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A Simple Sell Strategy That Helped Us Outperform Sensex by 45%!

Apr 1, 2016

In this issue:

» FIIs turn net sellers: An opportunity for small investors?
» Beware of the upcoming IPO boom
» Market roundup
» ...and more!
0:00
Rahul Shah, Co-Head of Research

Ask any experienced investor what he finds more difficult of the two, buying stocks or selling them and 9 times out of 10, it is going to be the latter we believe. Isn't this surprising? Come to think of it, how difficult is it to create rules around buying and selling and then stick to them. Just as one rushes in to buy after most of an investor's conditions are met, can the same not be applied to selling?

Blame it on evolution

Well, the answer perhaps lies in the way we humans have evolved. Early in our history, we faced a lot of dangers in our bid to survive. And this made us extremely risk averse. After all, the pleasure of finding few extra berries out in the wild can easily be given up if one is likely to encounter a huge carnivore.

Unfortunately, this tendency has been hard wired into our brains and makes its presence felt almost everywhere. The difficulty in selling stocks is a manifestation of exactly this tendency we reckon.

The action of selling stocks, especially after it has suffered a significant decline just doesn't come naturally to us. Even though this could be the more rational thing to do from a returns perspective. What more, whenever it's time to clean up the portfolio, we often tend to get rid of winners and hold onto our losers, hoping that over time, our losses will be made good.

Discipline is the key

Thankfully, what has also been hardwired into our brains is the ability to learn from our mistakes. Our impetuous, mercurial mind can be made to teach rationality through proper feedback and continuous training. And most successful investors do develop the ability to approach selling by developing a strict discipline of sticking to the rules of selling.

These rules aren't easy though. Most of them tend to focus on arriving at the intrinsic value of the company and then selling the stock when the price is close to matching the intrinsic value. But the concept of intrinsic value is itself fluidic we reckon and a moving target in case of most companies. In light of this, how does the ordinary investor out there develop simple enough rules of selling?

An easy way out

This is where some of the principles of Benjamin Graham should come into play we believe. He once opined that investors should follow a very simple rule for selling. Once they invest in the stock, they should sell it either when it is up 50% or two years whichever is earlier.

Well, now it can't get any simple than this we believe. And it isn't that this rule has been plucked out of thin air. Although the concept of valuation isn't exactly rooted in perfect science, Graham wanted to make it as objective as possible. And therefore he rested his valuation on not some future earnings but measurable parameters like book value, net current assets and current sustainable earnings of the company.

Besides, he always insisted on a margin of safety of at least one third of the intrinsic value of the company. Now, a 33% discount translates into an upside of 50% and this is exactly what Graham hinted at when he said an investor should look for gains of at least 50% in a stock. And his two-year exit criterion was thrown in to give the stock enough time to recover to its intrinsic value. If it doesn't', it is sort of a value trap and hence, should be removed from the portfolio as per him and replaced by another stock.

Therefore, as we just saw, while the approach does appear simple, it has sound logic behind it and is likely to do a much better job than the other SELL strategies out there.

We are happy to say that it is a pretty similar SELL approach that we've adopted in our new portfolio recommendation service, Microcap Millionaire, based on the principles of legendary Benjamin Graham.

Has this approach helped us achieve our desired results? Indeed, it's helped surpass expectations.

Since its inception in February 2014, the service has yielded 65.5% compared to the Sensex's 20.2%. It's worth noting that the markets have seen both an up and a down cycle in this period. Irrespective of the market cycles, the service's process is outperforming the Sensex by a wide margin - a fabulous 45.3%.

And the future could be better. After a long wait, the cycle has turned once again. Realism has set in. The markets have corrected. And the time is ripe to make adjustments to the portfolio. From 35%, the portfolio is undergoing reallocation to a 75% position in stocks. Here is your opportunity to join in and be among the first to access the new portfolio...not to mention everything else Microcap Millionaires has to offer. Click here for access to Microcap Millionaires...


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2:00 Chart of the Day

FY16 was not a very good year for stocks. Below average monsoons, global economy slowdown, US tightening interest rates, poor earnings... Nothing was in India's favour. No wonder foreign investors lost patience. As per an article in Livemint, FIIs pulled out net US$ 2.2 billion from stocks in the year, the highest outflow since 2007-08- the year of global financial meltdown.

FIIs Turn Net Sellers After Six Years

However, domestic institutional investors (DIIs) are singing a different tune. After being net sellers for six years, they have turned net buyers in FY 16.

Who should you follow?

Well, if we take corporate earnings as the base, one has reasons to be hopeful.

We believe that Sensex can rise 70% over next 2-3 years.

Why are we so convinced?

We pulled the data for Nifty companies that suggests that profit margins were at a ten-year low at the end of FY15. Now profit margins are known to revert to the mean in the long term. Which means that even if they rise to the average of the last ten years, not immediately, but three years out, the upside would be close to 70%. Well, there is an interesting analysis and table that supports this belief. If you are interested in further details, please click here.

In fact, the correction in the markets after a brush with life time high has offered lot of actionable opportunities for retail investors. No wonder Tanushree Banerjee, Managing Editor, Stock Select, recently came up with not one but four buy recommendations.

3:35

While decisions on rate cut do not impact our long term view on stocks, it is a significant factor influencing markets in the short term. While the market is expecting 25 basis points rate cut, Ajit Dayal, in a recent article in The Honest Truth is willing to challenge the consensus. He has in fact tossed a googly - "Could the RBI reduce interest rates by 100 basis points (1%) in the monetary policy meeting to be held on April 5th 2016?" And there is sound thought process behind why he believes so. While this may sound a little extreme, his argument holds water . Some of his reasons to expect so are significant reduction in consumer price inflation, a room for big cut in the real interest rates, benefit to banks due to larger rate cut. Not to mention that this could be the last window of opportunity for the RBI Governor. If you want to know more about why he thinks 1% rate cut is possible, visit here.

However, that is just a part of the picture. In a recent article in Vivek Kaul's diary, Vivek makes a point exactly opposite of what Mr Dayal is making, i.e., RBI should not cut the repo rate by 1%, or at least not all at once. His reasons are equally sound - the strongest being that banks have not passed the cut in deposit rates to the lenders and that the entire thing needs to be viewed from the point of view of savers as well. To know more about Vivek's views on interest rates , please click here.

We will have a clear answer on this on 5th of April 2016. But what are your views on the quantum of interest rate cut? Who do you think is right - Ajit or Vivek? Click here to vote. You can also send us your comments or share your views in the Equitymaster Club.

4:00

While the secondary markets remain choppy, primary markets have a different story to tell. 2015 was the year of revival for IPOs after a gap of four years. And as an article in Firstpost suggests, this year the momentum will be stronger.

Against a backdrop of slowdown in the global primary markets, India ranked amongst the top six countries on IPO activity in the first quarter of calendar year 2016.

According to an EY report, IPOs in India are set to hit a six-year high in 2016 and are estimated to raise more than US$ 5 billion. As more companies come up with IPOs, one can expect a mad rush to subscribe to them.

Our regular readers are well aware of our view on IPOs. Irrespective of the market conditions, investors will be better off only if they invest in the companies having strong moats and at reasonable valuations. One needs to be even more cautious while subscribing to them as they lack the track record unlike the already listed businesses.

4:45

Following a negative trend since the opening of the trading day, the Indian indices continued to remain under pressure in the post noon trading session. Sectoral indices traded on a mixed note with stocks from the telecom, IT and energy sectors bearing the maximum brunt.

The BSE Sensex ended lower by 72 points (down 0.3%) and the NSE Nifty ended lower by 25 points (down 0.3%). The BSE Mid Cap index ended 0.2% higher while the BSE Small Cap index traded up by 0.9%.

4:55 Today's Investing mantra

"There seems to be some perverse human characteristic that likes to make easy things difficult." - Warren Buffett

This edition of The 5 Minute WrapUp is authored by Rahul Shah (Research Analyst) and Richa Agarwal (Research Analyst).

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