Wednesday, October 25, 2006

Secrets of Stock Pickings (Golden Rules)

Secrets of identifying undervalued stocks

I belong to a category, what they term as ‘Small Investor’. Often those smart marketing executives from brokerage houses call me with their brilliant market/stock ideas and promise that if I trade with their company they will double my money with in few days. They are even ready to lend me money in case…. They probably know that as a ‘Small Investor’, I am the easiest prey for them!

I often ask them some very simple questions…and the replies most of them gave ensured that I don’t have a ‘Relationship Manager’ till now. I want to share some of my simple learning’s of stock picking with you all.

The 5-step investment approach

• Understand the stock market movements– It generally follows similar pattern over a time. • Identify the Industries in favor with big investors. • Look for undervalued companies with excellent businesses. • Buy the stocks at reasonable prices • Sell the stock when you feel it’s stagnated – Don’t fall in love with your stocks.
Presuming that the biggest problem with all of us is identifying undervalued stocks, I limit my future discussion only to it. As we all know valuation is a relative term (relative to intrinsic value) and therefore, a security can be undervalued either in terms of present market price (Value Investing) or future growth potential (Growth Stock).

What is Intrinsic Value?

It is defined as the perceived actual value of a security, as opposed to its market price or book value. Investor perception does matter but perceived value does not come from vacuum. It is possible to estimate value of a security from its financial fundamentals and the price should not deviate too long form this value. The most frequent technique of value estimation is discounting the free cash flow (FCF) by a risk factor. Using the intrinsic value as benchmark I place undervalued stocks under two broad heads – Value picks and Growth Stories.

Value Picks
Value picks are those stocks that currently trade at a low price relative to their fundamentals (i.e. dividends, earnings, sales, etc.). Therefore, stocks that have a relatively high dividend yield; low price to sales ratio; and/or low PE ratio would tend to be classified as value stocks. The low valuations that value stocks enjoy are often as a result of some type of bad news (i.e. poor earnings report, bad press, legal issues, etc.).
Value-stock investors believe that the market always overreacts to news, either good or bad. When the news is good, the stock price rises out of proportion to the long-term affect that news is likely to have on the company’s future performance. By contrast, when unexpected bad news happens, the share price typically takes a worse drubbing than the fundamentals dictate.
To be a value investors look out for companies with sound financial statements after assuring yourself that the problems are temporary, or manageable. For example, Hindustan Lever (HLL) was a certain value pick at Rs. 100-105. Keep constant watch on such fundamental blue-chips and look out for lower than average price-to-book or price-to-earning ratios. In the long-term the scrip should confirm to its averages. Hold these stocks as their prospects brighten and they become growth stories. One caution- You may have to hold the scrip patiently for 2-5 years to unlock its value.
Growth Stories
The recent rally in mid-caps relate to this theme. Growth stories are companies whose earnings are expected to grow at an above average rate relative to the market. A growth stock usually has a high P/E ratio and won't pay a dividend as it has large capex & other expenses. I am not disclosing any such scrip
in this article as it is not what the article is meant for. The article will drive you to discover such ideas yourself by inspiring you to get answer to the following questions:
1. Is there indication of market correction in the near term? Remember patience is the key to finding value picks and growth stocks may fall sharply in event of any market correction. 2. Has the company demonstrated a consistent history of growth in revenues? 3. Future - Importantly, examine how fast the company is expected to grow and how? Look for its order book, existing clients, technical tie-ups and above-all market acceptance/size for its products. 4. Price to Sales ratio - I am particularly for companies with comparatively low price/sales ratio over a period of 2-3 years, as it shows that the share price is not appreciating with rising income. However, do satisfy the reasons why a company is trading at a low multiple. There may be compelling reason to stay away. 5. Price Earnings Growth Ratio (PEG) – Current PE ratio tells about past. Try to project 3-5 year earnings growth (use historical CAGR to start with) and then calculate PEG ratio. A PEG of less than 1 indicates that the firm may be undervalued. 6. Free Cash Flow (FCF) – At the end of the day it’s the free cash in your hand that matters. Free cash flow is the cash from operations less capital expenditures and other investments that are necessary to sustain and grow the business. Prefer companies generating more free cash.
Don’t get panicked by intermittent downs. Share prices take breather in-between wherein few investors get-out and many more buy-in for a value/ growth story. However, always do periodic reviews to ascertain in-case there has been a substantial change in the fundamentals or qualitative characteristics of the company. A good idea is to set a target return from the share and sell it off without regretting later in case its price moves up further!

By - Bratin Biswas

The Power of Gold

James Surowiecki wrote a wise and moronic piece on gold in the New Yorker. His wisdom is centered on the insight that neither gold nor paper money are true wealth, but only relative measures, subject to adjustment.
"Gold or not, we’re always just running on air," he wrote. "You can’t be rich unless everyone agrees you’re rich."
In other words, there is no law that guarantees gold at $450 an ounce. It might just as well be priced at $266 an ounce, as it was when George W. Bush took office for the first time. Since then, a man who counted his wealth in Krugerrands has become 70 percent richer.
But gold wasn’t born yesterday, or four years ago. Mr. Surowiecki noticed that the metal has a past, just as it has a present. He turned his head around and looked back a quarter of a century. The yellow metal was not a great way to preserve wealth during that period, he notes. As a result, he sees no difference between a paper dollar and a gold doubloon, or between a bull market in gold and a bubble in technology shares.
"In the end, our trust in gold is no different from our trust in a piece of paper with ‘one dollar’ written on it," he believes. And when you buy gold, "you’re buying into a collective hallucination – exactly what those dot-com investors did in the late nineties."
Pity he did not bother to look back a little further. This is the moronic part. While Mr. Surowiecki looked at a bit of gold’s past, he did not see enough of it. Both gold and paper dollars have histories, but gold has far more. Both gold and dollars have a future. But, and this is the important part, gold is likely to have more of that, too.
The expression, "as rich as Croesus," is of ancient origin. The king of historic Lydia is remembered, even today, for his great wealth. Croesus was not rich because he had stacks of dollar bills. Instead, he measured his richness in gold. No one says "as poor as Croesus." We have also heard the expression, "not worth a Continental," referring to America’s paper money during the Revolutionary War era. We have never heard the expression, "not worth a Krugerrand."
Likewise, when Jesus said, "Render unto Caesar that which is Caesar’s," he referred to a denarius, a coin of gold or silver, not a paper currency. The coin had Caesar’s image on it, just as today’s American money has a picture of Lincoln, Washington, or Jackson on it. Dead presidents were golden back then. Even today, a gold denarius is still about as valuable as it was when Caesar conquered Gaul. America’s dead presidents, whose images are printed in green ink on special paper, lose 2 percent to 5 percent of their purchasing power every year. What do you think they will be worth 2,000 years from now?
A few years before Jesus, Crassus, who had made his fortune on real estate speculation in Rome, decided to put together an army to hustle the east. Alas, such projects almost always meet with disaster; the attempt by Crassus was no exception. He was captured by the Parthians and was put to death in an unusually cruel and costly way. He did not end his days with paper money stuffed down his throat, and certainly not dollar bills.
No, they poured molten gold down his gullet – or so the story has it. Gold has a long history. And during its history, many was the time that humans were tempted to replace it with other forms of money – which they believed would be more convenient, more modern, and most importantly, more accommodating. Gold is hard to find and hard to bring up out of the earth. By its nature, the quantity of gold is always limited.
Paper money, by contrast, offers irresistible possibilities. The list of bright paper rivals is long and colorful. You will find hundreds of examples, from assignats to zlotys, and from imperial purple to beer suds brown. But the story of paper money is short and predictable. Since the invention of the printing press, a new paper dollar or franc can be brought out at negligible cost. Nor does it cost much to increase the money supply by a factor of 10 or 100 – simply add zeros. It may seem obvious, but adding zeros does not add value.
Still, the attraction of being able to get something for nothing has always been too great to resist. That is what makes goldbugs so irritating: They are always pointing it out. Even worse, they seem to enjoy saying "There ain’t no such thing as a free lunch," which comes as a big disappointment to most people.
Once people were able to create money at virtually no expense, no one ever resisted doing it to excess. No paper currency has ever held its value for very long. Most are ruined within a few years. Some take longer.
Even the world’s two most successful paper currencies – the American dollar and the British pound – have each lost more than 95 percent of their value in the past century, which is especially remarkable since both were linked by law and custom to gold for most of those years. For the dollar, the final link to gold was severed only 34 years ago.
Some paper currencies are destroyed almost absentmindedly. Others are ruined intentionally. But all go away eventually. By contrast, every gold coin that was ever struck is still valuable today, most have more real value than when they first came out of the mint.
Central bankers reported in early 2005 that 70 percent of them were increasing their reserves of euros. As for the world’s erstwhile and present reserve currency, the dollar, they seemed to have, not growing reserves, but growing reservations. We also have reservations about the dollar. Whatever it is worth today or tomorrow, we are sure it will have less worth eventually. That it is not regarded as worthless already is remarkable. The average dollar is nothing more than electronic information. It exists thanks only to the ability of digital technology to keep track of it. Relatively few dollars ever make it to paper, and many of them end up in the pockets of Russian drug dealers and African politicians. Most dollars inmost people’s accounts are not even graced with the image of a dead president; when the end comes, they won’t even be useful for starting fires.
It is imperial vanity that keeps the dollar in business. And it is vanity that will make it worthless. Economists want money they can control.
Central bankers want money they can debase. And politicians want money they might get their mug on. The trouble with gold is that it turns its back on world improvers, empire builders, and do-gooders. It is money that no central bank promotes and none destroys. It is money that exists only in a tangible form, a real metal – a number on the periodic table.
"Gold goes up and down, just like other kinds of money," say economists. Which is true. "You can protect yourself from inflation in other ways," say the speculators. True again.
"Gold pays no dividends or interest," say the investors. True.
Nor will gold cure baldness or add inches to your most private part. Even as money, gold may not be perfect. But it is better money than anything else. Gold was around millions of years before the U.S. dollar was invented. It will probably be around a billion years after. This longevity is not in itself a great recommendation. It is like buying a suit that will last longer than you do; there is no point to it. But the reason for gold’s longevity is also the reason for its great virtue as money: It is inert; it yields neither to technology nor to vanity.
The world improvers will always be with us. They will spend more than they have, boss other people around, and generally make the world a worse place to live. They will offer proposals like those of Thomas L. Friedman. The nice thing about gold is that it is so unresponsive. It neither laughs nor applauds. Gold is money that no central bank promotes and none destroys.
Paper money is a handy tool for the world improvers. They use it like politicians use civil service jobs and generals use heavy bombers – to get their way. Whatever the vapid ideal du jour, it takes money to pursue it. Given enough money, the poor can be fed and housed. The middle classes can be given free medical care and low-cost loans for houses. The upper classes can be given contracts and favors. Enemies can be summoned up, bombed, and reconstructed. Bread, circuses, war – the imperial program costs money.
How to get more money for these great new programs, these marvelously worthwhile ideals, these fabulous public spectacles? Gold flatly refuses to cooperate. It doesn’t even give a reason. Instead, it stays as mute and reticent as a dead man in front of a television. No matter how persuasive the advertising, the man is not going to go for it.
Paper money, on the other hand, barely needs encouragement. Start up the presses! Lower the interest rate! Relax reserve requirements and lending standards! Sell more bonds! Create more paper! Paper money is ready to go along with anything. Like George W. Bush, it never met a boondoggle it didn’t like. Sooner or later, it ends up as worthless as the projects it was meant to pay for.
Gold is merely the subversive investor’s way of protecting himself.
By - Bill Bonner and Addison Wiggin
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