Should I buy stocks now?

Yes, but you need to be more choosy about the shares you pick than ever before. If you can't, let a fund manager do it for you.

By Narayan Krishnamurthy        Print Edition: June 14, 2007

You would think after three years of high growth with the Nifty hitting successive highs, most stocks would now be untouchably expensive.

But that’s not really true — the market is trading only slightly above its long-term average valuation. There are several reasons for this.

The most common method of valuing stocks is via the P/E or price-earnings ratio, which compares price to earnings (profits) per share. Corporate earnings have grown very fast in the last few years and even outpaced the stunning rise in stock prices.

Historically, the average P/E for Sensex has been about 16. At the bottom of the market in 2003, the Sensex sported a P/E of 8. Today it’s trading at a P/E of 17—that’s just a touch above average levels. The second reason that the market is not over-valued is that the majority of stocks have actually travelled down in the past year.

According to a study by Morgan Stanley for instance, in the Sensex group of 30 mega-caps, the positive return has been almost entirely generated by just five stocks.

Reliance, Bharti, Infosys, Reliance Communications and ICICI Bank have been the top five gainers. Remove these, and the rest of the Sensex collectively lost money.

In the same study, Morgan Stanley concluded that it was the same story across the entire Indian market. Out of 2,389 Indian stocks covered by Morgan Stanley, almost 67% had suffered a price loss in the past 12 months.

So, two-thirds of the market is actually trading lower than it was a year ago. However, although two out of three stocks lost ground, the total return was positive; the stocks that did gain scored large returns.

 Naturally, certain sectors are more overvalued than the market as a whole. “Remove some of the technology stocks and you will find, certain stocks to be undervalued and very impressive to enter right now. Banking for instance,” says Prateek Agarwal, head-equity, ABN Amro Mutual Fund.

When earnings and prices zoom as they have since May 2003, when the Sensex was trading at about 3180, stocks will always feel more expensive.

Says S Naren, co-head – equities, ICICI Prudential Mutual Fund: “Most investors don’t believe the earnings component of the valuation calculations right now and hope that either it will fall a lot or at least, get to a level at which they feel it is comfortably valued.”

This is the third straight year of double-digit salary hikes. India Inc was happy to reward its employees because profits grew at 20% plus. But we are more interested in future performance than in past. And with cyclical assets such as stocks, the past performance does not offer more than a rough guide to future prospects.

But there is consensus that growth will remain positive. Corporate earnings may grow at a slower pace in 2007-8 but it will continue to grow.

 The Sensex basket is projected to see EPS rise at 17% in 2007-8 according to calculations done by Merrill Lynch. Specific sectors will do better. Investments there may provide higher returns.

Most of the time, the Sensex has traded between PEs of 10 and 20-21 although it has peaked at far higher levels and dropped lower as well. If we assume 2007-8 EPS growth at 17%, this means a range of Sensex movement between 10000 and 17000 in 2007-8. The current level of 14338 is roughly in the middle.

Another reason why stocks seem expensive is that interest rates have risen steadily over the past year and appear likely to continue rising in the near term. In the short term, fixed return instruments have become attractive; they offer higher assured returns. But inflation is also a cyclical phenomenon. As and when inflation falls and fixed returns drop, stocks will regain their lustre.

“We will all know only in hindsight whether today’s stock valuations are expensive or cheap,” says Mugunthan Siva, chief investment officer, Optimix. True—but the long term performance of stocks suggests that any long-term portfolio needs some equity exposure. In the long-term, stocks outperform all other financial instruments and the risks drop as the holding period increases.

 But, what is the best way of picking a winning stock especially in market where two out of three stocks have lost ground? A monkey chucking darts at quotes will get it right about that often. Efficient Market theorists believe that this ratio cannot be easily improved in an efficient market where everybody has similar access to information.

Efficient market theory leads to index-investing where the investor just passively mimics the indices. That way they at least get average returns.

There are many approaches to trying to beat Dalal Street. Every business has multiple variables and analysts weigh these differently in trying to find the best businesses.

Financial service provider Religare relies on the CANSLIM method, following Current quarterly earnings, Annual earnings, looking for New products, classifying companies as industry Leaders and Laggards, and watching for Institutional ownership and Market trends. Other schools of thought rely on various forms of numbercrunching to arrive at buy or sell decisions. There are no guarantees that any of them will get it right.

Stockpicking is more an art than a science, based on intuition and gut as much as number crunching. “Buying a stock is about getting a piece of a good business at what you believe is a good price,” feels Siva. And, he maintains that stock market investing is only for active investors. Passive and not-so-active investors should head for equitydiversified mutual funds instead.

“When you realise that owning stock is the equivalent of owning a piece of the company, it follows naturally that to pick the best stocks you have to thoroughly research the company, its peers and the business as a whole,” explains Amitabh Chakroborty, president (equities) Religare Securities. And even if you do all this, you can be blindsided and get it wrong.

Nonetheless, familiarising yourself with the company’s products, competitive standing and its numbers will help you feel confident about your picks. When you get it right, the returns can be spectacular. Last year, for example, ailing financial institution IFCI turned around and delivered 330% returns. A new business such as Bharti has returned 2094% over the past four years. One such major winner can compensate for several big losers.

But there are risks and you need to work hard to pick stocks and track their performance. If you decide that you cannot afford to spend that time or you lack the necessary expertise, opt for mutual funds instead.

In the short-term, stocks may fluctuate randomly. But “eventually, stock prices reflect the economy’s vigour,” asserts an upbeat Ajay Bagga, CEO, Lotus India Asset Management. There are indications that the economy will grow at a hot pace until 2020 as Goldman Sach’s famous BRIC report projects.

The India growth story is intact. “The Indian economy is to continue a pattern of sustained growth, with minor blips here and there. But largely things are favourable on the corporate earnings front,” exclaims Naren. And, growth could accelerate if there’s a good monsoon.

But even the most optimistic market analysts agree that the pace will not be as high as in the past three years. Even so, “there are no tell-tale signs of the markets tanking, which should comfort investors”, assures Chakroborty. If you are buying stocks, you can diversify risks across sectors or even across size. Small caps, midcaps and mega-caps frequently move out of sync. If you own some of each category, returns should smooth out.

How Kapur did it

 Management consultant, 34-year-old Samir Kapur knows that an occasional loss is inevitable in any game. But he is driven by the competitive spirit and the need to be a winner. “Stocks were no different, at least as far as my approach was concerned,” he says.

Kapur started with Rs 2 lakh four years ago, with a strategy that involved ploughing in more funds as and when he felt he had the skills to scale up. What Kapur did was to set personal milestones and exit points where he felt comfortable at having met his anticipated targets. He found SIPs a great concept and started out with it to average out the cost of acquisition.

He still continues to do this. “It’s like any game, the more consistent and involved you are, the more you enjoy and understand the intricacies of the game,” he laughs. He exited some real estate stocks when the Sensex touched 10000 and diversified into mid-cap funds.

He is looking at real estate now. “It’s like substituting a player in a game after you have taken the maximum out of him,” he says. Kapur has definitely got hooked on to the investing game turning into a winner who has grown his net worth.

Betting long term

 Now who would not want to get on a sure thing? Imagine making a wager where the probability of your loss is zero (at least statistically). Sceptics will scoff at the thought of such a bet and in all probability, call it “fixing”. Most punters seek the fabled pot of gold at the end of the rainbow.

Chasing the dream of the “big win”, they lose money consistently. But, what is the difference between the steady losers and those who win small fortunes consistently over the long term?

MONEY TODAY looked at the rolling Sensex returns over varied time frames of 1-, 3-, 5-, 7-, 10- and 15-years; the results validate the theory of long-term investing; as the time period is extended, the possibility of losses drops.

You are never a loser in the long run; even if you don’t make stupendous gains. This conforms to the belief that, if you buy and hold good businesses, equity delivers decent returns with diminished risks.

Since it was launched 28 years ago, the Sensex has grown at a CAGR of over 19%. There have been good years and bad years. But surely a return of 19% over three decades is ample reward for just buying and holding? Why risk losses by seeking bigger gains?

How do I pick a fund?

First see how the fund fits into your investment plan. Then look at its expense ratio and its performance record.

The simplest way to acquire a diversified stock portfolio is to buy mutual funds instead of stocks. How do you pick a fund? It’s not hard—if you can reverse the thought processes followed by most retail investors.

 Most investors hunt for high returns first (and some stop right there, inviting absolute disaster). Others go on to glance at risk, then make a cursory check of the expenses and finally think about how a fund fits in with the rest of their investment plans.

By reversing that order, you can vastly improve the odds of finding the right fund for you. First, see what funds fit with your overall investment plan. The next-to-last thing most people do—but the second thing you should do—is to check on expenses. Returns fluctuate but expenses stay forever.

Next, look at risk. One selling pitch adopted by agents and distributors is to review fund returns over the last three years. Even though funds issue a statutory warning that past performance is no guarantee of future performance, salespeople know most investors disregard that.

Every prospectus carries an upwards-pointing graph showing how much the fund has delivered. What goes up can come down just as rapidly. Ask yourself if you are prepared to stomach the losses if that trend reverses its direction! If the answer is “no”, look for another, less risky fund.

A mutual fund investor can diversify across businesses with ease. But it does require a little thought to diversify intelligently. “Diversification depends on which kind of funds you own, not on how many you own,” says Siva. Nine equity-diversified funds with the same theme or five different debt funds—is diversifying by numbers, which just doesn’t work.

But a mid- or small-cap fund along with an equity-diversified fund, a growth fund or an income scheme with a closed-ended fundthat’s diversifying by kind and it helps shelter you against the risk that everything you own will crash at the same time.

Last of all, examine performance. Dozens of studies have confirmed that past returns have little or no predictive value.

A fund that did well in the past has the same chance of doing well in the future, as a coin that came up heads on the last toss has of coming up heads again. Don’t base your choice only on past returns.

How Bhushan did it

 Four years ago, paediatrician Prabhat Bhushan discovered a malady in his investment portfolio—sluggish growth and a feeling of lethargy.“The earnings from my insurance policies, post office schemes and PPF were slowing down with every passing year,” he says.

His diagnosis: the portfolio needed a tonic. So the 49-year-old doctor stepped into the unchartered world of stocks. “I entered the stock markets with great trepidation,” he reminisces.Today, he is as comfortable with stocks and funds as he is with his practise. “I enjoy the way the markets behave.You need to anticipate its moves just like a child can develop complications and be unable to even talk about it,” he laughs.

Analogies apart, the doctor started with an initial investment of Rs 50,000 and slowly increased his stakes. “I could have never earned the returns earned by my stock investments had I stuck to fixed return instruments,” he confides.With his portfolio now valued at a few lakhs, the doctor issues the equity prescriptions to others as well.

Bhushan is comfortable only in the secondary market because he thinks IPOs are like lotteries. He sometimes looks for tips on the Net but prefers to invest in growth companies. It seems like equity was the right prescription for his ailing investment portfolio.

ETFs

An alternate approach to pooled investing is buying shares of exchange traded funds (E TFs). Each ETF tracks a particular market index, such as the Nifty, Nifty Junior or BSE Sensex. ETFs are listed on the stock market and traded throughout the day. The price moves up and down to reflect demand and supply, though it never varies significantly from the fund’s NAV.

Says Sanjiv Shah, Executive Director, Benchmark:“ETFs tend to cost less to own than actively managed equity funds and even some index mutual funds, a cost that’s calculated as an expense ratio.” Remember you pay a commission or brokerage to buy and sell, as you do when you trade in stocks. But on cost, ETFs are attractive compared to actively managed funds.

Another potential advantage is that E TFs have lower churn and hence, lower expenses than actively managed funds.That’s because E TFs are not trying to beat the market.The portfolios change only if the underlying indexes change and they must rebalance.

Some traders use ETFs to capture index volatility. Investors use E TFs to achieve greater diversification and index-comparable returns at lower cost. But, of course, E TFs can lose value in a falling market because their returns track that of the market indices.These are low-cost instruments but they carry risk.

(With Devangshu Datta)

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