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Lessons On Buying Stocks

lessons on buying stocks
How To Select The Right Stocks At The Right Time
The seven lessons in this course explain the characteristics of successful stocks and the forces that push them up. The first seven lessons explain specific traits to look for when buying stocks.

Earnings: The Indispensable Element Of Great Stocks

The Importance of Earnings

For any businessman, the rate at which he can increase his earnings or profits is a very important indicator of the success of his business. Similarly, in case of a company, the rate at which its earnings can increase over time is a key indicator of the potential of its shares to increase in value.

In this lesson, you'll learn how to find companies with the best earnings growth and avoid some pitfalls that trick many investors.

What are Earnings?

Earnings, also called net profits or net income, are what a company makes after paying all its expenses, including taxes. Companies usually calculate their earnings every quarter - March, June, September and December – and then publish their annual accounts at the end of the year, which shows the earnings of the entire year.

What is ‘Earnings per Share’?

Earnings per Share (EPS) is calculated by dividing the net profits earned by the company during the year (after paying all expenses and taxes) by the total number of equity shares issued by the company. For example, if a company has earned net profits of Rs. 100 crores during the year and has issued 1 crore equity shares, its EPS for the year will be Rs. 100 (Rs. 100 crores / 1 crore). The EPS is most relevant for equity investors.

Rate of Increase in Earnings/Profits is Important

Most of us have often regretted missing a great investment opportunity in spite of seeing the company, or its product or service becoming a household name, which, in turn, resulted in its share price zooming up.

A decade of comprehensive research covering fundamental and technical analysis of the greatest stock market winners - stocks that doubled, tripled, and went up even more – showed that there are 7 common characteristics among the big winners with earnings growth being the most important factor. (The other winning factors from the study are discussed in subsequent course lessons.)

In case of 3 out of 4 companies, average earnings increased by 70% or more in the quarter immediately after which their stock prices started spiraling up.

Earnings of 75% of these top-performing companies grew over 5 years before their stock prices started rising.

Acceleration (rate of growth in earnings) is also Important

Acceleration is an increase in the earnings/profits growth rate every quarter. Earnings of top-performing companies accelerate over the previous three or four quarters. When such companies catch the attention of professional/institutional investors, their stock prices spiral upwards.

(For a detailed description of the importance of institutional investors, see "Sponsorship: Catching The Stocks The Pros Are Buying.")

Here are 3 key factors that you must look for:

At least 25% growth in quarterly earnings-per-share over same quarter in the previous year; for example, compare profits in quarter ended 31 March 2017 with profits in quarter ended 31 March 2016.

Earnings accelerating/growing in the three most recent quarters; for example, earnings growing in quarters ended 31 March 2017, 30 June 2017 and 30 September 2017.

Earnings per share (EPS) for the year having increased by at least 25% of the past 3 years; for example, EPS for the year ended 31 March 2017 having increase by at least 25% of EPS of years ended 31 March 2016, 2015 and 2015. Remember 25% is the least you should look for; ideally higher the EPS growth, more attractive the stock – 100%, 200% or even more. Strong companies with good management teams, innovative products and leadership in their industries boast the best earnings and reflect the best investing potential.

The P/E ratio

Now that we have understood the importance of EPS, let’s link this to the market price of the company’s equity share. This will help us judge whether the company’s stock is expensive or available at a reasonable price. P/E stands for Price/Earning. The P/E ratio is the market price of the company’s share divided by its EPS. For example, a stock quoted at Rs. 50 a share with EPS of Rs. 5 has a P/E ratio of 10. In other words, the stock is selling at 10 times its annual earnings. You must compare the P/E ratio of the stock with the average P/E ratio of the industry the company is a part of. For instance, if the company is a pharma stock quoting at a P/E of 25 while the average P/E of the pharma industry is 35, the company’s stock could be available at a reasonable price. However, you must consider the P/E ratio along with other factors before making your investment decision. For instance, if the company does not have good growth prospects, then it may not make sense to invest in the company’s stock even at a low P/E ratio.

Evaluating Earnings

Assessing the performance of more than 5,000 companies listed on the stock exchange needs time, research skills and a team of experts to analyse loads of data. Besides, this is an on-going exercise where you need to continuously study the quarterly performance of all these companies in order to locate winning stocks.

StockAxis.com compares the earnings performance of all the traded stocks on the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE) using its proprietary Rating System. The Fundamental Rating measures each stock on a scale of 1 to 99 (99 being best) for a quick assessment. A Fundamental rating of 80 means that stock is outperforming 80% of all other stocks based on earnings growth. Seen another way, a stock with an Fundamental Rating of 80 is in the top 20% of all stocks in terms of recent quarterly and annual earnings growth.

Our research shows that the stocks that make powerful gains usually have an Fundamental Rating of 85 or higher.

Our proprietary Fundamental Ratings System (FRS) includes not only earnings growth but a number of other important factors such as sales growth, return on equity, profit margins, industry vitality and a stock's price performance. The top 100 stocks that come up in the FRS are then analyzed and the 'top 50 stocks pick ' are presented to you in the market analysis section. Invest in these stocks to grow your wealth.

(Subsequent lessons will go into detail about each of these factors.)

Myths about earnings

Myth: You should buy stocks with low P/E ratios.

Conventional wisdom says stocks with higher P/E ratios are overpriced and should be avoided. But the truth is that the best stocks (stocks with high growth in earnings) often have high — some would say ridiculous — P/E ratios when they start their big climbs. And they continue having high P/Es throughout their advances. Some of the best performing stocks in history seemed to be 'overpriced' before their biggest price moves.

Key Points to Remember

  • Don’t invest in stocks with merely a promise of a rise in earnings; insist on best earnings performance. This way, you will pick stocks with the best probability of making substantial gains.
  • Look for companies reporting earnings growth of at least 25% in the most recent quarter.
  • Find companies with earnings that have accelerated in the three or four most recent quarters.
  • Identify stocks with annual earnings growth of at least 25% over each of the previous three years.
  • Don't overemphasize on the price/earnings (P/E) ratio as a way to compare a company's stock relative to its earnings.


Sales, Profit Margins and Return on Equity (ROE)

Key Fundamentals: Sales, Profit Margins, Return on Equity (ROE)

Sales growth, profit margins and return on equity are vitally important in evaluating a company's health. This lesson explains the importance of these financial parameters and how to identify well-performing companies based on these parameters.

Sales (or Turnover) Growth

A company’s sales figure shows the money earned by the company from sales of its products or services. This figure indicates the amount of demand for the company’s products or services. Increase in sales results in increase in a company’s earnings. The other way to increase earnings is by reducing expenses. Ideally, a company should aim to increase sales while controlling expenses.

A company with strong sales growth to support its earnings growth is an important parameter for stock selection. Think of sales growth as the foundation under your house: if it is loose, it's not as stable as one with all the structural elements in place. When you see a company increasing its sales, it's telling you its business is drawing larger demand and is structurally sound and prepared to expand and generate the earnings capable of boosting its stock price.

Higher demand is driven by a number of factors including a larger number of customers, customers increasing their purchase volume, introduction of new products, expansion into new markets and improvements in existing products.

The top performing companies show consistent double- or triple-digit sales growth. It's even better when the percentage growth rate increases quarter after quarter. Such acceleration is the hallmark of quality growth companies. They reflect a well-managed organization.

How high should sales growth be?

The three most recent quarters should each have strong sales growth of at least 25% compared to the same quarters in the earlier year; for example, sales in the first quarter of the current year should have grown by at least 25% over the first quarter of the previous year; similarly, sales of the second quarter of the current year should have grown by at least 25% over the second quarter of the previous year. Alternatively, sales growth should be accelerating in the last three consecutive quarters.

Watch for Pitfalls in Sales Figures

Look for companies with sales growth that is sustainable.
Sometimes an increase in sales can be deceptive; it may not necessarily be what you expect. For instance, if a company relies on only a handful of customers for business, even if these customers have bought more from the company, losing even one of these customers would result in a fall in sales. Similarly, a company that relies heavily on exports will face a problem if the Indian rupee appreciates vis-à-vis other currencies or if there is political turmoil or an economic downturn in the markets where the company exports its products. In case of a pharma company that gets the bulk of its sales from a few flagship products, any fluctuation in demand for these products will result in a fall in sales. In case of a retail company, setting up new stores will increase the sales figures but it may hide the fact that sales in existing stores have fallen. To provide a clearer picture, retailers report sales store-wise and as a whole. Some companies record sales that are expected to take place a few weeks or months later in order to show a healthy sales figure. For some companies, sales are higher only because of the impact of inflation and not because of an increase in demand; this is typical in commodity companies. You must look for companies where sales growth can be sustained and reflects real growth.

Profit Margins: Another Way to Assess Earnings Performance

Profits are what the company is left with after all expenses. Profit margin is calculated as ‘profits as a percentage of sales’. As an investor, look for companies that generate an increasing percentage of profit out of every rupee of sales. The larger the margin, the better a company is at managing and leveraging its business.

Studies of the greatest winning stocks revealed that most showed strong and even expanding profit margins before they made huge price moves. While higher profit margins indicate one of the qualities of a well-performing company, the margin numbers vary widely among industries. For example, profit margins of companies in the pharma industry will vary from margins of companies in the FMCG industry. Look for companies whose margins are among the best in their industry.

Let's take profit margins one step further. There are two types of profit margins – after-tax margin and pretax margin. After-tax margin is the profit remaining after payment of all expenses and taxes; pretax margin is the profit after all expenses except taxes.

Sales Rs. 100 crores
Pretax Profit (after all expenses but before taxes) Rs. 10 crores
Pretax margin (Pretax Profit/Sales x 100) 10%
After-tax Profit (after all expenses and taxes) Rs. 8 crores
After-tax margin (After-tax Profit/Sales x 100) 8%

Analysts and investors assess both pretax and after-tax margins. Some prefer pretax margins because they show realistic profitability without the distortion of varying tax rates.

You should look for annual pretax profit margins of at least 15%. After-tax margins should be at all-time highs for the company or within 10% of the high.

  • Look for companies with annual pretax profit margins of at least 15%.
  • After-tax margins should be at all-time highs or within 10% of the high.
Increase in profit margins are different from increase in earnings
  Quarter 1 Quarter 2
Sales Rs. 100 crores Rs. 80 crores
Pretax margin (Pretax Profit/Sales x 100) 10% 13%
Profits^ Rs. 10 crores Rs. 10 crores
Profit margin (Profit/Sales x 100) 10% 13%
^Profits have remained the same while margin has increased.
You see how a higher margin doesn't automatically mean bigger profits?

Of course, increasing profit margins alone doesn’t make for a good investment. You need to keep an eye on all the key fundamentals. Rising profit margins mean little if sales are dropping, unless there's a change in strategy and the company drops inefficient product lines, for example.

Return on Equity (ROE): How Efficiently a Company uses its Shareholders’ Money

ROE is one of the most popular ways to evaluate the financial performance of a growth company. ROE, sometimes called earnings power, indicates how profitably a company is using its shareholders' money. It is also a reliable indicator of what a company can earn in the future. High ROEs, year after year, tend to reflect increasing profitability and superior management. Cyclical stocks, those that roughly move along with the economy, usually show more mediocre ROEs.

  • Avoid companies with less than 17% return on equity.
  • Top-performing companies tend to have ROEs of 20% to 30%; sometimes 40% or even higher.

You should generally avoid companies with less than 17% return on equity. ROEs vary among industries, but this is the minimum you should find acceptable. And be sure to compare a company's ROE with ROE of its competitors for an objective assessment. In most industries, the top-performing companies tend to have ROEs of 20% to 30%. Occasionally, companies will boast ROEs of 40% or even higher. The higher the percentage, the more efficient a company is in utilizing its capital.

ROEs have been increasing over the past several decades, largely because high technology has helped cut costs and boost productivity.

The next steps

Get a complete picture of the stock by assessing…
1. Sales growth
2. Profit margins
3. Return on equity
4. Earnings growth
5. Institutional sponsorship
6. Relative price strength
7. The stock’s price chart

Now, let's say you've found a company with (1) great sales growth; (2) attractive profit margins and (3) high return on equity. What's next? Earnings growth! Don’t forget to check this parameter (the earnings lesson discusses how to evaluate earnings). Additionally, you must also assess ‘institutional sponsorship’ (the amount of buying by mutual funds and other institutional investors; this is discussed in the sponsorship lesson) and relative price strength (Relative Price Strength Rating ‘Technical Rating’ assesses a stock's price performance over the past 12 months and compares it to all other stocks. The rating is expressed on a scale of 1 to 99, with 99 being the best. This is covered in the ‘Leaders’ lesson.) You must also study the stock’s price chart to complete the stock selection picture.

KKey Points to Remember

  • Strong sales growth is a key indicator of a company's success. Quarterly sales growth should increase at least 25% in the most recent quarter. Otherwise, sales should be accelerating.
  • Profit margins tell you how much of a company's sales remain after expenses. Generally, the higher profit margins, the better.
  • Return on equity measures how well a growth company can produce earnings with shareholders' capital. Look for ROEs of at least 17%.


Sponsorship

Catching the Stocks the Pros are Buying

Being large investors, Foreign Institutional Investors (FIIs), mutual funds and other professional investors exert a large amount of influence in the stock market. They buy and sell stocks in large quantities, which, in turn, impact the stock prices upwards (whey they buy) or downwards (when they sell). Here, you'll learn how to spot the stocks in which these institutional investors are interested in.

About Institutional Investors

Institutional investors’ stock trades result in a stock’s price moving up or down dramatically.

Institutional investors include mutual funds, FIIs, domestic financial institutions, pension funds, banks and other financial institutions that trade in stocks in bulk on a daily basis. In fact, institutions account for a massive chunk of all trading activity. Clearly, this implies that when institutions target a stock for purchase, it's more likely to go up in price thanks to the increased demand they create.

Institutions make a living buying and selling stocks. They employ analysts, researchers and other specialists to gather comprehensive information about companies. They meet with executives, evaluate industry conditions and study the outlook for every company they plan to invest in.

Don’t forget to check the fundamentals

While following stock purchases and sales by institutional investors is smart, it’s also important to check the stock’s fundamental parameters before making your trade. Check the company's earnings, sales growth, return on equity, etc. Factors such as the stock's Relative Price Strength, the industry group's performance and the health of the overall market must be considered too.

Key Points to Remember

  • Institutional investors represent the bulk of trading activity in the market. As such, their buying and selling power can move a stock's price up or down dramatically.
  • You can learn to spot which stocks institutions are buying and selling by watching for surges in trading volume.
  • Look for stocks with an increasing total number of institutional owners in recent quarters. Look for those stocks that are owned by more funds each quarter.


Check the Industry Group

The Strongest Industries Often Produce the Best Stocks

Research shows that one of the key reasons for a stock to move up is due to the strength of the industry it belongs to. This means tracking the performance of industry groups is important. In this lesson, you'll learn how to do this plus identify stocks in the most attractive industry groups.

Most rising stocks belong to leading industries. Investing in the right industry group is almost as important as investing in the right company. View the top 10 industry groups on www.stockaxis.com.

Economic conditions and trends, in large part, determine which industries and sectors rise to lead the market. Each new market cycle is led by certain industries. In the late 1990s, for example, telecommunications and Internet-related industries were the leaders. Through much of 1993, generic-drug makers led the market by offering less expensive medications to a cost-weary pharmaceutical market. In the market cycle of 2004, construction and realty related industries led the market. The later part of the 2003 – 2007 boom saw infrastructure companies do extremely well. The period 2009 to 2015 saw the revival of IT and pharma industries, both of which are export oriented. The last couple of years have seen consumer and NBFC sectors out-performing the markets. Companies in the top-performing industries usually enjoy strong demand for their products and services that can drive up their stock's price.

Some of the Leading Industries in History

Here are a few examples of historically successful industries and the factors that propelled them to the top. As you can see, economic conditions and trends can play a huge role in determining which industries lead the market.

Industry
:
Fundamental Factors
Biotechnology
:
Breakthroughs in gene research
Wireless
:
Growth of "anytime, anywhere" communication technology
Internet infrastructure
:
Demand for high speed connections
Renewable Energy
:
Rise in crude oil and technology breakthroughs in renewable energy

Watch for a "Follow-On" Effect

Sometimes, a major development in one industry results in related industries later reaping follow-on benefits. For example, in the late 1960s in America, the airline industry underwent a renaissance with the introduction of jet airplanes. The increase in air travel a few years later spilled over to the hotel industry, which was more than happy to expand to meet the rising number of travellers.

But this may not always be the case. Don't assume that just because it's the rainy season, umbrella manufacturers will suddenly surge. You must still look for quality companies capable of producing healthy earnings, sales, resulting from exceptional products and services.

Check Industry Performance

You don't have to scan every single stock to find out which industries are leading the market. Each day, StockAxis lists the top 10 industry groups out of over 125 different industry groups by analyzing the price performance of all stocks in each group over the latest six months. This is a realistic period in which to observe market trends.

Why over 125 industry groups? The Indian economy is fragmented and industries tend to expand to ‘sub-sectors’ that eventually become industries in their own right. Take the computer sector, for instance. It's not just PC makers. There's also Computer-Graphics, Computer-Education, Computer-Hardware, Computer-Peripheral Equipment, Computer-Services, and Computer-Software, which itself is divided into large, medium and small enterprises. More specific industry classifications make it easier to pinpoint specific areas leading or falling behind.

Industry Sectors: Another Great Way to Analyze Markets

Reading sector movements helps judge the overall market because different sectors perk up at different stages of the business cycle. For example, the defensive sector rises during times of economic weakness or when investors think the economy is headed down. This sector includes supermarket chains, utilities, etc., which are sometimes viewed as havens during market slumps. People don't change their spending much in such industries even when times are tough. The high-technology sector has been strong during expansion phases.

Companies Making New Price Highs

Look for sectors showing the most stocks making new price highs.

Another excellent way to spot market leadership is to look at stocks making new 52-week price highs. Look for sectors showing the most stocks making new price highs. These are usually the leading market sectors.

Key Points to Remember

  • Much of a stock's price rise is due to the strength of its industry. You must invest in stocks belonging to industries that are displaying strength and market leadership.
  • Different industries move to market leadership as economic conditions and consumer trends change. You can identify the new leaders by watching the top 10 industries with top stocks making the most new price highs.


Find the Leaders

Leading Stocks are Leaders for a Reason

The stocks outperforming the market tend to continue performing well, while lagging stocks are likely to remain underperformers. Here, you'll see why this is an important lesson for investors and how to identify the leading stocks.

The Best-Performing Stocks Continue Performing Well

Stocks that are doing well, tend to keep doing well.

How many times have you concluded that a stock's best days are behind it, only to watch it soar as you stand on the sidelines? This assumption has often come back to haunt investors. In reality, the stocks that are doing well, tend to keep doing well, while those slumping will, in all likelihood, continue to do poorly. Why? Well-performing companies manifest their strength through superior performance in terms of earnings, sales, profit margins and, yes, even the performance of their stock.

  • Choose the leaders (even at a higher price)
  • Ignore the laggards (even if they are available cheap)

A study of the greatest stock market winners found that all-star stocks had, on average, outperformed 87% of the market before they began their most dramatic price advances. In other words, they were already in leadership positions. This concept is contrary to the popular bargain-hunting mentality, but is based on historical facts.

How to find the Leaders

Use the StockAxis Technical Rating to identify today's leaders.

If you want to find next year's winning stocks, look at the better-performing stocks today. Remember, the biggest winning stocks historically have been, on average, in the top 13% of stocks at the time they began their major advances. To help you identify today's leaders, we have developed the Technical Rating. This rating compares the price performance of each stock over the last 12 months, with extra emphasis on the six most recent months. Stocks are rated on a scale of 1 to 99, with 99 representing the top 1% in terms of price movement. So a Technical Rating of 85 means that stock is outperforming 85% of all stocks in terms of price performance.

A good starting point for stock selection is identifying the top two or three stocks with the highest Technical Rating in an industry group that's leading the overall market.

Evaluating Potential Leaders

Following StockAxis’ Technical Rating, consider for investment stocks with its rating of 80 or higher.

Any stock worth considering should have a Technical Rating of 80 or higher. This way, you're concentrating on the top 20% of price performers. In fact, the most successful stock selections generally have Technical Ratings of 90 or higher just before breaking out of their first or second base structure.

Any stock below a Technical rating of 70 is not in leadership territory. If you consider any stock with a Technical Rating of less than 70, keep in mind that you're automatically ruling out the top 30% of the market. It's possible that these stocks will still go up, but it's more likely they'll have only lacklustre performance. Bottom fishers, those investors looking for a bargain among down-and-out stocks, are tempted to buy stocks with low ratings. But history proves that the most powerful stocks have shown prior strength and aren't rebounding from last place.

Another Useful Tool: The Relative Strength Line

It's best when the relative strength line moves up at a sharp angle, showing the stock is outperforming the market. A line moving down indicates the opposite: a weakening stock. The relative strength line offers other clues:

  • It's a positive sign when the line begins moving higher before the stock price itself does. A rising line indicates underlying strength in a stock; frequently, it's just a matter of time until the price itself begins moving higher.
  • If a stock's line stays on an uptrend, that's positive. It shows the stock is keeping ahead of the overall market, acting as a confirmation of the stock's uptrend.
  • If a stock's relative strength line fails to follow along with a new high in price, that's a warning signal. This shows the overall market is moving up faster than the stock. This may signal the stock is weakening, though the price may not reflect it immediately.

Relative strength lines that start drifting lower over a period of time, even if prices remain steady, indicate the stock is weakening. This also shows the stock is slipping in comparison with the rest of the market.

Avoid competitors available for cheap

Another common temptation among investors is to seek out stocks that resemble leading stocks in terms of having similar products or services, but are trading at lower prices than the leaders. You're better off sticking with the leader of the industry, even if its share price is higher. Take the IT industry. Wipro, after the 2000 crash, fell about 90% from the peak of Rs. 1700; the price of the stock was only about Rs.350 in early 2008 after 8 years of the crash. On the other hand, infosys made a new high and rallied higher sending its stock price up during the same span of time. This is not a rare example, for any industry. The moral: stick with the leading stocks in a leading industry group.

Assess all parameters before making your selection

No investor should pick stocks based on a single factor. You must weigh the full picture, including a company's earnings, industry group performance, institutional sponsorship and chart patterns. (Institutional sponsorship, chart patterns and other important elements will be explained in detail in subsequent lessons).

Key Points to Remember

  • Relative Price Strength Rating measures a stock's price move over the last 12 months compared to all other stocks.
  • Look for stocks with high Relative Strength. The better-performing stocks tend to go higher, while the lagging stocks tend to lag even more.
  • The Relative Strength line helps confirm a stock's upward price movement. You want to see the RS line moving in a strong uptrend.


Avoid ‘Bargain’ or ‘Cheap’ stocks

New Price Highs Mean New Opportunities

Many investors have missed the opportunity to invest in great stocks only because they had reached new price highs. Unfortunately, most investors believe that the stock, after having touched its new high, has become expensive, and the only way forward, is down. These investors are then disappointed when they see these stocks touching new highs going forward. The truth is, when a stock touches a new high, it usually is the time when the stock begins its major climb.

Buy High, Sell Higher

Research shows that the best-performing stocks make new highs before they make their major leaps in price.

How many times have you heard the phrase, "Buy low, sell high"? This is the conventional wisdom in the investment world; however, research shows that the best-performing stocks make new highs before they make their major leaps in price. Moreover, stocks at new highs tend to continue moving higher, while stocks making new lows tend to continue to move even lower.

Stocks that seem too ‘expensive’ and risky to most investors are likely to continue rising. And those that seem ‘cheap’ usually go down.

This is a concept many investors find difficult to accept. They assume it's too late to buy a stock that's reached an all-time high. But the great paradox of the stock market is "Stocks that seem too ‘expensive’ and risky to most investors are likely to continue rising. And those that seem ‘cheap’ usually go down."

Price rise implies greater demand

Why does a stock’s price rise? It indicates greater demand for that stock as investors (primarily institutional investors) raise their expectations about the company’s growth prospects. On the other hand, stocks whose prices reach new lows usually indicate poor business prospects, which, in turn, results in lower demand from investors for that stock.

Investor Interest is Important

Some stocks may have very strong fundamentals or great stories, yet they don't go up because there's little investor interest. So while you wait for a stock to be ‘discovered’ -- if it ever does -- other stocks are moving into the spotlight.

Often, the Best is yet to Come

Would you shy away from stocks that more than doubled within the past year? Consider taking a look at what happened with the greatest stocks of every bull market. They looked overpriced and risky to buy just before their biggest move up.

In a good market, opportunities such as these, which start with new price highs, will surface every two or three weeks. In fact, if you ignore this simple rule, you would miss out on just about every major winning stock.

As a rule, don't buy any stock that has risen more than 5% past its buy point.

However, there can be such a thing as an "over-priced" stock: one that truly has gone up too much, too fast and is likely headed down. As a rule, don't buy any stock that has risen more than 5% past its buy point. The buy point is explained in the lesson on charts.

Overhead Obstacles

One reason new highs represent better opportunities is because of something market pros call overhead supply. Suppose a stock that once traded at Rs.50 falls to Rs.25. If it starts making its way back up, investors who bought near Rs.50 start hoping the stock gets back to the old high so they can sell and break even. This presents selling pressure near the Rs.50 mark. But once it clears that Rs.50 hurdle, the stock is no longer burdened by disappointed investors looking to wipe out their losses.

Avoid Cheap Stocks

Perhaps you're one of those investors who think they'll hit the jackpot buying a low-priced stock that goes on to make huge gains. Some investors equate cheap stocks with better value or low risk. If a stock is cheaply priced, then you can't lose a whole lot, right? Wrong. The truth is that trying to consistently make money with cheap stocks is difficult, at best. Stocks are cheap for a reason. Think of a stock's price as a measure of its quality and, consequently, its potential. Stocks selling cheap have a much smaller chance of making major advances, because they're usually companies lacking good performance records. Also, professional investors shun low-priced stocks because they tend to be lightly traded, making it harder to move in and out of such stocks.

So, you can see what research bears out: it's best to look for new highs in quality stocks. It's especially good when the stock is coming out of a base. But don't wait too long: As soon as you spot a buy point -- and if all other factors are in place, such as good earnings growth -- it's time to have confidence and conviction and make your move. Otherwise, you may miss your opportunity.

Avoiding Pitfalls

Like you've seen in earlier chapters, you don't want to buy a stock on any single factor. Where a stock is in relation to its 52-week high and low price, is just one part of your stock-selection checklist. Other important ingredients are the Earnings per Share (EPS), the Relative Price Strength (RS), the Industry Group Relative Strength, and so on. These concepts are explained in the lessons on earnings, leaders and industry groups.

Also, be careful with stocks that make new highs on lower trading volumes. This could be a sign of a stock topping (reaching its peak), especially in cases when a stock has gone up at least 50% in a few weeks after an extended advance. When a stock goes up on low volume, it's a gain produced by relatively small purchases. It's much safer to go with a stock that makes a new price high on higher volumes, which indicates broader support for the stock.

Key Points to Remember

  • Quality stocks making new price highs just as they emerge from sound bases on higher volume are often likely to continue climbing, while stocks making new lows are probably headed even lower. Therefore, focus on the new price highs list for the best potential opportunities.
  • The great paradox of the stock market is that what seems too high and risky to most investors is likely to continue rising. And what seems low and cheap usually goes down.
  • You can think of a stock's price as a measure of its quality and, consequently, its potential. Typically, stocks higher in price reflect higher quality.


The Importance of Management and New Products

New Products, Services or Management

A stock’s price rises exponentially for a purpose – it is usually because of launching new products, new services or due to a change in the management. The price rise takes place because investors view the new products or services to be promising, or the new management to be more dynamic than the existing management. This makes it important to keep up with such developments in order to invest early in such promising companies

Success Stories

Here are some success stories of stocks that spiralled upwards due to a new product, new service or new management.

  • Tanishq, the jewellery brand of Titan Industries, though launched in 1994, took off in the 2000s; this led to the stock rising by over 100x since the start of 2000.
  • The successful launch of mobile phones led to Bharti Airtel rising from Rs. 20 in 2002 to over Rs. 500 by 2007, a rise of 2400%
  • The successful penetration of the international bike market by Eicher Motors led to its stock rising from Rs. 2,500 in 2012 to Rs. 28,000 by 2017.

It's worth emphasizing that success stories achieve greatness only with proven products or services. Often, gullible investors buy stocks because the company promises the cure for cancer or some other breakthrough technology. It's wiser to wait for products to prove themselves in the marketplace before investing in something untested. If a product really hits it big, there will be strong demand for a long time.

For the best companies, success isn't something that happens by accident. They never stop innovating and evaluating the future of the marketplace. As soon as one product is out the door, they're working on the next generation and new ways to sustain their leadership. Larsen & Toubro, Asian Paints, Maruti and Bharat Forge are great examples.

Companies' annual reports occasionally overhype achievements and developments, creating unrealistic expectations. Whatever annual reports promise should be carefully scrutinized.

Many Internet chat rooms and bulletin boards are notorious for stock hype, too. Anything you read in these sites needs to be taken with a big grain of salt. You never know who's posting the information, what their motives are or if details are even true. Rumours and "tips" are plentiful, though few have any truth to them.

Management is the key

You've probably heard about super-executives who rescue companies from the brink of bankruptcy or take them to astonishing heights. Visionaries such as these can be responsible for a powerful stock move. Apple Computer was faltering in 1997, when co-founder Steve Jobs returned to lead the company back into profitability. Under his leadership, Apple shares more than quadrupled over the next couple of years.

Good managers are visionaries, able to redefine business models.

What makes management outstanding? There's more to successful management than inventing the next personal computer or coming up with the next big trend in fast food. The management must also be adept at guiding companies through difficult times, adjusting to changing market conditions, taking advantage of new opportunities. Good managers are visionaries, able to redefine business models. Often, other companies emulate their successful strategies. These leaders demonstrate the ability to deliver on promises, meet growth projections and deadlines, building a reputation for credibility and integrity.

Key Points to Remember

  • A stock makes big gains often due to new products or services, or a change in management. But be wary of unproven products, especially if the company’s management doesn't have a solid track record.
  • Superior management is essential to a company's success. That's why sometimes a change at the top pushes a stock's price higher.
 
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