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Investing: Defence is the best offence!

Jun 28, 2005

In an earlier article, we had indicated the strategy that defensive investors need to follow in order to minimize the risk of losing the value of their investments. Now, as the Indian stock markets move deeper into uncharted waters and stock prices move under a cloud of volatility, it is time for small investors to step back and adhere to the discipline of long-term investing.In these volatile times, an investor should keep some benchmarks 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).

Sector: The investors should avoid sectors that are risky in nature, like those too dependent on the occurrence / non-occurrence of an event (commodities due to effect of China slowdown) or one that relies heavily on government policies (energy).

Sales: Investors need to select companies of adequate size (in sales and cash flow terms). A large balance sheet and a high market share helps a company to tide over the excessive volatilities of the industrial cycle.

Current ratio: This indicates financial security and the ability to meet short-term cash requirements. Defensive investors should generally select companies that have current assets double its current liabilities.

Long term EPS growth: This indicates financial sustainability. Earnings growth should at least be greater than 15% (at par with the expected earnings growth in Sensex companies) and not negative in the past three to five years. A long-term sustainable earnings growth also indicates the management's ability to reward stakeholders.

P/E ratio: This is one of the most important criteria in these times. While valuations differ across industries, investors should generally look at a 2-year forward price to earnings multiple of around 15 times for a growth stock (industries like software and pharma) and a price to earnings multiple of 6 to 8 times for stocks from the industries that are more dependent on the overall economic growth of the country (like FMCG).

Remember, these rules are strictly for investors who are defensive in nature and generally place high emphasis on the safety of 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.

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 shall maximise the chances of him garnering adequate return on his investments.

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