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Saturday, August 02, 2008

Investing in the stock market ... science of it!!!

Lazy Man Technique - No Stock Picking:

In a developed market like the EU or US, invest in an Index Fund (If in the US). Index funds have still not matured in India. So pick a Mutual Fund with at least a 10 year history of good performance and start a SIP on it.

Never have more than 75% of your portfolio in Equity. You should have 75% when you are most bullish about the stock market. When you think the stock market is most over-valued, cut down your exposure to 25% of your portfolio. The rest is of course in safer investments like Bonds, Savings Accounts, CDs, etc depending on your financial needs over the next few years.

Do not do re-adjustment of portfolio more than once a month. This ensures that you don't get addicted to doing changes everyday and fall into the trap of over-doing the rebalancing.

To avoid the Home market bias, invest atleast 33% of your Equity investments abroad (Choose Emerging Markets ETF or S&P500 or MSCI EAFE to get non-US developed market exposure).

The next step you could take based on how lazy or active you want to be is to mimic portfolios that have known to out-perform standard indexes in the past. Examples of this would be GDP weighted indexing, Dogs of the DOW, Highest Dividend Yielding Stocks, Small Cap Index exposure, Emerging Markets exposure


Now if you have decided to go to the next step and start investing in individual stocks, here are some characteristics of the stock you should look to invest in:

  1. Margin of Safety
    1. The stock should be off its 52 week highs and closer to its 52 week lows. This is a general guide-line - there will always be exceptions.
    2. The dividend yield on the share should be at least equal to the interest rate for a savings account (4-5%) if it is a company that consistently pays dividends. This ensures that there is low downside risk even if the stock does not go up too much in the short to medium term.
    3. Do not speculate and do not buy a rising stock unless you have strong reasons to believe the stock is still under-priced.
    4. Buy with the intention for holding for at least a year (To avoid ST Cap Gains Tax – Ideally forever)
  2. Intrinsic Value
    1. The earnings should show a consistent growth pattern over the last 5 (preferably 10) years. Use this to predict a LT CAGR. Research the industry it is in to see if this can be confirmed.
    2. This will rule out certain sectors like Pharma which have a strong variance in earnings especially in the early stages of industry maturity.
    3. Grow the current earnings at the calculated CAGR to get an estimate of earnings over the next ten years.
    4. Find the industry P/E ratio pattern over the past few years and apply a number closer to the lower end of the range to get the stock price = EPS * P/E.
    5. Apply margin of safety rule
  3. Company Characteristics
    1. At least 15-20% Return on Shareholder Capital
    2. Industry leader with a sustainable advantage over competition
    3. At least 33% of its 52 week high and preferably within 50% of its 52 week low
    4. Add other rules ... based on experience.
  4. Due Diligence
    1. Read management reports and annual reports to study how honest the management is.
    2. Review credentials of Independent Directors and how often they attend the meetings
    3. Are there any reasons for the stock price falling to recent lows (read news articles, message-boards, etc)?
    4. Check out the investor relations section of the company’s website. Run through the material available there.
    5. Read Press releases and look for consistency and honesty
    6. Look for scandals and controversies the company has been involved in and avoid all companies that stink of dis-honesty or manipulation of financials.
  5. Always track your annual short term capital gains and be ever-willing to lock in ST Capital losses to reduce your taxes. e.g. A stock you bought at 100 less than a year ago is down to 50. Just sell it right now and buy back the next day. The gain in taxes will more than make up for the transaction charges that result. Of course, do this only if you are going to have capital gains. 
The No.1 Rule of Investing should be "I shall not lose my Capital". 
Rule No.2 reads "I shall not forget Rule No. 1"

If you like this post, buy me a beer!

PS: This is a post written exclusively for my own reading in the future. Excuse me for some of the terminologies I used that might not make sense to you. I'll come back and clean it up some day soon.

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