My Simple 4-Step Framework to Avoid Losses in the Stock Market - The 5 Minute WrapUp by Equitymaster
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My Simple 4-Step Framework to Avoid Losses in the Stock Market

Aug 23, 2018

Girish Shetty, Research analyst, The 5 Minute Wrapup

I dread flight landings. Just the thought of a plane landing almost always gives me goose bumps. Somehow, I imagine the worst-case scenario.

According to Boeing's annual data on flight accidents, 48% of the accidents occur during the final approach or landing. This is followed by take-offs which is responsible for 13% of total accidents. So, there you go, the stats back up my dread.

Now I'm aware that flying is the safest mode of travel but somehow, I can't escape this feeling.

Some of you might feel this way too.

The two most critical points of air travel are take-off and landing. Now let's look at the investing world. Here too there are two things that matter the most: buying and selling.

If you buy right, you will have a smooth ride. Similarly, if you sell at the right time, you can save yourself from a crash landing.

But how do you buy and sell right? Is there a perfect time to buy and sell? Can you time both perfectly?

In my view, the answer is mostly no.

Then what can you do?

You can do the next best thing. Develop a framework to give you a broad idea on when to buy and sell.

This is what I recommend...

Stock Earnings Stock Price What To Do
Improving Down Buy
Improving Up Hold
Deteriorating Down Sell *
Deteriorating Up Sell / Don't Buy
* Except for cyclical businesses

As the initial step, this will be a good guide to follow.

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Now let's get into the nitty-gritties...

  • Improving Earnings and Falling Stock Prices:
  • This is the best time to buy. To do this, you need to have patience and a contrarian approach to investing. Remember, the majority will be fearful in these times. You will mostly find stocks in this phase during bear markets.

    Shortlist companies with strong fundamentals. If a company is improving its earnings when others are struggling, it might be the best time to get in. Think of IT stocks a year back when everyone had written its obituary and where they are now.

  • Improving Earnings and Rising Stock Prices:
  • This mostly happens when a bull market has just ended. If you have bought good stocks at the right price, it is time to hold on. This is the time when you will be rewarded for your picks when everyone is fearful.

    If earnings are constantly improving and fundamentals are intact then relax and enjoy the ride. There might be some minor turbulence on the way but rest assured, you are in a safe flight. Think Page Industries, Eicher Motors, Britannia, etc. Think of the massive wealth creation by these stocks for a decade.

  • Deteriorating Earnings and Falling Stock Prices:
  • It might be the right time to sell. These stocks had a good run. But their earnings are deteriorating. That's not a good sign.

    Think of the pharma sector three years back. Uncertainty regarding price erosion in developed markets as well as hostile US FDA visits, have changed a once defensive sector into a risky sector.

    Take note that this does not apply to cyclical businesses. That's a separate topic for another day. But if you want to know more about cyclicals, read this excellent piece by Sarvajeet.

  • Deteriorating Earnings and Rising Stock Prices:
  • This is the worst flight to get into. You're almost assured of a crash landing. Sell!

    Here, you'll find cases like Vakrangee, Gitanjali Gems, Shilpi Cable, Manpasand Beverages, and more. Despite poor fundamentals, these stocks will have a massive run up. Typically, this happens when a bull market is close to its peak.

    Avoid getting into such stocks in the first place. But if you already have, it's best to get out as soon as possible.

Selecting good stocks involves looking at them from multiple viewpoints. But having a basic framework will help you avoid fatal mistakes. Once you've done that, you're likely to safely reach your investing destination.

If you're looking for the best way to start this journey, I highly recommend this book, Equitymaster's Secrets: 2018 Limited Edition.

There are only 1,000 copies available. You can get your copy here.

Chart of the Day

What cycle of the markets are we in? Are we at the peak or is the party set to continue? The Sensex recently touched its all-time high of 38,400.

I believe, when earnings improve and stock prices also go up, it's time to hold on and enjoy the ride.

But the current situation is different. While the Sensex is reaching new highs, the mid cap index and the small cap index have corrected sharply this year.

Also, the recent earnings of non-financial companies presents a promising picture. But is it a true picture of what lies ahead?

Is the Growth Story Back for Listed Indian Companies?

For listed non-financial entities, net sales for the June quarter grew by 18.5% over the same quarter last year. Net profits were up by 33.6%.

This is good but remember, it was mainly due to the low base of last year. You see, at this time last year, a lot of companies were severely impacted by the twin effects of demonetisation and the GST implementation.

So, will this growth sustain?

Recent scenarios developing in global markets calls for caution. Rising interest rates and crude oil prices, along with trade wars can be a road-block for emerging markets like India.

With markets at peak levels, I believe a correction cannot be ruled out.

The time to short-list good quality stocks might just be around the corner.

Regards,

Girish Shetty
Girish Shetty
Research Analyst, ValuePro

PS: Dear reader, we would like to say a big thank you to all those who have claimed their copies of Equitymaster's Secrets: 2018 Limited Edition. We published only 1,000 copies and stocks are running out fast! This book is virtually free and we want you to get your hands on a copy before stocks run out. Just click here to get your copy now.

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SURESH KALWANI

Aug 25, 2018

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