Correction in Stock Markets

“Correction” is a relatively well known word in stock market circles and for someone who does not understand clearly what it stands for, this article might help finding what it is.

Deriving the Definition / Meaning

The definition for “Correction” lies in the word itself, but one just needs to associate that with stocks markets. The standard dictionary meaning for the correction is,

- an action to rectify something
- an action to set right (Correct) the anomaly
- to set right an error or misunderstanding

So, if rectifying something is termed as correction, many would be wondering what went wrong in stock markets to rectify. Here is my explanation.

Stock prices usually discount the future earnings into its present price. People buy stocks at a particular price expecting that the company’s earnings (EPS) would stand at a specific level which they call it as forward earnings. Sometimes they buy based on the present valuation as well. SENSEX levels just imbibe the same concept. Let me explain in detail.

Consider SENSEX as a company just like State Bank of India. Usually SENSEX trades around the PE ratio of 21 -22 at peak valuations (SENSEX PE is calculated by adding the 4 quarter earnings of all the 30 SENSEX companies) and sometimes in a crazy bull market it even goes above 25.

People expected that the Financial Year 2009 (FY2009) SENSEX EPS would stand around Rs.850 – 900. If we multiply the PE and EPS (21*850), we get 17850 and that’s the SENSEX target Indian Stock market was trying to achieve. So, stock prices shoot up from the March lows of 8000 to 17100 and we had a sharp rally based on the prediction that SENSEX EPS for FY2009 would be about Rs.850 - Rs.900.

Had the companies announced good second quarter results, there would have been no problem and the SENSEX might have moved up and even the FII’s (Dawood Ibrahim’s of Indian Stock Market) would have been confident about the India growth story. But since companies by and large announced muted and negative results, market realized that the FY2009 EPS would not be what they actually thought (Rs. 850) and it would be less than that. So, market realized the mistake that it took the SENSEX too far (Ahead of Earnings) and wanted to rectify the mistake or error which we call it as “Correction”. We can see number of corrections happening in the Indian Markets since 2002 in the following graph.

Foreign Institutional Investors (FII) started selling the equities (Domestic instituations followed and will follow as well) and market has declined to the SENSEX level of 15896 as of 30/10/2009. It would correct itself till what market decides the right EPS and PE in the short term. Please see the following graph to understand the relationship between net inflows from the FII's and SENSEX.

So the “correction” can be termed as a self provoked mechanism by which market automatically rectifies the errors or excesses committed by its participants. Historically if the decline is 10 percent or less then people term it as “corrections” otherwise it would qualify for a “Market Crash”.


My Opinion (31/10/2009)

Based on the BSE website, the current EPS is Rs.786 and PE is 20.21. But what they calculate is trailing 4 quarter earnings and not the FY 2009 EPS. So, let us reduce our expectation of FY2009 EPS of Rs.850- Rs.900 to Rs.800 - Rs.850. US market is trading around the PE of 14-15 and so does other developed markets. If we assume the same PE, then multiplying the PE of 15 with our new assumed EPS of Rs.800 to Rs.850 gives you the SENSEX level of 12000 to 12750. But India being a fast developing country with a growth rate of around 6 percent for the time being (Growth Rates might increase to the levels of 8 if all the parameters combine well), Investors are ready to put a premium on our scrips and hence we need to take that into account. So, we need to add that premium and there is no hard and fast rule to do that and I just personally assume the PE of 3 - 4 for the “India Growth” Premium and adding another 2400 to 3200, the SENSEX would stand at 14400 to 15200 to make sense.

We can also cross check this number by another method. Corrections are called Corrections if they decline by 10 percent or less historically. It just depends on who is calling it. Some people call it corrections even if the decline is 20 percent. But we will take it as 10 percent. So 10 percent of 17000 is 1700 and if we deduct that from the SENSEX level of 17000 which we had just a week back, then the SENSEX would stand around 15300 and SENSEX level of around 15000 seems to make sense. I am not into any technical analysis or any predictions but just looking at these numbers tells me that the SENSEX level of 15000 makes sense for our markets for the time being and I thinks thats where market is heading to. Anything less than that would be an undervalued market and anything more than that would be an over valued market. If the outlook for the earnings increases, then we might be forced to revise our assumptions and markets might head up. But the overall long term uptrend is intact particularly in case of our Indian Markets and I have no doubt that all these corrections are just aberrations in long term growth story and also an opportunity for the investors to accumulate good stocks.

Some Recent Major Single Day falls in SENSEX

1. January 21, 2008 - 1408 Points
2. October 24, 2008 - 1070 Points
3. March 17, 2008 - 951 Points
4. July 6, 2009 – 870 Points
5. January 22, 2008 - 858 Points
6. February 11, 2008 – 833 Points
7. May 18, 2006 – 826 Points
8. October 10, 2008 – 800 Points
9. March 13, 2008 – 770 Points
10. December 17, 2007 – 769 Points


Am I expecting a fall like this in near future?? Hell no hopefully. But anything can happen in these markets.

Kumaran Seenivasan

www.stockanalysisonline.com

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Best Mutual Funds in India - 2009

Since I started writing this blog, all my posts have been about individual stocks and stock markets oriented information. But there are people who can’t invest in individual stocks due to resource constraints or who would not like to get involved in the stock market directly. Mutual Funds are an option for them and I will discuss in detail about the same.

What are Mutual Funds / Why Mutual Funds?

As we know, lot of retail investors enters into the stock market and only the ones who have the knowledge and skill come out with good returns and other people return not only empty handed but with huge burden due to lack of even some basic knowledge. Also there are people who can’t afford to buy individual stocks or invest anywhere else (Like land or gold) as their monthly savings is in meager amounts. They will have very low risk appetite and ideally they would want to invest in companies like State Bank of India, Reliance Industries, Infosys Technologies, BHEL and L&T but to buy a single stock in any of these companies, one would require about Rs. 2000 and not everyone can afford it. To address the above discussed problems, Mutual Funds originated way back during the start of the 20 th century in USA. Here is my definition of a Mutual Fund.

“Mutual Fund is a pool of money collected from investors and managed by a professional fund manager to invest in stocks, bonds and money market instruments and the net profit is shared among the unit holders or investors based on their proportion of investment”. The diagram below explains in simple terms.

So, Mutual Funds collect the money from investors and funds usually generate anywhere between 1 Crore to 10000 Crore Indian rupees and is professionally managed by fund managers who have the required knowledge in the stocks markets. These managers invest the pooled money mostly in stocks and bonds and based on the performance of the fund’s investment portfolio, unit price is decided on daily basis. Unlike stocks, small investors can even buy the units in fractions and they can redeem it anytime just like stocks. Hence, Mutual Funds offer small and unknowledgeable investors a chance to invest in the stock market indirectly and get benefited without knowing anything about it and more importantly they can invest any amount.


Advantages of Mutual Funds

Professional Management: This makes the life easier for people who does not have any knowledge in stock markets or who does not have enough time to do the research on their own.

Diversification: The funds invest in large number (30 – 100) of stocks thus minimizing the risk of losing the entire capital. The idea behind diversification is to invest in a large number of stocks so that a loss in any particular stock is minimized by gains in others.

Low Cost: Since the fund buys and sells in large amounts, the cost is spread out among all the investors which brings the per head transaction cost low.

Simplicity: Anyone can invest and any amount can be invested.

Liquidity: Can be redeemed at any time.


Disadvantages:

The same advantages which I listed above can turn out to be a disadvantage as well. For example, professional management is a very vague concept and many a times, people with common sense beat the fund managers in terms of returns as fund managers have to go through lot of regulations and sometimes they lack flexibility as well. So, performance of the fund managers is a key here and most of them are closely watched. Also, there might be hidden costs which investors should be careful about. Mutual Funds do not operate as a non profit organization and they are primarily in business to make money.

Stocks or Mutual Funds

The answer should vary depending on individuals. If you are someone who have the adequate knowledge in stock market and do not panic in tough times, then stock investment can be an option for you. But if you are someone who does not know what stock is all about and fear losing money, then individual stock is not for you and better go for Mutual Funds. Mutual Fund is good even for someone who has knowledge in stocks but do not have enough time to do research and buy stocks. Hence, Mutual Funds are an option for everyone irrespective of knowledge and skill but stock is for ONLY knowledgeable investors.

What returns one can expect?

Good Mutual Funds return compounded annual return of anywhere from 10% to 30% depending on the fund manager's performance. Some selective high performance funds report even more than that. For example, DSPBR Top 100 Equity Fund has returned 38% annually since its launch in 2003. HDFC Top 200 fund has returned 32% annually in the last 5 years. If you are someone who will be happy with an average return of about 20% without spending much of your time, then Mutual Funds can be an option.

HDFC Top 200 Fund Summary (Till June 2009)

Best Mutual Funds in India

Large Cap Funds: These funds invest only in blue chip companies and large corporations.

DSPBR Top 100 Equity Fund
HDFC Top 200 Fund
Franklin India Blue Chip Fund
HSBC Equity Fund
Sundaram BNP Paribus Select Focus
Birla Sunlife Top 100 Fund
Kotak 30

Diversified Equity Funds: Money is invested in all the companies based on the growth opportunity irrespective of the size of the company.

Birla Sunlife Frontline Equity Fund
DSP BlockRock Equity Fund and DSPBR T.I.G.E.R Fund
Templeton India Growth Fund
Reliance Growth Fund
SBI Magnum Contra Fund
Fidelity Equity Fund
HDFC Equity Fund

Small and Mid Cap Funds: Money is invested in small and medium sized companies.

Sundaram BNP Paribus SMILE Fund
Birla Sunlife Midcap Fund
Sundaram BNP Paribus Select Midcap Fund
Franklin India Prima Fund
DSP BlockRock Small and Midcap Fund
Reliance Regular Savings Fund
Tata Growth Fund or Tata Midcap Fund

Kumaran Seenivasan

www.stockanalysisonline.com

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When to Sell a Stock?

The most intriguing question in the stock market has always been “When to Sell a Stock? This is in fact as much important as “When to Buy a Stock?” The selling point depends on what kind of investor you are. I just leave out the day traders as they have to sell it on the same day and group other investors into

Short Term Investors
Medium / Long term Investors

The selling point for the short term investors sometime differs from the Medium / Long term investors. If we consider 5 years or more as “Long Term”, then we would experience several corrections (over 5 year period) which would be very significant and each one of the troughs could be a selling point and one can sell at the troughs and then buy back the same stock at a lower price.

Short Term Example:

If you are a short term investor, it is better to fix a selling price or return percentage while you buy the stock and sell it as soon as the stock hits the target price. Because, often times price decline happens apparently for no reason and may be that’s the reason technical analysis was born in the first place.

Example: Venus Remedies

This stock was trading at Rs.210 in July 2009 and company has good fundamentals. In the recent rally, the stock reached the short term peak of Rs.310 (50% returns) and started declining and is available now for Rs.220. There was no change in the company fundamentals and nothing has changed since July. So, if one had set the “Target Price” in the first place, he / she could have profited significantly and can buy the same stock now at a lower price. Hence, setting a “Target Price” is one way of identifying the selling point.

Long Term Example

Long Term selling point should ideally be a “Maturity” value for your investments and it is one of the most difficult things to come up with. Again setting up a “Target Price” would be very helpful for the long term investment as well, but it is one of the very difficult things that I can think of. Because, in the short term, one can set 50% return as the target price. But it can’t be the “Selling Point” for the long term investment. If the company is really good and you fix the “Target Price” as 50% return, then you could potentially miss the multibagger. So, my suggestion would be to keep invested as long as the fundamental does not change significantly and market sentiment is positive. If you feel the market is reaching unsustainable levels, then just sell it even before peaking. Two things can be done to sell the long term investment.

1. Identifying the Market Peak and sell
2. Sell when the stock is heating way above the company fundamentals

Example: Reliance capital

Reliance Capital was trading at Rs.2875 on Jan 10, 2008 and the expected earnings per share for the full year at that time was about Rs.45 (PE Multiple of 64). Even if you have failed in identifying the “Unsustainable market” levels (SENSEX breached 21000 during that time), you could have certainly predicted that valuation for reliance capital at Rs.2875 was stretched for its fundamentals. Again it is a risk we need to take. Sometimes you might sell the stock thinking that the stock has reached the peak, but market sentiment or over optimism may drive up the stock price to unbelievable levels. But it is better to take profits rather than become a slave to the market crash.


General Guidelines to sell a Stock

The following points needs to be considered to sell a stock irrespective of the duration of investment. But, it is important to remember that you can’t get the “Selling Point” right all the time. Selling signals can come either from company itself or from the market.

Company Related Changes

Change in Fundamentals is the most important thing that one needs to consider while selling a stock. Certainly the following are the ones that come to my mind.

1. Earnings stop growing or Decline in earnings
2. Slow growth of Operating Cash Flow
3. Decline in Market Share
4. Negative Regulatory action specific to the company
5. No New Products or Enhancements
6. Decline in research spending
7. Change in Top Management
8. Increase in Debt without any expansion plans
9. Decline in the same store sales
10. Acquiring seemingly unrelated companies or relying on it for expansion
11. Increase in raw material cost
12. Patent Expirations
13. Cutting costs as a way of keeping the earnings

Market Related Changes

1. Stock is heating up way above the fundamentals
Ex: PE of company A is 60 without any specific reason while the peers are trading at the PE of 20.

2. Market in general is reaching new highs signaling over optimism
3. Insider Selling or even no insider buying
4. Increased competition
5. Negative Regulation for the entire industry
Ex: Just Yesterday (Oct 06, 2009) we saw TRAI announcing per second tariff plan and all the telecom stocks declined by 10%.

These are some of the points that I could come up with to identify the “Selling Point” but there could be others specific to the situation. I expect more discussions in the comments section related to this post as it would help everyone to learn few things in terms of selling a stock.


Kumaran Seenivasan.
http://www.stockanalysisonline.com/

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