How to avoid loss and earn consistently in Stock Market

by Presenjit Paul (Book Summary)

Chapter 1

 Basically, F&O is meant for institutional investors and hedge fund.

 Big companies or high net worth individuals hedge their positions using F&O. Future
trading is a great option for hedging.

 Intraday, short-term trading and F&O — all those are nothing but another form of
gambling.

 Brokers, stock exchange and government — only they can earn consistently from
trading.

 Short sell refers to selling first and then buying at a lower rate to gain on the same
day.

Chapter 2

Before purchasing cars, expensive mobiles or television, we undergo rigorous research.

While purchasing a stock do you conduct such rigorous research?

Chapter 3 — First step of picking winning stocks

1. Big profit doesn’t ensure real cash flow.

2. Profitable growth might be fuelled by external debt. In short profit growth doesn’t
ensure the quality of any business.

3. More or less many large enterprises alter profit numbers as they know amateur
investors will first focus on profit growth.
4. We should put the least priority on profit and sales growth numbers and more on
Return on Equity (ROE)

ROE (Return on Equity)

Increasing ROE over the last 5–10 years with improved operating margin and cash flow
is a signal of sustaining economic moat.

Debt

A clear understanding of debt to equity ratio will serve your purpose.

Debt to equity ratio = Total Liabilities / Equity

 Before investing in any stock, have a look at its debt to equity ratio.

 Check the ratio for at least three years.

 Greater than 1 (and increasing continuously) carries RED signal.

 (not relevant to banking and NBFC companies)

 If you find the stock having ROE of less than 12% (and decreasing) and a debt-to-
equity ratio of more than 1 (and increasing), then discard it.

 In 90% of cases, debt to equity ratio is sufficient enough to analyze the debt burden
of any company.

 Higher the ROE, better the investment option.

Chapter 4 How to evaluate Management

 Promoters or institutional investors purchase stocks via block deal or bulk deal from
the open market.

 Companies or individuals other than the promotors holding more than 1% of the total
share capital need to disclose their details.
 Promoters increasing stake via open market purchase is a positive signal.

 If the promoters raise their stake, it is comprehended that they have high confidence
in the business.

 Initial entry of big institutional investor is the first sign of good times.

 > Don’t take the decision based on the numbers. Dig deeper for the real picture
behind numbers.

FII — Foreign Institutional Investors (Smart people investing their smart money)

 Higher FIIs stake is interpreted as positive, and a lower FII stake means low
confidence of FIIs in the company.

 If FIIs sell their shares then it doesn’t mean that the company is fundamentally weak.

DII — Increased investment from DII is positive for any stock.

 You need to be careful if you find a stock where individual shareholding is increasing
while promotors/institutional shareholding is decreasing.

 Institutional investors are the most knowledgable (after promoters).

Pledging of Shares

Pledging of shares is the last option available for promoters to raise fund. It means that
no one else is ready to provide loan because either the company is in bad business
whose future prospect is not bright or the company has high debt and might be under
financial constraints, hence pledging remains the only option left.

If any company is already laden with debt then they don’t get a further loan without
collateral.

 If any company has a pledging percentage up to 2–8%, then it can be ignored.

 Always avoid companies where promoters are increasing their pledged shares.

 Avoid companies where promoters pledge more than 30% of the holdings and the
pledged percentage is increasing.
Dividend history.

 Companies those are consistently paying dividends over the last 10–20 years must
have a solid business.

ROE

 High and consistent ROE is an indication that the management is utilizing the capital
effectively.

Chapter 5 Valuation — It matters much

 If you purchase a quality product at an excessively high rate, do you find another
buyer to take it even at a higher rate? No!

 Identifying great business is the first step of successful investing.

Common Valuation Tools

1. Price to Earnings Ratio (PE ratio)

PE ratio = Current market rate / Earnings per share (EPS)

Best Usage of PE ratio

Compare with its historical average: If you find that a fundamentally strong stock is
trading much below its historical average then it might be a worthy investment.

Compare with its Industry Peers: Normally, a stock that trades at a PE below than
their industry peers is valuation wise more attractive. However don’t rely much on this
parameter.

 Exception: A large-cap Pharma stock that is trading at 30 prices to earnings ratio

may not be expensive whereas a small cap Pharma stock quoting at 20 PE might be
considered as expensive.
 High growth companies always demand a higher PE.

 Higher capital requirements translate low valuation.

Drawbacks of PE ratio:

1. Problem is that a company can easily distort their reported profit.

2. One-time income can easily inflate earning/profit and this lowers the PE ratio.
Similarly, the one-time expense can negatively affect the reported profit and this
translates into higher PE.

3. Cyclical firms: are those companies whose profit increases heavily during a
particular period, then decreases after some time.
Companies having fluctuating earnings are known as cyclical firms.

 Your purchase decision should not be based only on PE ratio.

2. Price to Sales Ratio (PS Ratio)

PS Ratio = Current price of stock / Sales per share

Advantages:

1. Total revenue (sales) is not frequently manipulated. Unlike PE ratio, the PS ratio is
not manipulated too often.

Disadvantages:

1. A company might report loss with increasing sales.

2. So while judging PS ratio, check the industry in which the company is operating.

3. Price to Book Ratio (PB Ratio)

 Book value per share indicates the amount that each shareholder should receive if
the company liquidates completely.
 Best usage: Banking and NBFC stocks, Capital intensive businesses.

Drawbacks: PB Ratio has almost no significance for software companies.

 Combining PB Ratio with ROE

 The one with higher ROE will have higher PB Ratio.

 Companies whose ROE and PB ratio don’t go hand in hand should be analyzed with
extra care.

 Lower the ratio, better the investment opportunity.

 Doesn’t have significance in the service sector or software firms.

 If a business can grow 30% annually then it should command the premium.

The easiest way to judge Valuation

(Compare with its historical average and the second one is to compare PE with average
growth rate)

 It doesn’t require in-depth understanding or complex formula to earn big in the stock
market.

 Comparing PE with Average Growth Rate

(it is the EPS that matters the most)

PEG ratio = PE ratio / Earnings Growth Rate (EPS)

1. PEG ratio (< 0.5) = undervalued. Great investment bet.

2. PEG ratio (0.5–1.0) = either undervalued or reasonably valued. Good investment

bet.

3. PEG ratio (1–2) = Reasonably valued. Check other parameters before investing.

4. PEG ratio (>2) Overvalued. Avoid.

PEG ratio combined with historical data will provide better insight on the valuation.
 First of all, find out the average PE ratio for the past five years.

1. Average PE (8–12)(20–40% discount than average) — which is less than the last
three years average growth rate, the range of 8–12 is considered undervalued.
Attractive entry opportunity.

2. Average PE (12–18)(near average) — Stock is reasonably valued. Good entry

opportunity.

3. Average PE (20–30+) — Overvalued.

If at the same time, PE ratio is greater than twice of the last three year’s average
profit growth rate then avoid the stock.

4. Average PE (5–8) (or below 5) — Attention!

Summary of the above example

1. Undervalued companies

current PE and PB ratio < last 5 years average

&
current PE is less than PEG (< 0.5) / 2

2. Reasonably Valued

current PE & PB ratio ~ last 5 years average

&
current PE is <= PEG (<=1)

3. Overvalued companies
the current PE is double of PEG (PEG >2)
&
current PE and PB are highest among last five years average.

Chapter 6 When to Buy and When to Sell

 If fundamental remains intact (and improving), one should not hesitate to add more
even after 100% or 200% price appreciation.

 If you can figure out an extraordinary business with great future potential then it is
never too late to buy.
 Timing should never be the cause of concern for high-quality stocks.

 Even during the market correction, ―great‖ or high-quality stocks don’t fall much.

 Stocks (mainly mid caps and small caps) hitting fresh lifetime high during choppy or
bear market require special attention. Those can become a great investment bet.

 Selling is difficult than purchasing a stock.

 Selling decision should be based on pre-defined criteria, not on the stock price
movement.

 Don’t hesitate in shifting to the better opportunities even if the stock has given a
multifold return in the past.

 You should exit at the first sign of trouble. (After investing in any stocks, later if you
realize that the initial buying decision was faulty then you should exit from the stock
at the earliest.)

 One should exit from the stock if the valuation becomes too expensive.

 A stock with PE of 40 may not be expensive, while a stock with PE of 10 can be

overvalued.

 Stay away from stocks those are recommended by everyone, and the stock price is
moving at an abnormal rate.

 If you purchase a high growth stock and later the growth outlook changes or some
external factor makes it difficult to grow, then you should sell immediately.

 Exit from a stock when your original purchase reason is no longer valid.

 Purchasing a high growth stock and continue holding it because cheap valuation is
one of the biggest mistakes that investors commit.

 Investors should immediately exit once a ―high growth‖ stock loses steam of growth
due to fundamental changes. Holding such stocks can only maximize loss.

 Investors should consider a change in the leadership position as one of the

important events and should make decisions based on it.

 Poor management can turn a great business into an ordinary one.

 Develop a predefined Exit strategy while investing in stocks.

 If the reason of purchase is clear then you won’t find any difficulty in exiting.
Deadly mistakes to be avoided

1. Investing in previous bull market stocks.

2. It’s hard to repeat the same trend.

3. Holding loses too long.

4. Maximum retail investors either hold the stock hoping for recovery or they add more
to average out their buying price. Both are deadly mistakes.

5. On the contrary note, an investor should not sell a stock just because the stock price
declined by 10–30%. If fundamentals remain intact, then there is nothing to worry.

6. Irrespective of your notional loss, you should sell losers and fill the gap with winners.

7. Investors prefer to hold losers for a long while booking early profit from winners.

8. Even after knowing something is wrong, some investors wait for a bounce back.

9. Losing money is painful but widening the loss is disastrous.

10. Pay maximum attention to losers.

11. Price correction due to fundamental deterioration is permanent in nature.

Don’t invest like a trader and don’t trade like an investor.

Chapter 7 Do’s and Don’ts to Avoid Loss in the stock market

 Over the short run the quality stock can move either in the upward or downward
direction but over the long term, it can move only in upward direction.

 You need to act like a business owner. Keep a close watch on the business industry
related news, quarterly result, and management interviews.

 If you can’t hold a stock for 10 years then don’t buy the stock for the next 10
minutes.

 Don’t take your investment decision based on short0term price movement.

 Never ever calculate profit/loss until you are selling stock.

 Perhaps, the stock market is the only place in the world where buyers shop less
during the discount session and prefer buying more at higher rates!

 As an investor, your only task is to select great companies and invest at the right
time. Following the prediction of the overall market movement is a wastage of time.

 Have a closer look at the business model, the financial numbers, and the future
outlook of the company.

 Investment opportunity in the prolonged bear marker doesn’t come frequently. Once
or twice in 10 years, such golden opportunities arrive. Most of the companies during
those periods are available at throwaway valuations.

 A market correction of more than 50% compared to recent peak brings such golden
opportunities.

Chapter 8 How to Construct your Portfolio

 Portfolio construction may seem like an easy task, but the truth is that proper
portfolio allocation is one of the most complex parts of successful investing.

 While diversification can help you in creating wealth systematically. Over-

diversification can erode your hard-earned money.

 The properly diversified portfolio must have a limited number of stocks but diversified
across sectors.

 You should follow (at least) quarterly results, all business related news, and
competitor’s status with management interview or interaction with any business
analysts and this will require at least 30 minutes per week in a single stock.

 Always remember, the number of high-quality stocks is always much lesser than the
poor(or average) quality stocks.

Misconceptions

1. Large-cap stocks always offer safety and a steady flow of return.

Fact: Banking sector responds first during any economic turnaround.
Fact: Small-cap investing is much more rewarding than large cap.
2. Stocks that have already doubled in recent past have less potential to move up
further.
Fact: If a company can perform well during adverse macroeconomic condition, then
it is expected to perform even better once the external business environment turns
favorable.

3. Stocks that fall sharply must have to move up sharply

Fact: Sharp fall in stock price is the first sign of trouble.
Fact: Price correction of more than 60% indicated red signal.

History says you can’t suffer loss if you invest in any stock market crash or any point of
time while 90% of analysts are in bearish view.

 During a major stock market crash (index is down by 50%+), it doesn’t matter how
well experienced or well qualified you are it is almost impossible to manage 20–30%
return.

 Gold and equity mostly move in the opposite direction.

 You need to sell off your entire portfolio much before such major stock market crash
and seat in cash.

 During the major stock market crash, investors need to maintain huge cash in hand
for 6–10 months or more.

 Stay away from high debt companies at any costs

 Increasing debt to equity ratio is an alarming situation.

 Even during favorable market situations, high debt companies fail to perform.

 Try to avoid companies where the promoter themselves are not holding a majority
stake.

 As a rule of thumb, avoid companies having a market capitalization of fewer than

300 crores with promoters holding stake less than 20%.

 It’s a serious matter of concern if the combined shareholdings of promoters and

institutional investors remain less than 20%.

 Being a small company, you won’t find a proper research report or reliable
information in the public domain.
High promoter pledging (and increasing)

It means that no one else is ready to provide load because either the company is in a
bad business whose future prospect is not bright or the company has high debt and
might be under financial constraint.

 During a bull market, pledging is not a problem because promoters can rely on the
optimistic value of their stake.

 Always avoid companies where promoters are increasing their share pledging. It’s
better to avoid such stocks completely.

 Stocks touching new low — More than 50% decline from the recent peak of any
stock indicates a red signal.

 Many times costly acquisitions with huge external debt and inability to turn around
the acquired company causes wealth destruction.

 Be aware of stocks which are going for costly acquisitions and opting for huge
external debt.

Chapter 9 Is it required to follow an equity advisor

 A mutual fund is not advisable for you as direct equity investment with proper
guidance will fetch better return across any market situation.

 Cross check the basics like ROE, debt level, growth numbers, shareholding pattern,
etc.

 With proper guidance, direct equity is far more beneficial and rewarding than a
mutual fund.

 If you are unable to figure out reliable equity advisory, then stay away with mutual
funds.

 As an individual investor, I can invest in any micro-cap or small-cap stocks but

mutual funds can’t.
 If you want to earn a great return then you need to buy when everyone is selling and
sell when everyone else is buying.

 Moreover, mutual funds can’t invest in quality micro caps and small-cap stocks
where the upside potential is huge.

1. Avoid entities that are promising extraordinary return and asking for huge fees.

2. Avoid entities that are not offering any logic behind stock recommendations.

3. Be aware of statements like ―99% accurate jackpot calls‖ or like ―100% accuracy
level‖.

4. Be aware of entities that are calling on a regular interval to sell stock tips.

Chapter 10 Quick formula for picking Winning Stocks

First step — (make sure to find out stocks those are matching all the following criteria)

1. Last three years average Return on Equity (ROE) and Return on Capital Employed
(ROCE) both are greater than 20%.

2. Debt to Equity ratio is less than 1. (Or heavily reducing for the last few years).

3. Promoters pledge less than 10% of their total shareholdings, or there is a clear
indication that it will fall below 10% soon. (Better if it is nil).

4. Last three years CAGR sales growth rate is more than 10%.

5. Last three years CAGR profit growth rate is more than 12%.

Second Step -

1. Valuation (Same as discussed earlier [Ch.5])

2. Stock price movement: In spite of having all the positive numbers if you find that the
stock is generating a negative return over the last three years then avoid it.

3. If last three years annualized return is less than 10% and last one year’s return is
negative then mark as AVOID.
4. If last three years annualized return and last one year’s return both are negative then
AVOID.

5. Only consider stocks for investment having last three year’s annualized return is
more than 10% with last one year’s return is positive.

 In the long run, or over a period of 3 years, the market can’t misjudge any particular
stock.

 Over the long run, the stock price is nothing but the reflection of the underlying
business.
(This is why you find a company that is growing at more than 20% over the last few
years with zero debt and ROE of 25% but trading at 50% discount compared to its
peers then you need to dig deeper.

 Don’t consider price movement for the short term.

Important points to remember:

1. The above formula is not applicable for banking NBFC stocks because parameter
like debt to equity ratio is irrelevant for them. For analyzing banking and NBFC
stocks parameters like NPA, NIM, etc will come into consideration.

2. During bear market, more companies (stocks) will pass the test. However, during a
bull market, only a few companies will pass the test.

3. The quick formula will work for most of the time. However, it doesn’t mean that those
stocks which are not passing the test will generate a negative return.

Two minutes Check-Up to Judge Any Company

1. Average last three years ROE is less than 10%.

2. Debt to equity ratio is more than 1 for the last three years and no sign of falling
down.

3. Promoters pledge more than 30% of their total shareholdings and no sign of falling it
down (rather increasing).
Based on the above three parameters, your decision will be as follows:

1. If all those three parameters hold true for a particular company then avoid the stock
at any cost. If you already hold any such stocks then exit from it immediately.

2. If any two of those parameters hold true, then avoid that stock.

3. If any one of those three parameters holds true then the stock requires in-depth
attention. If you want to take a conservative approach then avoid the stock as there
are 5000+ stocks in the market.

NOTE: It is not valid for banking and NBFC stocks.