PE VALUATION

How do the companies get the PE valuations? There are many models by which the companys are rated. However most of the models are highly complex, and offer precious little for the investor. I am writing down some of the observations on how the companies are getting their values.

Growth Potential: Its a very simplistic fact that higher the growth potential higher the PE, also it depends on the sector the company is in. For E.g. a company in a high growth sector usually get higher PE's than companies in more traditional low growth sectors. So lets say usually an IT company or a financial brokerage (my fav sector) would traditionally command a higher PE than lets say FMCG.

Size of the company: Usually companies that are bigger in size (>1000cr in valuation) would typically start commanding a PE higher than the cos that are small caps. This usually happens as the risk associated in investing in small cos in considerably higher compared to bigger cos. As we reach the large caps, the PE's usually stagnate at a higher level as the growth potential of these cos becomes more and more restricted. Ofcourse there would be divergences at lots of places considering the industry etc but as an observation this is what I have found.

Cyclicity: Companies that are cyclicals (meaning that the industry that they are in is dependent on the cyclicity of the prices of the main product. e.g. steel, cement cos) usually will command a lower PE valuation compared to other cos. This is because the cos in these sectors do not have under their control the power to control the price of the main base product. So lets say if steel prices crash around the world, there is precious little that an Indian company would do to maintain the same profits.

Commodity: Similar ot cyclicals are commodity cos. (For e.g. Sugar, Oil etc). These cos do not again have the pricing power, as the product they offer is not differentiated and hence the traditional law of marketing states that if you do not have a differentiated offering you cannot command a price premium. The problem with commodity cos is that they do not offer a brand to the consumer, they offer a product, and this limits their pricing, hence they depend on external factors to price their offering and hence their top and bottom lines are decided by the fluctuation of the base product, and the markets do not like this, hence the lower valuations.

BASICS OF TECHNICAL ANALYSIS

What are the most basic parameters that I look out for before making any investment. I am sure there are many other parameters that one can look for, but these are the ones that I have relied on and they have worked for me.

1) MA: Moving averages are the most basic and most simple and sometimes the most easily overlooked. It presents a simple case of how the stock is performing compared to its price performance in the last 7 days, 15 days, 30 days, 100 days, 200 days etc. It is a simple way to see the support and resistance levels in the long run, while in the short run its an effective way to gauge actually whether the stock is weak or strong. I usually follow that if a stock is trading above its 15 day MA then it can be safely assumed to be in an uptrend. Ofcourse just using MA is simplistic but its the first of the many indicators that can be looked into before entering into a trade.

2) MACD: Moving average conversion and divergence; this is a very critical parameter that I use when evaluating whether the stock is in a upward trend or downward trend. This indicator is best used to enter or exit a stock, specially when the trend lines are changing from negative to positive territory or vice versa. Also this gives a sense whether to stay invested in a stock or exit it depending on the positivity or negativity of the trend.

3) RSI: Relative Strength index. RSI is an important parameter telling us about the potential of the movement of the stock upward or downward based on the principle of scrips being overbought or oversold. RSI has certain benchmark limits which tell us whether the stock has a potential upside left in the rally. If the stock breaches certain RSI limits usually kept at 70 (usually indicating overbought) and 30 (usually indicating oversold) . its a potential entry or exit signal if it agrees with the other technical parameters. But depending on markets (and in my experience) it usually breahces 80 and 204)

Volumes: Usually they say that volumes precede the price. Well to a certain degree it is true, and I think more true with small cap and mid caps. Whenever there is a sudden spurt in volumes it will be accompanied with the fluctuation in price for the scrip (offcourse exceptions in the Indian markets are there, wherein bogus stocks also achieve high volumes but lets leave them for the moment). For a genuine scrip, if the accumulation / distribution shows a trend increase, it should also show a price increase accompanying it.

BASICS OF FUNDAMENTAL ANALYSIS

What are the most basic parameters that I look out for before making any investment. I am sure there are many other parameters that one can look for, but these are the ones that I have relied on and they have worked for me.

FUNDAMENTAL ANALYSIS:

1) Profit Earnings: Not only do I look for consistency in earnings lets say for the last 6-8 quarters but also what has been the growth. For e.g has the rate of growth of profits been more than the industry average, is the company beating its competitors by a big margin, do the growths look sustainable. A good way to choose a company for investment is to see whether it is consistently giving higher profits for the last 6-8 quarters.

2) PE: Price to Earnings ratio is the most critical ratio for any stock. Though it depends on various factors such as the companys growth projections, the industry scenario, cyclicity of the stocks etc. It is very important to have in perspective what it means and whats a good PE to enter a stock (or even exit it). There are many theories wherein people say that it is not prudent to buy a stock that has a PE > 12, but there is no sacrosant rule to follow on this parameter. There are cos that quote a PE of >100 and still go higher, whereas there are many good cos for e.g. cyclicals that quote a sub 10 PE and still go nowhere. So getting a sense of PE would involve being in the markets for a longish period of time and closely following the PE's. However a word of extreme caution, PE in isolation cannot and should not form a basis of investing (however a majority of people I have met commit this mistake!)

3) Absolute size: Well you wouldn't want to invest in a company, that is on paper worth only your milkman's cows! One has to analyse whether the company one is investing has a decent size (decent can vary from perspective) but is safe to put your money in cos that have a market cap of at least a 100 cr plus. I usually try and follow this rule. Technically speaking if you are a safe guy then you should not venture below midcaps, that would generally be in the region of 5000cr, but then the returns expectations should also be lowered a bit. Remember lesser the risk lesser the returns. But one has to draw the line how much risk one is willing to take. As a rule one should not invest in dubious or penny stocks no matter what!

TECHNICAL ANALYSIS IS A MUST

Now once you are convinced about the fundamentals of the company, that would include among other things, the earnings, the profit record, the profitability, the growth perspective, the reserves, the industry scenario, quality of management etc amongst others then comes the analysis of the technicals. Technical parameters are equally important as fundamental parameters to enter into a trade. Although one might argue that technical parameters are more importnat if one is making a short term trade. But i feel that they also play an important role when one is initiating longer trades. It doesnt hurt if you get the stock 5% cheaper does it!

BASICS OF INVESTING

The most critical thing is a dilema when to initiate a trade. When to enter is perhaps as important as to when to exit. But to exit, one has to enter. So the decision of entering becomes a very important one.

Set Targets:

Not only Price but time targetsFor initiating a trade, it is very important, to have set targets in mind. Targets not only for price but targets in terms of time value. It is important to ascertain what are the expectations from a trade and how much do you hope to make. This is important not to curtail your earnings but to have realistic expectations.

Donot marry a stock:

Now if you have decided that you have a time frame in mind lets say a year. Then the first thing that needs to be done is to get the fundamentals check done. There are various parameters that need to be checked. I have mentioned a few in the next post. It is important not to be stuck on a particualr stock, it is far more important to get the right stock. So the way to evaluate a decision to enter should be first find the right company and then enter, rather than finding a company first and then searching whether the company is right or not. In short it does not pay to be stuck on a particualr company. One is there in the stock markets to make money and the only decision to choose a company should be to make good returns.

Initiating a Trade

The most critical thing is a dilema when to initiate a trade. When to enter is perhaps as important as to when to exit. But to exit, one has to enter. So the decision of entering becomes a very important one.Set Targets: Not only Price but time targets. For initiating a trade, it is very important, to have set targets in mind. Targets not only for price but targets in terms of time value. It is important to ascertain what are the expectations from a trade and how much do you hope to make. This is important not to curtail your earnings but to have realistic expectations.

Risks of investing in a single trade in equity markets

They say that if you survive today, you can fight another day! Most inexperienced traders commit a mistake of investing their entire capital on few trades. Its what we call in common parlance as "All or nothing approach". What this ensures is that if you had started with an initial capital a string of a couple of big losses can put you out of trade. However the appeal to double / triple the returns becomes a motive strong enough to throw cautions to the winds. However every time a trade becomes a winner the entire capital is deployed to trading again and inevitable the wrong trade will take all of it away. As a rule people have different amounts that they would risk in a particular trade. Some keep it at 1%, others at 2%, however as a rule I think its not advisable to put more than 5% on a single trade. Even if the 5% capital is lost, it wont force you out of trade and although it would take you a 5.2% gain on your next trade to come back to the original value of your investment its still better than losing 30% of your capital on a single trade and needing 50% on your next trade just to recover back!!!So remember some key facts:
The more you invest in a single trade, the larger will you need to recover in the subsequent trade if the trade goes into a loss.
Always preserve some capital to trade for tomorrow, no matter how tempting the opportunity might seem
It always pays to go in with a trade, knowing where is the stop loss and more importantly sticking to the stop lossRemember this holds true for traders and not investors. For investors it makes sense not to diversify too much!

Nifty Derivative Series Reversals - An Observation

There is an interesting observation that I have noticed over a period of time. The derivative series of nifty opens up with a trend that is usually in divergent direction to the main trend of that series. This is a very subtle observation and requires in depth analysis but experienced traders will know that it definitely occurs. The possible reason could be that most of the positions are made as soon as the series gets over, now if the markets move up, most of the people take up positions in that direction for that series. Also what I have observed is that if the trend has not reversed by the mid month there is very very less likely hood of the trend reversing for the series after that. For e.g. if the series for May is going down from first Friday of the month of the series till the mid of the next month, then in all likelyhood the series would continue on its path till the last thursday of the month. However this is not a sacrosant rule and is violated many times. This brings me back to the point, that traders should not rush to take up positions during the first few days of the series without properly checking up on the technical analysis of the market.