Equities VII

Chapter 2 Module 7 - Do it yourself - Basic investment strategies

A few benchmarks for stocks - A quick and easy measuring stick. These are a few benchmarks that can help you decide if you should spend more time on a stock or not. They are easily available and can be of great use in screening good stocks. Revenues/Sales growth. Revenues are how much the company has sold over a given period. Sales are the direct performance indicators for companies. The rate of growth of sales over the previous years indicates the forward momentum of the company, which will have a positive impact on the stock's valuation. Bottom line growth The bottom-line is the net profit of a company. The growth in net profit indicates the attractiveness of the stock. The expected growth rate might differ from industry to industry. For instance, the IT sector's growth in bottom-line could be as high as 65-70% from the previous years whereas for the old economy stocks the range could be anywhere in range of 10- 15%. ROI - Return on Investment ROI in layman terms is the return on capital invested in business i.e. if you invest Rs 1 crore in men, machines, land and material to generate 25 lakhs of net profit , then the ROI is 25%. Again the expected ROI by market analysts could differ form industry to industry. For the software industry it could be as high as 35-40%, whereas for a capital intensive industry it could be just 10-15%. Volume Many investors look at the volume of shares traded on a day in comparison with the average daily volume. The investor gets an insight of how active the stock was on a certain day as compared with previous days. When major news are announced, a stock can trade tens of times its average daily volume. Volume is also an indicator of the liquidity in a stock. Highly liquid stocks can be traded in large batches with low transaction costs. Illiquid stocks trade infrequently and large sales often cause the price to rise/fall dramatically. Illiquid stocks tend to carry large spreads i.e. the difference between the buying price and the selling price. Volume is a key way to measure supply and demand, and is often the primary indicator of a new price trend. When a stock moves up in price on unusually high volumes it could indicate that big institutional investors are accumulating the stock. When a stock moves down in price on unusually heavy volume, major selling could be the reason. Market Capitalization. This is the current market value of the company's shares. Market value is the total number of shares multiplied by the current price of each share. This would indicate the sheer size of the company, it's stocks' liquidity etc. Company management The quality of the top management is the most important of all resources that a company has access to. An investor has to make a careful assessment of the competence of the company management as evidenced by the dynamism and vision. Finally, the results are the single most important barometer of the company's management. If the company's board includes certain directors who are well known for their efficiency, honesty and integrity and are associated with other companies of proven excellence, an investor can consider it as favourable. Among the directors the MD (Managing Director) is the most important person. It is essential to know whether the MD is a person of proven competence. PSR (Price-to-Sales Ratio) This is the number you want below 3, and preferably below 1. This measures a company's stock price against the sales per share. Studies have shown that a PSR above 3 almost guarantees a loss while those below 1 give you a much better chance of success. Return on Equity Supposedly Warren Buffet's favorite number, this measures how much your investment is actually earning. Around 20% is considered good. Debt-to-Equity Ratio This measures how much debt a company has compared to the equity. The debt-to-equity ratio is arrived by dividing the total debt of the company with the equity capital. You're looking for a very low number here, not necessarily zero, but less than .5. If you see it at 1, then the company is still okay. A D/E ratio of more than 2 or greater is risky. It means that the company has a high interest burden, which will eventually affect the bottom-line. Not all debt is bad if used prudently. If interest payments are using only a small portion of the company's revenues, then the company is better off by employing debt pushing growth. Also note capital intensive industries build on a higher Debt/Equity ratio, hence this tool is not a right parameter in such cases. Beta The Beta factor measures how volatile a stock is when compared with an index. The higher the beta, the more volatile the stock is. (A negative beta means that the stock moves inversely to the market so when the index rises the stock goes down and vice versa). Earnings Per Share (EPS) This ratio determines what the company is earning for every share. For many investors, earnings is the most important tool. EPS is calculated by dividing the earnings (net profit) by the total number of equity shares. Thus, if AB ltd has 2 crore shares and has earned Rs 4 crore in the past 12 months, it has an EPS of Rs 2. EPS Rating factors the long-term and short-term earnings growth of a company as compared with other firms in the segment. Take the last two quarters of earnings-per-share increase and combine that with the three-to-five-year earnings growth rate. Then compare this number for a company to all other companies in your watch list within each sector and rate the results on how it outperforms all other companies in your watch list in terms of earnings growth. Its advisable to invest in stocks that rank in the top 20% of companies in your watch list. This is based on the assumption that your portfolio of stocks in the "Watch List" have been selected by using some basic screening tools so as to include the best of the stocks as perceived and authenticated by the screening tools that you had used. Price / Earnings Ratio (P/E). Read about this most important investor tool in the next part of this module.

The P/E ratio as a guide to investment decisions Earnings per share alone mean absolutely nothing. In order to get a sense of how expensive or cheap a stock is, you have to look at earnings relative to the stock price and hence employ the P/E ratio. The P/E ratio takes the stock price and divides it by the last four quarters' worth of earnings. If AB ltd is currently trading at Rs. 20 a share with Rs. 4 of earnings per share (EPS), it would have a P/E of 5. Big increase in earnings is an important factor for share value appreciation. When a stock's P-E ratio is high, the majority of investors consider it as pricey or overvalued. Stocks with low P-E's are typically considered a good value. However, studies done and past market experience have proved that the higher the P/E, the better the stock. A Company that currently earns Re 1 per share and expects its earnings to grow at 20% p.a will sell at some multiple of its future earnings. Assuming that earnings will be Rs 2.50 (i.e Re 1 compounded at 20% p.a for 5 years). Also assume that the normal P/E ratio is 15. Then the stock selling at a normal P/E ratio of 15 times of the expected earnings of Rs 2.50 could sell for Rs 37.50 (i.e rs 2.5*15) or 37.5 times of this years earnings. Thus if a company expects its earnings to grow by 20% per year in the future, investors will be willing to pay now for those shares an amount based on those future earnings. In this buying frenzy, the investors would bid the price up until a share sells at a very high P/E ratio relative to its present earnings. First, one can obtain some idea of a reasonable price to pay for the stock by comparing its present P/E to its past levels of P/E ratio. One can learn what is a high and what is a low P/E for the individual company. One can compare the P/E ratio of the company with that of the market giving a relative measure. One can also use the average P/E ratio over time to help judge the reasonableness of the present levels of prices. All this suggests that as an investor one has to attempt to purchase a stock close to what is judged as a reasonable P/E ratio based on the comparisons made. One must also realize that we must pay a higher price for a quality company with quality management and attractive earnings potential.

Fundamental Analysis Fundamental Analysis is a conservative and non-speculative approach based on the "Fundamentals". A fundamentalist is not swept by what is happening in Dalal street as he looks at a three dimensional analysis. The Economy The Industry The Company All the above three dimensions will have to be weighed together and not in exclusion of each other. In this section we would give you a brief glimpse of each of these factors for an easy digestion The Economy Analysis In the table below are some economic indicators and their possible impact on the stock market are given in a nut shell. Economic indicators Impact on the stock market 1. GNP -Growth -Decline -Favourable -Unfavourable 2. Price Conditions - Stable - Inflation -Favourable -Unfavourable 3. Economy - Boom - Recession -Favourable -Unfavourable 4. Housing Construction Activity - Increase in activity - Decrease in Activity -Favourable -Unfavourable 5. Employment - Increase - Decrease -Favourable -Unfavourable 6. Accumulation of Inventories - Favourable under inflation - Unfavourable under deflation 7. Personal Disposable Income - Increase - Decrease -Favourable -Unfavourable 8. Personal Savings - Favourable under inflation - Unfavourable under deflation 9. Interest Rates - low - high -Favourable -Unfavourable 10. Balance of trade - Positive - Negative -Favourable -Unfavourable 11. Strength of the Rupee in Forex market - Strong - Weak -Favourable -Unfavourable 12. Corporate Taxation (Direct & Indirect - Low - High -Favourable -Unfavourable The Industry Analysis Every industry has to go through a life cycle with four distinct phases i) Pioneering Stage ii) Expansion (growth) Stage iii) Stagnation (mature) Stage iv) Decline Stage These phases are dynamic for each industry. You as an investor is advised to invest in an industry that is either in a pioneering stage or in its expansion (growth) stage. Its advisable to quickly get out of industries which are in the stagnation stage prior to its lapse into the decline stage. The particular phase or stage of an industry can be determined in terms of sales, profitability and their growth rates amongst other factors. The Company Analysis There may be situations were the industry is very attractive but a few companies within it might not be doing all that well; similarly there may be one or two companies which may be doing exceedingly well while the rest of the companies in the industry might be in doldrums. You as an investor will have to consider both the financial and non-financial aspects so as to form a qualitative impression about a company. Some of the factors are History of the company and line of business Product portfolio's strength Market Share Top Management Intrinsic Values like Patents and trademarks held Foreign Collaboration, its need and availability for future Quality of competition in the market, present and future Future business plans and projects Tags - Like Blue Chips, Market Cap - low, medium and big caps Level of trading of the company's listed scripts EPS, its growth and rating vis-à-vis other companies in the industry. P/E ratio Growth in sales, dividend and bottom line

Value, Growth and Income Growth, Value, Income and GARP are one of the most rational ways of stock analysis. A brief on each of them is given here for your understanding. Growth Stocks The task here is to buy stock in companies whose potential for growth in sales and earnings is excellent. Companies growing faster than the rest of the stocks in the market or faster than other stocks in the same industry are the target i.e the Growth Stocks. These companies usually pay little or no dividends, since they prefer to reinvest their profits in their business. Individuals who invest in growth stocks should make up their portfolio with established, well-managed companies that can be held onto for many, many years. Companies like HLL, Nestle, Infosys, Wipro have demonstrated great growth over the years, and are the cornerstones of many portfolios. Most investment clubs stick to growth stocks, too. Value Stocks The task here is to look for stocks that have been overlooked by other investors and that which may have a "hidden value." These companies may have been beaten down in price because of some bad event, or may be in an industry that's looked down upon by most investors. However, even a company that has seen its stock price decline still has assets to its name-buildings, real estate, inventories, subsidiaries, and so on. Many of these assets still have value, yet that value may not be reflected in the stock's price. Value investors look to buy stocks that are undervalued, and then hold those stocks until the rest of the market (hopefully!) realizes the real value of the company's assets. The value investors tend to purchase a company's stock usually based on relationships between the current market price of the company and certain business fundamentals. They like P/E ratio being below a certain absolute limit; dividend yields above a certain absolute limit; Total sales at a certain level relative to the company's market capitalization, or market value. Templeton Mutual funds are one of the major practitioners of this strategy. Growth is often discussed in opposition to value, but sometimes the lines between the two approaches become quite fuzzy in practice. Income. Stocks are widely purchased by people who expect the shares to increase in value but there are still many people who buy stocks primarily because of the stream of dividends they generate. Called income investors, these individuals often entirely forego companies whose shares have the possibility of capital appreciation for high-yielding dividend-paying companies in slow-growth industries.

Keep investing, panic not on your existing stocks Here's the best tip we can give you if the volatility in the market has spooked you or if you had seen a large profit wash away in the falling market: ignore your stocks right now and keep your investing attention to something else. Focus all your efforts and time on the company your stock represents. That's because there are really two elements at work when investing: the stock, which is part of the stock market, and the company, something the stock is supposed to represent. But the company works in a different universe from the stock market, involved more in the real world of profits and losses rather than the emotional tide of fear and greed, the two major forces behind the stock market. With the uncertainty prevailing in the market, fear is rampant and some of it is justified, but there are lots of good companies that might be hammered by that emotion. That's why you'll do better if you research your companies in depth rather than trying to figure out if the morning sell off is the beginning of the end or just a hick up on the road to true wealth. But let's say you've done all your numbers, and everything looks great. You've checked for the latest news and you still can't tell why your stock is down. Then you might want to call the company directly and ask for the Investor Relations department. Don't expect the investor relations person to tell you any secrets or unpublished information but you can ask a few questions and get a better feeling about the company: 1. Why is the stock down so dramatically? Are there rumors the company has heard? If so, what is the company's response to them. 2. Is there anything the company can say about the stock being down? 3. Are the officers of the firm buying or selling the stock? 4. Is the company buying its own shares right now? You will hence get a sense of how the company is responding to its stock being down, and maybe hear about news that has just been published but you haven't read. Then, when you've done all you can to determine that the company in which you've invested is indeed doing everything well, you can ignore the stock and be assured that this too shall pass. If you determine that the stock is down for a good reason and seems to be going lower, then you can sell it and move on to another company. In either case, you can make a decision based on the company and not the stock.

Go for quality stocks and not quantity New investors often want to make a quick buck (some old investors do, too). Sometimes you can do that if you get lucky. But the really big money in investing is made from holding quality stocks a long time. Many investors ask for information on cheap stocks. The usual premise is that they don't have much money, and they want to own thousands of shares of something, that way when it goes up, they'll make big money. The problem is these stocks don't go up. They're a scam for the brokers, and the spread between the bid and the ask on these stocks is enormous, making it impossible to sell them at a profit. Instead of trying to buy thousands of shares of a worthless stock for Rs 10000, let's see what else you can do with it. These examples are all split adjusted and show what that Rs. 10000 can do when you buy the right stocks. If you had bought Infosys in 1991 for Rs share (split adjusted), you would own n shares Obviously it's easy to look back to find great stocks. And you had to hold onto these volatile issues to reap these rewards. But the point is that quality stocks are worth holding. In the above examples, the owners have paid no taxes because there have not been any gains taken. The only commission paid was the original one. And as long as the stocks continue to produce good earnings, there's no reason to sell them. Again, it's easy to pick the good ones looking back, going forward, which stocks are the best ones to own? Do your research thoroughly. Build a portfolio of stocks, one stock at a time, even with Rs 10000. Be sure to diversify over several industries over time. And only buy the best, no matter how few shares that might be. Then be patient, keep up with the news on the stock, and let the stock grow. That's the way the big money is made.

How many stocks should you own? Buying a large number of stocks is time-consuming and will distract you from focusing on the absolute best stocks. Most investors simply cannot keep track of a large number of stocks, so concentrate on just a few of the best. Use this simple guideline to determine the number of stocks to own: Less than Rs. 20,000 1 or 2 stocks Rs. 20,000 to Rs. 50,000 2 or 3 stocks Rs. 50,000 to Rs. 2,00,000 3 to 5 stocks Rs. 2,00,000 to Rs. 5,00,000 5 to 7 stocks Rs. 5,00,000 or more 7 to 10 stocks

Some more Stock tips 1. New products, services or leadership. If a company has a dynamic new product or service, or is capitalizing on new conditions in the economy, this can have a dramatic impact on the price of a stock. 2. Leading stock in a leading industry group. Nearly 50% of a stock's price action is a result of its industry group's performance. Focus on the top industry groups, and within those groups select stocks with the best price performance. Don't buy laggards just because they look cheaper. 3. High-rated institutional sponsorship. You want at least a few of the better performing mutual funds owning the stock. They're the ones who will drive the stock up on a sustained basis. 4. New Highs. Stocks that make new highs on increased volume tend to move higher. Outstanding stocks usually form a price consolidation pattern, and then go on to make their biggest gains when their price breaks above the pattern on unusually high volume. 5. Positive market. You can buy the best stocks out there, but if the general market is weak, most likely your stocks will be weak also. You need to study our "The market talks. Listen, to spot the best." - Module 8 and learn how to interpret shifts in the market's trend. 6. You should not buy on dips. This is a strategy that doesn't give you a strong probability of making a profit. Remember a stock that has dipped 25% needs to rise 33% to recover the loss and a stock that has dipped 50% needs to double to get back to its old high. Read about them in detail in the next module. Equites VIII