The buoyancy in stocks is empting investors.
Here's a guide for first-time entrants to the equity markets.
Two months ago, D P Tejas, a 21-year-old student of IIT Kharagpur, bought his first stock, Crisil.By investing in stocks directly, Tejas wants to avoid the fee that mutual funds charge. With optimism abounding about the prospects of both the economy and the markets, first-time investors are entering the equity markets in droves. But investing in equities can be risky, especially when indices are close to their alltime high levels. In this week's cover story, we draw a road map for first-time investors in stocks. Find out what you need to learn before you enter the stock markets and the points to pay heed to while investing. We also warn you about some of the common pitfalls to avoid. INVESTING THROUGH MUTUAL FUNDS For several reasons, we would advise first-time investors to enter the equity markets via mutual funds. According to Nimesh Shah, managing director and CEO, ICICI Prudential Mutual Fund, “While it is true that equities are necessary in a portfolio to meet longterm financial goals, jumping straight into the equity markets without knowledge and expertise may not be a prudent decision.
Investors should utilise the mutual fund route to derive the benefits of professional management, diversification and flexibility at a low cost.“ His views are echoed by others. “First-time investors will be better off entering the equity markets via exchange traded funds (ETF) and index funds,“ says Vishal Dhawan, chief financial planner, Plan Ahead Wealth Advisors. These are low-cost funds that allow you to invest in a basket of stocks belonging to one of the major indices, such as the Nifty, Sensex, Nifty Junior, S&P 500, and so on. Investors don't have to worry about choosing the best fund or fund manager when they invest in these passive funds.
Once you have lived with these passive funds for a couple of years, tested your ability to hold on to equities in declining markets, and educated yourself about how to choose the right funds, you may graduate to investing in active funds. The bulk of your equity corpus should be invested in mutual funds. Only a small amount of money, ring-fenced from the rest of your corpus, should be invested in the equity markets directly. Bangalorebased Puneet Arora (see picture), who entered the equity markets directly in January 2014, has taken this precaution. BEFORE YOU INVEST
No quick gains At the very outset, investors must accept that the equity markets are not a route to quick riches. “Greed and speed are the worst enemies of sound investing,“ says investment analyst R Balakrishnan, a former mutual fund CEO. All direct investments in equities should be made with a time horizon of at least 3-5 years. If you ignore this tenet and adopt a high-churn strategy, you will soon come to grief.
“You may get lucky on your first punt and make some quick money. Then, inevitably, you will buy something that will keep sinking,“ says Balakrishnan. If the markets tank and the uneducated investor is left holding stocks of suspect quality, his corpus value erodes rapidly and does not recover for a long time, if ever. Many investors get so badly singed by their first such brush with the equity markets that they decide to stay away from stocks forever.
Educate yourself
Before you start investing directly in equities, make the effort to educate yourself. “If you won't invest time in educating yourself, then direct stock investing is not for you,“ says Balakrishnan. Learn the ropes of investing from an unbiased source with no conflict of interest. Says Dhawan: “Many brokerage houses today run short-term learning programmes on equity investing. Brokerages earn more when you transact more. Hence, they have a vested interest in teaching you investment strategies that involve a high churn,“ he says.
In our view, the approach with which you stand the best chance of making money is one based on fundamental analysis and buy-and-hold. Also, by reading investment classics, you may have the best chance of developing an approach that is time-tested (see Classics that can guide you). Balakrishnan suggests that in addition to investment books, you should also read Michael Porter's Competitive Strategy, which will help you identify businesses with sustainable competitive advantages.
Start small
Initially, bet only the money that you can afford to lose entirely. “It will take about 2-3 years of regular work for a few hours every week to get an idea of how to invest in stocks.
This process cannot be hastened. Any losses incurred during this period should be treated as the cost of learning,“ says S G Raja Sekharan, who teaches wealth management at Christ University's Institute of Management, Bangalore, and has recently authored an investment book titled, How to Get Rich and Retire Early.
Stick to large-caps first
The segment of stocks in which you invest is also important. First-time entrants in the equity markets will be better off sticking to large-cap stocks for two reasons. One, the volatility in large-caps is much more palatable than in midand small-cap stocks.
Two, a lot more information is available on largecap stocks. Since they are intensively tracked by both the analysts and media, more is known about their business and management. This minimises the probability of unpleasant surprises. The chances of falling prey to issues like aggressive accounting and cooked books are also lower among these stocks.
Develop an exit strategy
Develop a clearly defined sell strategy even before you enter the markets. “Once you are in the game, taking the right decisions becomes difficult unless you have a strong decision framework in place,“ says Dhawan. This decision framework, he suggests, should be based on a mix of fundamentals and valuation. If a stock's fundamentals remain sound but its price has fallen, you should buy more.
If the fundamentals have declined while the valuation has run up, you should sell. If the fundamentals remain sound but the valuation has run up, you may perhaps book partial profits, and so on.
WHEN YOU START INVESTING Stick to your circle of competence
Gain a sound understanding of a company's business model before investing in it. Unless you do so, you will not know whether to hold on to its stock or sell it whenever the stock price tanks. Stick to simple businesses whose functioning you can understand easily.
The business should also ideally have a consistent operating history. Its 10-year historic revenue and profits should show a smooth and gradual increase. Beginners should avoid stocks with volatile track records of financial performance. It is also best to stick to unchanging businesses. To quote Warren Buffett: “Severe change and exceptional profits don't mix.“ That is why Buffett avoids investing in technology stocks where today's leader is soon replaced by another.
Says Raja Sekharan: “Stick to companies whose products and services will not become obsolete anytime soon.“ He cites the example of Nokia, a good business that has today been overtaken by Samsung and Apple. “Businesses like banking will not change much in the next 20-30 years,“ he says. Steady businesses tend to make steady profits for their shareholders. In businesses where the product line changes frequently, a lot of the money has to be ploughed back into research and development so that the company is able to come up with tomorrow's winning products.
Invest in companies with moats
Buy-and-hold type investors should select companies that enjoy sustainable competitive advantages. It is intrinsic to capitalism that if a company enjoys outsized profits, a number of competitors enter the field and drive down profits. However, some companies manage to remain highly profitable for a long time. These are the ones that possess an economic moat. They have one or more of the following characteristics: a strong brand, a low cost advantage, high entry barriers for rivals, and high switching costs for customers wanting to move to rivals.
Opt for quality management
Satyam Computer was a well-regarded company until its promoter's shenanigans were discovered. The stock price tanked almost 85% as shocked investors rushed to exit. If you don't want a similar fate to befall one of your stock holdings, do some due diligence on the company's management. Watch out for management that doesn't act in the best interests of minority shareholders. Check the announcements made three-four years earlier by the management to see whether it has managed to bring those plans to fruition.
This will give you an idea of its execution skills. Balakrishnan suggests that you should look up Sebi's website and trawl the Internet for bad news on promoters. He suggests avoiding companies where the promoter holding is less than 30%.
Don't invest in high-debt companies
When the economy is expanding, many companies tend to overstretch themselves.
Some take on more projects than they can handle. Others undertake costly acquisitions funded by debt. “If the economy turns, the company's revenue may plummet, but the interest on debt will still have to be paid,“ says Raja Sekharan. This can severely dent the company's bottom line. The debt:equity ratio and the interest coverage ratio are two parameters that tell you about a company's degree of leverage.
Buy at the right valuation
Usually retail investors enter the markets when they are at a high and valuations have already become stretched. Remember that the higher a stock's valuation, the lower the prospective returns from it. “Study stocks and build a list of the ones you would like to buy. Work out the price points at which you would like to buy those stocks. Then wait patiently for prices to reach those levels,“ suggests Ashutosh Wakhare, founder, Money Bees Institute, which conducts investor education programmes.
Bear in mind that the stock that is cheap is not necessarily valuable. It is better to pay a reasonable price for a quality business than a low price for a poor-quality business (see Valuation parameters you should know).
Measure your returns
Finally, be diligent about benchmarking your performance either against a broad market index or the category average returns of mutual funds. If after a year or two, you find that your direct stock portfolio has failed to match these yardsticks, you would be better off taking the fund route. Use portfolio trackers available on Indian financial websites.
WHAT YOU SHOULD AVOID
Novices should steer clear of some of the common pitfalls of equity investing if they don't want their first foray into the equity markets to end badly. Avoid investing in futures and options. These are highly leveraged bets that can result in steep losses.
Trading on margins--funds borrowed from your broker--is another high-risk strategy that should be avoided. Do your own homework and ignore tips. Day trading should also be eschewed. “Investors make money, not traders,“ says Wakhare.
Finally, if the current bullishness in the markets continues, a large number of initial public offers (IPOs) will be launched. Firsttime investors should avoid them for the simple reason that less information is available about these companies than about players which have been listed on the bourses for over 5-10 years. Besides, when the sentiment on the street is upbeat, promoters tend to price their IPOs expensively.
Chosen well, stocks can be a rewarding investment. Observe the comprehensive list of dos and don'ts listed above and your foray into the stock markets should be both safe and profitable.
Please send your feedback to etwealth@indiatimes.com
