When the stock market crashes.........!

THE last three to four years have proved to be a roller coaster ride for the stock market. 

The Sensex doubled from a level of 3000 on May 3, 2003, to 6000 in January 2004. When the Bharatiya Janata Party lost the elections in May 2004, the market plummeted to 4500 (a 25 per cent drop in just four to five months). 

But within six months, the market recovered and again, the Sensex touched 6000 before the end of 2004. Thereafter it was almost a one-way journey right up to May 2006, when the market hit the 12,000 mark. 

Later, the market saw a sharp correction when it dipped to 9000 level in June 2006. But pretty soon, it crossed the 21,000 mark by January 2008.

Since then, we have witnessed some pretty sharp falls. And the fact that it doesn’t seem to be bottoming out, is making investors a lot more nervous. Of course, volatility is not something new. But the sharp ups and downs are scaring even the old-timers who are in this business.

Part 3: How PE ratio can reveal true value?

PE: an indicator of margin of safety

Let's assume you buy a share at Rs 550 whose EPS is Rs 50. In one year, you earn Rs 50 on an investment of Rs 550, that is, a return of about 9 per cent.

You can earn 8-9 per cent risk-free returns on bank deposits as well. So, the margin of safety in this case is practically nil.

To reduce the risk, we must have a higher gap.

Thumb rule: Warren Buffett recommends this gap to be at least 1.25-1.5 per cent.

Last word: During a bull run, investors pay a high price for any and every share. So, it becomes difficult to find stocks with a high margin of safety.

It is in bear markets, as the one we are in now, that there are opportunities to spot the gems.

Part-2 How to find out a share's value?

How to find out a share's value?

To begin with, you can read financial statements and understand the nitty-gritties of stocks. 

If you are willing to walk that extra mile, then pay heed to these valuation methods that Warren Buffet swears by: 

Method 1:
Look at the net liquid assets per share. 

Net liquid assets per share = Current assets (cash, debtors, liquid investments etc) - liabilities
Number of shares


Thumb rule: Warren Buffet prefers paying not more than two-thirds of such value for a stock.

Method 2: 
Look at the PE (Price to earnings) growth ratio.

PE growth ratio = Market price/ Earnings per share
  Annual EPS growth

where Annual EPS growth = Current year's EPS – previous year's EPS x 100
  Previous year's EPS'


Thumb rule: A PE growth ratio of 1 indicates a fairly valued share; less than 1 means undervalued; and more than 1 means overvalued.

Buy low, sell high: How Buffet does it! Part 1

BUY low, sell high. 

This is the most popular theory in stock market investing. But the question is -– how would you know when a stock's price is ‘low’?

The key: Compare a stock's price with its ‘value’.

How is price different from value? 
-- Price is what the market is willing to pay for the share at a given time. It fluctuates from minute to minute.

-- Value of a stock is the worth of its underlying business. It is more stable as fortunes of a company do not change overnight.

Buy when price is lower than value
If a share's value is Rs 150 and price is Rs 125, then you get the stock at a discount of Rs 25.

While there is no guarantee that the price will not go below Rs 125, the probability is low.

This principle is called the 'margin of safety' and finds it roots in the teachings of legendary investors -- Warren Buffet and Benjamin Graham.

Secrets to stock investing Lesson 3

Lesson 3

The moment people buy a stock, they expect it to double soon. They see the stock ticker 10 times a day. They call their broker a couple of times daily to find out what is happening. 

I have one question for such people. Can you set up a steel plant in one day? Can you build a power plant over the weekend? Can you start a mobile company and expect to have 1 million customers on 
Day 1? No. 

Businesses take time to set up, acquire customers and generate profits. Only when the companies increase their profits will the share price also increase.

Therefore, having bought a good business and good management, give it time to prosper. If you don’t have the patience, you might as well go to a casino or call-up Shah Rukh Khan at KBC. 

Moral: The stock market is a serious long-term business, not a make-money-overnight casino.

Secrets to stock investing Lesson 2

Lesson 2

Recently, I read that if you had invested Rs 1 lakh in Infosys at the time of IPO, it would be worth about Rs 64 lakh (Rs 64,00,000) now. But how many people made that kind of money? None, I guess, except the employees and a lucky few who bought the shares but forgot about it. 

Answer honestly: wouldn’t you have sold the shares when it doubled or tripled or became a ten-bagger? How many of us would have had the patience to hold on?

The problem is, we watch stock prices, not businesses. If people had kept track of the business, they would have seen the company had the potential to grow at 30%-40% per annum. Then they would have never sold their shares.

I know many people who got out at 10,000 Sensex levels, thinking the markets will correct and they will re-enter at lower levels. They are now ruing their decision. The problem: they were so obsessed tracking the Sensex that they didn't see strong economic and business growth. 

Moral: Watch business growth, not rise in stock prices.