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Lessons in how to pick a stock
Gautam Dev |
September 08, 2005
Some things never change, whichever part of the globe you are in. This holds true particularly when it comes to investing in the stock market.
Get Ahead reader Gautam Dev, who studied in Kolkata and did his Masters from the Indian Institute of Technology, Kanpur, tells us about his experience in the American stock market.
Read on for his very amusing narrative on this experience, which left him poorer but, nonetheless, wiser.
And, yes, do learn from it. The principles he discusses are as applicable to investors in India as they are to those anywhere else in the world.
"You should play the stock market."
This was the advice I was given sometime in 1997.
It sounded impressive. But, since I did not know too much about shares or the stock market, I asked a colleague for help.
The initial part was simple: opening an account with a stock brokerage company.
What next? This time, my knowledgeable colleague had no light to throw on the subject.
So I decided to get into the game by myself.
Grasping the basics
The first thing I did was log on to Yahoo finance. On the top of the screen, I saw Dow, Nasdaq, S&P 500, NYSE Volume and Nasdaq Volume. What on earth did these terms mean? And volume? Isn't volume related to space?
It did not take me long to figure out they were just indices, like the Sensex (The index has just one job: To capture the price movement. So a stock index will reflect the price movements of shares. Since stocks are supposed to reflect what companies expect to earn in the future, a rising index indicates investors expect better earnings from companies and vice versa).
I soon learnt how to get quotes and how to place an order for a stock. But I had no idea there were a variety of orders: market order, limit order, stops order... to name a few.
"Do you plan to buy growth stocks or value stocks?"
Huh? What on earth was the difference? Logically, growth stocks are those that grow and have great future prospects, so are they not valuable? And don't value stocks have the potential to grow?
"You should apply technical analysis to your stock picking strategy," another stock guru confidentially told me.
At first, I thought it would be too complicated for me to handle. Then, I figured it out.
Actually, it was quite simple. Stocks on the uptrend in the graphs tend to go up, and stocks which show a downtrend tend to go down.
I could never figure out what was so technical about that!
"I will give you a surefire way to make big money." This came from a dear friend, so I was all ears.
Here is the conversation:
Friend: "Watch a stock you want to buy until it gives a buy signal."
Me: "How does one identify that signal?"
Friend: "Look for rising momentum."
Me: "What's that?"
Friend: "It's a combination of a rising price and volume."
Me: "After that?"
Friend: "The stock should have four consecutive days of a steady climb followed by two 'down' days, with diminishing volume. It is important that the 'down' days don't go below the 10-day average.
"Watch if any divergence occurs between the 10-day standard deviation and the 20 exponential stochastic indicator.
"If these conditions satisfy, place a buy order after four days of watching, if the volume is above average."
Dear reader, if you think I am going to explain that to you, forget it. I never figured it out myself. And, yes, if you are not sick by then, there is another lengthy procedure to determine the 'sell' signal.
Don't ask me what it is. I was not listening!
Television: Boon or bane?
"You should watch CNBC if you are tracking the market."
The advice never stops.
I did (watch CNBC that is). And saw Maria Bartiromo speaking from the New York Stock Exchange at the top of her voice with all the frenzy behind her.
Well, the stock market can't be that boring after all.
Lesson 1 in stock picking: "Investors should not just study individual stocks but look at the overall economy and try to gauge the market."
This one came from an analyst who looked extremely savvy on television.
I took him seriously enough to began studying economic data: Consumer Price Index, unemployment, wages and so on and so forth. The government declared the unemployment figures and it turned out to be the lowest in 50 years!
Great news for the market!
Guess what? The stocks tumbled big time!
Later in the day, some analyst cockily informs me this reaction was expected. His explanation: "What is good for the main street is not good for Wall Street."
Lesson 2 in stock picking: "Good earnings drive up stock prices." Heard this one on the telly too.
One morning, a company announced excellent earnings for the year and the stock price went down!
The same analyst came on television to tell stupefied investors like me that the good news was already 'priced' into the stock.
Let me explain. The price of a stock increases if there is 'good news' concerning it. But if people have already anticipated the 'good news', they tend to buy the stock and the price goes up before the 'good news' becomes public. And, when the 'good news' is finally announced, no one is surprised or running to buy it.
So, as the analyst explained, when the news actually came out into the open, the stock went down due to profit taking (massive selling). According to him, this was a classic case of buy the rumour, sell the news.
Got it? Everyone bought when the rumour of good earnings was floating around and sold when the news was announced.
The Midas touch in reverse
By now, I was watching CNBC and furiously surfing the Net. And I was ready to take some bets.
I soon discovered I had an inherent knack of picking up stocks that would tumble soon after I bought them.
Let me narrate one incident so you will understand what I am talking about.
I bought a stock at $30 with the intention of selling at $40.
Unfortunately, it immediately fell prey to the force of gravity. That day it closed at $28.
Never one to give up, I put a limit order to sell at $ 30 (it is an order to sell the stock at a specific price; in this case, $30). At least, I would break even!
The next day, it opened at $27 and continued to slide downwards to close at $26.
I did not give up. Patience is a virtue; just hang in there.
A week later (an eternity for a stock player), the stock closed at $20.
I had no choice; I sold.
The very next day, the stock got upgraded by an analyst, and it rallied like there was no tomorrow. It closed at $29 for the week.
My losing streak continued and was periodically interrupted by a few winning trades. It went like this: lose-lose-lose-gain-lose-lose-lose-lose-lose-lose-gain and so on.
Ah! The Internet boom!
At some point, I began watching Internet stocks that seemed to be ruling (even when every other stock price was down).
However popular their Web site was, I did not find their business impressive. In fact, I could not make head nor tail of it.
The companies did not have any revenue or profit! Their employees drank beer on Fridays, played table tennis in the office, dressed casually to work and wore long hair. Cool! But how did all this contribute to the stock's value?
Who am I to judge? The market gurus knew what they were talking about.
According to some, investors buy shares of these companies not because of what they are today, but what they will be two centuries down the road.
Impressive! I am unsure about my life two hours down the road.
Others say the price of their shares is rising because they are new economy stocks. Their stock price cannot be valued on old fashioned parameters like profit and revenue. They have to be valued on the promise they have in store for the future.
Since everybody was buying these stocks, I decided to buy them too. Why should I be left out? So I bought some shares of Amazon.com.
This was at a time when Amazon was losing money and had no prospects of turning in a profit in the foreseeable future.
Bingo! This time, the stock price went up after I bought it!
The stock doubled in a month or so. I sold all the shares and made a packet. Miracles do happen.
In another month, the stock price doubled again. Alas, I had sold all my holdings.
But if I could just have a few more good bets like this one, I would be a millionaire.
With that thought, reality stopped and fantasy took over.
Gautam Dev is a naive stock market investor currently based in the US. Would you like to drop him a line?