How would you decide whether Hindustan Lever is a better buy in today's market or is Infosys Technologies? Or for that matter should you be investing in stocks at all? Well, to answer these questions it requires nothing short of a thesis. Nevertheless (the ideal solution is better avoided!) we make an attempt to equip the retail investor with a tool that will help him identify an investment opportunity.
The diagram below is a representation of a classical Top Down approach to investing in stock markets.
In order to capture the essence of the top down approach to investing, letís evaluate each one of these investment criterions.
Politics has a very strong bearing on stock markets. Investment decisions continue to be weighed down by prospects of instability in the government. Indian investors are well versed with the fallout of such a scenario.
Then again, investors must analyze or look into policy initiatives of the government and weigh whether they will be pursued at all or not. One example of this is the disinvestment of holdings in the domestic energy and telecom sector, which comprises public sector companies such as Mahanagar Telephone Nigam Limited (MTNL) and Bharat Petroleum Corporation Limited (BPCL). These companies have failed to move in sync with a bullish market largely due to the uncertainty regarding government policy. Other policy initiatives of the government, like the decision to participate in the World Trade Organization (WTO) also have a bearing on the markets.
For example, in India's case, we require a stable government with a strong sense of fiscal discipline. At the same time, there is a need to push through the second phase of reforms. If the incumbent government were not to deliver on any of these counts, one can expect an adverse fallout on the bourses (surely in the long run).
How the economy performs is influenced to a great deal by the political climate in the country. To put it another way, the economy cannot continue to post robust growth in absence of a conducive policy environment. Moreover, with India becoming a member of the WTO and foreign capital finding its way into the country, the need to track the global economy has never been felt as much.
In the Indian case, performance of the agricultural sector is a key factor affecting overall economic growth. This is not only due to the fact that this segment accounts for over 25% of domestic GDP. But it employs over half the Indian population, which looked at it in one-way, is a massive consumption base. Therefore if the agricultural sector were to falter (due to a weak monsoon or for some other reason) overall economic growth will surely be affected. Companies with a high exposure to rural markets (or agriculturally dependent) will be worst affected.
Another factor that needs to be looked into is the fiscal deficit of the government. This can be met either from borrowings or creating money. While exercising the first option puts upward pressure on interest rates, the latter contributes to inflation. Thus, either option, if not handled well, can have adverse consequences for the economic environment and stock valuations could be hurt.
Investors must also take note of developments in foreign trade and forex reserve position of the government. Exchange rate movements too can have significant impact on corporates. These are just some of the important economic indicators that need to be looked into while deciding where to invest.
After having looked into the broader parameters, an investor must carefully analyze the industry in which he proposes to invest. For example, an investor can assess the industry on certain factors like: demand, supply, bargaining power of suppliers, bargaining power of customers, threat of substitutes and existing competition (akin to Michael Porterís model). Such an analysis will clearly bring to light the state of the sector. For the sake of an example letís analyze the cement sector in brief.
Demand for cement is estimated to grow at over 8% per annum over the next few years even as capacity additions slow down to a trickle. Demand growth in FY00 was put at 15%, marginally lower than the increase in supply. Growth in future will benefit from increased spending on infrastructure i.e. roads and housing. As there is no substitute for cement, there is no threat of an alternative for now. However, there is intense competition in the sector, which has led to a pressure on realisations. Indeed, in FY00 realisations increased only marginally despite the surge in demand. Consequent to this, the bargaining power of customers is also higher. However recent consolidation in the sector is a step towards limiting the level of fragmentation in the sector. As consolidation gains pace the sector can benefit from lesser price competition and in turn possibly better realisations.
Letís suppose an investor zeroes in on the cement sector. The next step is to identify the promoter/management he wishes to invest in. Taking our example forward, during the recent slowdown in the Indian economy, a number of cement manufacturers posted a sharp decline in profits. However, Gujarat Ambuja Cements came out relatively unscathed. Credit for this needs to be given to the management. Investors must choose Ďproactiveí managements, which are capable of generating above industry average returns.
After having seen that the policy environment in conducive, the economy is expected to remain buoyant and the industry scenario for, say, cement is positive, there is a need to decide on a company to invest in. A company in the cement sector can be expected to do well only if the other macro factors are favourable. However, within the sector companies earn differential returns mainly due to company specific factors. For example, for a cement company location (with reference to markets and raw material deposits) is of prime importance. Cement companies in south India are facing intense competition and are facing a decline in realisations. However, the situation in the eastern markets is better. Then there are issues pertaining to financial performance, efficiency and costs of production. These are just some of the factors that need to be evaluated.
Letís take another example. In the software sector some companies earn higher margins mainly due the value added nature of their work. Infosys, which is gradually venturing into software products, commands margins that are substantially higher than, say, NIIT, which draws a large part of its revenues from the highly competitive computer education business. Then issues such as employee turnover need to be looked into, as people are their key assets. Among the other factors that are of importance are the customer profile and their geographical spread (North American markets usually yield the highest returns).
The top down approach is a tool with the help of which investors are likely to find sound investment opportunities in stock markets. Such an approach helps bring much needed objectivity to the decision making process and must be made use of by investors.