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How can retail investors trade profitably in the stock market

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You will find two kind of investors/ traders in the stock market:

  1. Those who think they cannot predict when the stock will go up. So they concentrate on value investing strategies ( I outline these below).
  2. Those who use technical analysis and devise manual or automated trading systems around it.

Two famous value investing strategies are outlined below:

  • Cigarette Butt Strategy: This involves buying decent companies at bargain price. One looks for companies with low debt, decent Price earnings, price to book value, and RoE (even 8%-10% RoE is decent) kind of companies with decent cash flows (hopefully +ve free cash flow) and steady growth. These typically are not high growth companies (more like steady growth), but they may be one of the leaders in their niche. They may face temporary issues which may lead to a sudden drop in their prices, which makes them attractive buy. But their bread and butter businesses are resilient and mature enough that there demand has a steady growth and hence the stock prices can be expected to reach the equilibrium again. The idea is to buy these stocks when they are beaten down and sell them off when they provide 60–70% types of years in 1–2 years. The exit strategy is to sell when they run up by 60–70% or in a couple of years if these returns don’t materialize.
  • Moat Based Value Investing: The idea is to invest in companies which have a sustainable advantage over their competitors or in companies which are operating in industries with sustainable advantage or moat (eg. Pharma, Banking etc.). These companies are often characterized with high RoE, and surplus cash flows which they can invest in their business to derive high returns. These company may rarely be available for low price to earnings (except market crashes) and one may need to pay what may seem like high price to earnings to own them (A P/E of 25 may not be a deterrent to buy these companies as it may be more normal for them to trade at higher earning multiples).

 

In case of value investing these days it is common for retail investors to concentrate on finding multi baggers (strategy 2 above). Strategy 1 is often looked down upon but the fact is it is much easier to implement and also it is very profitable (realistically ask yourself this: Which business promises 60% kind of return in 1–2 years?). (You can look for details around this in the all time classic book above)

Interestingly when Warren Buffet started out in the stock market his bread and butter strategy was the cigarette butt strategy (He has often confessed it was very profitable, but not easy to implement if you are investing big amounts). But since these days he only speaks about moat based value investing, people pay little attention to the cigarette butt strategy. The fact though is that many investors still use both these strategies. In fact only 20% of stock owned by Buffett are held for long term (like buy and hold forever strategies). Source: The Myth Of Buffett Buy-And-Hold. To quote from the article:

fortunately some college professors did the heavy lifting. They analyzed Berkshire Hathaway’s quarterly filings from 2006 all the way back to 1980, 2,140 quarter-stock observations.CXO Advisory had a nice summary of their work. In the words of the professors:

…we observe a median holding period of a year, with approximately 20% of stocks held for more than two years. At the other end of the spectrum, approximately 30% of stocks are sold within six months.

Yep, Warren Buffett has 100% turnover. He blew out 30% of his portfolio selections within six months, and held about 20% of his picks for the longer run. That is active trading by any definition.

Retail investors should not only listen to what big investors are saying. Rather you should also watch what the big investors are doing and form conclusions on their actions in the stock market, not just on their lectures. From the above quote it should be clear that there is more to Warren Buffett’s investment strategy than just holding on to every stock for the long run. Also it is very likely he may still be utilizing the Cigarette Butt  Strategy.

There is also another kind of investor in the stock market, those who use technical analysis. They may either create trading systems that have an edge or use advanced technical analysis techniques (like elliott wave/ neo wave analysis) to trade for long term investing.

The technical analysis one usually comes across as a retail investor consists of patterns which have already lost their edge because so many systems / traders are already trading around those systems (think of how higher arbitrage trading results in lack of arbitrage opportunities). Hence most of it should not be used for trading unless the trading system has been thoroughly back tested. This is where most retail investors are beaten because they think if they see a pattern then it should work in a certain way. The reality is that even a good technical trading system may be right only 50–60% of the time and the money is made by repeatedly trading the system in a mechanical way. This is why back testing becomes important as otherwise it is not possible to judge the profitability of the system.

Elliott wave analysis and Neo wave analysis are progressively complex and it may take considerable amount of time and practice for one to understand and apply these techniques profitably. But if you are looking for an example of trading purely on elliott waves here it is:

Just Dial: Power of Wave Analysis in dealing with incomplete data – Indian Insight

Just Dial: Is Wrong Wave Count = Losses? – Indian Insight

I personally recommend using everything you know from value investing strategies to Elliott waves. Imagine how confident one can be about his investment if he uses value investing principles and then enters the market based on advanced technical analysis. Let me share an example of one of my recent trades. If you are a regular reader you would have heard me talk about this call of mine on Gold prices:

Can Gold shine in 2016? – Indian Insight

This analysis predicted an upside of over 25% in Gold. Given this insight I looked for opportunities in the stock market that may benefit from a rise in Gold prices. An opportunity I came across was Gold loan companies.

Gold loan companies take Gold as collateral from customers and give them around 70% of the value of Gold as loan. So the logic was simple:

Higher Gold prices = Higher Loan Disbursed = Higher Interest = Higher Revenues

This was the profit & loss track record of the company I was looking at (Manappuram Finance):

Source: Screener.in

The Gold prices peaked in 2011–2012 and this is reflected in peak revenue coming in FY2011–2012 as well. (March 2012 numbers which is FY 2011–2012). There was a decline in revenue since then in spite of adding more branches and expanding customer base. This was primarily because the fall in Gold prices far outweighed these positive factors.

Ergo if our technical analysis of Gold prices was correct, we should have accordingly anticipated an uptick in revenues and profits as well (considering the company has been churning out good RoE as well). What was more this company was paying a dividend of 1.8 Rs. every year and the stock was trading around Rs. 20 (Div. yield of around 9%, you don’t get so much on fixed deposits!)

This was not all. Elliott wave analysis of the stock’s price was also pointing to an impending rally. Chart (with wave count) below:stock market tips

We see here a basic 1–2–3–4–5 impulse wave followed by an A-B-C correction. This basic elliott wave pattern tells you that once this correction ends you are likely to see a major rally far exceeding the previous rally from around 10 levels to 40 levels. The outcome within next 12 months:

manappuram stock market

This stock rallied from sub 20 levels to 90+ levels in less than 12 months. A decent multi-bagger.

So how should retail investor approach the stock market?

As a retail investor the idea should be to develop an investment framework, continue to add to your set of tools and refine your framework with experience. Every decision of buying or selling should be taken within this framework. You may differ on the techniques you may use (value investing, technicals or both!) But this is probably the only sustainable way to trade profitably in the stock market.

Disclosure: I don’t have any investment in any of the stocks mentioned.

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