonstrates this: "If I'd bothered to ask myself, 'How can this stock go any higher?' I would have never bought it as stock price already went up twenty fold. But I checked the fundamentals, realized that company was still cheap, bought the stock, and made seven fold after that." The point is to base a decision on future potential rather than on what has already happened in the past.

8. Adopt a long-term perspective.

Large short-term profits can often entice those who are new to the market. But adopting a long-term horizon and dismissing the "get in, get out and make a killing" mentality is a must for any investor. This doesn't mean that it's impossible to make money by actively trading in the short term. But, as we already mentioned, investing and trading are very different ways of making gains from the market. Trading involves very different risks that buy-and-hold investors don't experience. As such, active trading requires certain specialized skills.

Neither investing style is necessarily better than the other - both have their pros and cons. But active trading can be wrong for someone without the appropriate time, financial resources, education and desire.

9. Be open-minded

Many great companies are household names, but many good investments are not household names. Thousands of smaller companies have the potential to turn into the large blue chips of tomorrow. In fact, historically, small-caps have had greater returns than large-caps; over the decades.

This is not to suggest that you should devote your entire portfolio to small-cap stocks. Rather, understand that there are many great companies beyond those in the Small Cap Index, and that by neglecting all these lesser-known companies, you could also be neglecting some of the biggest gains. We have already experienced the multibagger returns from lesser known companies recommended under Hidden Gems service in past, our stock picks like Camlin Fine Sciences, TCPL Packaging, Kovai Medical, Wim Plast, Acrysil, Mayur Uniquoters, Balaji Amines, Rane Brake Linings etc have delivered returns in the range of 500% to 1800% over period of 2 to 5 years.

10. Don't miss to diversify your equity portfolio

Its always wise to have stocks from different sectors and Industries. Do not expose your self to many stocks from the same sector. Be it IT, Consumers, Finance, Infrastructure, Pharmaceutical or any other sector, you must have a proper mix of all with suitable allocation based on future outlook of that sector and industry. Most of the companies from capital goods and Infrastructure sector have not performed since last 6 to 7 years but private banking stocks, NBFCs, consumers and automobile companies stocks are making new all time highs. Hence, its important to stay diversified with your stock investments.

Value investing has never been a "hot" strategy for investing in stocks. In fact, no long-term strategy ever generates much buzz. This is partly because we live in a "quick-buck" culture that values immediate gratification more than a thoughtful approach to investing in stocks.

However, most investors are better off taking the long-term approach than trying to out trade the professionals.

There is always a loud chorus that proclaims buy and hold investing in stocks dead and a fool's game. No doubt if investors have the education, time and energy to devote to investing in stocks, a variation of buy and hold may produce better results.

That's just not the real world. Most of us have many other commitments on our time than we have time for already. Besides, some of the biggest fortunes on Dalal Street have been made with a long-term perspective and many of these fortunes were made with value investing as a core strategy.

What factors should you consider when evaluating a value stock? Before we answer that question, maybe we should briefly define value investing.

Value investing is finding a stock that is selling at a discount to its intrinsic value or companies that the market has undervalued for some reason unrelated to its economic fundamentals.

Benjamin Graham pioneered the value-investing concept and recognized the biggest flaw in the strategy: deciding what a company's intrinsic value is.

Margin of Safety

For this reason he always counseled for a margin of safety that provided room should your calculation of the intrinsic value be off.

This is important because the key to successful value investing is buying at the correct price. Graham's strategy called for a strict discipline on price, which included his margin of safety.

If he could not buy the stock at that price, he would pass.

Many modern stock pickers scoff at the rigidity of his system, yet Graham and his pupils, such as Warren Buffett, have made fortunes sticking to the strategy.

Financial Statistics

Here are some of the financial statistics value investors study, historical and forward:

• Price to book ratios

• Price to sales ratios

• Price to earnings ratios

• Price to cash flow ratios

The value investor will look for these ratios to be below the major indices benchmarks for a company's industry group.

However, let's be clear. Value investors are not looking for companies on the way to bankruptcy. They are looking for companies that have been beaten up by the market for no real fault of their own.

One of the ways you can make sure the company is on solid footing is to look at its financials.

Debt Ratios

Look in particular at its debt ratios (debt levels should be low) and look for good cash flow. A company with manageable debt and good cash flow is worth getting to know better, regardless of how the market is treating the stock.

How does a good company become a value stock? Several things can happen.

The company may not have a glamorous product. Some products just don't get much attention, but still must be produced, for example, those orange barrels you see on highway construction sites.

The growth prospects for the stock may not be high relative to other opportunities in the market. During the dot.com stock frenzy of the late 1990s, almost any stock that wasn't high tech became a value stock in comparison.

If a stock is selling at below Rs. 15 - 20, some investors think there must be something wrong with the company. This is an irrational response, but it happens.

Conclusion

Successful value investing depends on identifying a stock that is trading under the intrinsic value of the company and buying with a margin of safety in case you have misjudged the intrinsic value.

A question that every investor must ask is when should I buy a particular stock?

The answer will vary somewhat depending on whether you are investing in a growth stock or a value stock.

Growth investors expect the company to continue a steep rate of earnings (or in some cases, revenue) growth in the near future. They buy with a certainty that, if growth continues as anticipated, the price of the stock will rise also.

Value investors look for stock trading at a price lower than it is inherently worth. They are willing to hold the stock for an extended period and reap a large profit when the market discovers this hidden gem and bids the stock price up.

Price/Earnings Ratio

Investors often turn for part of their decision-making to a close look at the stock’s price/earnings ratio or P/E.

The P/E is a measure of how much investors are willing to pay for the company’s earnings. You calculate the P/E by dividing the current stock price by its earnings per share.

It is important to note that using the P/E by itself doesn’t give you a complete (or in some cases accurate) picture of the stock’s value.

Several factors can change the P/E. First, earnings per share may not show a true picture of the company’s earnings thanks to monkeying around with the numbers.

How P/E Is Calculated

Second, P/E can be calculated using the previous four quarters of earnings or it may use projections for the next four quarters. The difference can be dramatic.

You also must remember that various economic and market factors can raise or lower the price of the stock.

Given all that, the P/E is still helpful as part of the process of deciding whether to buy a stock.

A stock’s P/E tells you what other investors are willing to spend for the company’s earnings. For example, a P/E of 15 says investors are willing to spend Rs. 15 for every Rs.1 of earnings.

A high P/E says that investors expect the stock to be a strong performer and are willing to pay a premium. A low P/E says the market has less confidence in the company’s long-term potential.

A low P/E may indicate investors sense trouble ahead for the company. It also may indicate that other investors have overlooked this stock and are not placing the correct value on it.

The Right P/E

But, what is high and what is low for a P/E?

The P/E becomes more meaningful when it is compared to a benchmark. In most cases, you will want to see how other companies in the same industry rank.

If other companies in the same industry, are reporting P/Es in the low 20s, but the company you are considering has a P/E of 10, you need to find out why.

This may be a buying opportunity if you don’t uncover problems.

A stock with a P/E higher than its peers may be overpriced.

So, the answer to the question of when to buy a stock (in particular, a value stock) is when the P/E is lower than its peers and you can find no significant problems with the company.

Most of us have relatives who like to fashion themselves as ‘stock-gurus’, with their stories revolving around how they ‘could have been’ millionaires now, if only they had held their nerves. The stock that comes up frequently in these conversations is Infosys. If you had invested Rs. 9,500 to buy 100 shares of Infosys in the IPO (that went undersubscribed in 1993), 51,200 shares (adjusted for bonus issues) worth sum of Rs. 4,89,70,240 would be in your kitty.

Infy has given CAGR returns of whopping 42.6% to investors during last 24 years (that too after keeping dividend payouts aside). Infosys got listed in June 1993 at price of Rs. 145 per share and investment of Rs. 9,500 in June 1993 is valued at 4.9 crores today. But, is Infosys still the key to riches? As often repeated, past performance is no guarantee of future results. So, how does one find out the next ‘Infy’?

A Fast Grower is a small yet aggressive & nimble firm, which grows roughly at 20-25% a year. This is an investment category which can give investors a return of 10 to as much as 200 times the investment made by them. No doubt, it remains a favourite of Peter Lynch!

In 1950s, the Utility & Power Sector were the fast growers with twice the growth rates to that of the US GDP. As people got more power-hungry gadgets for themselves, the power bills ran through the roof & the power sector surged with booming demand. Post the Oil Shock in 70’s, cost of power generation became high with power tariffs going up; people learnt to conserve electricity. Demand, thus, fell and power sector witnessed a slowdown. Prior to it, similar decline was observed in the Steel Sector & Railroads. First, it was the Automobile Sector, and then the Steel, followed by Chemicals & Power Utility & now the IT Sector is showing signs of slowing down. Every time, people thought, rally in the fast growers of the age would never end, but it did end, with people losing money as well as their jobs. Those who thought differently like Walter Chrysler (founder of Chrysler Corporation), who took a pay cut and left the railroads to build new cars in the turn of the last century, became the next millionaires.

Three phases involved in their life cycles, are:

1. The Start-Up Phase: Majority of the companies either burn up all the cash or run out of ideas by the end of this phase. Maximum casualties have been observed here, making it one of the riskiest phases. However, maximum returns can be made from them, if one enters near the end of this phase.

2. Rapid Expansion Phase: The Company’s core proposition has worked now, with the strategy being replicated by expansion of product/service portfolio or consumer touch points.

3. Mature Phase: Growth slows down, either due to high debt or low cash, owing to the massive expansion witnessed in early stage. Fall in demand or legal restrictions might also contribute to faltering growth.

The trick is to track, which phase the organization is in, at the moment. If the firm is in late start-up phase with possibility of moving to rapid expansion phase, buy the stock when it is still cheap. Once firm’s earnings start falling with its products witnessing poor demand, it’s time to bid goodbye to the stock.

The key parameters involved in Peter Lynch’s ‘two minute drill’ are:

1. P/E Ratio: avoid stocks with excessively high P/E

2. Debt/Equity Ratio: should be low

3. Net Cash per Share: should be high

4. Dividend & Payout Ratio: should be adequate

5. Inventory levels: lower the better

Stay away from companies which are being actively tracked, followed & invested in by large institutional investors. News about buy back of shares or internal stakeholders increasing their stakes should be construed as positive.

Checks specific to Fast Growers:

1. The star product forms a majority of the company’s business.

2. Company’s success in more than one places to prove that expansion will work.

3. Still opportunity for penetration.

4. Stock is selling at its P/E ratio or near the growth rate.

5. Expansion is speeding up Or stable

One must judiciously walk the tightrope between the unquestioning belief that made the stock to be held for so long and the fear of the end from nose-diving prices due to a one-off bad year. The key is to always keep revisiting the story & ask some pertinent questions like ‘What would really keep them growing?’, ‘What is their next offering? or ‘Are their products & services still in vogue?’ It is here, that one must track the point of time when the phase 2 of the firm’s expansion comes to an end. This is usually the dead-end for organizations as success is difficult to be replicated. Unless, innovation happens, downfall is imminent & thus, an exit is necessary. P/E of these stocks is drummed up to unrealistically high levels by the madness of crowd towards the end. One must keep one’s eyes & ears open to signs, which mark the end of the road for these fast growers. A great case in point is Polaroid which had its P/E bid up to 50, only to be rendered obsolete later by new technologies.

A sure shot sign of a decline is a company which is everywhere! Such a company would simply find no place to expand any further. Sooner, rather than later, such a company would see its ‘Manhattans’ of earnings reduced to ‘plateaus’ of little or no growth, simply because no space is left to expand further.

1.The quarterly sales decline for existing stores.

2. New stores opening, though results are disappointing: weakening demand, over supply.

3. High level of attrition at the top level.

4. Company pitching heavily to institutional investors talking about what Peter Lynch calls ‘diversification’.

5. Stock trading at a P/E of 30 or more, when most optimistic estimates of earning growth are lower than 15-20%, thus, unable to justify the high price.

Fast Growers, which pay, are ephemeral & one misses them more often than not. It is a High Risk & High Gain Category of Stocks. One must remember along the classic risk & return principle, that when one loses, one loses big! So, if you are in the quest for magnificent returns, a Fast Grower can be your bet provided you know when to bid Goodbye!

Cash Cow

However, the useful life of power plants spans many years and when the debt on the plant is repaid the facility can become a real cash cow for the utility.

For other industries, a large debt load may signal something seriously wrong. Of course, any company might pickup a big note if it just bought a building or a competitor.

There are several tools you can use to determine whether a company is exposing itself to too much debt.

The first is the Debt to Equity Ratio. This ratio tells you what portion of debt and equity is used to finance a company’s assets.

Formula

The formula is: Total Liabilities / Shareholder Equity = Debt to Equity Ratio.

A ratio of 1 or more indicates the company is using more debt than equity to finance assets. A high number (when compared to peers in the same industry) may mean the company is at risk in a market where interest rates are on the rise.

If a company has debt, it has interest expenses. There is a metric called Interest Coverage that will give you a good idea if a company is having trouble paying the interest charges on its debt.

The formula is: EBITDA / Interest Expense = Interest Coverage.

EBITDA is Earnings Before Interest, Taxes, Depreciation and Amortization and measures the operating performance of a company before accounting conventions and non-operational charges (such as taxes and interest).

Ratio

The resulting ratio tells you whether a company is having trouble producing enough cash to meet its interest expense. A ratio of 1.5 or higher is where companies want to be. A lower ratio may indicate that the company has trouble covering interest expenses as well as other costs.

Debt is not a bad thing when used responsibly. It can help businesses grow and expand. However, misuse of debt can result in a burden that drags down a company’s earnings. 

We learnt from the great crisis of 2011 that companies with high debt on their books simply get slaughtered. While debt per se is not bad (if the company is able to borrow at a lower rate and deploy it in its business at a higher rate, the operating leverage works in its favour), excessive debt with high interest and repayment obligations can crunch the stock in times of downturn. So, as a long-term investment philosophy, it is best to steer clear of high-debt companies. 

Avoid Investing in Companies with High Capex Requirement 

We know the demerits of investing in stocks like Suzlon & GMR which have an insatiable appetite for more and more capital. To feed their perennial hunger, these companies dilute their equity by making FPOs, GDRs & FCCBs resulting in total destruction of shareholders wealth. Companies should be lean and mean requiring minimal capital but generating huge returns there from.