Discipline is the Key

In the book, "What works on Wall Street", author James O'shaughnessy found that one of the reason why academics adopted the flawed "random walk" hypothesis of the stock movements is because of inconsistent methodologies used by fund manages themselves. Fund managers do not adopt a well-defined strategy and stick to it, they tend to go with the flavor of the month stocks, to adopt new paradigms when they see fit, to rebalance portfolios constantly and generally move about in a random manner. By analyzing the returns of fund managers academics were unable to find any managers who had consistently been able to get far above average results in a statistically significant manner. They erroneously concluded that it is the market that is rando. In reality the market does reward certain approaches over time, but none of the market professionals studied ever stuck to any of these approaches. Rather than random stocks, it is clear that it is the investors who are random. 

The one factor that unites all of the great investors is that they have a simple formula that is applied consistently over time and can be easily stated in a book. As complicated as Warren Buffett's methods are, you could write a book about him and state with great precision how he goes to work analyzing stocks, in fact many books about him have indeed been produced. Buffet states that, to be a successful investor does not require one to have a high IQ but rather it requires two things:

A. A strong intellectual framework on which to base your decisions;

B. Not letting your emotions corrode the framework. 

The 80% of managed funds that fail to beat the market do so because of complicated and ever changing strategies, or lack of strategies as may be the case. To paraphrase James, "If you can't write down and explain your technique on a piece of paper, you don't have a technique."

There are approaches that consistently beat the Market!

It is important to adopt an approach that works, and stick to it. The reason why most investors fail is that they go chasing better results elsewhere and tend to move out of sectors just when they are about ready to start making big gains. 

Today's equities markets change fast. Factors are influencing stock and bond prices today that we could not even have conceived of just a few years ago. Yet investing concepts and resources that we have been taught to use for decades have not changes, and they no longer work. This leaves investors, stuck using increasingly obsolete methods and tools to cope with new market dynamics and challenges. This sad state of affairs was evident as tends of millions of investors lost nearly half of their life savings in late 2008 and early 2009 by heeding "conventional investing wisdom" or relying on advisers. 

Identify Market Trends

Stock market is known to be brutal to investors who invest unscientifically or based on hearsay. While no one can predict stock price movements with certainty, it helps to take an educated guess or informed decision before investing. Technical analysis of stock prices enables investors to do just that. Trend analysis of stock price movements using some useful technical indicators can help gauge the overall direction in which prices are moving, and how they may behave in future. Let us look at some simple but powerful technical indicators:

1. Simple Moving Average (SMA):

A single price point contains almost no information useful for investing. On the other hand, when you take a series of consecutive price points and take their average, you get a composite data point. This is called a Simple Average. For example, the average of a stocks price points on 10 consecutive trading days is a 10 day simple average of the stock price. When you successively determine the simple average by including the most recent price point and excluding the oldest price point, you get a Moving Average (MA). For Example, you can calculate the 10-day simple average of stock prices on Day 1 to Day 10, followed by the 10 day simple average of Day 2 to Day 11, and so on. This gives you a series of 10 day simple averages, which when jointed together, gives you a 10 day simple moving average (SMA) trend line of the stock price. As daily stock prices are usually volatile, SMA help to smoothen the curve and determine the overall trend or direction of the stock price movement. 

2. Exponential Moving Average (EMA):

The Exponential Moving Average (EMA)is similar to the SMA but allocates weightages to each price point, with more recent price points getting higher weightage, unlike the SMA which allocates equal weightage to all price points. 

Formula: EMA = Current Stock Price x Multiplier + EMA of previous day x (1 - Multiplier)

Multiplier can be calculated as: Multiplier = 2/(No. of Price points + 1)

EMA will be more sensitive to recent price movements than earlier ones. Due to this, an EMA will "hug" the price movements more closely than an SMA. Some of the popular MAs are 10-Day, 12-Day, 20-Day and 26-Day for short term trends, and the 50-Day, 100-Day and 200-Day for long term trends. 

Support Levels & Resistance Levels

Both SMA & EMA can be used as "Support" or "resistance" trend lines. When the stock price is on an uptrend, it tends to "bounce" off certain price levels that coincide with an MA trend line. That is, the price refuses to drop below the MA. This is called a Support level. This can be an interim entry point for buying into the stock, assuming the uptrend will sustain over your investment horizon. However, if price movements start breaking through the support level, it can indicate a trend reversal and investors can consider exiting the market. 

The MA indicators are lagging indicators and should be used only to confirm a trend or trend reversal. However, entry or exit point for the investor into or from the market usually precedes a trend confirmation or reversal as indicated by Moving Average.

Hunting for Gains from Investing in Undervalued Sectors/stocks

A financial security or other types of investment that is selling for a price presumed to be below the investment's true intrinsic value. A undervalued stock can be evaluated by looking at the underlying company's financial statements and analyzing its fundamentals, such as cash flow, return on assets, profit retention an capital management, to determine said stock's intrinsic value.  Buying stocks when they are undervalued is a key component of Warren Buffet's value investing strategy. There is no guarantee as to when or whether a stock that appears undervalued will appreciate. There is also no single correct way to determine a stock's intrinsic value - it is basically an educated guessing game. 

Valuation Measures for Finding Undervalued Sectors/stocks

1. Price-Earning (P/E) Ratio: 

• The price earning ratio is a valuation measure that indicates how much the market values per Rupee or Dollar of earning of a company. 
• It is computed as: (Market Price of Share/ Earning per share)
• PE is represented as a multiple. When one refers to a stock as trading at 12x, it means that stocks is trading at 12 times its earnings. The PEx based on historical earnings is of limit value. The prices change dynamically, while the reported earning is updated every quarter. Therefore, prices tend to move even after the historical earning per share is known, in anticipation of the future earnings. 
• It is common to look at the PE multiple of the index to gauge if the market is overvalued or undervalued. The PE multiple moves high when prices run ahead of the earning numbers and the market is willing to pay more and more per amount of earning.
• Many would consider a market PE of 25x or above as an overvalued zone. When markets correct and uncertainty about future earnings increases, the PE multiple also drops. A value investor, who would like to pick up stocks when they sell at lower valuations, may be interested to purchase when PE is low. 

2. Dividend Yield: 

• Value investors, who look for the opportunity to buy a stock at a price lower than its fundamental or intrinsic value, prefer a combination of law PE, low PBV and high dividend yield. 
• Dividend yield compares the dividend per share to market price per share. 
• A higher dividend yield would mean that the income potential of the share is not yet reflected in the market prices. A lower dividend yield is associated with a higher valuation for a share.  It also used as broad levels with which to measure market cycles. 
• A bull market will be marked by falling dividend yields, as prices move up. A bear market will have a relatively higher and increasing dividend yield as prices tend to fall. 

3. Price to Book Value (PBV): 

• The PBV ratio compares the market price of the stock with its book value. It is computed as market price per share upon book value per share. The book value is the accounting value per share, in the books of the company. 
• It represents the net worth per share. An important limitation of this number is that most assets on the books of the company are shown as cost less depreciation, and not inflation adjusted. Therefore the realizable value of the assets is not reflected in the book value. 
• If the market price of the stock were lower than the book value, the stock is deemed to be undervalued and undiscovered. Analysts would concur that the market prices have fallen more than what is justified by the value of the stock, and would consider the price attractive to buy. 
• In a bullish market when prices move up rapidly, the PBV would go up, indicating rich valuation in the market. However, there may be other reasons for a stock being sold for less than its book value such as the poor investments made by the firm in the past which needs to be written down subsequently. 
• Hence investors should not rely only on PBV for their investment decision and should understand that not all stocks that trade at a discount on their book values are bargains (under-valued). 

4. Net Cash Flow: 

• It is the cash flow which is left after all necessary cash outflows have been deducted. These cash outflows include both operating expenses & capital expenditure.  It is a primary determinant of whether a company's stock is undervalued or not. In case, a company possesses net or free cash flow, it has the financial capacity to invest in R&D, paying existing debts, launch new products, provide timely dividends to shareholders etc.  
• Some qualitative fields based on which it is determined whether the stock of a company is undervalued or not are –
• The earning history of a company. 
• A company is not indulged in any financial scam. 
• the products offered by a company and whether such products have the potential to sustain and be profitable in the future. 
• A company's credit rating which denotes its debt-reliance. 
• A company's profit or loss during the previous recession. 

Value investors analyse these fields and other related factors and metrics to determine whether the stock of a company is undervalued or not.

Who should Invest in Undervalued Shares? 

Undervalued stocks have considerable potential to yield substantial returns if investors can properly reckon and analyse the different variables which are related to such stocks. Besides, analyzing companies and its shares to determine whether each organisation’s earning potential shows promise in the future requires significant technical knowledge.

Value investors duly wait for market conditions which will render the market price of a stock below its intrinsic value. These investors follow the principle that if they can purchase a share at a discounted price, where they procure a similar product, why should they purchase it at its face value or higher.

Advantages of Undervalued Stock

⦁ Prices of undervalued stocks automatically return to their original value or intrinsic value, which is why profits are assured.

⦁    It presents an opportunity to purchase shares at low prices from well-established or promising companies.

⦁    These stocks also feature low risk due to the fact that such undervaluation is cyclical and the company has the potential to attain its intrinsic value.

Disadvantages of Undervalued Stock:

⦁ Every investor cannot decide to invest in such funds.

⦁ It is time-consuming.

⦁ Investors run the risk of flawed analysis.

Hence, investors should begin by investing in less risky financial instruments when they initially begin. For investors looking for short term gains these may not prove to be fruitful as undervalued stocks need time to show their true worth. However, if you are a patient investor who has done exhaustive research and believes in the fundamental soundness of the business, then investing in undervalued stocks could be a rewarding experience.