Monday, March 30, 2009

How to Select Best Stocks?

I have already posted two posts; one with best stocks for long term investment and another with best small cap stocks. Although I have mentioned the criteria that I considered while selecting the stocks, I would like to describe in detail about those factors in this article.

As we all know, there are more than 5000 companies listed in the Bombay Stock Exchange (BSE) and in my view there are at least 500 decent companies to choose from. So, as an individual investor we need to develop or follow some sort of criteria to select the best possible stocks that suit everyone’s risk profile. I did follow few things to select the stocks that I have listed in my previous posts and would like to share with you.

Criteria to Select Stocks

1) Earnings Per Share (EPS) and PE Ratio

EPS and PE are probably the most used criteria around the world in selecting stocks and it’s not without any reason. EPS and PE values are arrived from important information and that’s why people tend to use it as a single significant factor. But I would actually start with EPS and PE Values and then go on to drill down more about other factors. There is no particular PE Value you can stick with. Lower the PE of a stock (when all other things remain good), better the value. But instead of looking at current year PE, I would suggest to take the average of 10 year PE (At least 5 Yrs) and make sure the stock price is not more than 25 times of that average PE Value. Also look at the forward PE ratios to get the sense of what lies ahead.

2) Book Value

Book Value per share is the total asset value of the firm divided by the total number of shares. Looking at this value might give some confidence about the firm’s worthiness. Also book value per share would be the amount shareholders might get if a company sells all the assets and distribute the proceeds for some reason. If you are able to get good stocks with a stock price less than the book value, it would be good. But make sure you do not pay more than 1.5 times of the book value unless you have some credible evidence about any particular company’s growth.

3) Debt / Equity Ratio

If you divide the total debt by the total equity value, you get this debt/ equity ratio and it gives you the sense of company’s indebtedness. If a company has less than 1 DE ratio, then you can say that the company is in a good financial condition. So, I prefer to invest in companies with less than 1 DE ratio.

4) Current Ratio

If you divide the current assets by the current liabilities, you get the current ratio and bigger this value, better the company among peers.Because current ratio indicates the company’s ability to meet short term financial dealings and we need to make sure that a firm is in a decent position in terms of short term financial needs.

5) Profit Margin

If you divide the net profit by revenue, what you get is the net profit margin and you can calculate net operating margin and other similar values in the same way. Better the margin, better the business and we need to make sure that any particular company earns a decent margin. Select the company with better margins among the peers.

6) Return on Capital Employed (RoCE) and Return on Equity

Return on Capital Employed and Return on Equity indicates the company’s profit making ability in return to the capital employed or the equity position. Again, better the value; better the company and its business. So, peer level comparison might be helpful to select better stocks.

7) Dividend History

If a company has paid dividends continuously over a long period of time, then you can be sure of its intention to share profit with you and also the better handling of the surplus cash available. Hence, looking at the dividend history is important and might help you to make a better decision.

8) Profit Growth

Consistent and decent profit growth over a long period of time is an important factor that we need to look into if we are going to stick with that stock for lengthy periods. There is no single number to think about but we can select the stock with consistent profit growth among peers.

9) Cash Flow Details

As I wrote in one of my previous articles, cash flow is as important as a balance sheet and looking into it gives you an idea about company’s financial health including cash inflow and cash outflow. Consistent growth in cash inflow and better use of it is essential to any company’s success. Hence, carefully look at the cash flow statements (including footnotes) if you are going to invest large amount of money.

10) Business Segment and Future Potential

In stock investments, it is very important to look at the business segment in which the company operates and also the future potential of that particular business as a whole. As you might have seen, a company might be good and if the business is not doing well, it makes little sense to invest in it. You also need to consider if the business is cyclical or non-cyclical or consumer oriented or government owned etc…to get real understanding about the risk of any particular stock. If you are interested in small cap stocks, this is most important factor that one needs to consider in my point of view.

11) Size of the Company

Size of the company is positively associated with the risk potential most of the times. Conservative investors prefer to invest in large cap stocks and risk taking investors who wants to make more money invest in mid cap stocks and also the so called “Multibagger” small cap stocks. So, it really depends on the individuals risk appetite as mid caps and small caps are the ones go down much during the bear phase and go up much during the bull market. Large cap stocks usually have economies of scale benefits and they always stand to gain the volume advantage. Hence lesser volatility.

12) Competitive Advantage

Competitive advantage in the market place is essential for consistent financial performance. If a company operates in a segment where barriers to entry are huge, then you can be sure of your capital at least and your margin of safety is more. Warren Buffet calls this as “Economic Moat” and no wonder he has been so successful.

13) Brand Value or Product Differentiation

Good brand value brings customers on a more consistent basis and that’s the reason FMCG companies command higher valuation all the time. If a company produces a product which is different from others and is difficult to replicate, then that particular company will always command better valuation as investors are confident about its survival over a long period of time.

14) Goodwill

This is an intangible asset companies create over a period of time and it is gained with help from media, political support and solid client base. It usually has some effect on investors.

15) Market Scenario

Finally market scenario comes into play and no matter how big the company is and which business segment it operates, the stock price move according to the market scenario and I am sure most of the people would have good idea about it as we are witnessing once in a life time situation these days.

These are the factors I considered or consider while selecting stocks and it is not necessary to analyze a stock through all of these parameters. You can leave out some criteria for a particular company or you can give more importance to a particular factor and things like that. You can be flexible based on your risk profile. For example, I give more importance to business segment and future potential along with market scenario while selecting small caps and individuals can follow similar patterns according to their skills and risk appetite.

Kumaran Seenivasan.


Sunday, March 22, 2009

Value Unlocking (New Listing of Subsidiaries)

The following question was posted by one reader in the comments section and I would like to present my views regarding the same in this article.


“When the stock market was on top a year before, there were many companies like ICICI, HDFC, Sterlite, Kotak and Reliance trying to demerge and list their subsidiary companies and create value unlocking for the share holders... just as the example we saw when two Ambani brothers were divided...

Most of the banks are planning to list their subsidiaries, how do you see this as wealth creation for a particular stock in coming 2 or 3 years as market might be better then and so will the companies go for it.

Don't you think we should consider this value unlocking thing while selecting a stock when planning for 2 - 5 years horizon?”

My Views

Since, there is no straight answer for this question; I wanted to post an article presenting my views.

What is Value Unlocking?

Theoretically we can define value unlocking as a process by which subsidiaries of a large corporation(s) are listed as separate business entities. In general Value Unlocking is considered to be beneficial for both the shareholders and the management. But why do companies do that?


The reasons for value unlocking are many and it depends on the situation. I would like to list out few reasons.

1) To optimize the growth: Companies like ICICI and HDFC are private banking organizations and their extraordinary growth has lead them to expand their reach to every kind of business including banking, housing, securities and asset management while keeping the main business as their priority. Hence, the subsidiaries tend to under perform because of the lack of adequate focus on them and to optimize the long term growth companies tend to list their subsidiaries as separate business organizations.

2) Strategic Decision Making Process: Some companies start their subsidiaries and some companies buy their subsidiaries. But many companies lack the business or managerial expertise needed to give meaningful direction for the subsidiaries. Many companies go for acquisitions and if they keep the acquired business as it is, then it would prove to be futile. Very few companies actively determine how much of the group's profits should be generated by their main business against less profitable but faster-growing businesses with greater medium- and long-term potential, and what strategic moves they need to make in the short term to reach their goals.

Without more active management of the subsidiaries, most conglomerates end up with a business mix that is the result of past decisions rather than a strategic choice that makes sense for long-term success.

For example, many conglomerates still hold on to underperforming subsidiaries, preferring to subsidize their losses rather than scrapping them entirely from their portfolio. Compared with the management teams at the subsidiaries, executives at the parent companies often lack the industry-specific knowledge and managerial experience to exercise meaningful oversight. Without a proper dialogue with the subsidiaries, it is no wonder that most centers end up as simply consolidators of financial data. Hence, companies try to list their subsidiaries separately so that they can be administered by a professional management which will be helpful for better decision making process. When you do that, suddenly you tend to see the
under performing subsidiaries turning out to be the “Cash Cows”.

3) Better Execution: Perfect example for this is Reliance – RPL. Many large corporations do this for executing the important projects in a timely manner and once they complete the project they merge it back with the parent company.

What is in there for shareholders?

Value Unlocking is widely considered to be beneficial for the shareholders in the sense that the shareholders of the parent company might get some shares in the newly listed subsidiaries. In another way, some retail investors might not be interested in the business of parent company but they would be interested in the high growth subsidiaries and in such a scenario newly listed ones would be boon to them. Either way it is going to be beneficial. But in my view promoters and large investors stand to get benefited more than the retail investors in the whole process.

Why do companies go for it only during bull market?

Like everyone, companies or promoters also want to make hay while the sun shines. If they do it during the bear market, value will rather get locked. Hence, to get a better market value for the subsidiaries, they do it during the bull market.

Do we need to consider these things while investing for a long term?

You need to focus more on the present valuation of the company as a whole rather than their value unlocking potential in future which might or might not materialize. For example, I believe ICICI stock is pretty cheap at the current price and you will reap rich rewards in the future on the basis of parent company alone and if at all they are going to list their subsidiaries down the line, of course you will get benefited either through shares in the newly listed firm or through rights purchase. So, if you think about value unlocking while selecting stocks, then there is a greater chance, you will buy it over priced thinking that you will be compensated in the future and there is no guarantee for that. Hence, it is better to take a long term view based on the present valuation of the company rather than what is hidden.

I request the readers to share their views on this topic in the comments section.

Kumaran Seenivasan


Wednesday, March 18, 2009

Best Small Cap Stocks - India 2009

Before listing the potential Small Cap stocks, I would like to let the readers know that the timing of the last post “Best Indian Stocks for Long Term Investment” was so perfect that many of the stocks in that list have gained decent returns in just 5 days (Current Rally) and I am listing them below.

1. Tulip Telecom - 30 percent

2. Rolta India - 15 Percent

3. Aditya Birla Nuvo - 13 Percent

4. Welspun Gujarat - 15 Percent

5. Axis Bank - 15 Percent

6. ICICI Bank - 15 Percent

7. Punjab National Bank - 15 Percent

This again bolsters my view that best stocks can give you decent returns in the short term and above average returns in the long term. In my last post, I have listed 40 best stocks for long term investment and in this post I list 30 small cap stocks that have great potential. I picked these 30 stocks out of the 482 BSE Small Caps listed in

Potential Small Cap stocks

1. Usher Agro Limited

2. Nectar Lifesciences

3. Aegis Logistics

4. CMC Limited

5. Supreme Infrastructure

6. Rohit Ferro-Tech

7. Pleithico Pharmaceuticals

8. TTK Prestige

9. Shree Cement

10. Amara Raja Batteries

11. Lloyd Electric and Engineering Limited

12. Gayatri Projects

13. Rajesh Exports

14. Gitanjali Gems

15. HEG Limited

16. ABG Shipyard

17. IPCA Labs

18. Arvind Ltd

19. Coromondal Fertilizers

20. Transformers & Rectifiers

21. EMCO Limited

22. Jyothy Laboratories

23. Fullford India

24. Abbott India

25. Dlink India

26. Deepak Fertilizers

27. Hawkins Cooker

28. Kaveri Seeds

29. BASF India Limited

30. Bharat Bijlee

I am also giving here 3 SENSEX stocks that I did not include in the Best 40 list but I think too good to be left out.

Reliance Industries Limited
Sterlite Industries
Readers can list other small cap stocks in the comments section if they know about its future potential.

Kumaran Seenivasan


Saturday, March 14, 2009

Best Indian Stocks for LongTerm Investment

As I mentioned in the last post, I have identified 40 companies which can give promising returns in the long term if we stick with it. In fact one can do more research on this list to construct a well balanced portfolio based on the individual risk potential. If we continue to invest from current price levels irrespective of whether the market goes down or up, there is a strong chance to get above average returns over the 5 year period.

What I have considered while selecting these Stocks?

1. Book Value
2. Current and Past EPS and PE Ratio
3. Debt / Equity Ratio
4. Current Ratio
5. Future Potential(Main reason for Selecting Commodity Stocks)
6. Size of the Company
7. Comparative Advantage or Uniqueness

I have listed the companies group/sector wise and I request the readers to do more research on these stocks to make their own judgement.

1.State Bank of India
2.Larsen &Toubro
3.Hindustan Unilever
7.Bharti Airtel
8.ICICI Bank
9.Tata Steel

Outside Sensex


10.Axis Bank
11.Punjab National Bank
12.Yes Bank or Bank of Baroda


13.Torrent Power
14.CESC Limited


15. Rallis India
16.Chambal Fertilizers
17.Tata Chemicals
18.Gujarat State Fertilizer Corporation
19.Kaveri Seed Company


20.IPCA Laborotaries


22.Mahindra Finance


23.Bhushan Steel
24.Sesa Goa
25.Jindal Steel
26. Indian Hume Pipe Company

Engineering and Infrastructure

27.IVRCL Infrastructure
28.Hindustan Dorr Oliver Limited
29. Supreme Infrastructure
30.Lakshmi Machine Works


31.HCL Technologies
32.Tulip Telecom
33.Geodesic Information Systems(If you believe in VAS)
34.Crompton Greaves 
35.Jindal Photo (Small Cap) or Siemens (Mid Cap)


37.GE Shipping
39.Mundra Port and Special Economic Zone
40.Aditya Birla Nuvo or Clariant Chemicals

Note: I have included Technology Sector for the people who believe in it. Because, I have a feeling that the stocks in this sector can be affected by innovation and new entry very easily than others. But we can have few selected stocks from this sector as it has high growth potential. One might have a feeling that I have left out few good companies. But if we continue to feel like that then we might end up with 100 good companies and never be able to construct a well diversified portfolio.Hence, I tried my best to limit the number of companies to 40.

Tips to Construct a Good Portfolio:

1. Select atleast 7 SENSEX Stocks from this list.
2. Spend 50 percent of your investment in the SENSEX stocks that you have selected.
3. Select 10-15 companies outside of SENSEX from this list or the companies that fit into your scheme of things.

4. Spend another 30 percent in the Large/Midcap stocks you selected.

5. Spend the rest (20 percent) in Small Caps that you selected.

6.Continue investing from current levels irrespective of the Market ups and downs.

7.If the Bull market sets in, then stop investing when the SENSEX gains 75 percent from the current levels (Around 16000). This is for the long term investors only.

8.Do not reconstruct your portfolio unless SATYAM like situation arises for any of your stocks.

9.Never get swayed by any stocks outside of your portfolio once you have selected the best companies after careful research.

10. Just sit and enjoy when the Bull market sets in and book the profit when you reach the desired (Very Important) returns.

Sectors that I am interested in:

2.Power & Energy
4.Engineering & Infrastructure
5.Pharmaceuticals and
6.Commodities(For long term)

Conclusion: I have selected the stocks based on my own intuition and I request the readers to do more research to pick the stocks that best suit individual interests. I have also listed a 10 point rule to construct a well balanced portfolio based on what I am certainly going to do. But individuals can change the rule according to their liking without any major modifications (Only if they are interested to construct a long term portfolio). I sincerely request everyone who read this to share their views about these stocks or other stocks they believe in.

Kumaran Seenivasan.


Wednesday, March 11, 2009

My Portfolio and Historical Perspective

As a blogger, I have been writing about all the basics about stocks. But I also would like to let the readers know where I have had interest in the past and the mistakes I have made and what I have learnt. Given below is the list of stocks I have bought in small quantities and I have followed them closely during the past year. Like everyone, I have also met with negative numbers but the only difference is I have not sold majority of them. Now I have learnt few things based on my stock selection and in forthcoming articles I will list out the stocks that I am going to invest in at the current prices.

List of Stocks
2. L&T
16. RNRL
17. RPL
26. ICSA

In the list, I think I have selected few very good stocks like NTPC, Cadila Helathcare and Gujarat State Fertilizer Corporation, that did not depreciate that much. In fact I bought NTPC when the SENSEX was around 16000 and I still have positive numbers.
Apart from these, majority of them declined more than 25 percent eventhough most of the companies in this list posted decent Q3 results if not great results. You can understand from this what Market can do?

I am keeping majority of these stocks as I believe that these companies can ride out the present turmoil and will get back to the positive territory when the market improves. How do I say that? I just guess from the histroy. Following graph shows that Rs. 1 Lakh invested in 1992 before the crash lost more than 50 % of the value but in 2 years and 3 months time, Rs. 1 Lakh has been recovered. Of course, one should have invested in good companies.

Another example is 2000 tech meltdown and the following graph depicts how long it took for the market receovery to regain back the same value of investment. It took almost 4 years to recover the capital investment. The important thing we need to understand from these graphs and history is that if you have invested in good companies, then there is a good chance to get back your capital investment(If you are a long term investor) atleast if not returns.
What do I mean by good companies?
I define companies as good companies if they have the follwoing characteristics.
1. Competitive Advantage in the Market Place
2. Not adversely affected by closely related innovations
3. Area where entry of new firms is difficult or sufficiently in a large market that can allow multiple players with significant revenues
4. Not affected by policy decisions
5. Strongly related to the day to day life

If a company has atleast 3 characteristics out of these 5, then I would term it as good companies. I will give one example of how a good company can potentially become a bad company.

Example: Financial Technologies is a very good company and its EPS is one among the best and also in a safe business. But recently National Stock Exchange has introduced its own software and they are giving it for free to the brokers. This action might potentially reduce the earnings of Financial Technologies. But we do not know for sure what will happen. The important thing to understand is just the basic behind it.
Hence, if you have invested in good companies and failed to book profit at the higher levels, then you can wait with a hope to get back what you have lost. The list I gave given above has many good companies and some bad companies. So, I prepared a new list of stocks replacing the bad companies with the good companies that are availabe at cheaper valuations which I will list out in the next article.
Note: I am not recommending any of these stocks and request the readers to use their judgement. But please wait for the future articles with new list of stocks in which you can do more research and invest.
Mistakes I have made: I had significant exposure in HPCL and I sold that stock when the SENSEX was around 14000 and bought Tanla Solutions, Tata Steel, Welspun Gujarat and Bharathi Shipyard. Though the stocks I bought are good stocks, I bought it at a wrong time that depreciated heavely. HPCL was a good pick and I still do not know why I sold it (Bought HPCL around 220 rupees). Now HPCL share price is Rs. 255 and the value of the stocks I bought replacing that can't be told.

Kumaran Seenivasan.


Monday, March 9, 2009

Penny Stocks and Associated Frauds

Guest Author : Shabu Thachat

Penny Stocks are scrip’s which are valued less than 5 in most of the currencies and some of them are even less than 1. So, we are talking about the Penny scrip’s in this article.

It is bit confusing at times, as lot of good stocks come down to 5 and below. We cannot label all of these shares (below Rs.5/-) as actual Penny stocks and even if we treat them as penny stocks, some of them have good growth potentials and may be the future multi-baggers. Investing in such stocks might create great wealth in long term. I will publish another post about few good penny stocks later in this blog. But why do stocks are valued less than 5 rupees or dollars?

There are several reasons behind a share price getting cheaper and I will list out some of them below.

1. Inferior management
2. Negative earnings
3. High scale debts
4. Global trends and trend changes in products
5. Untimely listing
6. Better competitor’s entry
7. Negative rumors or certain sentiments on issues related to the company
8. Not being the darling of media

Basically these shares don’t have enough buyers or demand to get a higher valuation.

The advantage of Penny stocks is its affordability and everyone can buy it because of its low value. For example, you can purchase 10000 shares just for Rs. 5000/- at 50 paisa per share. If this share reaches even at Rs 1/-, you will get 100% return and this is the beauty of these stocks and if you have enough patience, some of them can change your life forever.

The volumes of such shares also exceptionally low compared to others as well as the number of trades. Some brokers and group of individuals are specialized in the trade of penny stocks. My request to the new and innocent investors is, to stay away from intraday trading of such stocks. It’s hazardous, until you are not fully aware of the penny stock stunts behind the screen.

With a low volume stock, it is easy to manipulate the share price. For Example, if you have Rs.1 stock trading 50,000 shares a day and someone comes to buy 25000 shares then it will have considerable effect on the share price for sure. It can happen to any stock but the probability is more in penny stocks as its value is so cheap that you can trade in a candy to a stock. People might even trade due to its teasing numbers. For example some people are happy to have 10000 shares in their account rather than 10 State Bank of India shares for the same value of investment.

Boiler Room Tactics:

Penny stocks are also the favorite trading tools of some unethical people who work in Boiler Rooms because of its low volume. Boiler Room is a practice where unethical brokers / sales people convince potential investors (Rather scapegoats) to buy an insignificant stock. Obviously, the price will go up because of increased demand and the brokers/insiders in the boiler room sell their shares for an ample gain. By the time you want to sell, it is often too late. You will lose the major part or all of your investment.

A considerable percentage of price increase or Penny stock in a Top Gainer’s list in a particular trading session, may guide some innocent investors to wrong buying decisions. Anticipation of further price hike leads them to purchase such stocks which finally land them in a heavy loss. Online intraday traders are the major victims of such fraudulent activities because they trade on the basis of tips or baseless information.

If an unknown person/firm advises you through Phone/SMS/Mail to buy a penny stock showing the percentage growth on a particular day or so, please be alert. They are experts to trap you by their lexis like “This share price is very much low….. the company is going to merge with so and so…….the company have got an order from so and so…….” or anything which tries to establish that the stock is hot. Please be very careful.

Thousands of people fall in such scams everyday. The boiler room brokers/insiders are skilled enough to make you feel that you are going to miss out a life time opportunity if you don’t buy the recommended scrip at that particular time. If you jump in then it is difficult get out without severe burns.

Pump and Dump:

One of the usual penny stock frauds is the Pump and Dump. A tiny group of speculators will gather some large number of shares of a penny stock. Once their positions are in place, they will release positive financial news, which so unexpected and can drastically affect people's insight of the particular stock. The intention is to grab short term investors to involve trading illogically. The news would be probably false, but before it is discovered, the price of the scrip often shoots and the original insiders might exit with big profits.

Poop and Scoop:

The other variant of Pump and Dump is a penny stock deceit called the Poop and Scoop. Here the insiders spread highly unconstructive bogus rumors about a company in order to bring the price down. These people buy as the scrip sink and wait for a recovery in price once the rumor is dissolved.

The other side of Poop and Scoop is, these people sell their holdings before releasing such news and after the following turn down, they make big purchases and keep for a profitable sell after the suspension of rumors.

Front Running:

Another penny scam is known as Front Running. Here, the news is factual and the insiders/brokers are well aware of what is going to happen. They take good positions before the news becoming public. And the rest you know. It is also illegal.

Circular Trading:

The another term Circular Trading is, when a stock has been laying idle for a long time, insiders trying to increase the importance of that particular scrip. They use multiple accounts and will trade the same shares back and forth between their own accounts to create the symptom of motion in that particular scrip. The artificial hike in prices and falsified number of trades may attract some investors. Once a third party placed an order, it will be executed and the insiders will exit with good profits.

I am not against investments in penny stocks. But Trading, especially intraday is harmful without proper intelligence. Some of the penny stocks are in this category because of the global melt down. Do your home work before investing in any of the Penny stocks especially on their fundamentals. A lot of hidden gems are there which will come out and show their growth after this ill-fated period.

Shabu Thachat, Calicut, Kerala.


Friday, March 6, 2009

Stock Market Analysis – Selected Readings

I recently read few Articles / Descriptions about the investment style adopted by Benjamin Graham which also covered about his two books “Security Analysis” and “The Intelligent Investor”. I would like to share two of those articles in addition to one outstanding thesis work based on Graham’s investment philosophy.

In the first article, Richard M. Rockwood gives a brief account of what Graham has written in the bible of Investment “Security Analysis”. Rockwood has in fact given the essence of Graham’s investment methods and I think it would be extremely useful to people who have not read the Book or who does not have time to read it either. Please visit the following link to access the article or download the same.

The second article has been written by Jason Zweig (He is the one who revised “The Intelligent Investor” in 2003) and he gives his view points about Graham and his ideas.

But he explains more about Graham as a person and why he is considered as the Father of investing. You can read the article at the following link or download the same.

For investors who are more interested to know how Graham’s investing methods would be applied to our own benefit, I have uploaded a research thesis written by two Swedish students. They have tested the Graham’s methodologies to the present day Sweden stock market and proved that they could beat the market. They have explained in great details about how to select the stocks based on Graham’s methodology, various factors to keep in mind while selecting stocks, reasons for value investing etc. If you read the full paper, I am sure you will get more idea about value investing and you could apply the same in your investment approach.

You can find the complete thesis at

Since, it contains more pages; you would be better served if you download the paper and read it.

Kumaran Seenivasan


About Me

Native Place : Jangalpatti, Karur District, Tamilnadu, India.
Father : Late N.Seenivasan
Mother : Papathy
Family Background: Agriculture

Education : B.Sc (Agriculture) - Tamilnadu Agricultural University
M.Sc (Applied Economics) - Haryana Agricultural University
M.S (Applied Economics) - University of Arizona, USA.

Profession: Marketing Analytics Manager at AbbVie, Chicago, USA.

Interest : Novels, News, Cricket, Stocks and Investments, Blogging.


Sunday, March 1, 2009

Stock Markets and Business Cycles

We all talk about Business Cycles and most of us including Harvard educated economists fail to spot the course of its direction. In this scenario, I do not think average retail investors have ideas about business cycles and its relevance with the stock market. I aim to bring more general view of business cycles and stock markets to understand the future that lies ahead of us based on the history.

What does Business Cycle Mean?

In simple terms, we can define it as the uphill and downhill travelling of our economy or economic activity for a certain period of time in a long term growth trend. I can in fact compare this with the way human life shapes up.

Example: Assume a single human life as a separate country. Majority of the people, irrespective of the status of the individual have ups and downs in their life but the long term growth both physically and financially remains intact. Sometimes our growth is more than what we anticipate (Boom Phase) and sometimes nothing goes right whatever we try (Recession). But between good and bad times, we see normal days with little hiccups (Sideways movement of stock market). The reason I relate single human life with a separate country is, the magnitude of ups and downs vary with individuals so as the Boom and Recession phase of a country.

Image Source: Google Images

If you are someone who wonders why I see relevance between human life with business cycles and stock markets when we can find some other economic concepts, then I specifically choose simple law in economics which is Law of Diminishing Marginal Utility. There is a strong relevance but with a small difference.

In simple terms, law of Diminishing Marginal Utility states that interest or satisfaction on consuming something declines marginally with each additional unit. The relevance is “There is a Limit for everything”. There is also one more closely related law which is Law of diminishing marginal returns which says that a firm or company might reach a place from where each additional unit of input would bring less return than the previous unit. Same thing applies to the economy as well. There is a limit for everything and if it goes upwards, then it should and it will come downwards because we are the ones who shape the business cycles. Many think that business cycles happen just like that and people do not have any part in it which is wrong. Consumer behavior is the one which shapes the business cycle patterns.

The two simple laws which I mentioned above have relevance with the aggregate demand which shapes the economy as a whole. All these concepts like Boom, Recession, Trough and Expansion are simple to understand just like what happens in the micro level. Consumers are the ones who create the demand which shapes the production of companies and employment. If the consumers have positive feel good factor, then they just spend more money thus increasing the aggregate demand. To meet the demand for the good, companies employ more people and produce more which gives the positive economic outlook and we call it as boom.

The positive outlook eventually leads to over supply of everything including goods, houses, credit and loans (More Money Supply). As I said in the Law of Diminishing Marginal Utility, people reach a place where they do not create the same aggregate demand and start to spend less which forces the companies to cut production and layoff employees because of Law of diminishing marginal returns. The person who does not have work, of course will default on loans and mortgages as they have no means to repay it which leads to the recession and some companies go bankrupt and some survive. Hence, consumers are the ones who shape the economy. You might ask, if consumers are the ones, then why the hell you and I can’t predict?

The reason is simple. If you and I are the only consumers in the market, then of course we can predict perfectly what is going to happen. But in reality we have about 7 Billion consumers around the world and each one behaves differently and has different tastes and preferences. They all act differently at various points but act similarly if there is a popular sentiment regarding the market. If people feel good about the market, then they spend more and save less because they are confident that they will get work consistently and save money in small amounts. They just want to enjoy more at present. But if they feel bad about the market, then they save more and spend less as they plan to survive the bear phase if they lose the job. So, in essence consumers linked aggregate demand, employment/unemployment, production and government actions are the ones that shape up the Boom or Recession.

Image Source: Google Images

The graph explains the phases of business cycle which identifies the culprit who is responsible for boom or recession which is Aggregate demand and aggregate Output and we discussed it enough. But let’s look at the X axis which is labeled as Time. Now you should understand why people invest for long term. Business cycles come and go but the long term growth remains intact. If you have selected GOOD COMPANIES to invest in, then you should be confident that you might get good returns over long term. Of course people who exit at the peak and buy it back at the bottom which is a different story and only select few can do that. If everybody who enter the stock market earn OVER A LONG PERIOD OF TIME, then there won’t be any stock market and we need to coin some other term for that.

Relevance of Business Cycle with the Stock Market

By now you might have understood the relevance of business cycles with the stock market. If not, here is the brief description. As I said earlier, if the aggregate demand is more, then companies employ more people (People earn money) to produce more which increases the company earnings. People are positive about the stock investments as they believe in the future growth and start investing on stocks.

Too many people chase the stock market thus increasing the stock price. Some people make profit and some not. Once the companies start cutting production due to decreased aggregate demand, earnings become less both for companies and people which influences the investor decision to exit the stock market to cut their loses. Many people lose money and if you are the one who earned money after investing in a peak, you can claim yourself that you are next to none in stock pickings. In short Boom gives the positive outlook for the stock market while recession gives the negative outlook.

When will we get out of this recession?

According to National Bureau of Economics Research (NBER), there have been 32 cycles since 1854 and all have followed the same pattern keeping the long term growth intact. The average period of contraction (Peak to Bottom) for those 32 cycles is 17 months. The following table gives you the business cycles associated with various time periods and the average time taken for each of the actions. If you look at the 1945-2001 period (We are associated with only this period), the average time taken to hit the bottom from peak has been 10 months.

But have we hit the bottom now? NO. That itself proves that the situation we are in is comparable to 1854-1919 period and it can be even worse. But what we can be sure of is there is always a tomorrow. Remember that India or few other countries could not have experienced the same kind of impact during these very early periods (This table is Associated with US). Do you know the reason? Because, countries had less international trade relations then than now.

Note: Comparing periods often can be misleading in the sense, governments did not resort to any serious regulatory action during the earlier periods which is not the case now. Also please look at the currency standards then and now.

Table 1. Business Cycles Average Recovery Time Period

Source: NBER

Conclusion: If we compare the present situation to the worst period (1854-1919), then we should hit the bottom during the last quarter of 2009 considering that previous peak ended in 2007 December. But if we compare ourselves with the overall history, then we should hit the bottom by the end of 2009 second quarter. In my view, nobody can predict exactly when these things will happen. But I can guess that the economy might improve by 2010 first quarter onwards and if you are an investor who is new, you can wait for some more time before plunging in to the stock market. If you are an experienced investor who does not mind about time, then you can buy good companies even now.

Kumaran Seenivasan.



This is a blog about stock market investments, investment strategies, and related topics. Any statement made in this blog is merely an expression of concerned authors opinion, and in no case should it be interpreted as an investment advice to buy stocks, sell stocks, or for that matter advice for any other issues be it money related or not. By using this blog you agree to (i) not take any investment decision, or any other important decisions based on any information, opinion, suggestion or experience mentioned or presented in this blog (ii) verify any information mentioned here, independently from your own reliable sources (for e.g. a registered investment advisor) and thereby check for possible inaccuracies. This blog is to create investment wisdom among general population and the authors are not responsible for
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