Let’s understand the common mistakes made by stock traders and investors, read the excerpt below.
To start with, let us understand two basic fundamental pointers to be kept in mind before buying any stock. These are the bare minimum requirements.
EPS Growth Rate: EPS is the single most important criteria while selecting a winning stock. We should look for an EPS growth rate of over 18 per cent quarter on quarter and year on year. A company can generate earnings in various ways, some not so honourable. I prefer high-quality earnings. In other words, where do the earnings come from? Did the company post better results because of stronger sales? If sales were strong, was it only because of a single product or one major customer? In that case, the growth is vulnerable. Or are the surprisingly strong results due to an industry-wide phenomenon or an influx of orders from numerous buyers? Maybe the company is slashing costs and cutting back. Earnings improvement from cost-cutting, plant closures and other so-called productivity enhancements walks on short legs. Such improvements can show up from time to time, but sustainable earnings growth requires revenue growth. So along with the EPS growth rate, we need to check the quality of the earnings as well to ensure that it is sustainable over time.
Beware of management communications as they have learnt how to manage expectations. One gimmick is to warn the public of a potential earnings problem, which will cause analysts to lower their earnings estimates. Then the company reports earnings that are better than the lowered estimate. This will result in an earnings surprise; however, it will be a surprise in the context of a lower consensus comparison. So beware of what is happening around and don’t take anything at face value. Also, beware—the company may be increasing its profits by reducing the expenses. A company can increase profits by cutting jobs, closing plants or shedding its losing operations. However, these measures have a limited lifespan. Eventually, a company will have to do something else to grow its business and increase its top line. Therefore, check the story behind the earnings growth. The ideal situation is when a company has higher sales volume with new or current products in new and existing markets as well as higher prices and reduced costs. That’s a winning combination of a winner stock.
For example, let me show you the ten biggest wealth creators from 2018 to 2023. Just check the PAT CAGR and Return on Equity (ROE) of the majority of these stocks. ROE is the measure of a company’s net income divided by its shareholders’ equity. ROE is a gauge of a corporation’s profitability and how efficiently it generates those profits.
Sales Growth Rate: The EPS growth rate is sustainable if it is combined with the sales growth rate. We look for 18 per cent CAGR sales growth rate, quarter on quarter and year on year
too. For beginners, these two can be the initial filters to look out for while selecting any stock. Stock trading is not an easy task. We all want to earn a lot of money from it but it takes a disciplined approach to do so. It is easier said than done as historically we have seen that even the best investors cannot avoid making mistakes while trading.
In this section, we will talk about the most common mistakes which are part of the trading approach of a large number of traders and investors.
1. Trying to catch the falling knife: This is probably the most common mistake. Most traders and investors are obsessed with the so-called all-time high price of a particular stock. This is why when a particular stock falls, some investors keep buying it without analysing the reasons for the fall. This generally works as a trap for investors; they keep buying at lower prices and the stock keeps falling. Investors must strictly avoid this approach and always analyse the reason why the stock is falling. Always remember, only a loser buys a losing stock. If you find yourself in a hole, stop digging.
Always set yourself a rule of maximum loss of 8 per cent in one stock position. Also, when you average down, you forget the principle of portfolio sizing and end up having 25–30 per cent++ in a single portfolio because of which now your portfolio returns will be completely dependent on the performance of a single stock.
Also, if your stock falls 20 per cent, it has to rise 25 per cent to reach its cost. If the stock falls 25 per cent, it has to rise 33 per cent to reach its cost. If a stock falls 50 per cent, you need 100 per cent returns to reach your cost. Hence, never try to catch a falling knife.
2. Not cutting your losses: As a part of the portfolio, an investor must always keep track of where he is losing and earning. Getting back to your paid price is sometimes just a game of hope; this is why most investors don’t want to cut their losses, even if they are very small. They need to understand that the capital which is stuck in the loss-making trade can be utilized for some other trade to earn better returns. Many people think that presently they just have a loss in the books and that as soon as they book it, it will be their booked loss. Our mind treats booked loss versus loss in books differently, but in reality, we need to understand that both are mathematically the same and hence should be treated in the same way.
3. Afraid of buying at a higher price: If you study the charts well, you will understand that there is something called a breakout. Sometimes, a stock performs well and goes up with huge volumes because it is about to give a breakout which will take it even higher. Investors don’t understand this properly and think that the stock is going to fall soon. But actually the opposite happens. As the stock has given a breakout, it will continue to rise and the investor will lose an opportunity. The biggest psychological reason for the same is recency bias. We feel that a stock which was available at Rs 300 is now available at Rs 330, so there is no use buying it and we keep waiting for the price to come back to Rs 300. Usually if it’s a good breakout, it will never reach that level. And when it does, then probably the trend has reversed already and the juice in the fruit is drained.
4. Selecting stock due to lower valuations: In a universe of more than 4000 stocks listed in India, you will find at least 200 stocks which are trading at less than 10 Price to Earnings Ratio (PE) which makes them very attractive to invest in theoretically. Before putting any money in those stocks, we need to understand why these stocks are trading at lower valuations. The reason is simple: it is because of the company’s performance. The company does not have the potential to perform well in future. The market is not ready to give a better valuation to them. Ask yourself: Is a particular stock available at a cheap PE or is it a cheap stock in itself? If you pay too much heed to the PE of a stock, you can never be a growth investor or trader. Although it may come as a surprise to you, historical analyses of superperformance stocks suggest that by themselves, P/E ratios rank among the most useless statistics. The standard P/E ratio reflects historical results and does not take into account the most important element for stock price appreciation: the future. Sure, it’s possible to use earnings estimates to calculate a forward-looking P/E ratio, but if you do, you’re relying on estimates that are opinions that often turn out to be wrong. If a company reports disappointing earnings that fail to meet or beat the estimates, analysts will revise their earnings projections downward. As a result, the forward- looking denominator—the E in P/E—will shrink and, assuming the P remains constant, the ratio will rise.
This is why it is important to concentrate on companies that are reporting strong earnings, which then trigger upward revisions in earnings estimates. Strong earnings growth will make a stock a better value.
