Protect Downside, Increase Upside - The 5 Minute WrapUp by Equitymaster
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Protect Downside, Increase Upside

Jul 4, 2016
In this issue:
» Focus on limiting downside could go a long way in enhancing returns in stock markets
» The global economy is not doing that bad!
» Market round up
» ...and more!
00:00
Richa Agarwal, Research analyst

Putting money in stocks - despite the best analysis, data, and knowledge - is a probabilistic game...more so in the short term. You can have the best company...recommended by the best experts...yet you cannot guarantee success. The best you can do is increase the probability of success by taking informed decisions.

One of the most common bases for buying a stock - future projections - is also the most common reason for failed recommendations. There is a limit to perfection here. Demand, supply, regulations, management, costs, substitutes...the list of variables affecting a company's prospects is long. Get any one of these wrong and your chances of being right on the others drop precipitously. The challenge becomes greater as you move from the well-tracked large-cap space to less-covered small caps where information might be limited.

And I'm talking only about the business. Bring in the valuations and the puzzle becomes even more challenging. Apart from the business itself, valuations reflect a multitude of macro factors that you might not have thought about, let alone projected.

So how can you raise your odds of success?

Protect the downside...and the upside will take care of itself.

In the long-term, protecting the downside includes ensuring margin of safety in valuations... Or picking up a cyclical business (that has proved itself resilient across cycles) at the trough of the cycle. If the stock is a consistent dividend payer, your chances of success increase.

The hunt for the next Hidden Treasure recommendation took us to meet the management of one such company. It enjoys a clear monopoly at the state level. Despite the cyclical nature of its industry, the return ratios have been resilient and the balance sheet clean.

Owing to the recent commodity slowdown, the stock is trading at a significant discount to its historical long-term valuations.

That's good news ...because the worst seems to be factored in. We believe that at these levels, the risk reward ratio is favorable from a long term perspective. Not to mention the downside protection with a dividend yield of close to 4%.

Do look out for the next issue of Hidden Treasure to see if the stock makes the cut and becomes a recommendation.

Do you think focusing on protecting the downside is crucial to success in stock markets? Let us know your comments or share your views in the Equitymaster Club.

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02:50 Chart of the Day

Pick up any financial daily... Your chances of coming across a positive news is rare these days.

What has gone wrong, and what could go wrong are all that one gets to read and hear.

Brexit, Rexit, China slowdown, pessimistic economic forecasts are the flavor of the season. But a recent report from the global bankers' bank, the Bank for International Settlements (BIS), comes as a breath of fresh air.

As suggested in an article in Livemint, the report states global economy is not doing that bad at all. The global economy is in fact growing at rates higher than during 2001-02 and close to the levels seen in early nineties. If one adjusts for demographic trends, like working age population, growth per person slightly beats long term trends. One reason for this pessimism could be anchoring bias - comparison with selective high growth period.

If you keep that period out, global GDP growth per working age person was 2.63% higher than the average of the 20 years preceding the crisis.

Global Economic Growth: It's Not All Gloom and Doom


The report then goes on to say that the potential growth could be lower due to decline in the working age population.

But let's focus on Indian economy here. We believe India, being the youngest nation, is much better placed than the rest of the world when it comes to demographics. As far as opportunity in stock markets is concerned, we further believe that this could be an inflection point. If you focus on corporate profits as a percentage of GDP, and if you believe in the theory of mean reversion of profit margins, there is a positive news.

The aggregate data we have pulled for Nifty companies suggests that profit margins were at a ten-year low at the end of FY15. Even if they were to rise to the average of the last ten years, not immediately, but three years out, we believe that the upside in corporate earnings would be close to 70%.

Put differently, markets could go up by 70% over the next three years if profit margins revert to the mean and the valuation multiples stay at current levels. And we're not even considering the gains from potential interest rate cuts.

Now we are not guaranteeing these returns. But when everyone is busy painting a gloom doom scenario, we believe we have a strong reason to be optimistic.

04:30

The Indian Indices continue to remain firm in the post-noon trading session amid strong international markets. Sectoral indices witnessed healthy buying interest with stocks from the realty and PSU leading the gains.

The BSE Sensex is trading higher by 186 points (up 0.7%) and the NSE Nifty is trading up by 52 points (up 0.6%). The BSE Mid Cap index is trading higher by 0.7% while the BSE Small Cap index is trading higher by 1%.

04:50 Today's Investing Mantra

"You only have to do a very few things right in your life so long as you don't do too many things wrong."- Warren Buffett

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

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3 Responses to "Protect Downside, Increase Upside"

P d dabu

Jul 6, 2016

Protecting downside is of course vital. At the same time focusing on growth is equally vital. It is important to pick up growth shares at a sensible price. Some of my successful investments include Ajanta Pharma, Yes bank, Aventi feeds Axis bank etc It is vital to make investments with a long term horizon. I prefer shares which have potential to grow at twent to thirty percent per annum over long term.

Like 

SJ

Jul 4, 2016

I don't understand how come the information on small caps is limited? Are you not looking for listed stocks? And if they are listed, public information is always there. You also have one on one talks directly with the management which you endorse as the best way of evaluating small cap stocks.You are having insider information, so that way the results should be better than any other recommendation service.

And how can you separate business from valuations? Valuations are a result of the business variables you talked about and not a fancy term to be used in conjunction with business.

In short, all I can make out is, if your recommended stocks go up, "We recommended it, we did back breaking research".
If they go down, "It's all probability. It's the forecast."

I can only smile at the way you handle things.

Like 

Abhay Dixit

Jul 4, 2016

India's demographic dividend has been discussed frequently and in depth. Is this against developed - semi developed countries or world average? Secondly, what is the demographic profile of say Nigeria, Somalia, Syria, Iraq, Iran etc? If they have profile similar to India, how will it affect world economy and sentiments?

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