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Sensex at 12k: What should I do next? - Views on News from Equitymaster
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  • Oct 12, 2006

    Sensex at 12k: What should I do next?

    Infosys 2QFY07 results are finally out. The company, easily the metaphor for the new vibrant India Inc., has more or less for quite some time now set the tone for the results season. Thus when Infosys manages to beat street estimates, it is more or less confirmed that atleast the new economy companies are going to do an encore. In times such as these, where even the most pessimistic investor can see optimism as far as his mental faculties allow him to see, markets do not hesitate in giving these companies their due. We are talking about rewards in terms of further addition to their already gargantuan market capitalisation.

    Wait! Aren't we supposed to see a pause in rally and witness some correction given that valuations have started looking expensive? This million-dollar question must have surely crossed your mind. If you are one of those investors who have been thinking along similar lines, then we believe you are making one of the most fundamental mistakes of trying to time the market. In other words, you are hoping that markets would fall and you would then invest your hard earned money so that when the market regains its northbound journey, you will profit along the way. If it was this simple, everybody ought to be rich and people wouldn't have lost their shirts trying to play the market. History suggests that no successful investor has ever made substantial returns by trying to predict the timings of the fall and rise in stock markets.

    Now that you have got your basics right, let us try and find answers to the relevant questions at hand.

    Question number 1: Should I invest in the market at current levels?
    The answer to this question would be - "It depends". If short term liquidity is important to you i.e., if you would need your invested money to be liquidated within a year or two then the answer would be that it is not a right time to invest in the markets at current levels as valuations for most of the good quality companies are looking expensive from a one to two year perspective. Hence, only modest returns can be expected from them, which makes them vulnerable to sudden outflow of funds or any overheating of the economy. Good quality companies abound on the stock market currently but no matter how good a company is, your returns would eventually depend upon the price that you pay for the company. Higher the price, lower would be your return and vice versa. Hence we would like to re-iterate that if in the near term you are expecting sizeable gains from your portfolio, then the risk-reward ratio is definitely not in your favour.

    Now let us talk about the long-term perspective. Legendary investor Warren Buffett was once asked on his long-term approach to investing and he retorted that - "...if I am able to arrive at a correct picture of how a company's earnings might look five, six years from now or may be even longer than that and if I am able to get adequate returns at the current price then I would consider investing in those companies." Applying this principle to the Indian scenario, we think very few people would doubt that we are an economy whose star is on the ascendant.

    With GDP growth in the region of 8% despite a shoddy infrastructure and with easily the highest number of people in the most productive age group, there is little doubt that we may maintain or even exceed the current GDP growth rate. Thus with such kind of market to address to, a lot of our good quality companies would continue to show robust growth in earnings. However, not all companies are likely to share the spoils equally and in the end only those companies with rather impregnable competitive advantages are likely to emerge as winners. This brings us to the next question.

    Question number 2: If long term is what I am looking at, what companies or sectors I should consider investing in?
    We believe there is no clear-cut answer to this question. There is no fixed formula that works in investing because had that been the case everyone would have copied it and would have become rich. Thus no matter how sophisticated your analysis is, you cannot completely remove the risk of going wrong. The solution thus lies in minimizing risk and the way you do this is by sticking to what is called as your circle of competence and zeroing in on companies with strong fundamentals.

    Here again, Buffett's wisdom might prove useful. In one of the recent AGM's of his famed company Berkshire Hathaway, the legend had mentioned that he always has three paper trays in front of him denoting yes, no and too hard. In other words, investment ideas that he wouldn't understand would find their way in the too hard pile and this particular pile is the one that remained full most of the times. He is of the opinion that if you are not able to predict how the earnings of a company would look like in the long-term for various reasons, you should not pursue it any more and switch to companies that you are able to understand. He calls this sticking to one's circle of competence. Everyone has his own circle of competence and its better if one just sticks to it. This circle may expand over time but at any given time depending on your circle of competence make your investment decisions.

    Now something about a fundamentally strong company. According to us, there are some virtues that characterise a fundamentally strong company. Strong growth potential, consistently high margins, adequately leveraged, strong cash flow generation and last but not the least, the management, that is on the same side as shareholders.

    Everything we just indicated can however come to naught if the price that is being paid is too high for your pre-determined time horizon. Hence keep an eagle eye on valuations.

    The points that we are trying to make not only hold true at the current index levels but at all levels. However, this is the time where an investor has the tendency to overlook fundamentals and get swayed by sentiments, hence it is only apt that we reinforce these principles at current levels, where vulnerability is at its peak.



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