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Golden rules for a roaring bull market

BS Smart Investor Team | September01, 2003

Question: What should you do when the bulls refuse to be cowed? Stay with the party, courting greater risk in the hope of even greater rewards? Or hedge your bets, by booking partial profits? Or should one bail out, since discretion is always the better part of valour?

When The Smart Investor asked Jyoti Vaswani, head of equities at JM Capital Management, whether it's time to sell, she said, 'No.'

"One needs to understand what is driving share prices this time around. This rally has been driven largely by liquidity. We are seeing in the equity markets today what has been happening in the debt markets over the last couple of years," she said.

"The last trigger for the debt markets was the repo rate cut last week, and we should see more money being shifted to equities by various classes of investors. Even after the bomb blasts in Mumbai last Monday, the markets made a comeback with a vengeance. So sentiment and liquidity are what is driving this rally. So I don't agree that it's time to sell stocks."

Shouldn't one expect a correction after the Sensex zoomed 1,300 points without pausing for a breather? Vaswani is dismissive.

"There could be a small correction, may be about 100-200 points maximum. But there is unlikely to be any major correction which could take the index down by 400-500 points."

"See, there were people predicting a correction when the Sensex crossed 3500, 3700 and 3900, but it never happened. So if you are a medium-term investor, the way to go about it is to ride the wave. Make the best when the going is good. Don't be in a hurry to sell. In fact, one can look at minor corrections as opportunities to buy again."

We persisted: "What are you bearish on?" Again, there was little pessimism in the reply. "That's a really tough question - to find something that will fall when the whole market is rising. I am not bearish on any sector. Because even the technology sector, I think, will finally participate in the rally. It is just that the sectors and stocks that perform in the market will keep changing from time to time. So, one needs to churn the portfolio to keep pace with the market."

That, coming from the head of equities at a domestic mutual fund with nearly Rs 4,000 crore (Rs 40 billion) in assets under management, sums up Dalal Street's current bullish mood that shows no signs of abatement.

With corporate performance in the June quarter exceeding expectations, with the economy set to top six per cent growth following a good monsoon, and with earnings projections being upped almost across the board, no analyst worth his salt is willing to enter a bear note.

On the contrary, they believe that the markets should rise even further.

Does this mean that anything you invest in will turn to gold? Not quite. Vaswani says that your effective returns will depend on how well you gauge the market mood and churn the portfolio.

Despite the broad bullishness, stocks that are in the limelight today may not be front-runners in the coming months.

On the contrary, the laggards of today may well turn out to be the winners of tomorrow.

The Smart Investor spoke to market mavens and investment pros to distill the essence of good investing approaches for the current roaring bull market. We have a list of six golden rules to maximise gains from it.

Rule 1: Stick to the desired asset allocation

Asset allocation is the key to successful investing, say experts. Even though equities may outperform debt substantially, it will not be wise to put all your investments in equities.

Investors should allocate assets among various asset classes - primarily equities and debt - based on their risk appetite. Being overweight by about 10-20 per cent in equities may be justifiable this year, say fund managers, but not too much more.

In other words, if you are advised to allocate 20 per cent of your investments into equities based on your risk profile, you could consider a maximum exposure of 40 per cent currently given that equities are poised to surge ahead.

"Being 20 per cent overweight in equities is justifiable this year considering the relative attractiveness of equities," says Dileep Madgavkar, chief investment officer, Prudential ICICI Mutual Fund.

More importantly, it is important to review the portfolio values periodically and rebalance the portfolio to adhere to the stated allocation plan.

In bullish times, the value of equities tends to rise faster and the equity portion in the portfolio can become disproportionately higher.

Downsizing the equity component to stick to the original allocation can help in guarding asset values when the markets start falling.

Rule 2: Distinguish between stocks for keeps and trading

Whenever you buy a stock, be clear about your objective behind the purchase - whether you have bought the stock as an investment or a trading bet.

Trading stocks are not bad as such. But they require you to work harder and act quicker. The way to approach a stock as a trader is very different from approaching it as an investor.

Rule 3: Buy with adequate margin of safety

That's where attractive purchase prices can help. As a matter of fact, selling stocks is no different from buying them.

"If you get into a stock because it is undervalued, by the same logic, you should get out when it is overvalued. The key is to understand the worth of the stock at any given point," says Raamdeo Agrawal, managing director, Motilal Oswal Securities.

He recommends keeping a sufficient margin of safety when buying a stock and not relying on making a good sale ever.

"As long as I am sufficiently prudent in deciding my purchase price, even a mediocre sale gives me a good return on investment, or at least helps me conserve my capital," says Agrawal.

Reaffirms Parag Parikh, the mentor of Parag Parikh Financial Advisory Services, "Much of the success in investing emanates from getting the purchase right. If you buy the right kind of business at the right price, you can seldom make a loss."

Rule 4: Sell when value is realised

Some stocks may rise sooner than you may have anticipated. In the kind of frenzied bull run that we are witnessing today, investors may see their target prices being met in a matter of days.

Here time should not be of any consequence. If you feel that your investments are adequately valued, you should exit regardless of how long you have held them.

There are times when stocks begin to quote at extraordinarily high levels within a short period after you have invested in them.

Although investors are often advised to invest for the long term in equities, if you get extraordinarily high returns within a short span, it is wiser to get out, say experts.

Normally, most investors - and these include the pros - start with price and valuation targets. However, these get revised with the flow of new information.

But more importantly, investors often fall in love with their stocks, not just because the stocks have worked well or made money for them, but because the whole world believes that there is still steam left.

Experts say that at all times, it's important to take a dispassionate view and sell stocks.

On the contrary, some undervalued (not discovered) stocks tend to lie low for a very long time before they start rising. When the rise does happen, it is rather swift and here one could run the risk of selling too early.

For instance, take the case of HDFC Bank. The stock hit the bourses in 1995 and was quoting for a long time at Rs 30. In the next three years the stock surged to about Rs 50, but the big gain came in the subsequent two years when the stock surged almost five times to Rs 250.

The key here is not just to look at how the stock has performed in the recent rally alone, but to recognise the fact that the stock has caught the attention of the market and, hence, could attain fair value sooner than later.

Says Parag Parikh, "It's important to assess the value of your stocks constantly and see if the stock has the potential to grow further. A stock may have got re-rated from a earnings multiple of 8 to 12, but may still hold scope for growth. So, it is critical to wait till the full potential is realised rather than exit hurriedly," he says.

Sometimes, if you have entered a stock really early, selling it after the stock peaks and corrects itself can also yield significant returns. But then, a more prudent option is to take home profits when the fair price is realised.

Rule 5: Keep a watch on relative valuations

The real cost of a stock is not the price you pay for it, but the opportunity cost of not putting your money in another stock with a greater potential to rise.

You sell a stock not only because it may have peaked, but because there are other stocks that may perform better. Let's say you hold a smaller phrama company and find that a larger one is also available at the same multiple. It may make good sense to switch.

"A larger company, with more liquidity and visibility, will be preferable," said Prashant Jain, head of equities, HDFC Mutual Fund in an earlier interview with The Smart Investor.

Stockbroker and investor Rakesh Jhunjhunwala also emphasises this point. "While it is necessary to go into absolute valuations, one should look at relative valuations also and pick the most attractive stocks," he says.

While buying a stock most investors look to buy the cheapest of the lot. Indeed, that is the right approach. However, it may not be a good idea to buy a stock just because it is cheap in relative valuation terms.

Explains Jhunjhunwala, "When stocks become overvalued there is little logic in holding on to them just because they appear cheaper than others." He would not count on the fact that a greater fool will emerge to buy your stock.

Rule 6: If you realise a mistake, exit

Even while we are talking about selling stocks in a bull market, experts emphasise that if investors make mistakes, they should exit immediately even at a loss.

If you realise your analysis was flawed or that you got carried away for any reason, it's good to get rid of a stock as soon as possible. Waiting for a better price at such instances may prove to be quite dangerous.

"In case of mistakes, historic cost or cost of acquisition should not be of any relevance," says Prashant Jain.

Investing vs trading

Investors

  • Buy and hold/wait for the market to come back: Financial professionals typically encourage investors to diversify their investments, buy stocks with solid fundamentals, and hold them until they are ready to retire. "Ignore the ups and downs" they say. "In the long run, you'll come out on tops." This is sound advice if your time horizon is long.
  • Averaging: It is a process of buying a fixed ruppe amount of an investment at regular intervals, and is often praised by the investment industry as the best approach. The investor, who allocates a certain amount of money monthly or weekly into his investment fund, buys whether the market goes up or down.

Although the portfolio will lose money when the market drops, the shares purchased at increasingly low prices will add that much more to the bottomline when the market turns back up.

  • Never use a stop-loss: If you do, you might take yourself out of a winning trade prematurely, right? This is really just another way of looking at the buy-and-hold attitude. Long-term investors often don't have cut-off points.

Risk control for investors comes in the form of diversification and, hopefully, conscientious selection of assets like quality stocks and bonds. Conservative investing consists of buying relatively stable areas of the market, and then sitting back and letting the market do its thing.

  • Never short the market: For most people, investing rightly means owning an asset that can eventually be sold at a profit. If you try to time the market, you'll usually miss out on more than you have lost had you stayed in from the start. So, investors cannot afford to short the market to buy back later.
  • Focus on fundamentals: If you buy or sell State Bank for investment with a time horizon of at least six months, then focus on its fundamental characteristics, balance sheet, company value and earnings potential.

Last but not the least, the price at which the scrip is available should be less than the value determined by you and leave a margin of safety in case the earnings potential does not materialise.

Traders

  • Never buy and hold/wait for the market to come back: For the short-term trader, whose longest-term trade may be a month or two, and more commonly two days to two weeks, the buy and hold approach will eventually result in financial ruin. It is always essential to cut your losers and let your winners run.

This means that when a trade turns sour, you get out and move on to the next opportunity. If you stay in this trade thinking, "I've seen the market come back time and time again," you'll inevitably experience the one time the market does not.

  • Never average: Traders who average out costs -- buying more shares as the market falls or shorting more as the market rises -- are committing one of the cardinal trading sins: getting addicted to a losing trade. When the market goes against you, the right response is to admit you were wrong and get out.
  • Never trade without a stop-loss: For traders, stop-loss orders are almost always the first line of defense against risk. Trading is a process of exploiting short-lived opportunities in the market that emerge for various reasons, such as overreaction to an economic report or a move to a technically significant price level.

Whatever the idea behind the particular trade, it's essential to determine in advance when the market indicates that the idea is no longer working. This is where you should have your stop-loss order. "Trading without stops is like driving without brakes."

  • Shorting is an integral part of trading: As the current markets have shown, stocks go up and stocks go down -- the latter much longer (and more severely) than people often think it possibly could. Buy puts or look for short-selling opportunities. Trading with the trend -- up or down -- can make life a lot easier, and profitable.
  • Focus on technical parameters: If you try to buy and sell 1000 shares of State Bank, which you're going to liquidate in two days or even two weeks, its balance-sheet won't do you much good.

Short-term, the market and individual stocks get pushed and pulled by a variety of forces -- portfolio rebalancing, rumours, news and investing fads -- that sometimes have nothing to do with the fundamentals.

Source: Motilal Oswal Securities


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