To become a successful stock investor, one requires a framework — a methodology according to which one acts in the stock market. The uninformed investor, having no framework, looks to the market for guidance and ends up getting confused and losing money.

Value investor’s approach

In his book The Dhandho Investor, Mohnish Pabrai, who runs the Pabrai Fund in the US, offers a framework that one could learn from and adapt. The crux of this approach is to buy a stock, which you believe has an intrinsic value of Re 1, at 25 or 40 paise. Often, due to some external circumstance, the market prices a stock at a very low price even though its business is quite sound. To take a recent example, throughout 2008 a lot of good stocks in India were available at very attractive valuations not because anything had gone drastically wrong with their businesses, but because foreign institutional investors had withdrawn funds from the Indian market because of troubles in their mother country.

This approach requires that one learns to determine the intrinsic value of a stock. Discounted cash flow (DCF) analysis is one way of doing so. Buy stocks trading at around 40-50 per cent of their intrinsic value and sell them when the value approaches 90-100 per cent. Many investors may find it difficult to master DCF analysis. They could use the PEG approach (PEG is price to earnings ratio divided by the growth rate in earnings). Buy stocks that are trading at a PEG ratio of around 0.5 and sell when they approach 0.9-1.

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