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Investing rules: Lest you forget! - Views on News from Equitymaster
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  • Feb 15, 2005

    Investing rules: Lest you forget!

    As the Indian stock markets move into uncharted waters, and stock prices move under a cloud of volatility, it is time for small investors to step back and take note of some of the key rules for safe and defensive investing. In these times, the rules spelt out by the legendary investor, Benjamin Graham, should come in handy for 'defensive' investors, or those who are risk averse in their investing habits. A defensive investor is one who generally places high emphasis on the safety of his capital through avoiding serious mistakes while making investment decisions. Also, a defensive investor is one who aims at freedom from effort and the need for making frequent decisions.

    In these volatile times, thus, such an investor should keep some benchmarks for himself while selecting his portfolio of stocks. Only this would be of help in his need for making less frequent decisions. These are some of the characteristics that a defensive investor should look at in a company, or the potential investment target(s).

    Adequate size of the enterprise: This is one of the most important factors while selecting a company for investment. Investors should note that small companies or those that are in the nascent stages of their development are more likely to have a volatile future than bigger corporations. While an aggressive investor would have interests in such small yet growing companies, this should not be a defensive investor's cup of tea. He should be content in having large and strong companies in his portfolio.

    Sufficiently strong and stable financial condition: A sufficiently strong financial condition of a company should be another top priority for defensive investors. They should make sure that their investment target (company) has a strong balance sheet and profit and loss account, and a very strong cash flow statement. This is because, more than book profits, it is the strong cash position that is of help for the company in times of pressure and uncertainty. Also, for a company to be a sound investment target, not only should it have a history of decent earnings growth, but also stability in the same. A company with a volatile earnings growth history is more likely to be a risky proposition.

    Dividend growth: A consistent dividend payment record is another indicator of the sound financial position of the company. While there might be instances when a growing company is ploughing back earnings towards future growth rather than paying large dividends, investors must see that there are no grave inconsistencies in dividend payments.

    Moderate P/E ratio: A moderate price-to-earnings ratio is a very useful indicator for a defensive investor. This is because a relatively lower P/E would save investors from paying a very high price that does not justify the value of an investment. Also, a history of moderate or less-volatile P/E's also helps the investors' cause. This is because a company that has had volatile P/E's in the past is a case of investors building up 'irrational expectations' of its growth.

    Apart from these performance parameters, Investors should also take note of the 'management quality' - its vision and the past track record. All said and done, while the rules mentioned above are benchmarks that every defensive investor needs to apply before making any investment decision, the fact that he should do his homework carefully should not lose relevance. This means that he should research well about the company's history, its business model and factors that are likely to affect its future performance. Also, the investor should have a long-term (more than 3 years) investment horizon for this maximises the chance of garnering adequate return on investments.



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