(This appeared in the Deccan Chronicle of 14/5 & 15/5 – About waking up too late and then worrying about markets and stocks)
TIMING THE MARKETS
One of the readers of this column asked this question:
“I am a follower of your thoughts on investments, being long term, but when do v start buying when markets start correcting, how long should v wait to buy, i understand experts say don’t catch a falling knife, we do not know when will markets stop, then how to buy?”
This line of thinking presumes that there is a lot of things to buy and once the ‘market’ starts to fall, we can buy. Buying is so easy. One can buy whenever the mood seems favourable. Or when the noise is so high that everyone around us seems to be buying and selling stocks. Everywhere there is talk of IPOs and Warren Buffett. It is as if all it takes to make money is to simply buy some stock and then sell it at a higher price.
When money starts to burn a hole in our pocket and we succumb to the noise, it is probably the path to rags from riches. To buy something in the stock market, we must know what we are going to buy. It is not like going to a restaurant and choosing at random from a menu that is handed over to you. Not all stocks will give us similar returns.
Once we identify a stock that we like, the question is when should one buy it? Ideally we should be buying at a price that can give us good returns. Thus, lower the better. Easy to say. But the stock keeps going higher and higher, you say. Are there any measures that we could use to put our finger and pull the trigger?
It is logical to presume that so long as a company keeps growing, its stock price will keep going higher and higher. In a steady state market, where everyone is perfectly logical and rational, prices will keep moving up steadily, in line with the earnings. So you take a measure of past earnings growth and take a call on whether the growth rate will be sustained or not. In my last column we talked about using the Balance Sheet check to see if the company is healthy or not. Fortunately, our markets are not rational and hence they are always in a zone of over optimism or pessimism.
So, we do not have to be bothered with the Index per se. Yes, if everyone is negative on the economy and on the stocks, all shares will decline in price. In a normal market or in a bull market, everything goes up. Some go up faster than the others. So, in essence we have to bank on gyrations in the market to ‘time’ our buys or sells. The markets keep getting pushed by institutional investors who believe that money is given to them to ‘invest’ and hence will buy stocks for over ninety percent of the money they collect. However, an individual is under no such compulsion. We can wait for our time.
The precondition for shortlist is good fundamental analysis. Now, we have to buy in such a way that our downside is minimised and upside is maximised. I do not recommend using High/Lows as a tool. Simply because as the earnings grow, the valuation also rises. A good proxy to use is the Price to Earnings (PE) ratio. If we take a long history, for instance, I can see that a stock like Hindustan Unilever has traded between PE ratios of 25 to 50. This is a wide range and offers enough actionable space. Thus I will buy this when the PE is closer to 25 rather than 50. It is possible that the PE may never touch 25 or could even go below. For me, it is just one trendline that I use as a support. Similarly, when choosing a stock to sell, I would pick the one that is closer to its historically high PE. While there is no guarantee that this will predict the tops or bottoms, it gives us a process that eliminates our bias and preferences. We may see a market index swinging between a PE of 15 and 24 or so, but each stock will have its own swing range.
It is useful to remember that there is no perfect tool to measure the ‘fair’ value of a stock. It can be only a range. Precision is simply not possible, since the market is a sum of expectations rather than a precise measure of historical earnings. Thus, by using some yardstick, we are able to ‘time’ our buys and sells, with reference to valuations rather than a mere number.
Having a process, helps us to keep our emotions at bay. Emotions generally work to reduce returns from our investments.