You have bought stocks just because your aunt, your friend and your milkman had bought stocks. Initially you were euphoric, dreaming about big bucks that the stocks would fetch. But soon your joy turned to sorrow, when you saw the value of your stocks started fluctuating wildly. If you are in this situation, then read on for some tips to safeguard yourself against stock market losses.
• Study the fundamentals of the company: Many investors are swayed by the stock prices, but ignore the fundamentals of the company. This means if the price you are paying for the stock does not justify its value, then you are sure to lose money in the long run. This is evident from the stock prices of companies like Himachal Futuristics that today are available at Rs 14 from the Rs. 33.40 during 2003. So the investors in this stock have lost heavily.
• Think long-term: Stocks are not a gamble but an asset class that will make you rich over long-term. Many people don’t understand this and so end up losing money.
• Expect volatility: Over the short-term, stocks are expected to be volatile. Markets are irrational and they react to slightest bit of good of bad news. This introduces volatility in the markets.
• Avoid greed and fear: The legendary investor Warren Buffett says, “”The fact that people will be full of greed, fear or folly is predictable. The sequence is not predictable.” It is a fact that greed and fear have been responsible for people losing money in stocks.
• Don’t churn the portfolio: Government and brokers do love it when you keep on churning your portfolio. They are the ones who end up becoming rich, as you have to pay brokerage and taxes each time you buy and sell stocks. So avoid the temptation of churning your portfolio.
• Diversify your portfolio: This is last but the most essential tip. Diversification will help you meet your financial needs during the time of crisis. It will also ensure you don’t have to sell your stocks for a loss, just to meet your crisis.
Till now we have seen the important valuation ratios that help you decide whether the stock is worth buying or not. Now let us take a look at the operational efficiency of the company. It highlights how effectively the company is able to run its business. The first ratio that we look at the Current Ratio.
This ratio tells you the amount of liquidity available with the company in order to fulfill its business commitments. It is obtained by dividing the current assets (those assets that can be quickly sold off to get cash) by its current liabilities (immediate debts).
Current ratio=Current assets ÷ Current liabilities
Usually, if the current ratio of 2:1 for a stock is regarded as suitable, since it gives a sufficient safety margin to the company in order to fulfill its operating cash requirements. If the current ratio is low, the company may have to raise money from other sources like borrowing from lenders both individuals and financial institutions or distribute new equity for fulfilling their commitments.
But if the ratio is very high, it implies the company is not using its assets optimally. It is just sitting on its assets. This can significantly affect the company’s long-term returns. Compare the current ratio of the company you are interested in with that of its rivals.
What makes investors like Warren Buffet and Benjamin Graham successful in the stock market? Why is it that some people make money in stocks while others don’t? The answer – they follow the simple mantra of investing: buy low, sell high.
Though this mantra is popular amongst stock market investors, the question is how do you define low. What is low? How do you know that the stock price is at the lowest?
To understand that, check if the market price of the stock is lesser than its value. This is because market price is the price the market is ready to pay for the company’s share. The value is the price of the company’s business. Unlike the price of the stock which fluctuates from moment to moment, the value of the company’s business is stable, as the nature of the company’s business doesn’t change very quickly.
When we say buy low, we mean buy the stock when its price is lower than the value. This lets you get quality businesses at bargain prices.
E.g. if the value of the company’s business is Rs 200 and its price is Rs 130, the stock is said to be available cheaply.
It is called as “margin of safety” principle, advocated by Warren Buffet and Benjamin Graham.
In the next part, we’ll see how to calculate the value of the company.