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Investing: The top down approach

Jan 23, 2007

Amidst the bull run that the stock markets are witnessing and the euphoria that it has created, investing in the right kind of stocks with a disciplined approach has assumed significant importance. In this write-up, we shall focus on the top-down approach that is one of the most popular methods of identifying the right kind of stock.Economy: In fundamental analysis of stocks, the macro-environment is an important factor that determines the outlook of the economy and the industries to be impacted by the same. For instance, excess liquidity will lead to firming of interest rates, which in turn would affect the profitability of companies with a high level of debt (in the form of high interest costs). In today's times, concentrating only on the domestic economy is not sufficient. Given India's efforts to integrate with the global economy, global factors such as the US interest rates, crude prices and currency movements and the impact of the same on India also needs to be monitored.

Regulation and politics: Politics play an important role in determining the direction of the economy, industries and consequently companies. This is because for any economy to grow and prosper, it needs to implement policies and reform measures that may yield benefits over the long term. Thus, an unstable political environment not only hampers economic growth but also tends to adversely impact the stockmarket. This was amply proven in the elections in May 2004, when the UPA government came into power. The government's focus on infrastructure development, steps to curb fiscal deficit and simplifying tax structures are some of the important factors to keep an eye on.

Industry: The next step is to understand the industry in which a company operates. For instance, the impact of macro-economic factors and government policies for different industries tend to be different. Also, understanding the dynamics of the sector assumes importance. For instance, given the fact that the oil and gas industry is highly regulated, the government's stand on kerosene and petrol prices becomes critical. For the pharma industry, considering that exports have been gaining momentum, investors need to understand the generics environment in the regulated markets vis-a-vis that in the unregulated markets and so on. For the auto industry, which is facing pressure on the input side (read steel), the movement of steel prices plays an important role in determining the fortunes of this industry.

Company: Once an investor has decided upon the industry, the next step is to determine which is the best company in that particular sector. The first and foremost parameter in this regard is the quality of the management. The management's vision in anticipating changes in the sector, strong financials and proven track record play an important role in steering the growth of a company. Besides this, the position of the company in a particular sector (for instance whether it is the market leader or the second best player), its scale (in terms of bargaining power with the distribution chain) and so on are some of the factors that need to be considered.

To sum up...
At the end of the day, it becomes important to invest in a fundamentally sound company with a strong management, the ability to deliver results even during adverse conditions and reasonable valuations. This means that investors will need to research the companies well, read the annual reports and keep track of whether the company is on course to achieving its objectives. Ultimately, this is what will reward shareholders with steady returns in the long-term.

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