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'Defend' your investment! - Views on News from Equitymaster
 
 
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  • Dec 16, 2005

    'Defend' your investment!

    As the BSE-Sensex scales new heights (which it has been doing for the past 6 months now) and the index heavyweights ostensibly get 're-rated', retail investors get embroiled in a cloud of apprehensions as to how to 'defend' one's investment. It is thus, we propose to introduce you to the legendry investor Benjamin Graham's principles of 'defensive investing'.

    Each of these will serve as a filter to weed out the speculative stocks from a conservative portfolio. Also, one must keep in mind that the said principles are in tune with Mr. Graham's definition of an 'investment' as "one that generates 'adequate returns' (considering the additional risk involved) and promises safety of principal".

    1. Adequate size of the enterprise: In the world of investing, there is some safety attributable to the size of an enterprise. A smaller company is generally subject to wider fluctuations in earnings. While risk inclined investors occasionally ignore the size of the company (and thereby go for smaller caps) for "higher returns", the same is certainly not advisable to the risk-averse ones who wish to guard their investment against pendulum-like fluctuations.

    2. Sound financial condition: Analysis of financial soundness is a prerequisite when it comes to investing in equities. Of course, the evaluation of the same involves judgment of several parameters such as the debt to equity ratio, the interest coverage ratio, the current ratio and the return on invested capital. Ideally, a stock should have a current ratio of at least two times. Benjamin Graham also insisted that long-term debt should not exceed working capital. Nevertheless, the debt component is bound to be heavier for financial entities and utility companies. Having said this, one needs to check a company's ability to service its debt liability through the interest coverage ratio (EBIDTA / interest liability). This should act as a strong buffer against the possibility of bankruptcy or default. Last but not the least, one must also gauge whether the entity is generating returns on invested capital that are remunerative enough for the risks taken.

    3. Earnings stability and growth: For a company to win investor confidence, it must necessarily have a track record of profitability and growth. Excessive volatility in earnings and stunted growth (in comparison to peers) are signals of risks that the company may not be able to counter unforeseen circumstances and keep pace with competition. Also, earnings stability and growth must be sustained, despite cyclicalities.

    4. Dividend record: The company should preferably have a dividend history over the past five years and have a dividend payout ratio comparable to that of its peers. Nevertheless, in the case of 'growth stocks', there might be instances of the company refraining from dividend payment so as to plough back profits. Having said that, there must not be sudden instances of inconsistencies in dividend payment.

    5. Moderate valuations: For inclusion into a retail investor's portfolio, a stock must necessarily have moderate valuations be it in terms of price to earnings (P/E) or price to book value (P/ BV). This is because a relatively lower P/E (or P/BV as the case may be) would save investors from paying a very high price that does not justify the value of an investment. Also, this acts as a safeguard against overpaying for a security.

    While we would advocate the above principles to be used as guidelines for long term investing, it certainly does not relieve investors of their responsibility to study individual stocks based on their management quality and uniqueness of business model. The efforts, no doubt, would stand in good stead when the tide turns.

     

     

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