Expectation of future earnings is perhaps the most important single factor affecting stock prices. Projected earnings are the key element for establishing a stock’s intrinsic value. If the market expects earnings per share to increase, the price per share would go up; likewise if the market anticipates earnings per share to fall, the price per share will decline. There may not be any empirical study defining the relationship between future earnings and market prices in India, it is a guess that the market price anticipates earnings by about six months to a year. This roughly means that the expected changes in earnings six months to a year from now would be reflected in stock process today. If you can anticipate earnings per share ahead of the market, you will be richly rewarded. As the Institutional Investor put it, earnings are the name of the game and always will be. If you are more adept in playing this game than others, you have a greater chance of being a winner.
While forecasting future earnings, do not rely on mechanical extrapolation of the past trend. Empirical studies suggest that past growth in earnings is almost useless in predicting future growth in earnings. Bear in mind the following insights provided by the extensive empirical work on the time series behavior of earnings.
1. There is a substantial degree of randomness in the time series behavior cod earnings. Put differently earnings follow a martingale process, implying that successive changes in earnings are independent. However, this process is superimposed on an upward trend.
2. Whenever departures from randomness have been found, correlation coefficients of successive changes in earnings have been found to be slightly negative. This suggests that earnings behavior is characterized by mean reversion. A good or succession of good years were more frequently followed by a poor year and vice versa.
Leverage your Portfolio when you are Bullish:
You may at times feel very bullish about some shares but lack the funds to buy them. On such occasions you may consider obtaining overdrafts/loans by pledging your existing securities.
When you buy shares with the help of a loan obtained by pledging your existing securities, you are essentially leveraging your portfolio. This tends to raise your risk exposure as it enhances your portfolio beta. So, resort to it only when you feel that the potential reward justifies it. Remember that interest on borrowings is a tax deductible expense.
Take Swift Corrective Action:
The smart investor knows when to shed a share, which is a losing proposition, but the dumb investor does not. The average investor is reluctant to sell at a loss. This is understandable. Since he bought the shares to make a profit, he cannot reconcile himself to a loss. Yet, one must have the candor to admit one’s mistakes – we all make mistakes in our investment decisions and we must have the courage to discard losing shares. When the market price of a share is less than what you have paid for, perhaps you have erred. So, you must cut your losses as early as possible rather than wishfully think that the share will rebound so that you can break even. There is a simple way of doing this. When you buy a share, specify the stop loss limit (It may be 5 to 15 percent) When the share falls by 10 percent (or whatever your stop loss limit is) unload it. This may be an easy approach to discipline your self and avoid irrational considerations like loss of pride sentimental attachment to the share, or wishful thinking about its recovery.