How to Avoid Permanent Losses in the Stock Market

A sea of red...that's what market indices looked like yesterday.

From what I hear, the HMPV virus that has caused this scare is like a regular flu. And yet, the markets have caught a cold.

Rs 10 trillion was wiped out in a day. Today, while markets have taken a breather, it will take a lot more to make up for the yesterday's losses.

A sharp correction was also seen in the smallcap space.

It's like the broader markets were looking for an excuse to correct. They found it in the virus.

The signs of a correction have been here for a while.

The marketcap to GDP ratio, inflated valuations, over 1,000 stocks trading at a PE (price to earnings) of 35 or more, SME IPO oversubscriptions, inflows in the smallcap schemes beating that of largecaps, percentage of intraday traders in the age group of 20-30 (up from 17% to 45% in the recent years, Source: RBI Financial Stability Report)...

Excesses must correct. I would not blame the virus.

As Warren Buffett has said:

A pin lies in wait for every bubble. And when the two eventually meet, a new wave of investors learns some very old lessons: First, many in Wall Street will sell investors anything they will buy. Second, speculation is most dangerous when it looks easiest.

I don't know what level the markets will be by the end of the day, tomorrow, or a year from now. No one has consistently successfully timed the markets.

While we do not know, we can prepare.

Volatility is an inherent aspect of equity investing, it cannot be avoided. For successful wealth creation, one has to develop the capacity to suffer downcycles in the near term.

Avoiding debt to buy stocks and prudent allocations can help you do that.

Another aspect of preparation is the time horizon. Even if you do get caught up at the wrong end of the industry or market cycle, having a long-term time horizon could avoid turning volatility into a permanent capital loss as long as the business is resilient.

That was about holding stocks. But the fact is that the real preparation starts from the buying decision itself.

Or even from choosing not to buy if entry price does not offer margin of safety.

You see, while the balance sheet and quality of India Inc's earnings has improved, a lot of the companies are priced to perfection. Buying them at any price is unlikely to work, as the price trajectories of stocks like DMart, Asian Paints, FMCG companies and banking companies suggest.

If you do decide to buy a high PE company based on growth expectations, keep the following table in mind.

Required Earnings Growth Rate for a Set of Entry and Exit PE

Exit PE		Entry PE
		25	30	40	50	75	100
	15	36%	45%	59%	72%	97%	116%
	20	24%	32%	45%	56%	79%	97%
	25	15%	22%	35%	45%	66%	83%
	30	8%	15%	27%	36%	56%	72%
	40	-2%	4%	15%	24%	42%	56%
	50	-9%	-3%	7%	15%	32%	45%
	75	-20%	-15%	-7%	0%	15%	27%
	100	-28%	-23%	-15%	-9%	4%	15%

Source: Equitymaster

It shares a rough visual for the required earnings growth rate for given set of entry and exit PE (price to earnings) multiple, for your investment to make 15% return.

The hurdle rate of 15% is the minimum required rate of return for someone aspiring to ride a growth stock in my view.

The entry rates are what Mr. Market is offering you. At the time of buying, you could choose the exit rate based on the growth phase and the median PE of the industry or sector in which you are investing. Do keep in mind that the median PE for Sensex is 20.

For instance, if you are buying a decent quality business for which the stock trades at 50 times PE and if you expect the PE to normalize to 30 by the end of three years, that means the earnings will have to grow at 36% CAGR for three years. This is a tall ask for most companies.

Anything lower is likely to lead to underwhelming, even negative returns. As such, the buying decision must be rooted in your conviction and visibility on growth.

Lastly, be realistic in your return expectations. As the legendary investor Peter Lynch has said - In the business of investing, if you're good, you're right six times out of ten. You're never going to be right nine times out of ten.

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Warm regards,


Richa Agarwal
Editor and Research Analyst, Hidden Treasure
Equitymaster Research Private Limited (formerly Equitymaster Agora Research Private Limited) (Research Analyst)