Stock markets: What to depend upon? - Views on News from Equitymaster

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Stock markets: What to depend upon?

Jun 17, 2005

As indices touch reeling heights and Foreign Institutional Investors (FIIs) continue to pump in money, investment decision in equities become agonizing. One does not know which way to follow. Whether it is the market sentiments or the strong sectoral prospects as predicted in reports and pink papers that one should chase? Or whether one should stick to the time tested norm of evaluating the underlying value of the stock.When we asked our investors this question, a majority (64%) seemed to rely on 'strong growth prospects', while 21% believed that cheap valuations were of utmost importance. The remaining 15% however, gave in to the 'sentiments'.

Positive sentiments: You must have heard about the 'efficient market' where investors' knowledge magically and correctly sets the best price for a stock. Unfortunately, even when bales of information are available through the click of a mouse, the market is too often inefficient and prices do not always reflect the underlying value. As the legendry investor Mr. Benjamin Graham put it, "The market price is frequently out of line with the true value. There is however, an inherent tendency for these disparities to correct themselves." Undervaluations may persist for an inconveniently long time and the same applies to inflated prices. However, like all other good things, the 'over-optimism' must also subside. While it is true that almost every stock goes up in a bull market, it must be noted that those that are devoid of fundamentals would be the first ones to tumble at the slightest scent of a trend reversal. Positive sentiments should therefore, is not a factor that one should bank on.

Strong prospects: Investors must look for companies that not only benefit from an economic expansion but also survive at the eventuality of a downturn. In an economic upturn, almost any and every company is optimistic. But what investors need to be wary of is whether the figures will be sustainable when the cycle reverses. For investors willing to do an extensive spadework, companies with strong balance sheets, a historical record of earnings (with minimum volatility) and attractive dividend payout must be the green light.

Cheap valuations: As an investor, one's objective must be to pay less than the company's intrinsic worth. 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 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. However, as been seen in recent times, the so-called 'efficient' market has become irrational and is awarding unjustifiable valuations to earnings (say for some mid-caps companies). Thus, at 6,900 levels investors should not only look for good companies but also 'appropriately valued' companies.

To conclude...
In the current times, when the markets are unpredictable, risk can be associated with paying a higher price for a stock that does not justify value of the holding or that already factors in the growth for the next few years. And in these times, it is an imperative for equity investors to give heed to one of the most important concepts of investing known as the 'margin of safety'. The concept widely propagated by Mr. Graham has time and again saved investors from losing their hard earned money in the whirlwinds of the stock market. It only means that investors should keep a reasonable 'gap' between the price they pay and the potential value of their investment. This not only provides a cushion from possible downfalls but also offers better return on investment. The bottomline is that sentiments and prospects are but a temporary phase. If there is one criterion that investors can rely perpetually on, it is 'Fundamentals'. After all, who does not value money? Investments are but a complex version of the same!

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