Investment fundamentals


In this article we are outlining some fundamental considerations which ordinary or small equity investors must follow in order to get good over all returns on their investments. The basic advise is invest in those companies that are fundamentally strong; have a sound business model and a capable management with a good track record.

The stock markets undergo very mild to wild fluctuations in an undefined time period. There are several reasons for this:

Ø Vis-à-vis other emerging economies’ capital markets, the Indian stock market is expensive. Therefore, Foreign Institutional Investors are looking elsewhere for better returns.

Ø Companies have already started announcing quarterly results but the impact is yet to be determined.

Ø Rising interest rates have a significant impact on market movement. Firstly, this resulted in a higher borrowing cost for corporate companies, thereby pressurizing their margins. Secondary higher rates offer investors better returns in debt securities resulting in a shift of funds from equities. Thirdly, equity markets discount the higher interest rates and as the discounting rate increases the market valuation reduces.

This uncertainty results in making investment decisions difficult. To overcome this difficulty, we should understand the basics:

(i) De-coding The Numbers:
Before taking an exposure to any company, you need to analyze its financial strength by looking at some of the key ratios.

(ii) Debt- Equity (D/E) ratio:
This ratio indicates the magnitude of the company’s borrowings vis-à-vis its equity. A high D/E ratio indicates that the company is largely financing its growth with external borrowings. A rising interest rate regime would mean an additional interest burden, which could be met through company earnings. All things being equal, opt for a company with a lower D/E ratio, vis-à-vis its peers.

(iii) Price-to-Earnings (P/E) ratio:
This tells whether the company is over-priced or not. However, the P/E must be used in conjunction with the company’s future growth. If a company has a high growth potential and is trading at a P / E that could be higher vis-à-vis the industry/peer P/E, it does not mean that the company is over-priced.

(iv) Return on Net worth (RONW) ratio: This ratio reveals the returns generated by the company with the shareholders’ capital. To determine consistency in shareholder returns, one should look at a 3-year RONW trend. Ideally, opt for a company with a higher RONW ratio.

Understanding Relevance of Value Investing:

In this investment methodology, those companies stocks are chosen whose shares are currently under-valued by the overall market. A value investor aims to take an exposure to such companies assuming that sometimes in the future, the market will realize the value of the stock.

Undertaking Growth Investing:

Opt for those companies that have a high growth potential. However, these companies might not be trading at a low P/ E. A marginally high P/E must not be taken as a negative factor. The company’s business model must be checked whether the growth is achievable or not. Examine the industry potential in which the company operated; its customer base; and the competitive environment.

Seeking Consistent Dividend Payers:

Companies aim to meet share holders’ regular income needs by making dividend announcements. Dividend paying companies should form a part of investors’ direct equity portfolio. Investors should not get misguided by the quantum of dividend being paid but they must look at the ‘dividend yield’ that is the result of dividing the annual dividend declared per share, by its share price. A firm with a higher dividend yield is the best option.

The period between April’03 and April’06 is considered to be one of the golden periods in the history of the Indian stock market. The Sensex rose from 2,993 points in mid April ’03 to an all-time high of 12,612 points sometime in May ’06.. Subsequently, the markets fell but then soon climbed to 10,930 points in about 2 months.. This ascent with its fair share of downward ‘blips’, showed that there is no certainty about the market sustaining this upward movement.

Sometimes, it is beneficial to avoid the herd mentality. The pre-occupation with the market’s ‘favorite stocks’ results in certain fundamentally strong companies being ignored due to various reasons. Once these companies find favor, their share price would witness a rise. The above discussion outlines a methodology even for a novice in stock market to maximize returns on his or her investment absorbing upward and downward movements of the markets.