Stock Markets have created exceptional wealth over last 40 years but for a vast majority, the potential of equity investment has failed to translate itself into their bank accounts. This ‘failure of success’ has been due to structural inefficiencies in the trading mechanism as well as speculative behavior on the part of investor.
A whole lot of structural issues, like stock exchange management, information dissemination etc. got resolved with establishment of National Stock Exchange (NSE) digital trading platform but the question of financial education has yet to completely answered. The exposure of Indian households to equity assets in their financial balance sheet is among the lowest in the world at 14%, says the 2020 report by Motilal Oswal Securities.
Valuing an Equity Share
Stock market is by itself neither rational nor irrational, it is the action of some of the participants that may be irrational at times. There are two aspects to equity investment – selection of the company & timing of purchase & sale of equity share transactions. Before an investment is initiated, it is important to gauge fair value of the underlying asset. Different methods to value an equity share are –
- Asset Method – Book value of a share or its Q-ratio (market value of a company divided by its assets’ replacement cost). The equivalent for other assets would be the replacement cost analysis.
- Income Method – An equity share would be worth its earnings i.e. present value of the future benefits of ownership. In other words, P/E (price earnings ratio) or CAPE (cyclically adjusted price earnings) ratio. Its real estate equivalent would be gross rent multiplier
- Greater Fool Method – This measure of valuation assumes that an asset is deserving of a price at which it is traded because efficiency of market would not allow otherwise. However, this assumption psychologically detaches the price from asset being valued & then, it is the price that starts getting traded instead of the asset. An asset is bought only on the expectation that there is a greater fool out there, who would be willing to pay a higher price.
Approaches to Equity Investment
Equity Investment could be approached by analyzing fundamental strengths, trading technical or a combination of both.
Fundamental Analysis is a valuation of intrinsic worth of a company & of all factors that could influence its future price. There could be top-down or bottom-up approach to fundamental analysis. Top-down approach takes a macro view of the economy, analyzing capital flows, interest rate cycles, currencies, commodities, indices, world geography etc. It then proceeds to narrow down the search by analyzing the industry & companies in that sector. Thereafter, it identifies competitive strength of the shortlisted companies, with special emphasis on to its financial statements. Conversely, bottom-up approach starts with company with best financials & widens the analysis to various factors that could potentially affect the profitability or its competitive strength.
Technical Analysis is a methodology of forecasting direction of future prices, through study of historical data of price & volume. It is premised on the theory that price movement of a security is just a matter of statistical analysis as all publicly available information has already been factored into the market price. Another underlying assumption is that all price movements follow a certain pattern or trend, which tend to repeat over time. The attempt is to understand the market sentiment or mass psychology & forecast the future price.
Combining the two – Equity market is a dynamic market place with a socio-economic weather, that seems to get affected by everything & anything. A combination of both approaches is sometimes used to have a rounded view of this very complex, dynamic environment. Fundamentals guide the selection of equity share & its’ fair value, while timing of purchase & sale may be driven by technical in their short-term context.
There are any number of ways to make money in the stock market – buy & hold high quality stocks; timing cyclical stocks / business turnarounds; stock discovery-based P/E expansion; macro-based themes; sectoral themes and many more. Based on the financial goals, risk tolerance & time horizon, an investor needs to have a set of principles that would guide his investment process.
Such a formulation could be managed either actively or passively. The choice between the two depends on the perception on how much outperformance over average market return is possible through investor intervention. Proponents of passive investment (e.g., index fund) feel that the higher expense of active management & additional risk due to it, is not adequately compensated by the returns. Active investment management would be the preferred option if it is backed by in-depth knowledge & research and goal is to significantly outperform the average return. The two fundamental strategies are
Growth Strategy – Growth strategy is a stock buying approach which prefers companies that have grown at an above average rate in top-line &/or bottom-line and that are expected to continue to do so. Growth stocks are designated as such, based on historical & future earnings growth; profit margins; returns on equity (ROE); & share price performance. Growth investors expect to gain through capital appreciation, as opposed to dividends payouts. Higher growth rates are expected to push up share price at much faster pace as long as above average growth rates are maintained & company gains more & more competitive strength.
Value Strategy – Value strategy is a stock buying approach which prefers shares that appear to be trading below their intrinsic value. The historical evidence suggests that share market overreacts to good as well as bad news & share price can move away from company’s long-term fundamentals in a big way. Value investing seeks to buy stocks that are available at discounted prices, in the belief that gains would emerge when things get back on even kneel – either stock market reverts to fundamentals or cyclical problem goes away.
Historical stock market performance has shown that:
- Growth stocks perform better when interest rates are falling & corporate earnings are rising. However, they go down equally fast when the economy starts cooling.
- Value stocks do well early in an economic recovery but typically lag in a sustained bull market.
- A combination of growth & value stocks has the potential of high returns with less risk. It becomes possible to gain through different economic cycles – favoring either growth or value investment style – thereby, smoothing returns over time.