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5 TOP stock market survival tools
Vishal Chhabria, Outlook Money
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July 07, 2006

Adventure enthusiasts travel for hours to get to Devprayag in north India to get the buzz of white-water rafting. Swinging up and down the 130-km stretch, they get the heart-stopping thrill of dropping off rapids called Roller Coaster, Crossfire and The Wall.

However, you need not exert too much and get the same bone-chilling ride on the Great Indian Stock Market this season. Markets dropped 16 per cent, rose 3 per cent and again dropped another 17 per cent before rising 15 per cent across the period of about a month and a half, losing Rs 11,37,953 crore (in 2,685 actively traded companies) and then regaining Rs 3,62,515 crore.

Definitely heart stopping. No wonder that the adventure tourism destination has shifted from the wild waters to the Great Indian Stock Market. Reach there through your computer terminals, the cell phones, the TV terminals and the brokers office.

For those less inclined to the nerve-racking sport, there is another way to play the game. Without the rough ride. Those who want to play vicariously and without the stress can look at equity mutual funds to get their share of the stock market growth, but those who like the excitement of stock picking need to get their feet wet in the water.

Outlook Money brings you a survival guide to surfing, staying dry and getting ahead on the stock market rapids. Five life-saving tools that you can't do without. But there are conditions on who can sign up for this ride.

Who Can Ride

Just as those with a heart or back problem are discouraged to strap on the life jacket for the white-water rafting expedition, the Great Indian Stock Market needs you to be mentally and financially fit to take this ride. You should ride only if you can stay for three years or more.

Short-term riders are likely to bleed and bleat a lot. The stock market works for the retail investor over the long term, day traders and brokers are able to monitor markets on a minute-to-minute basis and may be able to cut losses and get off.

But typically retail investors get the rough end of the ride when markets fall off the top. Anybody who cannot afford to lose this money in the short-term will get a bad dunking.

Just as a rough rider on the rapids should have ideally completed his medical insurance before leaving home, the player on the  Great Indian Stock Market needs to have done the basic financial structuring that allows him to take a risk. This means that his basic life and medical insurance should be in place, his asset allocation must be decided in accordance with his risk profile (See  box: The Risk Capacity Game).

The core portfolio with long-term debt instruments like PPF and PF should be on course. Only then, the resources allocated to long-term equity should be used for this adventure sport.

Rules of the Game

Now that you've been allowed in, there is some ancient wisdom propounded by venerable gurus who have been there and done that. Read on to get to know the rules of the game that work.

What you need is a combination of spirit, grit, determination and prudence. World famous investment gurus have the same advice.

Peter Lynch, America's No. 1 money manager has said in his famous book One Up on Wall Street: 'It seems to me the list of qualities ought to include patience, self-reliance, common-sense, tolerance for pain, open-mindedness, detachment, persistence, humility, flexibility, a willingness to do independent research, an equal willingness to admit mistakes and the ability to ignore general panic.'

He also suggests that if people ignore the ups and downs of the market and the endless speculation about interest rates, in the long-term (anywhere between 5 and 15 years), their portfolio will reward them.

Grit and determination are essential because holding on when the ride gets rough can yield big time results. For instance, since January 1990, companies like ITC, Hero Honda and Infosys Technologies (since 1993) among a few others, have delivered astonishing returns. Investments in these companies have grown at a compounded annual rate ranging 33.9 per cent to 72 per cent in the last 16-odd years.

Put that in absolute figures and that will stop your breath for a moment at least. An investment of Rs 10,000 in ITC in January 1990 is today worth Rs 12.5 lakh (Rs 1.25 million), while a similar investment in Infosys [Get Quote] in June 1993 (when the stock got listed) is worth over Rs 1.15 crore (Rs 11.5 million). And that's excluding all the dividends.

Fit the bill? Learnt the rules? Here is your ticket. Enjoy the ride. Remember you are now in for the long term and here are the promised life-saving tools, not just to survive the stock market rapids, but to stay on top as well.

1. Get a good boat and hold on tight: Value Investing

If Benjamin Graham (See below) in 1954 coined the term 'value investing', other investment gurus like Warren Buffet, Irvin Kahn and Charles Munger took it forward. Although value investing means different things to different people, the core of this strategy is to follow quantitative or fundamental analysis.

Thumbs Rules

  • Investigate before you invest and not vice versa.
  • Buy companies doing business that you understand.
  • In times of panic, be greedy and buy good companies.
  • Control your emotions -- greed and fear.
  • Be honest with yourself -- book a loss if you think you have gone wrong.
  • Avoid momentum investing.
  • Do not fall prey to herd mentality and take tips with a pinch of salt.
  • Buy more of a stock if it falls, provided you have confidence in the company.
  • Don't gamble -- no day-trading, no leveraged deals and no loan against shares.
  • Follow your stocks periodically and see that all conditions (such as entry barriers and basic investment ingredients) continue to be in place.
  • Hold a company (stock investment) for 3-5 years.
  • Always look for bargains.
  • Look for businesses that are in potential growth areas.
  • Avoid companies that are in a dying business segment, even if they offer value.
  • Invest in businesses which have a sustainable competitive advantage.

It believes that all clues that are relevant to identifying a stock market winner are present in the balance sheet of a company. The company's annual report and share price data, it believes, gives enough pointers to arrive at whether a stock is expensive or cheap. So, apart from looking at how fast and consistently the net profit figure is growing, other clues are the debt-equity ratio that needs to be low, the dividend track record uninterrupted and the price-to-earnings and price-to-book-value ratio be low.

The trick is to identify and buy stocks that are cheaper than the intrinsic value of the company. The key determinant of the decision is value and not price. And just like white-water rafting needs you to hold on confidently, whatever the size of the drop, do the same with value picks: invest with conviction and hold on patiently.

Another approach to value investing looks at picking up high dividend yield stocks that throw off regular income, apart from gaining weight in price. Finally, as Manish Sonthalia, vice-president, equity strategy, Motilal Oswal, says: 'Don't take a short-term approach to value investing. If you believe the value will be much higher in future, you should not get out when the stock appreciates by 20-30 per cent.'

One way to get to these stocks is to check the value of cash, liquid or business assets a company owns and buy only those companies that are quoting much below their intrinsic value. This value at some point of time should get unlocked, though the ways in which it is done could differ.

For instance, we have seen in the past, and even recently, how demerger of different businesses owned by a company into separate companies results in the unlocking of value for its shareholders. Some examples include Godrej [Get Quote] Consumer, Dabur India [Get Quote] and Reliance Industries [Get Quote].

Also, many a times, the stock market tends to ignore companies that are largely under-performing in their respective businesses, and treats them with poor valuations. That's a perfect time to buy such stocks.

For example, Raymond was once (in April 2000) quoting at Rs 75, when it had reported Rs 32.6 crore (Rs 32.6 million) net profit for 1999-2000. Then, its enterprise value (market capitalisation plus debt of Rs 764 crore, or Rs 7.64 billion) stood at Rs 1,327 crore (Rs 13.27 billion). But, if one were to analyse the value of its net liquid assets (cash and investments of about Rs 100 crore, or Rs 1 billion), and its steel, cement and textile businesses, the company's worth was much more.

In fact, excluding the steel and cement business, which Raymond sold for a consideration of Rs 1,126.9 crore (Rs 11.269 billion) a year later (resulting in profit on sale of assets of Rs 455 crore, or Rs 4.55 billion)), the company's value (mainly the textile business) in terms of value per share worked out to less than Rs 30. Today the stock is quoting at Rs 404.

Likewise, Bajaj Auto [Get Quote], too, was once available at a throw-away price. It was only later, when the market recognised it and rewarded with higher valuations.

However, in such situations, investors need to take a call on how soon and successfully the management can turn the business around. This last call -- will the management turn the company around or utilise the undervalued assets -- is where pure number crunching fails to work. So, it is imperative to go beyond mere value and look at the management also.

To sum up, seek value but also ensure that the other important ingredients like management quality, business potential, past track record and growth potential among others, are not questionable elements. But do be careful of mistaking a waterfall for a rapid. Is the low discounting due to a company being in a dying industry or is it reflective of an unethical management? This waterfall will never let your boat surface ever again. So do your due diligence.

2. Invest in expensive oars: Wealth Creators

Good for low-risk investors or the retired, is the strategy of buying wealth creators. These are companies, who on a long-term basis, continue to generate high levels of return on capital employed, require the least amount of capital, pay high dividends (as a percentage of annual net profit), have significant competitive advantages, completely write-off expenses (don't defer them to subsequent years), pay huge taxes and still manage to consistently grow revenues and profits year-after-year.

Not just dividends, the share price too grows year on year, though maybe at rates that are more mature than a pure growth play. Over the long term, these companies are real wealth creators, having thrown off income and given capital appreciation too.

And over a period of time, a small investment emerges as a pot of gold. For example, Gillette has a huge untapped market in India. The company has significant technological advantages, healthy margins and returns and, needs little money to keep its business growing, which is why it can continuously grow for many years to come.

But such companies don't come cheap. You need to pay a high price to be a part of this business as valuations are typically high for wealth creators. Companies with a consistent performance track record and capable of rewarding shareholders through handsome returns (stock price and dividends) can be classified as wealth creators.

Not many manage to stay afloat on the stock market rapids. If we look at some 4,700 listed companies, less than a dozen will stay afloat on these parameters. Companies like Gillette, Proctor & Gamble, and GlaxoSmithkline, among a few others make it to this list.

However, it is not that once a wealth-creator will always be so. The company could do badly or some external factor could change the rules of the game. For example, Hindustan Lever [Get Quote] went out of favour of the market for no fault of its own. The company was and continues to be efficient, but the big change that has happened is that its competitors have learnt the tricks of the trade and have become equally competitive.

They have managed to become negative in working capital, generate high return on capital employed, expand their distribution and supply chain in an efficient manner using the latest technology, and can now be said to be on par with Lever.

Warren Buffet

Background: A follower of Benjamin Graham, Buffet used a modified value-investing approach after he made a mistake by buying Berkshire Hathaway, then a textile firm.

Investment philosophy: Investors should bet on companies that not only fit the Value Investing criteria, but their business should have solid economics behind it. They should ask questions about the earnings growth and consistency in margins, return on equity and whether they retain earnings for future growth.

On applying Buffet's wisdom: There are a handful of good businesses that fit the bill -- Procter & Gamble Hygiene & Health Care, Gillette India [Get Quote] and GlaxoSmithkline Pharmaceuticals [Get Quote].

Benjamin Graham

Background: The original proponent of the value investing theory and the author of the pathbreaking Intelligent Investor, a Bible for many stock market investors.

Investment philosophy: Investors should bet on companies satisfying quantitative criteria covering valuations and financial parameters (for 10 years), as they are considered cheap as compared to their intrinsic value. Markets would some day recognise this and price them higher.

On applying Graham's wisdom: In the present market conditions, one will home in on: Aftek Infosys, BASF India [Get Quote], Hindalco [Get Quote], Indoco Remedies [Get Quote], Neyveli [Get Quote] Lignite, SCI and Tata Investment Corporation [Get Quote].

Philip Fisher

Background: Fisher followed a growth-based investing philosophy. Fisher's most famous investment was Motorola, a company he bought in 1955 (still a radio manufacturer) and held until his last days in March 2004.

Investment philosophy: Invest in stocks at reasonable prices and allow them to grow. Hold on as long as possible and till its long-term growth prospects remain intact. To choose a stock, investors should ask questions (to the company's suppliers, competitors, and consumers), pertaining to company's quality and market potential of its products, pricing power, potential for growth in sales besides, qualitative factors like the company's R&D facilities, its relations with labour and public, depth of management and controls.

On applying Fisher's wisdom: This could work well in India too, which is currently the second fastest growing economy. Companies like ITC, ICICI Bank [Get Quote], Mahindra & Mahindra and NTPC would figure here.

So, don't buy and forget. It is important to continuously monitor the company to ensure that its inherent strengths and competitive advantages remain in place, which in turn will enable it to consistently grow your money.

3. Choose a less crowded raft: The Contrarians

If all the rafts are going down, can you afford to go up? Sometimes going the other way yields rich returns.

Contrarian buying is one such investing strategy that many money managers use to maximise returns.

This is how it works: when the stock markets are rising, people are seen chasing stocks that are in the news. Hence, most likely their stock valuations will not be cheap. During such times, there are other stocks that may be ignored simply because the news channels are not chasing that story.

Behavioural finance calls this Availability Bias, that is, people base their investing decisions not on the full information set, but on recent events that caught their eye. So they invest in a stock that has been discussed in the newspapers or the investing channels on TV.

This bias causes investors to overreact to market conditions, be it in a positive or a negative way. The contrarian approach looks at ignoring all the noise and walking the less crowded path.

Remember the time when the FMCG index (a composite of FMCG companies) under-performed the index for a length of time, even though some of the companies were doing quite well? The contrarians ignored the market and bought and sure enough the market realised its mistake and valuations improved, making the contrarians rich. Markets tend to over-react.

For example, ITC got beaten down on the market consequent to the government slapping an excise claim against the company. The contrarians got in, because though the implications meant a sizeable dent in the company's financials in the short-term, it did little to impact its long-term prospects.

Investors should use this short-term irrational behaviour of the market to their advantage to buy good stocks at cheap valuations and reap higher returns. Importantly, 'contrarian strategies are relevant in all markets', says Tridib Pathak, chief investment officer, DBS Chola.

He adds: 'It makes more sense when the risk levels are higher. Besides, every year a good number of stocks will perform and some others will not perform. So, the focus should be on stocks that have not performed, but are fundamentally good companies. Here, the risk will also be lower.'

In the current context, oil marketing companies like HPCL [Get Quote], BPCL [Get Quote] and Indian Oil [Get Quote], for long, have been treated as untouchables due to the government policies that have proved to be adverse for them, leading to decline in profitability for these companies.

But, should there be a favourable change in policy or should crude oil prices decline to lower levels, the fortunes of these companies could change for the better. Hence, laying a bet on these companies could prove to be beneficial. Keep a watch for such opportunities to boost your gains.

4. Strap on the life jacket: The Good Businesses

Instead of just looking at the profit figure, the good business seekers go deeper and look behind the net profit figures. There could be hidden black holes from which the raft will never emerge. For example, does a fat profit figure hide the fact that the company may not be providing for expenses, both current and future?

Look for red flags like higher profits but lower than previous dividends. And despite having profits, is the company yet raising funds (through equity dilution and debt) for expanding business? Go a little deeper into the business and there will be more clarity.

Some of the 'bad business' companies can be identified by not enjoying pricing power and being in the low margins business. More importantly, the cost of staying in the business (includes setting aside resources for future growth) is not well taken care of by the existing business.

Companies in sectors like steel and cement will tend to figure here. Their profits are mostly not in their control and are cyclical in nature. When the economy is on an upswing, they tend to do well, and when not, they tank. It is at the peak of the cycle when profits are very high that investors tend to get carried away by looking merely at the sharp rise in profits.

On the other hand, within the commodity sphere, there are some companies that have managed to convert a commoditised business into one with reasonably strong entry barriers like brand, technology and innovation.

Consider Asian Paints [Get Quote], which is merely a paint manufacturer but has a strong brand value. It has also used technology to innovate various products that meet the rising needs of the consumer. And all this has been achieved, while ensuring that it earns respectable margins and return for its stakeholders. Likewise, Pidilite Industries [Get Quote] too, which is apparently in a commodity businesses, is a good bet here.

5. Put a motor on the raft: Potential Leaders

These are the new untested stocks that can win you any white water challenge or sink your boat. New players in old and new businesses and sectors can give you a geyser or suck you into a black hole. Look at an HDFC Bank [Get Quote] and an ICICI Bank and see how they have come from behind and changed the rules of the game, which is why they also enjoy higher valuations even as compared to SBI [Get Quote], the industry leader.

Then, look at telecom newbie which is now an entrenched player: Bharti Airtel [Get Quote] (earlier Bharti Tele-Ventures), which has changed the landscape of the telecom business. Look further in the past and you see a decade-old example in Hero Honda in the two-wheeler industry.

The key here is to spot them young, which in turn will  enable your portfolio to grow fast. Although some track record (including reasonably healthy financials) is desirable, more importantly, you should have enough conviction about the capability of the company to grow. In short, there should be reasonably solid visibility for growth (revenues and earnings) and potential for the industry to emerge bigger in size.

And finally, even if there is some equity dilution that may happen during the course, keep a tab on the net impact, which should be earnings accretive, an important element that will ensure a healthy appreciation in the share price. Companies like Yes Bank [Get Quote], PVR Cinemas (entertainment) Pantaloon [Get Quote] and Trent (both from retail space) can prove to be good bets.

Whew! You survived it. Now comes the hard part, of actually putting all this investment theory into practice. Happy rafting.

The Risk Capacity Game

Answer these questions to find out if you should even think of direct stock picking. This quiz will throw up an answer that will roughly tell you if you have the risk-taking ability. You may like to take more risk, but you may not have the profile to do so, if you get a low score on this test. Tick the one most applicable to you.

1. How old are you:

2. Over the next ten years your annual family income is likely to:

3. You are financially responsible for:

4. Your income source is:

5. How far away are your major financial goals?

6. Your savings, including retirement plans, are:

7. You live in:

8. How many years until you expect to retire?

Score in the following manner:
Choice a: 1 point  Choice b: 2 points  Choice c: 3 points

Your score: 8-13. Very low risk capacity. Stay away from direct stock market investing. This adventure sport is not for you. All equity exposure should come through mutual funds.

14-19. Medium risk capacity. You could look at allocating a small part of your equity asset allocation to direct stocks. Build a core portfolio with funds and then selectively use direct stocks to take more risk.

20-24. High risk capacity. You certainly have the ability to go white water rafting. Use the five tools we discuss to stay dry. Happy stock picking!

Inputs from Tejas P Bhope

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