Why Studying Businesses Is of Limited Use in the Stock Market

The history of stock markets is full of investment wizards who picked wonderful stocks by studying their underlying businesses: what a company makes, what its market is, who its competitors are, where the industry is headed, how solid its financial strength is, and so on. True, such an approach can generate rewards, but what about the link between a real business and its stock? When you buy a company's stock, you are buying a piece in its business, but does the stock really mimic the business?

The unfortunate truth remains that a stock may not always follow its underlying business. Though the correlation between a business's performance and its stock performance is positive, there are a plethora of other factors that impact the stock. Since you buy the stock and not the real business itself, you become vulnerable to the eccentricities of the stock market.

Take for instance the market sentiment. Even if you have picked a good stock, it may not go anywhere (or rather go down) because of the sentiment prevailing in the market, even when the underlying business is doing just fine. Consider this fact: A stock starts racing in sheer optimism even before the underlying business has turned around. Further, talks of a buyback, a stake sale, a merger, etc., all drive stock prices, when the underlying business hasn't shown any improvement. A dilution in equity hits the stock, while the business remains unharmed.

You may want to take comfort in the stock-market adage that over the long term, a stock traces the course of its underlying business. And you are right. But over this “long” term many things will have changed for the business itself—for the worse. So, you can't really rely on the long-term theory. What's the message then? In the stock market, while it pays to keep an eye on the underlying business, that's not the only way to make money. What will work is a well-crafted strategy based on what moves stock prices. The strategy, what I call a model, will clearly tell you what and when to buy, how to track progress, and when to sell and take your profits home. 

Don't Disregard Your Profits

The one aspect of stock investing which surprises me the most is that money loses its significance in the stock market. What I mean by this is that investors behave differently toward money in the stock market than they do in their daily lives. In daily life, many of us have a cautious approach toward money (which is good); we tend to think twice before spending it. And surely we don't want to lose it.

In the stock market, investors frequently show a complete disregard to profits. The other day someone told me that she wasn't selling a stock that was showing a huge gain just because she didn't need the money. Another “fundamental” analyst said he preferred to keep stocks for the long term, even if it meant losing on the profits the market was offering him. Further, one bright fellow stayed invested because he didn't know any other stock to invest in. I bet the same people would behave differently outside the stock market.

I am not saying that just because your stock shows some profit, you should sell out. Selling a stock should follow a strategy, but it must be sold at some point because you make no money unless you sell it. Many times stocks become expensive in terms of valuations and it is prudent to sell them rather than blindly follow “long-term” investing principles. It's indeed wise to take money out of a stock and wait on the sidelines rather than say that you don't need the money or you don't know any other stock to invest in. You can always act later, but your stock-market profits may not always be there. The bear can quickly gobble them, while you preen yourself for being faithful to the investing principles given by your investment icon.

The profit that the market offers is real money. If you spend it, it will work in the same manner as your hard-earned money does. There's no difference. The need is to give your profits the top priority and do anything to protect them, even if it entails breaking any cherished principles of investment science. 

No Stock Is a Dud

A common complaint in the stock market is that stocks move up after you have sold them. During the time you hold onto them, they simply refuse to budge or rather head for the South Pole. Meanwhile, you find that many other stocks are racing up. This causes you to shift to them, and lo, you realize that they have stopped moving as well!

Then there are those you switch to so-called “better” companies from the “lousy” ones in order to benefit from the secular rise the better companies see. After some time, they discover that the lousy ones have raced ahead of the better ones.

One rule that comes handy in such situations is “No stock is a dud.” If a stock clears your criteria, you must hold onto it without getting swayed by the movement in the stock price. Don't sell it to buy something else—no matter how good the new opportunity appears to be. If a company does well, eventually it will be rewarded. Don't worry about the momentum either. Stocks can race really fast and make up for a lackluster performance in a few days.    

Even those stocks that every analyst and expert stays miles away from can show tremendous appreciation. In the current scenario, commodity stocks can well throw a surprise. Timing also matters. A stock that you bought at Rs 100 when comes down to Rs 25 is a nightmare. But if you buy it at Rs 25 and it goes up to Rs 50, it becomes a sweet dream. Again, the point remains that you should never underestimate the power of a common stock.

What to Do about Commodity Stocks

Commodity stocks around the world have taken a serious beating. A slowdown in China, a major consumer of commodities, is blamed to be the underlying cause. Added to this is the soaring crude-oil supplies, which have sent the oil prices at multi-year lows. Experts and analysts are asking you to stay away from commodity stocks till the “cycle” reverses.

Commodity companies, companies that manufacture metals and oil and gas, are termed “cyclicals”— maybe because their prices move up and down in a cyclical fashion. So experts say that the right way to invest in such companies is to ride them during an uptrend and dismount from them (or stay away from them) during a downtrend.    

I don't know anything about cycles. Nor do I recommend following them. However, what I do know is that many commodity stocks are currently trading at throwaway prices. Don't go by valuations as they could be misleading. Since earnings have been down for many commodity companies, they will be trading at either high price-to-earnings (P/Es) valuations or no P/Es (which means they are currently in loss).

It won't be a bad idea to take small exposures to the leaders of the sector. By “leaders” I mean the biggest companies in the sector. Don't buy for the full amount; buy in stages. As and when a turnaround happens, you will see their stock prices racing up. Don't wait for the bottom. No one knows when the bottom will arrive. The financial community may be looking at the cycle, but what I can tell you for sure is even when the cycle changes, it will still be looking at it for “clearer” signals. The stock market can move really fast and that too before any recovery is in sight. Your best bet is to pick the beaten stocks when they are writhing in pain, not when everyone else also gets into the buying mode.     

The Bear Is on the Prowl. What Should You Do?

Stock markets have again entered the bear territory. The reasons cited are many, ranging from the falling crude to the slowing China, to the US Fed increasing rates. Analysts and experts are suggesting that you should delay buying stocks as they can fall even more from here. They are asking you to stay away from certain “risky” companies and take shelter in “defensives.” Some of them have shunned the job of advising on shares and are asking you to buy mutual funds, thus passing the buck to fund managers. The financial community is speculating whether 2008 is back. 

I don't know whether 2008 is back. What I know is the way specialists are reacting and confusing the layman isn't new. In Stock Market Investing for Employees, I have dedicated a full chapter to stock-market crises and how to handle them. This chapter was important as crises are inseparable from the stock market. They will happen whether you like it or not. And when they happen, you need to do just nothing. You just need to stick to your stock strategy. Should you delay buying? No. If you have money, you should be buying no matter where the market is headed. If you wait for the ultimate market bottom, you may be waiting forever. The market may rebound and you may be left waiting.

The views of the financial community are pointless because they are not absolute. They are a function of the way the market is moving. If the market goes up, the financial community will support the rise with positive arguments. If the market falls, it will find enough doom-and-gloom reasons to worry about. The result: The average stock investor is clueless as always. 

As a stock investor, you would do well by focusing on the company rather than on the market itself. If the company deserves buying, you should be buying it. Don't wait for the elusive “better” deal. History does repeat itself in that market downturns do happen. The best response to them is to do whatever you would have done if they weren't there.