All that goes up.... - Views on News from Equitymaster

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All that goes up....

Jul 22, 2005

...must come down! But when indices defy this law of gravity, one gets tempted to 'make hay when the sun is shining'. It is then that a rational investor must resort to some of the time-tested maxims of investing. This is because, 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". We suggest, that the retail investors (the worst hit lot when the bull run subsides) must thus adopt some disciplined and prudent norms, to protect their investments from getting washed away with the tide.

  • Know the numbers and what they mean: Number crunching may not sound a very convincing proposition for finding value in an investment, but it is necessary to keep track of the said value. Here we do not mean to say that one must change his/her investment outlook based on quarterly results, but glancing over the key numbers may help to make a peer comparison or evaluate the correctness of the direction in which the company is progressing. Even in a long-term investment, one must not forget that the rule of 'ceteris paribus' may not always hold true, and thus it is necessary to periodically evaluate whether the investment still holds the same 'value' as it once did. A timely action may help you correct a wrong investment decision. In Warren Buffet's words, "Should you find yourself in a chronically-leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks".

  • Invest in the business you understand: The best way to safeguard one's capital is to not invest in a 'company' but to invest in a 'business'. Nevertheless, it makes better sense to invest in business that you understand. This can, not only help the investor in comprehending new business initiatives, but also in diagnosing the 'health' of the business. An understanding of the industry dynamics will also go a long way in cautioning you about the sector prospects.

  • Read widely to value prospects: Instead of getting swayed away by the market tips and hearsays, it proves worthwhile to keep oneself abreast with the latest happenings in the company/sector that you have invested in. Reading the annual report is an ideal way of familiarising oneself with a company, besides getting a feel of the quality of management.

  • Maintain a margin of safety: Investors must also 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. Also, businesses are subject to various internal and external risks, which may affect the earnings growth prospects of a company over the long-term. But if a portfolio of stocks is selected with adequate margin of safety, the chances of losses over the long term are minimised. Mr. Graham had aptly pointed out, "while losing some money is an inevitable part of investing, to be an intelligent investor, you must take responsibility for ensuring that you never lose most or all of your money."

  • Avoid buying "popular stocks": Stocks devoid of fundamentals often seem to get undue attention when markets are at their irrational best. But all that glitters may not be gold and every stock that goes up may not be an Infosys in the making! An investor's decision of buying stocks for the long term should be irrespective of the fact whether the market considers it to be 'hot' or not.

  • Know the underlying value: 'A good stock is no longer a good stock if you buy it at the wrong price' is another oft-quoted maxim. As an investor, one's objective must be to pay less than the company's intrinsic worth. A moderate price to earnings ratio (or price to book value ratio, as the case may be) 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.

To conclude...
No wonder the above lines may be sounding repetitive. But please understand the fact, that our basic objective of reiterating the above caveats, is to see to it that you (the retail investor) do not become the victim of the market irrationality. Equity as an asset class is and will remain attractive, especially in times of rising inflation. This is because while the returns on debts and money market instruments are negated by inflation, equities despite their higher risk profile are well compensatory. It is only necessary to wisely understand the risks and match them with one's individual profile. This can help you take the 'random walk' a la Warren Buffet way!

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