Financial education in very simple terms. The following article elucidates the thought process for investing in Equities… Read on..
Equity market investments typically yield high returns, particularly if invested over longer periods of time, although such investments are characterized by a high degree of price volatility in the short term. The volatility in our markets, particularly in the nineties, reflects significant shifts in the nature of the Indian economy, with the services sector gaining increasing importance. This fundamental change in the economy has resulted in a dramatic change in the nature of our stock markets with the services sector, including technology, assuming increasing importance. Investment in equities has dismayed many in the short term, but if executed in the framework of the steps outlined below, may help in better choices.
Identify your objective, given your needs, life stage and resources. If you want to increase the value of your investment in order to have a larger sum to spend at a later date, your main priority will be capital growth.
Identify your risk tolerance and then invest appropriately Young people at the start of their working lives will have a greater appetite for taking financial risk as compared to people at the end of their career who are looking forward to stable income and preservation of capital. These two extremes will exemplify the ability to take equity exposure. The young person is likely to be invested largely in equities for he can afford to take short term capital loss in anticipation of higher rates of return from equities. The elderly will be unable to take the risk of capital loss even in the short term as their ability to make back any losses will be limited by time and ability to earn.
Categorize your stock: Cyclical, Growth or Defensive Investing in cyclical stocks, such as those in the cement or steel sector, requires an understanding of the economic scenario. An active involvement in the investment is required in order to reap the maximum benefits of swings in economic cycles over time. The stock prices are likely to move through extreme highs and lows, and the ability to time entry and exit will be necessary. Growth investing refers to stocks in sectors where the future direction is clear for the medium term – such as technology. However even here, timing is key, for the stock may do nothing for a long time as momentum builds up and then move sharply thereafter.Defensive investing is that which is done from a long term viewpoint, where a stock is held on the premise that it will grow consistently and on a sustainable basis over time, such as those in the fast moving consumer goods sector. While the appreciation may, at times, not be as dramatic as cyclical or growth stocks, stocks that constitute defensive investments grow steadily over longer time periods.
Check out the technical position. Can you actually sell your investment when you want to? The liquidity of a stock is very important in taking an investment decision, for if there is very little free stock available in the market, buying and selling may well impact the stock price in an adverse manner. It is interesting to see what the price volume relationship is for a stock. So if a stock price is moving up or down on high trading volume, it is more likely that there is real interest in that price movement than if there is very little volume supporting the price move.
Know what the company does The fate of each stock is tied inextricably to the fortune of the underlying business, and the market’s perception of the future prospects for that business. The industry’s future potential in terms of projected demand-supply is key as is the company’s competitive position in the industry. The business model of the company should be considered, as well as possible future changes, and the ability of the company to sustain growth and momentum well into the future.
Know who runs the company The capability and integrity of management is even more important in determining the future viability of your investment. A strong, credible, experienced and shareholder responsive management team is critical for operating and growing a successful company. In the newer areas of our economy, management vision is also of significant importance.
Know the company’s performance The price earnings (P/E) ratio is the often quoted measure of a company’s value. This ratio divides the stock price by the year’s earnings, and is useful in arriving at comparative valuation. But the tool that is quite prevalent in professional evaluations is the return on equity (ROE), which is the year’s earnings divided by the net worth of the company. This when compared to the cost of capital for the company allows the investor to gauge the company’s wealth creating ability. Apart from the ratios the investor must also focus on the sustainability of earnings growth.
Know the company’s valuation Two stocks may have the same EPS but different P/E’s. This is because ROE may be different and its sustainability may be different. Broadly speaking, the higher the sustainable ROE, the higher the P/E rating. A high P/E does not therefore necessarily imply an overvalued stock. Stocks with high sustainable ROEs are likely to trade at high P/E multiples.
Know the price target Having selected stocks and built a portfolio, it is now imperative to track these investments closely. One method of doing so is to set expectations, by identifying a target price, and to re-evaluate the stock when this target is reached. Here, it is important to consider opportunity costs. If there is a loss on a stock, should one realize that loss and invest in another stock, which has a greater potential, or should one wait for the loss to turn into a profit. By not selling out of low return stocks to get into higher return stocks, investors miss out on opportunities.
Do you want a professional manager? Many investors mistakenly assume that they can purchase one or two stocks and they will do well. In the absence of good luck, this can be a dangerous strategy since there is always a risk of a stock declining in value or the business facing company specific problems. The more diversified the portfolio, lower is the risk of one poorly performing stock affecting overall performance of the portfolio. However, a good way of diversifying the portfolio is to invest through mutual funds where the professional fund manager and the rigorous investment process is likely to limit risk while maximizing profit, depending on the risk profile of the fund invested in.