Rules of the game

Markets have a mind of their own, and will  do things that don’t make sense given the available information on a company.

By Dipen Sheth | Print Edition: January 11, 2007

It might be new year’s time but the investing game is yet to change, and so are the rules. So my new year resolutions are anything but new. I’ve heard bits of them from gurus, Indian and videshi. They retain relevance in today’s edgy markets—brimming with fickle FII and hedge fund money.

Stick to rationality, don’t get fooled by randomness

Markets have a mind of their own, and will (more often than not) do things that don’t make sense given the available information on a company. If your research and fair value estimate on a stock is good (and this is admittedly a big if) you will be rewarded with growth.

So what do you do when your most confident research pick goes abegging while punters make merry on something you can’t figure out? Well, either figure it out, or leave it alone. I can’t figure out Atlanta (up six times in the last six months, no clear reason why), especially when compared with Patel Engineering, up 50% only, niche construction capability story, big order book, growing margins. So I’ll stick to my resolution, and leave Atlanta alone.

Chase growth, but consider the price

This is the GARP (growth at a reasonable price) principle at work, as opposed to GAAP (growth at any price). Markets reward growth, but only if it comes in value accretive ways. An immediate thumb rule that comes to mind is the PEG ratio, which roughly translates to the following dictum: the sustainable growth rate of a company’s earnings in percentage is a good P/E to give to its stock. This is why many frontline IT stocks continue to trade at around 25-30 times forward earnings, and why many mid-caps and commodity stocks (in spite of having had an amazing run) trade for single digit multiples. A key consideration is that innocuous term — sustainable growth. Consider how many of the companies you have invested have the opportunity, capability and customer franchise to deliver sustainable growth. You will suddenly want to prune that portfolio of yours.

Diversify, but only in moderation. Else don’t invest

If you know why you are buying a stock, you will be able to assign a rational (and often significant) weight for it in your portfolio. At its worst, diversification is a hedge against ignorance. You will never make big money by getting into 40-50 stocks. Most high-performing privately managed portfolios typically have 10 stocks, or sometimes less. Mutual funds diversify beyond this, but the best performers have concentrated holdings that have something like 15 stocks accounting for over half their holdings. The rest is scattered across where they are yet to make up their minds, but have begun to commit your money.

Be patient, but read the writing

The best of stocks often take months to “wake” up. This does not mean that you hold things that don’t make sense to hold, in the hope that someday a random fool will bail you out. Two obvious corollaries: (a) Look up the stocks that you are missing from time to time and see if they make fundamental sense. Compare them with your “sleeping beauties”. Don’t just be eager to switch, instead learn to discriminate between a randomly hot stock and a performer. (b) Unless terribly sure, average out your investment into any stock over a period of a month at least. Buy more when the price falls. This is known by the experts as accelerated rupee cost averaging.

(The author is a Head of Research, Wealth Management Advisory Services)

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