Possible ways of losing money in Stock Markets – 3

Hello Buddies! I have been explaining how do new investors lose their money in stock markets in the last few articles. This is a continuation of that series. 

Overview:

I am surprised at how some so-called professional investors and financial advisors endorse to invest in stocks that trade at PE ratios of 50 or more. I have discussed fundamentals for analyzing stocks. Let us understand what is a High Premium stock. The best ratio for analyzing the price of a stock or index whether it is trading high or low premium is its Price to Earnings or PE ratio. It could be correlated with interest rates determined by central banks of the nations on fixed or certificates of deposits or government bonds.

For comparison, the interest rate on the 10-year US government bond is 0.71% as of 14th August 2020. The PE ratio of the Dow Index is 28.26, which means the earnings yield of 3.54%. It makes reasonable sense to invest in Dow. According to analysts, the Dow is already trading at a high premium in the current scenario.

Now, the interest rate on the 10-year India Government bond is 5.97% as of 14th August 2020. The PE ratio of Sensex is 26.47, which equals an earnings yield of 3.78%. So investing in Sensex is less profitable than investing in Government bonds.

I will make it simple for you. As of the current records, putting your money in DOW ETF or index fund is better compared to US Government Bond. But, it is totally opposite in India; buying India Government Bond is much better than buying Sensex ETF or Index fund.

Comparing investing in Government Bonds and Index Funds is choosing between Debt and Equity. Usually, Equity investments provide more returns than Debt instruments. But, there’s a risk associated with high returns.

Purchasing High Premium Stocks:

A stock or index price has two compositions. One is based on earnings or business; it is called intrinsic value. The other is speculative price. A true investor should research before investing in any stock. The DCF or Discounted Cash Flow Analysis is the best indicator for finding the true intrinsic value of the stock.

Let us review the best IT stock in India, TCS. Currently, a TCS share is trading at ₹2242/- with a PE ratio of 26.95. The DCF value of a single share is around ₹2480/-. I used the calculator from this webpage. Take discount rate as 6%. You can find all the information required to fill in the boxes on the website screener.

So investing in TCS is a fair investment at this current price. For the last 5 years, the TCS share has provided a 10% annual return per year. At this rate of 10% per year, TCS share might be around ₹3650/- in 2025. But compare it with buying the same share at ₹1650/- in March; the annual return rate per year would be 17%.

Now, we shall see another famous stock, DMart, which is trading at ₹2178/- with a PE ratio of 138. Since the Free cash flow for the last 5 years is negative, I could not calculate the DCF intrinsic value. The sales of the company and share price are growing at 27% and 33% per year respectively for the last 3 years. If the company continues to increase its sales by 30% for the next 5 years, the share price would reach ₹8000/-.

Investing in large caps and blue chips is the best investment idea for new and retail investors. Both the shares I have mentioned above are blue chips. It takes some research from our part to find good investment opportunities. Compare the shares we discussed so far. If you ask yourself which share has the best probability, a company growing at 10% or 30% per year, you will find the answer for yourself. Investing in a company expecting it to grow at 30% year, that too at a high premium with a PE ratio of 138, is very risky.

Intrinsic Value and Speculative Price:

We have already discussed that there are two aspects to a stock price; the Intrinsic value and Speculative Price. The companies trading at high PE ratios are only because of speculation aspects. In case of any crash or economic crisis, the stocks lose their speculative price first. Any stock with low earnings and high speculations lose most of their value. 

As far as I am concerned, the intrinsic value has to be at least equal to the interest rate of a 10 year Government bond. I make sure that the stock price has zero speculation. This means the investment should provide a minimum of 6% per year as the Earnings yield. I look out for blue-chip companies with PE ratios around 16 with good fundamentals and business. For instance, currently, ITC is the best stock in the Nifty index available at a reasonable price.

You may find many PSU stocks like ONGC, IOC, Coal India with even lower PE ratios, which mean low Speculative price. Usually, PSU stocks are not preferred for long term investments since most of these companies are in Oil, Metals, and Mining businesses. Retail investors may find it difficult to understand financial statements and complex businesses. But, PSUs make very good investments with high dividend yields, backed by Government ownership.

Ultra-High PE Stocks:

Let us discuss one of the stocks trading in the Indian stock market with a PE ratio of over 1000. This means the earnings yield of such stocks is less than 0.1% per year.

Motherson Sumi Systems Ltd, as of the last 12 months (TTM), the EPS of this share is ₹0.09/-. It is trading at ₹120/-. Motherson Sumi is an acknowledged company with a well-established business of auto ancillaries. But the last 12 months have been poor for this company. This is not a deceitful company, but it seems to be trading at a very high premium to buy the stock. But there are some companies with ridiculous PE ratios and abysmal financials and businesses.

One of such stocks is Triveni Enterprises Ltd. I could not believe why this stock is listed on the exchange. It is trading at ₹75/- with PE ratio of 4296 as of 14th August 2020. Here’s a screenshot of its fundamentals.

There is nothing to explain on such stocks, just stay away from those. Usually, very new and innocent investors are trapped purposefully in these stocks by unscrupulous brokers and operators. You can find many stocks like these if you search on the internet.

Conclusion:

For new investors, investing in stock markets is not easy, but is not impossible. It requires a lot of research, knowledge, and patience

If you want to benefit from investing in equity instruments, buying at a low premium is always essential. Maybe we can’t time the stock markets, but we can be ready with some cash in hand in uncertain times like these days.

If you are serious about investing large capital over the long term, it’s much better not to follow the stocks mentioned in traditional media. Do your own research or find a good financial advisor. Please do know that a financial advisor or research analyst will charge for their service. If you find people sharing their secret recipe stocks with 50% returns for free, stay away.

Disclaimer:

I provide the information and my views on the website only to educate new investors, stock market enthusiasts, and the common public on equity or stock market investments. Please consult your financial adviser before making any investments in the stock market. In case of any queries, you can contact me via email ID: shivakumar.lachapeta@valueinvesting.online