The stories behind stock market crashes

A very interesting story was featured in Ankur Jain's blog. It's a bit long but harps on the following points -
a) A crash is the product of knowledge known to many
b) Ever increasing greed only hastens the inevitable crash
c) Bubbles are there everywhere - some see it, some don't

Another interesting aspect to the same was also found in Sanjay Bakshi's blog. The most interesting aspect is how naive people can be and follow the crowd. Check this out aswell. Here's to all cheaters ...

Are the markets set to tank

A question that most people are asking today. Markets are ideally guided by a lot of sentiments so I decided to fill in some numbers to check this out.

I randomly picked 170 midcap stocks (m-cap of 100 cr to 2000 cr; profitable cos.) comprising a total of 93,000 crores of m-cap. My immediate focus was an understadning of the P/E ratios of the stocks. The total weighted P/E (factoring in the m-cap of each stock) came to 31.6. This is mighty expensive.

I did a second analysis of m-caps .. this time of only the top 20 stocks (in m-cap terms) .. the P/E was 26.4. Again high.

Also let's see the rise in stock prices over the last one yr in these top 20 stocks (weighted for the m-cap aswell) - 108.18%. The profits of these cos. have increased by only 26% overall. Some people may say that these stocks were undervalued. Possible, but equity markets donot move on the whims and fancies of individual stocks. Let me prove this to you.

Look at the last one week data - the list of top gainers. Not one A cat company in the top 20 list, just two B1 cos. And yet the market was up a strong 250 points. Now in that list, the number of penny stocks (negative profits / P/E of greater than 50) - 8

Still ready to invest or, perhaps revel in cash .... !!!

A strategy that has outperformed the Sensex for the last 8 years

Termed as one of the most "mechanical" stock-picking approaches, this technique has been widely described in Michael O'Higgin's excellent book, "Beating the Dow".

O'Higgins defined his set of out-of-sight stocks as the ones which give the highest dividend yield. So his technique was simple -
1. Divide your money into 10 equal packets.
2. Now log on to any website financial website and extract the list of the top dividend yielding companies.
3. Invest equally in each of them
4. Revisit after one year. Sell off the ones which are no longer there in that list. Make another round of investment

If your stock is still in there - you would have made a neat 5-6% arising out of the dividend payout. If the stock is not there, it's because the stock value has increased or the dividend payout has been reduced. The incidence of the second happening is low, unless something drastically wrong has happened to the company or the industry per-se. (this might have been true in bubbles like the dot com boom)

I would recommend a filter mode here. Pick from the BSE 100 stocks only so that we can keep penny companies out. Or perhaps, pick stocks from only B1 and above scrips. (this may however mean a lower dividend yield and one tends to find more under-valued scrips in the lower capitalization levels)

My 10000 rupees on January 1, 2004 would have been invested in - (see article)
1. GE Shipping
2. Procter & Gamble
3. Hind Lever Chemicals
4. Tata Chemicals
5. Gujarat Narmada
6. HCL Infosystems
7. IDBI
8. Hero Honda
9. Neyveli Lignite
10. SSI

My 10000 rupees on January 1, 2005 would have been invested - (see article)
1. HPCL
2. Kochi Refineries
3. Hindustan Lever
4. Rashtriya Chemicals
5. Indian Oil Corporation
6. GE Shipping
7. Vijaya Bank
8. BPCL
9. Bank of India
10. Hero Honda Motors

So, if I were to invest my 10000 rupees on 2nd January, 2006 - (see icicidirect data. I have considered only 500+ cr m-cap companies)
1. Bongaigaon Refinery
2. J B Chemicals & Pharma
3. Hindalco Industries
4. Kirloskar Brothers
5. Pidilite Industries
6. DCM Shriram Consolidated
7. Kirloskar Oil Engines
8. SAIL
9. EID Parry
10. Hindustan Construction Co.

This technique is very interesting and takes little effort. Best of stock picking dummies like myself :-)

What price will you pay?

Company A and B are in the same business, with company A having a 2 time market share than company B. The nature of the industry is such that there are only two firms, A and B.

Company A's stock is currently trading at twice the price as that company B. Company B is currently on a new product project, which if successful - would mean Company B's stock going up by 100%, i.e. doubling. If the project is unsuccessful, company B's share price will halve as a huge amount of resources have been put on the same and losses will be considerable.

Also as a result of a "successful" new product project, company A's market share will reduce from a 2:1 share over company B to a 1:1 market.

Company A is valuing the business of company B for quite sometime. Now on Dec 19th 2005, we have the following information. The project has be "________". This information (success / unsuccessful) is only available to company B executives which they wil not tell company A until the deal is signed. What should company A do?

Some questions you may want to answer -
a) Should company A acquire company B?
b) If yes, at what price?
c) Best ways of dealing with company B to reduce risks/maximize profits?

Common Stocks and Uncommon Profits

On of the finest books on investment strategies ever written is by Philip Fisher in his book "Common Stocks And Uncommon Profits". Fisher summarized his investment philosophy into eight points:

1. Buy stocks of companies that have disciplined plans for achieving dramatic long-term growth in both profits and revenues. Such companies must also have inherent qualities that make it difficult for new entrants into that business to share in such growth.

2. Fisher prefers to focus on such companies when they are out of favor; i.e., market conditions are not favorable or the financial community does not properly perceive the true worth of such companies.

3. Hold the stocks that you buy until there has been either a fundamental change in the company's nature or it has grown to a point where it will no longer be growing at a faster rate than the economy as a whole. He also says that one should never sell his most attractive stocks for short-term reasons.

4. If your primary investment goal is long-term appreciation of capital, then you should de-emphasize the importance of dividends.

5. Recognize that making mistakes is an inherent cost of investing. The important thing is that the investor must be able to recognize such mistakes as soon as possible, understand their causes, and learn from them so that they are not repeated. A willingness to take small losses in some stocks while letting profits grow bigger and bigger in your more promising stocks is a sign of good investment management. Don't just take profits for the satisfaction of taking them.

6. Realize that there are a relatively small number of truly outstanding companies. Your funds should be concentrated in the most desirable opportunities. "For individuals (in possible contrast to institutions and certain types of funds), any holding of over twenty different stocks is a sign of financial incompetence. Ten or twelve is usually a better number."

7. An important ingredient of successful investing is to have more knowledge and apply your judgment after thoroughly evaluating specific situations. You should also have the moral courage to act against the crowd when your judgment tells you that you are right.

8. One of the basic rules of life also applies to successful investing -- success is highly dependent upon a combination of hard work, intelligence, and honesty.

Fisher concludes this book with the following paragraph:
"While good fortune will always play some part in managing common stock portfolios, luck tends to even out. Sustained success requires skill and consistent application of sound principles. Within the framework of my eight guidelines, I believe that the future will largely belong to those who, through self-discipline, make the effort to achieve it."