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Stockmarkets: What to look for? - Views on News from Equitymaster
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  • Jul 14, 2005

    Stockmarkets: What to look for?

    "Fools rush in where angels fear to tread," said Alexander Pope, the well-known eighteenth century English poet and writer. Well, we are certain that he was not referring to the stock markets when he said that, but the current market situation in India is not too different! With stock markets at unprecedented highs, much above what is warranted by fundamentals, it is only the 'fools' who would rush in to buy any stock at these levels. The 'fool' that we are referring to in this case implies the participant who is willing to pick up any kind of stock at such levels, giving least consideration to the inherent strength of the company and its future growth prospects and believing that 'the stock', like some other stocks will definitely give him bumper returns!

    Now, we are not saying that one should totally avoid the stock markets at this juncture. What we are saying is that investors need to practice caution and more of it now than ever before. With valuations looking fairly stretched, there is every reason to be cautious. Just look at the factors driving the markets up - liquidity is sloshing around like never before, Foreign Institutional Investors (FIIs) are pumping in hundreds of millions of dollars into the markets, even though stocks have run ahead of fundamentals (at last count, net FII investment in CY05 to date has crossed US$ 5 bn). Virtually all the indices, including mid and large-cap indices, have hit all-time highs. But none of this seems to be justified by fundamentals.

    Now take a look at some factors that we need to be concerned about - like stocks, unfortunately, oil prices are also at record highs. The US property market 'bubble' could top out anytime, reducing the spending power of the debt-ridden US consumer, by far the strongest force driving the growth of the global economy on the demand side, the slow job growth and wage growth in the US economy relative to the increase in productivity, China's overheated economy due for a slowdown, risk of terrorist strikes, geopolitical issues and so on.

    Therefore, given the above factors, if any of the above 'potential party-poopers' do materialize, India will surely be affected in some way or the other, as she becomes increasingly integrated with the global economy. So, what can an investor do in such 'bubbly' and 'frothy' times?

    Investors, please consider!

    Future growth prospects: For starters, one has to make sure that the company one is investing in has strong growth prospects. In a bull market such as ours at present, even the 'dud stocks' go up along with the real 'gems'. Therefore, in order to separate the wheat from the chaff, doing solid research on the target company is extremely vital. There is no substitute for this! The investor, before 'taking the plunge', must understand the fundamentals of the company, past performance and future growth prospects. Eventually, when markets do cool down and the smoke clears, it is only the 'gems' that will still remain standing!

    Management quality: Management is of utmost importance while choosing a company to invest in. For example, in the software industry, which is highly dynamic and competition is on a global scale, the management's ability to think out of the box and come up with innovative solutions to critical business problems will help a company stand out. With the 'global delivery model' pioneered by the likes of Infosys and TCS, the software industry has literally changed the way business is done in the industry and has forced MNC IT majors to do likewise and change their methods to suit the new paradigm shift of global service delivery. With a solid management quality and track record in place, top-tier software majors appear set for strong business growth over the next few years. These are factors one must look for in other companies and sectors as well.

    Cyclicality: Another factor that needs to be looked at closely is the cyclicality of the industry. For example, the steel industry is cyclical in nature. When demand soars, steel prices pick up due to lower supply and as capacities are added, demand is satiated and the gap between demand and supply is bridged, prices get back to the lower levels. The major factor that investors need to watch closely is the stage of the cycle. Of course, it is easier said than done, but one can observe broad global factors driving prices, such as a cutback in imports from China, a large increase in steel capacities in India and the trend of global steel prices to gauge the cycle. On the basis of this, one can come to a conclusion as to whether prices will remain strong or not and take a call on companies from this sector.

    Valuations: Needless to say, in such a frothy market, where liquidity rather than fundamentals is the main driver of the upward movement in stock prices, valuations take centrestage while choosing a stock. One needs to be careful, particularly if one is considering an investment in mid-cap stocks. Once again, to reiterate the point, we are not saying that there is no stock worth buying in this space, just that caution needs to be the watchword during the process of stock selection. Compare current valuations with earnings growth and see whether the market price justifies the earnings growth, actual and expected. If medium-term earnings growth is already factored into the stock price, quite clearly, the risk-return ratio is skewed towards risk.

    Free float: Another factor that needs to be considered is the 'free float' of the stock. As per the BSE, Free-float market capitalization is defined as 'that proportion of total shares issued by the company, which are readily available for trading in the market. It generally excludes promoters' holding, government holding, strategic holding and other locked-in shares, which will not come to the market for trading in the normal course.' The point to note is that, the higher the free float, the greater the stability and lesser the volatility of the shares, as a greater number of shares are traded by a wider audience of investors. It is also reflective of a more true process of price discovery, as a greater number of people get to express their views on the 'fair value' of the stock price, through buying and selling.

    It has always been seen in the past that retail investors generally begin to participate at the fag end of any bull market. They buy at the highest prices and sell when the prices have fallen considerably. Thus, in order to ensure that investors do not make such a mistake, considering the points we have listed above is an extremely vital part of the investment decision. Thus, we reiterate that there is no substitute for doing thorough research about the company and sector before taking a decision. Happy and safe investing!



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