Investment Strategies

Investment Strategies

We have discussed two broad themes concerning investment strategies here. One is about how different companies have differing characteristics, even though the underlying principle for every company is to provide adequate returns to its shareholders. The second theme is on a very famous concept of rupee cost averaging, referring to a technique of identifying a select set of stocks for investment, and buying into these stocks even when they go down, thereby averaging the cost of investment. First, we look at how companies can be segmented. Just as investors are classified as conservative, moderate or aggressive, companies too are broadly categorised into cyclical, defensive, growth, speculative and value. After all, State Bank of India and Infosys Technologies do not have similar characteristics. SBI is a play on the Indian banking sector and the economy at large. Hence it could attract longer-term investors who believe in the India story. On the other hand, investors in Infosys could typically be more of those seeking higher returns in software exports for a little more risk, and more concerned about the company’s quarter to quarter earnings. Hence, some understanding of the different types of stock segmentation is required to avoid unpleasant surprises at a later stage. Cyclical : In a cyclical business, a company’s earnings fluctuate sharply with a change in the business cycle. The cycle affects all companies within the industry. When the cycle heads up, companies do well with good growth in sales and profits, and investors buy their shares, leading to gains for shareholders. But when a downturn hits the industry, sales plateaus and profits decline. Cyclical companies typically operate in commodity businesses like cement, steel and paper. They lack product differentiation though good companies try to minimize the commodity element in their business, by integrating forward into products, or by expanding into new geographies. In cyclical stocks, the easiest way to make money is to get into the companies before the cycle turns up. If you get into cyclical stocks during a downturn, anticipating an upturn be prepared for a long wait. Defensive : Defensive shares offer a hedge during an economic downturn. They comprise companies whose products are necessary in any economic climate, and hence are relatively shielded during economic contractions. Sectors which have this characteristic include fast moving consumer good companies, utilities and pharmaceutical companies. But this theory may not hold good always; if these stocks have risen along with the market in a bull run, then they will fall too when the market declines. Investors can expect such companies to have relatively low business risk and not excessive financial risk. Growth : Growth stocks are companies that have valuations, which may make them seem expensive. But their sales and profits grow faster than market, which ensures that investors in these stocks gain, despite seemingly high valuations. Growth stocks, by definition, plough back most of their retained earnings back into the business, and also tap the primary market for funds more often. Investors pay a premium to buy these stocks, hoping to benefit from their superior growth prospects. The market price of growth stocks can also be very volatile. They usually move up faster than other stocks, but can come down sharply too. If an investor’s expectations of growth is not met, these stocks can fall sharply too. Growth stocks are also defined as those which will deliver better gains compared to other stocks in the market, with a similar risk profile. That’s because the market undervalued its potential at some point in time. A handsome profit awaits the investor, who can identify a stock, which can not only grow faster in terms of sales and earnings, but also is relatively under valued in the market. Speculative : It is a company whose business profile involves huge risk but can also bring in capital appreciation for its investors. Some examples are that of a company involved in new drug research, oil exploration or a company boasting of breakthrough technology. But even otherwise, shares of normally growing companies can turn speculative if they become takeover targets for the assets they own (land, machinery, copyrights, brands and so on) or are expected to benefit from a huge contract (tender for pipes used in deep-sea oil exploration). In stock market parlance, however, stocks whose prices are rigged, in which a group of people manipulate prices by spreading rumours, are also known as speculative stocks. Value : It is used to describe stocks that are trading below their intrinsic value. Value investors typically like to purchase stocks that are worth much more than what they paid for. Eventually, they believe, the market will recognize the true value of the stock and run up the price. But the term 'value' can be misleading. One, if intrinsic value is mistaken for replacement or liquidation value of a company. These last two measures are more relevant for an entity which is planning to acquire the company, not to an ordinary investor. Two, accounting measures such as price-to-earnings or price-to-book, used to specify value in a stock trading at a discount to its peers, lose relevance as they are based on historical numbers. And lastly, a stock which is trading at a discount may actually be rightly traded so because of certain business fundamentals. Public sector companies, turnaround companies, companies in asset-based industries, which normally trade at a discount to market, are often touted as value plays. Bear in mind that these categories still could mean different things to different people. And as investors, it is up to you to decide which stocks that suit your risk profile. Rupee-Cost Averaging How many times have you cursed your luck for not buying shares of Infosys Technologies when it was only Rs 400? Then again, you could have bought it for Rs 1,200 and even at Rs 2,000. Sounds familiar? As common investors, we all remember not having bought a particular share when it was cheap. Well, all's not lost. Here’s a new method to ensure that you don’t miss the next opportunity, even though it is not a panacea. It even helps you keep low your purchase costs. It is called dollar-cost averaging (rupees for us). It is an easy technique that requires discipline, in which a person invests a fixed rupee amount on a regular basis, usually monthly for purchase of equity shares. Let's say you have a monthly surplus of Rs 5,000 to invest in equity shares. This can be used to buy 10 shares of company ABC at Rs 500 per share. Or six shares of company ABC at Rs 500 per share and eight shares of company XYZ at Rs 250 per share. You could do this every month with the same companies or you could even expand the list of companies. The choice is yours. The idea is to invest a constant amount in a few selected shares over a longer term. To continue with the above example, you could have invested Rs 30,000 at the end of the sixth month, instead of a monthly Rs 5,000. But that would not have allowed you to lower your purchase cost. To benefit from fluctuating share prices, it is better to invest smaller amounts of money. Since more number of shares can be purchased when prices are low. But when share prices move up, a fixed amount will buy lesser number of shares. It turns out that this method will keep your average cost lower than the prevailing market prices. Assume that you had bought 10 shares of ABC at Rs 500 in the first month and seven shares in the second month as its price moved up to Rs 650 (5,000/650 rounded off to the lower denomination). Your average price would have been Rs 561.76 (9,550/17), leaving you a profit 88.23 per share (650 minus 561.76) or Rs 1,500. But if you had put off the purchase to the next month when you have a lumpsum Rs 10,000, you end up buying 15 shares (10,000/650 rounded off to the lower denomination) at Rs 650. Your gain by using the cost averaging method : two shares (17 minus 15) at Rs 650 that is Rs 1,300. Remember that stock prices often fluctuate for reasons unrelated to its fundamentals. With fixed rupee-cost averaging, an investor eliminates his or her chances of buying too many shares at too high a price. Periodic declines in a stock market give opportunities to buy at lower prices. A few do's and don't : Be sure that you have a steady stream of income. If income is not steady as expected, it could curtail purchases at times attractive for additional purchases. Make a short list of the shares that you want to buy. Run this method over at least six or seven stocks, since one or two stocks will end up being a disappointment. If fundamentals change, get rid of your under performers. Don't try to time your purchases. That could turn you into a speculator instead of an investor. If you think share prices are too high, don't purchase. Or buy stocks that you believe haven't yet appreciated. Lastly, don't hesitate to liquidate your portfolio before your target time horizon, if circumstances lead you to believe this to be appropriate. The rupee-cost averaging method is quite similar to a systematic investment plan, which all mutual funds tout. They work like this: After an initial minimum investment (ranging from Rs 500 to Rs 10,000 depending on the type of fund), an investor hands over post dated cheques for the next few months to the AMC (amount could range from Rs 500 to Rs 5,000). But be warned, that none of these approaches can save you in a declining market (in fact, you could end up buying more and more shares in a falling market).