Equity: To invest or not

The stock markets have rallied long and hard from March this year. Investors who invested in stocks before the onset of the rally are pondering on whether they should still be in the markets or book their substantial profits.

Quoting Shakespeare in financial columns is unusual but the current stock market environment warrants a quote. ‘To be or not to be’. That is the question. These famous words from Shakespeare’s Hamlet aptly sum up the state of an investor’s mind today.

On the other hand, many investors who doubted the durability of the rally and stayed out are finding out that the markets are showing no signs of weakness. So, they too are pondering over the question ‘to be or not to be’ in the stock markets at the current juncture.

Investors can probably get answer to this question by focusing on the macroeconomic realties before looking at individual stocks. The stock markets are considered to be forward-looking economic indicators. As a general rule, stock prices tend to lead the actual economy in the range of 6 to 12 months. For example, in 2008 the markets started to crash in January itself whereas the magnitude of recession unraveled only midway during the year.

Similarly, from March 2009 the markets have rallied strongly with minor corrections. So, are they indicating that recession is over? If so, it is not advisable to stay away from the markets. The markets represent the collective opinion of all participants on the current state of the economy. Those investors who can read these signals correctly will be able to capture the larger trends and make better returns.

Some long-term investors use the media as an indicator. Basically, they use contrarian indicators from the media to understand whether the markets are in the over-bought or over-sold zones. When the media is predicting gloom and doom it can be a sign of extreme pessimism and indicate that the markets have probably reached the over-sold zone.

However, these kinds of indicators can take a year or more to become reality. Long-term investors invest in the times of extreme pessimism. They hold on to their investments for three to five years to make superior returns. Looking back, the stock markets reached the point of extreme pessimism in October 2008. So, investors who invested in October 2008 went where ‘no man dared to go’ and have already reaped handsome returns on their stock portfolio.

Fundamentally-sound stocks are the first ones to bounce back from a recession. Actually investing in a well researched fundamentally sound stocks could be as safe as investing in bonds. There are many fundamental factors that guide investors in deciding which stocks to invest in. These factors tell whether the company is financially healthy and whether the stock has been brought down to levels below its actual value, thus making it a good buy.

Here are some strategies that can be used to determine a stock’s value:

Debt and current ratio>

From these two ratios debt ratio and current ratio you can get a good idea whether the stock is a good value at its current price. The debt ratio measures the amount of assets that have been financed with debt. The current ratio tells about the company’s working capital position.

Companies with high levels of debt can experience financial problems. In good times, debt can increase a company’s profitability by financing growth at a lower cost. But in bad times it can lead the company to insolvency. The number of companies that went insolvent in the US last year is a good indicator of the importance this ratio.

P/E ratio>

A very popular indicator used by many is the P/E ratio. But just using this indicator may lead to stocks that are a ‘bargain’ based on past fundamentals but are very ‘costly’ based on future forecasts. A company’s history should never be overlooked, and it should be compared to what the company’s current financial statements look like, and its future earning capacity. Ultimately, investors pay for the future earnings of the company when they buy the stock.

Although a company may seem like an attractive investment candidate because of a low multiple, unless it has catalysts on the horizon like interested institutional investors and strong revenue growth, the stock price cannot trend upwards. The best time to make long-term investments is when the company or the markets haven’t been performing so well. By using fundamental tools and economic indicators, investors can find those hidden gems that can turn big in times to come.