Four years into the longest bull run in the history of the Indian stock markets, all investors are worried. Is there a correction or a consolidation round the corner? What should small investors do at this juncture? The best advice is commonsensical.

As investment guru Warren Buffett remarked 20 years back: “An investor will succeed by coupling good business judgment with an ability to insulate himself from the super-contagious emotions that swirl in the markets.” So, what will work? Here are six things to keep in mind while investing:

BE A CONTRARIAN

Markets price in information very fast. In all the noise it’s easy to be misled. Legendary investor and Buffett’s mentor Benjamin Graham said, “For above average results, investors must follow policies which are inherently sound and promising, and not popular on Wall Street.”

Sounds simple? Investor behaviour is to the con -trary. In late 1999 to early 2000, when the worldwide technology boom was at its zenith, investors kept piling into the sector at ridiculous price-to-earnings ratios of 100 times and above. The crash that followed wiped out 25% to 90% of the value of IT stock globally.

PICK SOUND COMPANIES

Is the company making profits, is the profit increasing over time, what is its market share and is it increasing? Check if the return on equity (RoE) is high, given that Indian companies have one of the highest RoEs in the world. Also the earnings must be non-dilutive. The company must not be raising capital too often and not generating returns on the same. Focus on wealth creators, who generate high returns on the capital employed.

CHECK THE VALUATION

There are various ways to value a company. The Price-to-Earnings ratio is the most common. Look at the stock’s PE relative to the market, the sector and its competitors. Also look at the PE growth ratio, which factors in the growth of the company’s profits.

IT stocks might look overvalued on a PE basis, but given their growth potential of 30% plus, the PEGs would justify the price. Ditto for capital goods companies. Their valuations may seem high, but given their order books of 3-5 times annual sales, and their ability to scale up, they are in demand.

BUY WHAT YOU UNDERSTAND

The legendary Peter Lynch says: “Amateur investors can outperform Wall Street experts, since the best investing clues can be found at the mall, on the school playground, or at people’s workplace.” This is also key in deciding what not to buy. The dotcom bubble was a classic example of this. There were no cash inflows, only cash burn. The investor community was taken in by the “this time it’s different” mantra. The crash proved that the fundamentals are always the same.

Media is a positive example here. With Indian consumers earning more, spending more on leisure and with connectivity increasing, there is a huge media boom in India which will sustain for the next decades. As consumers of media, be it TV, print, films, cinemas, retail investors know what is working and what is not.

CHECK THE MANAGEMENT

This is very critical. A big industrial group of India had the best alliances with top notch foreign partners through the 1980s. However, each of these ran aground. Exceptional management makes the difference between success and failure in competitive and high-growth markets.

INVEST FOR LONG TERM

Buffett says, “Our favourite holding period is forever.” If you have done your homework well, you would have invested in companies with a sound business model, a clear market for their goods or services and an excellent management. After all this, it makes sense to “buy and hold”. In conclusion, I would refer back to the three most important words in investing — “margin of safety”.

At a 2007-8 Sensex PE of 17, in an economy growing at 15% plus in nominal terms, Indian markets still provide a strong “margin of safety” to intrepid investors. Time will tell if these intrepid investors also prove to be intelligent investors. As the Sage of Omaha says, “I will tell you how to become rich. Be fearful when others are greedy. Be greedy when others are fearful.”

By Ajay Bagga, CEO, Lotus Mutual Fund