Spot the trend to make money

Following the trend is a popular thing in the stock markets. The simple logic is that if others have done it, they would have reasoned it out. And we would tend to think that the ‘others’ are experts and we will not do wrong to follow it. Often, this trend of following, becomes a ‘self-fulfilling’ one and make the experts stand out even taller.

For instance, if I talk good things about a stock that is relatively undiscovered, the chances are very high that there would be some follow up action that is prompt and result in the stock price moving up immediately. What happens is that the stock is very likely to be one that is not among the actively traded ones. It is also out of favour with investors. Thus, a small quantity of buying would mean that one has to find ‘sellers’. Sellers who were quiet and now they see some demand, they immediately start to ask for better prices. This price hike will continue till the supply becomes abundant and then there are jobbers and traders who start controlling the movements. If there is a fundamental story to back an upmove, probably the price would settle higher. This move, from discovery to a new range of price, happens quickly. After that there is only sideways movement, with some false rises and falls. The early ones who got in, will get out. In a sense, the host will leave the party and leave the guests to settle the bills.

These moves happen in stocks of companies or industries that are seasonal or cyclical. Smart investors get in ahead of the crowd. For instance, if you take stocks of sugar companies, they went out of favour in 2014 and then languished. Small accumulation started around September 2015. After that it gradually inched up without much activity and on small volumes. In 2016 towards the end, ‘momentum’ investors turned to it. News reports of sugar shortage and price moves started coming in. The rally got its last legs. And now, there is a lot of noise and churning. Trend followers are getting on to the wagon. However, I am not sure that from here, the risk-reward is favourable. The early investors got their money more than doubled in the first year or so. They may have got out in part or full. Now, it is the traders and the late entrants who are creating the action in the stocks. Now, at some point, either sugar prices will peak due to fresh supplies coming in or some governmental action. And gradually the interest will wane off as the sugar cycle moves from shortage to surplus.

Same things can be noticed in stocks of PSU banks. Just take the PSU bank index (have used the Kotak Bank PSU ETF as proxy) and see the chart here. The same story would repeat over different time cycles for various sectors. So, how does one ‘spot’ a trend or play it effectively? Very often, we go late to the party and our short-term trades become long-term investments. Is there a way to avoid it? I have some thoughts that could help contain the risks.  

At the outset, never forget fundamentals. And my rule to this is simple. These cyclical stocks are ‘balance-sheet’ values and ‘profit-loss’ only impacts the prices and sentiments. Ultimately, for these stocks, the balance sheet is the baseline. And to me, that defines the ‘fair value’ for these kinds of stocks. This is simply because the final product is homogenous and there is generally no unique advantage that a single player has. Low entry barriers and excess global capacities are two characteristics. Thus, a sugar mill is a sugar mill. The replacement cost or the enterprise value should be the guiding benchmark for me. So, when I buy, it will be closer or below the book value/replacement cost. I will not go just by the book value, but also look at the ‘Enterprise Value”. A very high debt is something to be careful about. When buying above the ‘fair value’ put in rules. Rules should relate to time limit for holding, expected profit, and a ‘stop-loss’ level.

These rules should never be relaxed. This could result is less than maximum possible profits, but it will always prevent big losses. Even a small relaxation in rules can cause serious injury.

(The writer is an independent analyst. He can be reached at balakrishnanr@gmail.com)