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The Stock Market- Best Avenue for wealth creation and destruction

, November 3, 2015, 0 Comments

the-stock-market-wealth-marketexpress-inThey say the Stock Market is a place to transfer wealth from the impatient to the patient! Since the impatient are always larger in number compared to the patient, it literally “pays to be patient” while investing.

Stock picking has been unnecessarily made to look as if it is a complex task, but it is in fact just pure logic. If one applies the same logic while we buy vegetables to stock picking, I believe half the job is already done. Let me start by saying that over the past 50 years, equities have outperformed all other asset classes worldwide and it is safe to say that equities will outperform other asset classes over the coming years. This is especially relevant for India as, even if we assume a conservative estimate of average GDP growth between 5.5-6%, this would have a multiplying impact on the stock market and with sound investing principles. Even if just 3 out of 10 stocks in your portfolio turn out well, the overall portfolio would have outperformed the market by a healthy margin.

When investing, few fundamental areas to look into are:

The price to earnings ratio is a principle yardstick to judge the value of a stock. In a simple sense if a company is trading at 10PE, you are paying 10 dollars now for every dollar of profits that the company makes. Avoid investing in companies above 40PE, no matter how great the company is. It is possible that we may be overpaying for such a company and the growth needed for such valuations may not be achieved, which will lead to heavy crashes in the stock price. A small auto component company traded close to fifty times its earnings and when the growth failed to pick up, stock price crashed 35% within 10 days. One should compare the PE of a company to the overall PE of the industry, however, there are cases where the entire industry itself is overvalued and it is best to avoid the entire industry as such.

It is best to invest in debt free companies, as interest payments won’t eat into the operating profits and when the economy begins to turn around these companies tend to show healthy growth in profits. For a growing company with healthy expansion plans, a debt to equity ratio within 0.4x seems financially prudent and the company may be worth investing. Avoid companies that take on heavy leveraging for future expansion plans.

Return on Equity is the single most important tool for any investor. It can be applied to compare any company. It consists of three components; firstly the net profit margin i.e. the extent of profits made in relation to the sales, secondly the extent of sales in relation to the assets and lastly the assets in relation to equity, higher the assets compared to the equity indicates that the company has borrowed to add additional assets. It is, ROE= (Net Profit/Sales) X (Sales/Assets) X (Assets/Equity) where sales and assets cancel out leaving us with only the net profit and equity. By applying this yardstick, irrespective of the size of the company, the company with a higher return on equity (while giving focus to the extent of leveraging used) is more efficient at generating profits.

One must avoid any company that has inventory+receivables to sales ratio greater than or close to 1. Simply put, if the ratio is greater than 1, it shows that the company is inefficient in selling the product and has more products lying within the company rather than with the end user. However, a few exceptions exist in case of cyclical companies and it is best to compare the ratio with other peers in such a scenario.

Cash rich companies have the ability to withstand downturns and can utilize internal accruals rather than taking on debt financing to fuel future growth. Cash as a percentage of market cap ranging between 30-40% is a healthy sign and the company can be considered for potential investing asset.

A company paying regular and increasing dividends is a sign of healthy growth in cash flows and earnings. It also shows the management’s intent in rewarding the minority shareholders. Although a company may choose to keep the profits to themselves when the company is expanding rather than give it out as dividends. A consistent dividend policy can act as a proxy to gauge management’s intent. A company with a dividend yield of 3-4% seems appropriate in this context. Applying all these yardsticks collectively will give you a company that is well poised to give decent returns over the medium or long term. This will help a commoner to judge the value of a company rather than obsessing over the price on which it trades.

Market “Experts”

It was peculiar to observe “expert analysts” give a rosy picture about the future when the Sensex hit 30,000 earlier this year and the same analysts give a “grim outlook of economy” when the Sensex corrected to 25,500 couple of weeks later. Economic fundamentals don’t change within few weeks. India is in the midst of a structural bull run aided by a record decline in commodity prices, which has controlled the CAD to 1.9% of GDP in the first half of FY15 and according to RBI the CAD is further expected to decline to 1.5% of GDP for FY16 in spite of increased gold imports.

Only cause for concern to the Indian economy is the deficient rainfall that we received this year, this was the second year in a row where we saw deficient rainfall. Also India’s exports have dropped around 24.3% in September 2015, however, imports too have declined and as a net importing nation, India stands to gain more than it loses in the medium to long term. In the end it all comes down to the will of the nature and if rains fail again next year, the economy will be in trouble. However, its still early to push the panic button and till then let us all uncomplicated the art of investing and strive for long term wealth creation.

I would like to end this by quoting Oscar Wilde – “Who needs a cynic who knows the price of everything and the value of nothing”, this is especially apt for investing in stocks.