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The new laws of investing

The stock markets are being influenced by a host of domestic and global factors. A lowdown on what you should know about the changing dynamics of the market to swim with the sharks.

Rishi Joshi        Print Edition: February 24, 2008

Ramesh Damani, Member, BSE
Ramesh Damani
On January 22, 2007, when the stock market hit the 10 per cent circuit filter for the third time in its history, it sent a chill through the market. The last time trading was suspended was on May 22, 2004, and before that on May 17, 2004.

But despite the eerie coincidence of the dates and months, they were all sparked off by massive global sell-offs. While most analysts feel this is a transient phase and that the bulls will bounce back, the fact is that the stock markets are being influenced by a host of domestic and global factors. Besides, there are more market participants than ever before—like hedge funds, pension funds, mid-term foreign funds, apart from the rising number of domestic high net worth and retail investors.

That apart, a host of brokerages are giving diverse calls, and target levels of stocks differ widely between brokerage houses. An investor’s risk appetite is swinging rapidly from extreme optimism to bouts of pessimism. Just when investors were making their way back to the market, it has taken a sudden sharp U-turn. For retail investors, it’s time to learn how to swim with the sharks. Institutions control the table: Over the last couple of years, the Indian markets have been getting institutionalised. The share of domestic institutions and foreign investors in the market’s daily turnover has increased from 20-25 per cent to nearly 50 per cent during this period.

Raamdeo Agarwal, MD, Motilal Oswal
Raamdeo Agarwal
Says Manish Chokhani, Director, Enam Securities: “The market participants are changing. Large hedge funds, sovereign funds and international emerging market funds now influence the market significantly.” FIIs alone made a net investment of about $17 billion (Rs 68,000 crore) in Indian stocks in 2007. This was significantly higher than the net investments of domestic mutual funds, which pumped in about $1.7 billion (Rs 6,800 crore). But domestic institutions could emerge as major investors in stocks soon.

According to estimates by brokerage firm Sharekhan, insurance companies are likely to invest $5 billion (Rs 20,000 crore) in the Indian stock market in the last quarter of 2007-08, while mutual funds are likely to pump in $4 billion (Rs 16,000 crore) over the next few months. Analysts feel that more participants will make the markets safer for retail investors. On the other hand, as more foreign investors enter, the capital markets get increasingly influenced by global developments. The recent bloodbath on the bourses is an instance of how adverse news flow from the international markets can impact domestic markets as well.

Globalisation has its share of drawbacks: today, a day trader not only has to understand the implications of the RBI’s Governor’s actions, he also has to take cues from the Chairman of the US Federal Reserve. Says Raamdeo Agarwal, MD, Motilal Oswal: “An investor has to analyse news flows from across the world. Everything from the prices of commodities globally, the rupee-dollar rate to the state of the world economy have a significant influence on our stock markets”.

 Speculation is easier: For the day trader and the speculator, the market has dramatically changed over the last couple of years. The derivatives market is booming. Turnover in the futures and options market on days can almost touch Rs 1 lakh crore, much more than the cash market. For speculators, it gives great leverage since trading is done by only paying an upfront margin of about 20 per cent (on an average).

Critics claim that this makes market less transparent and more prone to instability and speculation. Their supporters say that derivatives improve an investor’s ability to manage risks and increases liquidity. But retail investors must make sure that they are able to diligently research both the derivative and the underlying asset, and watch out for excessive speculation.

Volatility is now endemic: In a globalised economy, the market takes cues from different sources. The state of the US economy, crude prices, the subprime crisis, the health of the Indian economy—all these factors impact the market and make it difficult to take a call on the direction of the market in the short term. Says Ramesh Damani, member, BSE: “High levels of volatility are here to stay. There will be occasional bouts of pain as the market corrects.”

One of the main reasons is the influx of hot money into the Indian stock markets through the FII route. Excessive flows of speculative capital make the market unpredictable. The recent market crash on January 21 and 22, for instance, saw FIIs as net sellers of more than Rs 4,500 crore. Recently, market regulator SEBI introduced new curbs on participatory notes on derivatives by FIIs to moderate inflows into the country.

Primary markets don’t set the tone: The primary markets were on song in 2007 with 112 companies listing on the exchanges last year, making India the fifth-largest IPO market in the year. If you were to include the FPOs that raised funds from the primary market, then the total amount mobilised will add up to well over Rs 40,000 crore during 2007. This, of course, had a lot to do with the boom in the secondary markets as primary markets take a cue from the secondary markets. But lately, the IPO market seemed to take centrestage as investors watched grey market premiums to make investment decisions.

 Ten rules for investing

  • Avoid trading in a volatile market

  • Do your homework before investing

  • Be patient.over the long term it's rewarding

  • Buy shares of companies with sound fundamentals

  • Don’t over-extend yourself in the futures market

  • Use derivatives to hedge cash market portfolio

  • Don’t invest in obscure mid-cap and small-cap stocks

     
  • Market dips are an opportunity to accumulate quality stocks

  • Make stock-specific investments. Don't just invest in sectors

  • Invest in high growth stocks with good long-term potential
The grey market premiums, however, have fallen significantly. Some IPOs—Emaar-MGF and Wockhardt Hospitals—have even reduced their price bands. Grey markets don’t set the tone for the success of an IPO and market watchers have a word of caution for investors. Says Chokhani: “Investors should completely disregard the grey market. It’s an unofficial market and can be misleading. Instead, focus on the fundamentals of the company.”

Smaller stocks are hit harder: In the recent market fall, mid-cap stocks bore the brunt of bear hammering. In three days the BSE Mid-cap index lost over 2,000 points, between January 17 and January 22. Before the market meltdown, however, mid-caps were in great demand and outperformed the frontline stocks. In December alone, the BSE Mid-cap index had risen 14 per cent compared with a 5 per cent rise for the Sensex. Clearly, investing in midcap stocks in an uncertain market is a risky bet as they tend to be more volatile. Says Chokhani: “Mid-cap stocks are high beta stocks and tend to fall out of favour very quickly in a declining market.”

The need for caution is even more essential, since several smaller stocks were frozen on the lower circuit during the market crash. This means there were only sellers for these shares and no buyers. This is because liquidity tends to vanish more quickly in these stocks. What’s more, they don’t bounce back as quickly as the large caps.

Mid-cap shares are considered an attractive investment avenue because their growth rates are usually very high. On the flip side, these are shares of relatively small companies and their revenues and profits may be more volatile than in large companies. Also, the availability of mid-cap shares for trading in the secondary market is limited in comparison to large-cap shares. The free-float factor, as it is called, is a key to active trading in shares, since investors want an easy entry and exit. The promoter holding in these companies is usually high, and they have very little public shareholding. All these factors make investing in midcap shares more risky.

Valuations are always correct: Among emerging market indices, the Sensex is on the higher side of valuations. Even after the recent market meltdown, it is trading at a trailing P/E multiple of around 23— higher than other indices like Hong Kong’s Hang Seng or Korea’s Kospi, which are trading at multiples of around 15. Analysts, however, feel that the valuations are not unjustified due to the strong underlying fundamentals of the Indian economy.

 Says Damani: “The Indian growth story is still intact and this is the reason for the premium given to Sensex valuations.” On estimated forward earnings for 2007-08, the Sensex is trading at a P/E of 18, which analysts feel is a fair valuation. But the problem arises when investors forget to watch the valuations.

Just before the crash, the Sensex was trading at 28 times current earnings and over 20 times forward earnings. Little wonder it corrected so sharply. The recent market crash has shown that stocks can even correct by 50 per cent. Retail investors usually get carried away by the momentum and buy when institutions are selling. But the easiest way to avoid nasty surprises in the stock market is to ultimately watch the price. It’s the tried-and-tested way of reducing the risks to your financial health.

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