ELLIOTT WAVE PRINCIPLE - BASICS

 

Even though I am a strong believer in a buy and hold strategy for the long term investor, I think investors who are more active in markets could look to ride the market cycles for greater profits. I have found the Elliott wave principle quite useful in predicting these cycles.

As anyone who has been in the stock markets long enough, knows fully well that markets follow cycles of boom and bust. Ralph N.Elliott, an American who worked in Mexico as a wireless operator, observed these cyclical movements of stock markets, by observing historical data of the indices while convalescing from a long illness in the 1930'. He postulated a principle that markets move in clearly identified waves over periods of time ranging from a couple of centuries down to movements in hours and minutes. Each wave can be subdivided into its component waves and each sub wave can be further subdivided and so on. This science is now known as fractals. Accordingly waves are classified from the "Grand Super Cycle" being the largest to the "Sub Minuette" being the smallest practically measurable wave.

As per the Elliott wave principle, an uptrend comprises of 5 waves, 3 up and 2 down. Each up wave is followed by a down wave. Up waves or impulse waves are labelled as Waves 1,3 and 5 and down waves or corrective waves are labelled as waves 2 and 4. Waves 1,3,5 comprise of 5 component waves each and waves 2, 4 comprise of 3 component waves each. At the completion of wave 5 a new market high is achieved. This is followed by a cycle of severe destruction comprising of 3 waves, which seek to erase most of the gains of the previous bull market. These three waves are labelled as A,B and C. Waves A and C, which are down waves each comprise of 5 component waves because the trend is now down. Wave B, which is an up wave comprises of 3 component waves.

The task before an investor is to identify the stage in the above cycles, which the market is presently in. Once this is correctly done, the investor can decide how the market is going to behave in the future and act accordingly. This can be particularly beneficial for longer term investors to decide when to liquidate their holdings or when not to enter the markets, so that they do not have to suffer the agony of seeing their portfolios diminish in value such as at the present moment. Also it prevents longer term investors from selling prematurely and thus not being able to capture the full extent of the bull run.

A drawback of this principle is that it calls for a lot of judgement on the part of the investor and has no rigid rules to go by. In fact this method is so flexible that different analysts can have different opinions on the present stage in the markets. But since markets do not follow any rules it seems only justified that any system which aims to predict market movements, similarly do not lend themselves to the rigidity of rules, but have an inherent flexibility to account for the vagaries of the markets. Therein lies the beauty of the Elliott Wave Principle, as it attempts to forecast market trends while at the same time is open to account for erratic market movements caused by sudden news flows, which cause a temporary aberration in the wave patterns.

MY TRADING SYSTEM

As you might have figured from my blog, I am basically a fundamental investor, though I reserve a small portion of my portfolio for trading (not day trading though, my typical investment period for a trade is about 30 days). My oservations on my trading experience are as follows.
1. It does make the whole process more exciting.
2. I use traditional charting methods like candlestick patterns, price patterns, moving avgs etc.
3. I am a long only trader. So no shorts & no F&O.
4. You can make money trading, but I don't know the sustainability of such returns since my fundamental investments have been over some time while I started trading only recently. However my trading returns till now have been positive.
5. Taking small losses and executing strict stop losses are the key to success. Easier said than done though.
6. I generally trade on the same stocks I hold in my fundamental portfolio. Thus I can save on STCG tax.
7. Whatever profits I make on trading I withdraw from the market. In case of losses I do not replenish my lost capital, but trade on the reduced capital.
8. I am not a compulsive trader. I buy whenever I feel comfortable and maintain inactivity if I get a bad feeling about the markets.
9. I generally try to guess the direction of the markets over a period of 2 -4 weeks and go long if I feel good about it. For instance I recently bought some Infosys. I already hold it in my long term portfolio. My logic is that Q1 results are expected to be good, and markets do not seem to have discounted this at current prices. So I am looking at an upside of about 15 % in about 2 weeks, while if it does not perform I will have some more of a good stock in my portfolio.

GARP INVESTING

GARP (Growth At a Reasonable Price) investing is an offshoot of the growth investing principles propounded by Philip Fisher and T Rowe Price. It involves identifying rapidly growing companies that are available for low PE multiples. If an investor gets it right, this strategy could yield multi baggers in due course of time because of two factors. One, the growth of the company and its per share earnings would increase over a period. Two, because it shows sustained growth over many years, its price to earnings ratio would get rerated.

One of the leading practitioners of this investment style, Peter Lynch, often looked at businesses which manufactured products that he liked and used. An aspect of his investment style involved going to shopping malls with his family to check out the brands that were doing the best sales. Then he would research the companies that owned these brands and come up with options for investment.

An important aspect of GARP investing is the PEG ratio. This is the ratio of the PE multiple of the company to its average growth rate in EPS over a period of 3-5 years. For small companies that are growing rapidly, a PEG of 1 is considered suitable for investment in the Indian context. Here rapid growth rates are seen in a variety of businesses and an investor can find many companies quoting at PEG of 1 and below. Are all these companies good buys on the basis of GARP? To determine that, an investor needs to look at the sustainability of that growth. For example a company growing at 25 % per annum for the past three years and quoting at a PE ratio of 15 may be a buying candidate if an investor can satisfy himself that the business can sustain growth rates of at least 15% if not 25 % over the next few years.

How does an investor ascertain that? Therein lies the art element in investing. He looks at the business prospects of the industry in which the company is operating, the brands it owns, how well its products are doing in the markets, its loyalty among buyers, service track record, capacity additions it has planned and the quality of its management.

A risk in employing GARP investing is that high growth and low PE businesses are available mostly in the small and midcap space. By nature these companies do not have the staying power to overcome prolonged adverse market cycles. This risk can be mitigated to an extent by selecting companies which have been around for some length of time and have demonstrated their ability to weather difficult conditions. Large cap companies can be considered buying opportunities at a PEG of 1.25.

Let's try and apply this methodology to the BSE Sensex. The Sensex is expected to deliver earnings of 970 for FY 08-09. In the past the Sensex earnings have been growing at 25 % per annum. Since a slowdown is expected due to inflation, crude prices and other factors, let us assume that the Sensex will grow at 15 % in future. Since India is among the top five markets in terms of market cap in Asia, it is analogous to a large cap company. Therefore, it deserves a PEG of 1.25.

Price/Earnings/Growth = 1.25

Price (Sensex) = 1.25 x Growth x Earnings
= 1.25 x 15 x 970
= 18180
So, when various analysts say that India at a PE of 17 is expensive compared to other emerging countries, they fail to take the growth rates into account. PEG normalises the PE ratios by adjusting for growth.
Brazil's GDP growth rates for the past 6 years are given below:
2003 1 %
2004 -0.2 %
2005 5.1 %
2006 2.3 %
2007 3.7 %
2008 4.5 %
Average GDP growth over 6 years = 2.73 %
The PE ratio of Bovespa was 16.8 as on 31.05.08.
Brazil being a commodity driven economy, these growth rates are in an era of high commodity prices. Even in such conditions adverse to it India has clocked a GDP growth of 8 % over 6 years. What would happen if commodity prices were to correct, as is widely expected? Therein lies the genesis of my arguments that long term investors should buy Indian stocks at present levels.

WHAT ANALYSTS PREDICT & WHAT ACTUALLY HAPPENS

I would like to highlight an interesting post on rediff where three different analysts employing different prediction methods predict their levels for the sensex in the coming year. The predictions were made on Jan 7 2008. They went something like this:

1. Milind Karandikar - using Neowave theory - Sensex between 27000 to 39000 in the 1st half of 2008,

2.Devangshu Datta - using technical analysis - Nifty between 6600 to 7000 in six to eight months with a bottom of 5600 to 6100. Really?

3.Mukul Pal - using Elliott wave - Sensex not extending beyond 24000 in 2008. The closest of the lot, but still wrong by a long long way.

I would like to ask these gentlemen their views in the present context, but they have chosen to not display their respective e-mail id. They would probably be bearish now, taking refuge in some jargon or some hedging terms which they have been careful to qualify their projections with. Readers may judge the value of the predictions for themselves by reading the article here.Its very easy and popular to simply extrapolate the current trend and on that basis come up with fancy figures. The real test of an analyst is if he can go against the mood on the street AND end up being right. In that respect I admire people like Gul Tekchandani and Ramesh Damani who had the conviction to go against the popular mood and point out the risks, when markets were at their peaks. Some like Morgan Stanley have been screaming from the roof tops about overvaluations since the index was at 8000 and are delighted that their call has been proved right finally with the index at 21000! Some call, guys. Even a stopped clock is right twice in a day.

WHAT DO INVESTORS DO NOW?

So, finally the dreaded inflation number has crossed double digits. Not barely crossed it, but has done so by a considerable margin. Stock markets have expectedly crashed and analysts are screaming "the sky is falling". So what do you as an investor do now? It actually depends upon your timeframe for investment and your reasons for investing in stocks. If your goals are long term in nature such as planning for retirement or children' education, it makes little difference to you how the Sensex reacted today.

Just forget about the markets for a while. Sit back and take stock of the situation. OK, inflation is at 11 %. Did it jump from 6 % to 11 % overnight? No, it took about 6 months to do so. If inflation was increasing continuously for months and the trend is now continuing there is nothing strange about it. What is it that is so sacrosanct about the double digit inflation figure? I cannot believe that inflation at 9.9 % is OK, but at 10.1 % it is going to wreak havoc on the economy. I am not trying to make a case that inflation is good or that it will not affect the economy. What I am saying is that inflation is a fact and that the markets have already fallen by more than 30% from their peaks, simply discounts that fact.

Can markets fall further? Maybe. Will markets eventually rally? Certainly. Take a look at the positives. Since, even the worst case scenario for the economy paints GDP growth at 7 %, I see no reason to believe that we are in a recession. If the markets can consolidate at current levels, waiting for inflation to come down and interest rates to stabilize it may not be such a bad thing for investors. By now the froth is out of the system, speculative positions are low, IPO' are dead, the panwalla is no longer talking stocks. If you have cash waiting on the sidelines, the time to invest a portion of it has come. You could invest 25 % of your cash in high quality businesses, using this window of opportunity. There are plenty of opportunities available, where outstanding businesses are quoting at reasonable valuations. Even if you do not invest, it would be a mistake to panic and sell out now.

Advance tax numbers point to a significant growth in corporate taxes. This cannot happen without profits rising. Again the investments in capacity creation that India Inc. has made in the past few years are about to yield results as this capacity goes on stream. Again it is expected that inflation would come down somewhat as new farm yields hit the markets. I am in no way trying to make out that all is hunky dory with the economy. But it is not a doomsday scenario as many would have us believe. I am simply trying to bring a sense of sanity to the all round fear factor prevalent in the markets. Luckily the crash happened on a Friday. We have 2 days to put things in the proper perspective and then decide our course of action. An old wall street saying comes to mind " Buy when there is blood on the streets, even if it is yours".

WHY MARKETS ARE NOT DRIVEN BY NEWS

In 2003, just before the start of the current rally, suppose someone was to predict a future event with a guarantee that if the predicted event DOES NOT HAPPEN, whatever you lose by taking a call on the prediction will be made good. The prediction was to go thus " Within 5 years the price of crude oil will increase by 650%". Knowing this prediction, what would you do? I would have shorted the stock market with all my might & I would have lost my shirt even though the prediction was accurate.
In an interesting e-book I came accross, the author gives many similar examples to prove that markets are not only unaffected by news, they actually go counter to the news. He shows that markets move fundamentals and not the other way around to prove the validity of the Elliott wave theory. Markets are not influenced by events but by the mood of the crowd and this in turn causes changes in fundamentals to happen. You might like to download this free e-book from the link given. I would like to start a discussion on this topic and any comments would be welcome.Download here

PASSIVE WEALTH CREATION

It is an established fact that over the long run, equities as an asset class outperform all other alternative asset classes including real estate. A RBI report on Currency and Finance, 1997-98 revealed the following returns over a 20 year period compounded annually:

Inflation    :     9.19 %

Gold        :    7.62 %

Bank FD'    :    9.19 %

Co. FD'        : 14.47 %

Equities        : 20.15 %
 

It shows that equities have spectacularly outperformed all other assets. I suspect that the difference would get even more pronounced if we were to conduct a similar study today.
 

It is clear that our choice of investments have to give us returns that beat inflation. A recent study revealed that only 2 % of savings in India are invested in equities. So, why are we Indians so averse to equity as an asset class? The reasons, perhaps, lie in the setbacks that Indian investors have received in 1992 and 2000. That apart, stock markets were regarded to be manipulated by operators and promoters had a reputation for unethical practices. Maybe investors who had burned their fingers were justified in having such beliefs.
 

But one cannot get away from the fact that our approach to investing in equities lacks discipline and is sporadic, with an overwhelming bias towards flavour of the month stocks. When stocks are down, we refuse to even consider them as investment options and when they go up, we chase prices which have already gone up substantially. This might work as a trading strategy, but is eminently ill suited to long term investing. The error is compounded when we go for trading, but fail to book losses and convert out trades to 'long term investments'.
 

A simple method for genuine long term investors to build wealth, would be to invest regularly in units of Index funds or Exchange traded funds (ETF') such as Nifty BeES. This strategy might not give you an adrenaline rush, but has some advantages which you might consider:

1. You invest in an index which is almost sure to go up in the long term, unlike some stocks which may simply disappear.
   
2. You invest regularly, in equal amounts every month, so that when markets are down you acquire more units and when markets are up you get less units, but the value of units already acquired in your account goes up.
   
3. You attain automatic diversification, thus avoiding the temptation to get into hot stocks.
   
4. You benefit from the growth in the economy, without any significant effort in stock selection or rebalancing.
   
5. Indices routinely weed out stocks which are no longer relevant and replace them with new stocks. You gain from shifting business trends.
   
6. You capture the long term effects of compounding, since your gains are embedded in the upward movement of the indices.
   
7. Since you hold for the long term, you do't have to pay any taxes, which increases the compounding effect.
   

 

You could do even better with actively managed funds, which have managed to outperform the indices, especially in the Indian context, but this comes with a dose of higher volatility.

 

PATIENCE – KEY TO WINNING IN STOCK MARKETS

Through most of 2007, when Infosys fell from a high of Rs.2300 to a low of Rs.1300, many investors panicked, thinking that it was the end of an era of one of India' greatest companies or even the entire industry. True to form Infosys not only rebounded back to 1900 levels as on date, but has done so in style, underscoring yet again the fact that panicking is injurious to one' financial health.

We have seen many a times, investors sitting on the sidelines in a bull market, waiting for a correction to invest and then investing at the peak , only to see markets come crashing down in a fall. At this point, they sell expecting the markets to fall further. And even if markets do actually fall more, the noise of pessimism all around makes them wait for still lower levels to invest and the cycle repeats itself.

The point I am trying to make is that if you have waited long enough for a correction, never ever enter until the markets have corrected. However long it may take and however painful it may be to see markets rise relentlessly, it will be far more painful to see your capital being swiftly eroded.

The key to success in the markets is not brainpower, but stomachpower or the guts to hold your nerve when others are losing theirs, both on the upside and down. Have faith in the universal law of nature " What goes up must come down and vice versa".

So even if you have invested at higher levels, be mindful that you do not panic after a severe fall. If you do want to panic, the right time to do so when the markets are at all time highs. Hold on to your stock in the hope that the India story still continues. Remember, this is why you bought, in the first place. The caveat to this is that your investment should be in fundamentally sound companies which hold the potential to rebound higher even if they suffer a sharp fall. If you have bought a weak stock, you should have sold when stop losses were triggered. Even after a significant fall, it is not too late to sell such stocks. Investors who have bought into basically solid companies at higher levels should try to average their costs on the way down, buying equally at every 10 % fall in the stock. Remember, time is on your side when you buy superior businesses led by capable managements. They have weathered many storms in the past and shall do so again in future.

If you have the stomach for the volatility which is the inherent nature of stock markets, but not the time or the inclination to study them, it would be a good idea to invest in diversified equity mutual funds, again spreading your investments across fund houses and market caps.

In conclusion I would like to draw your attention to the words of Jesse Livermore, one of Wall Street' famous speculators who said " The big money is not to be made in the buying or the selling but in the waiting".

 

 

 

BUY PHARMA STOCKS

Pharma companies, once the darlings of the stock markets are badly beaten down, so much so, that it is almost as if the bull run of 2003-2007 did not happen as far as investors in stocks of pharma companies are concerned. But recent events seem to suggest that pharma stocks are about to make a comeback. Various pharma companies in India follow different business models as follows:

1. CRAMS (Contract Research And Manufacturing Services)
   

   This model relies on the fact that India is considered a low cost manufacturing base at the same time having the necessary infrastructure and technical skills to ensure quality. CRAMS is a $ 35 billion global business and with close to $ 80 billion worth of drugs expected to go off patent over the next two years, this model represents a huge opportunity for Indian pharma companies. Prominent among these are Jubilant Organosys, Divis Labs, Shasun Drugs and Nicholas Piramal.
   

2. Generics
   

   Generics are drugs which are already on market in developed nations. An Indian company has to file an ANDA (Abbreviated New Drug Application) and prove bioequivalence of its drug with the drug already approved in the markets. This process takes 12-18 months but is a lot quicker and easier than launching a new drug molecule. A variation to this is an ANDA filing under Para IV of Hatch-Waxman Act of the US. Here a drug currently under patent is challenged and if the challenger wins, it gets a 180 days exclusivity period to sell that drug in the US market. Some companies following this model are Ranbaxy, Dr.Reddy, Glenmark.
   

3. New Chemical Entity
   

   A new drug molecule costs $ 300 million to $ 500 million to develop and takes around 15 years. Due to large upfront investments only the few top companies can enter this line of business. But, if successful in discovering such a drug, the pay offs can be huge, both in terms of share price and market profile. Clinical trials, which is an important cost and time consuming stage in the launch of a new drug is said to be cost effective in India due to large availability of volunteers, diverse and varied gene pool in the Indian population and low cost of technical skills. Ranbaxy, Dr.Reddy and Glenmark are some companies that follow this model.
   

4. MNC'
   

   Once considered the bluest of blue chips and commanding high PE ratios, these companies are now value picks due to their rock bottom valuations and high dividend yields. They are mostly active in the Indian local markets and are stifled due to price controls by the Government. But some of these companies have a huge pipeline of new drugs under development in their parent countries and new patent regulations in India would enable them to launch their drugs here. Some companies in this sector are GlaxoSmithKline Pharma, Novartis and Pfizer.
   

The Indian pharma market is projected to grow at 12% per year reaching $ 20 billion by 2015 according a McKinsey and Co report. This excludes opportunities for exports and outsourcing. India is projected to overtake Brazil, Mexico and Turkey to rank among the 10 largest pharma markets by 2015. Taking into account the huge potential held out by this sector, investors should consider investing in stocks of pharmaceutical companies, particularly since valuations are still reasonable for this sector. An interesting alternative would be to invest in sector specific schemes of mutual funds investing in pharma. This way an investor can get exposure to all the above options through diversification and since picking individual stocks in this sector could be tough, a fund manager might be able to generate better returns.

 

Free wheeling: Elliot Wave Analysis and the Indian Markets

A brief description of the elements of Elliot Wave Theory by Amit Sinha. This is one of my current topics of study. The article is well written in a language most investors can understand.
Free wheeling: Elliot Wave Analysis and the Indian Markets

ARE BUSINESS CHANNELS ON TV RELEVANT TO INVESTORS

When the Sensex was at 21,000, how many experts on the business channels were advising investors to sell? I can remember only one, Gul Tekchandani. All the others were busy predicting index levels from 24,000 to 30,000 to come up. Remember the reasons they were quoting to make you buy? Insurance companies have X 1000 crores to invest. Mutual funds have mopped up so many thousand crores. All this money was just waiting to enter the markets and promising to take it to new highs.

Fast forward to the situation now. When markets are about to hit 2008 lows, these same guys are advising you to sell, because the markets are headed still lower. Nice, easy way to make money guys, buy at 21,000 and sell at 15,000.

Another thing that bugs me about business analysts is that they give you all kinds of jargon in the hope that you believe that they know what they are talking about. This one is my favourite. An investor asks the analyst that he has bought a stock which is now showing losses. Should he hold or sell? The analyst advises him as follows " ABC stock has support at X levels, if it breaks the next support is at Y and if that breaks too, then it has long term support at Z". What does that tell the poor guy who has lost some money and hopes to get some quality advice about what he should do next. Come on guys. There is some real hard earned money here, not some paper trading game.

Then again the way these analysts encourage day trading is a real shame. They give out all kinds of daily calls, knowing fully well that day trading is a losers' game even for people with deep pockets, leave alone small investors. The poor guy watching TV sees a person with impressive sounding credentials, spewing out even more impressive jargon, giving him a tip. He does not realise that the tip is going out to a million more viewers like him, at the same time. So what is the value of that tip?

Truth be told, business channels are nothing but entertainment to the vast majority of investors out there. They are the new "Saas Bahu" soaps. Only they are infinitely more dangerous. At least you don't lose money watching soaps. Investors need to realise that there is no substitute for hard work to succeed in the markets. Tips don't work. Sure, you may make money a couple of times acting on tips, but eventually it is certain that you will lose.

Select whatever method you believe is the best for you. It could be fundamental, technical, growth, value, dividend yield, whatever. Study it well and only then invest your hard earned money. You may still make losses, but you know that you have done your best. As in all things, there is an element of luck involved in investing and perhaps this time luck was not on your side.

 

 

 

 

TOP 10 DO’S FOR FUNDAMENTAL INVESTORS

1. Never invest in tips and rumours.
   
2. Look at the products which you use and like. The companies making these products could prove to be very good investments.
   
3. Be on the lookout for solid businesses which are presently out of favour. Check the 52 week lows columns of newspapers. They make for good contrarian bets.
   
4. If the market capitalisation of a company is near its net current assets, it could be a good value pick.
   
5. Keep the business cycle in mind. Some businesses are cyclical in nature. Aim to invest at the bottom of a business cycle.
   
6. The market may know something that you don't about a stock. Check this out when you buy at rock bottom valuations.
   
7. Keep an investment timeframe of at least 2 years.
   
8. Do not panic in a market downturn. Review your reasons for buying and see if they remain intact.
   
9. Conversely be aware of changing fundamentals. If basic reasons for buying no longer remain valid, sell.
   
10. Remember the old adage " Buy when others are fearful, sell when others are greedy".

INTERESTING LINK

An interesting interview with Deepak Shenoy co-founder of MONEYOGA, where he discusses his motivation, investment philosophy and other views. A must read for all bloggers and investors.

FUNDAMENTAL VS. TECHNICAL ANALYSIS

The quandary facing an investor today is to decide what theory should he use in his process of stock selection. If he is taking professional advice, who should he turn to, fundamentalists or chartists?

Have you ever had the experience of completely researching a stock, looking into its ratios and the market potential of its products and then investing into it, only to find that after you have bought it, the stock simply stagnates or even goes down? In such cases do you have the conviction in your analysis to hold on to your stock through thick and thin, disregarding the market and the opinions of analysts to sell? If the answer is yes, then you have the most important attribute a fundamental analyst should have. Patience.

Then again who does not like an investment to appreciate right after one makes it? Technical analysis gives one an indication of the direction which a stock is poised to take and investment decisions are based solely on such indicators. Technical analysts do not give any weightage to the accounts of the company, its products or the quality of its management. The company might be bankrupt for all they care. Their decisions are based on what the charts tell them. However, should they go wrong they have stop losses to protect them. The argument for the chartists is 'cut your losses and let your profits run'.

So we come back to the original question. Which process does one choose? It all depends on your nature and your frame of mind towards investing. If you cannot take a loss, stay away from technical analysis. Because, if your analysis should go wrong, the chosen investment has no fundamentals to protect your downside. The stock could well crash to zero (or rather near zero). If you make a trade and your stop losses are triggered, it is imperative that you book losses and not revise your stop losses downward.

If you are a fundamental investor, it does not matter what the stock price does in the short run, as long as you have done your research. The key here is patience and the capacity to mentally bear any notional losses in the conviction that your choice is backed by solid homework and that the market has to recognize its potential in the long term. This form is only suited to long term investors. If the stock appreciates after your purchase, well and good. But your timeframe should essentially be a long one right from the outset. It is an investment sin to convert short term trades to long term investments after they have fallen.

Therefore a good approach to stock selection might be to first research a stock on its fundamentals and then use technicals to time your purchase. The negative being that a stock price may already have broken out by the time your fundamental analysis is done. A method I personally like and follow is to allocate a certain percentage of your portfolio (say 75 %) to stocks based on fundamentals and deploy the remaining funds to technical picks. I generally do not tinker much with the first group, but whenever I make a profit on my investments in the technical basket, I remove my profits from the markets and redeploy the principal in other picks.

BASICS OF TECHNICAL ANALYSIS

Technical Analysis is the science of predicting the movement of stock prices using chart patterns. These charts plot the stock prices against time. When a particular pattern is formed on the stock charts, it gives an indication to the technical analyst as to the direction in which the stock price is headed.

The rationale behind the science of forecasting stock price movements using technical analysis is that market movements are usually predicated by an activity in the stock by informed sources. It is often observed by investors that the price of particular stock goes up without any apparent reason and when the price is ruling quite high, a positive development is released by the company in the press.

No development of a significant nature, whether it is a takeover, a merger, a large order or a setback in earnings, takes place overnight. Technical analysts believe that well before any major news gets released in the market, the stock is accumulated or sold, depending on the nature of the news by informed circles. It may be fundamental analysts who have got wind of some developments through their research or it may be company insiders.

Any activity of this nature follows three phases viz.
Accumulation : Where large quantities of stock are bought without much influencing market prices.
Marking up : Where sharp upward price movements are seen due to sellers having sold out and buyers still buying.
Distribution : Where stock acquired at low prices are gradually sold out.
This is an example of bullish activity in a stock.
Bearish activity will similarly follow the phases of distribution, marking down and accumulation.

Such activity produces distinct patterns on stock charts. An experienced analyst can spot this pattern and use it to draw his conclusions as to the direction in which the stock should move.

Major patterns are classified into three categories as under:
1. Bullish patterns
Head and shoulders bottom
Double bottom
Rounding bottom
Triangular bottom
2. Bearish patterns
Head and shoulders
Double top
Rounding top
Triangular top
3. Continuation patterns
Flags
Pennants
Wedges

Volumes are an important consideration in the studying of patterns and no study can be considered complete unless due regard is given to significant changes in volumes.

Since chart patterns are far from infallible, the concept of stop loss is an important aspect of technical analysis. When the decision to buy or sell is made a stop loss is also incorporated into the calculations. This gives the investor protection against greater losses should his trade go wrong.

Resistances are determined to indicate to what levels a stock is likely to move up before it meets selling pressure and supports indicate to what level a stock can move down before it encounters buying demand.

Technical analysis therefore relies upon the human element in trading. Its price patterns capture the relative balance between buying and selling as well as directed action by insiders or groups of operators.

BASICS OF FUNDAMENTAL ANALYSIS

Investing based on fundamental analysis of stocks is considered by many to be the best form for the long term investor. There are two broad approaches in which fundamental analysis may be carried out.

Based on the present and future prospects

This approach consists of valuing a business based on various factors related to the products of a company, its markets, its competitors, its efficiency and service levels, its reputation in the minds of its customers.

An evaluation on the above parameters may be done by carrying out a market study of the company. One way to achieve this would be by talking to the company’ suppliers, customers, competitors, ex employees and dealers and distributors. Doing this would enable an investor to judge the strength of the company’ products in the market and its perception in the minds of its customers and competitors. An investor can thereby determine whether the company has strong customer loyalty for its brands, do its competitors have respect for its business acumen and does it treat its stakeholders fairly.

After a complete market study is carried out and the company has performed well on the initial checks, the management may be approached to discuss its future plans with regard to capacity expansion, launch of new products, fund raising plans etc.

Based on past performance

This approach consists of looking to the past to see how a business has performed so far, in order to give us a reasonable picture of how well it may be expected to do in future. This involves looking at published accounts and annual results of the company for the past 5 years and examining the following parameters:

a) Average rate at which the company is growing its sales.
b) Average rates at which the profits are growing.
c) Growth in per share earnings. This gives a clue as to whether the profits are keeping pace with dilutions in equity capital.
d) Market Capitalization (M Cap) of the company. (For more on this refer May 08 archives)
e) The dividend yield of the stock. (For more on this refer May 08 archives)
f) Price to Earnings (PE) ratio and Price Earnings to Growth (PEG) ratio.(I shall discuss this in depth in a future post)
g) The Net Profit Margins.
h) Return on Capital Employed (ROCE). This is the ratio of net profit to capital employed (Equity Capital + Reserves and surpluses)
i) Book value of each share. (Particularly applicable in case of Banking and Financials stocks)
j) Net Current Assets (NCA) of the company ( If the business is available at a M Cap near to its NCA, it may be further investigated as an attractive value buy)

After all these ratios are calculated they may be looked at in relation to the ratios of other companies in similar lines of business, to determine whether the company being investigated is undervalued or not. Ratios should never be used in isolation but as a benchmark against which other alternatives may be compared.

If both these approaches are combined, it cannot fail to reveal several undervalued stocks which may prove to be multi baggers once the market realizes their potential.

The above is only a brief summation of the principles underlying financial analysis and is intended to serve as an introduction to the subject. Investors are advised to further read up on the subject to broaden their understanding of the principles involved.