The post-pandemic period has given excellent returns to equity investors. After a sharp plunge in February and March last year, the stock prices of most companies have more than doubled from the lows. For example, the benchmark Nifty 50 index closed Wednesday at around 15,175 level, double that of its March 23, 2020 close of 7,610. The Mid and Small Cap index has performed even better during the period.
This shows in the numbers. Equity mutual funds reported net outflows for eight months in a row in February even as most stocks made fresh high last month. In contrast, stock exchanges and brokerages have seen a big jump in new investor registrations.
According to BSE, the number of registered investors is up 31 percent in the last 12 months, with the biggest jump coming from smaller centres and underpenetrated parts of the country such as Bihar, Uttar Pradesh, North Eastern States, Andhra Pradesh and interiors of Maharashtra among others.
The easy pickings for investors are now almost over and the market has turned volatile. For example, the Nifty 50 index has been oscillating around 15000 levels for nearly a month. In this period, it touched an intraday low of 14,467 and a high of around 15,500.
Retail investors can however still make good money in this market if they follow some basic rules of the game.
1. Have a hard look at the sectors and industries you are invested in. A company’s or stock’s performance is greatly influenced by the industry it belongs to. Most industries follow a different growth and valuation cycle and not all do well at the same time.
At any point, there are leaders and laggards in the market and they keep changing as the market evolves. Here is the summary of the last 6-month and 3-month performance of the BSE sectoral indices and the overall return of the benchmark BSE Sensex during the period. Notice the variability between the performance of various sectors.
For example, metals and mining companies have been the top performers in the last six months and three months. In contrast, safe haven sectors such as FMCG, pharmaceuticals and Information technology (IT), which had led the market in the early part of the rally last year, have now turned laggards.
A failure to do this could make your portfolio a laggard and you may even lose money.
2. Watch out for re-rating or de-rating of the stocks you wish to invest in. Historically, a large part of the changes in stock price comes from expansion and contraction in a company’s valuation. In other words, a stock becomes an outperformer when its price to earnings ratio expands. The process is called stock re-rating in market parlance. Conversely, a company’s stock price languishes if it gets de-rated by the market.
Take Reliance Industries for example. RIL became one of the top performing large cap stocks in the last three years as its price to earnings multiple more than doubled from 15.5x at the end of March 2018 to nearly 34x currently. As a result, the company’s market capitalisation is up 156 percent since March 2018 even though its annualised net profits are up just 17 percent during the period. Other big companies to see re-rating include Wipro and Infosys.
In contrast, ITC saw a de-rating and its P/E ratio declined from 33x at the end of March 2017 to around 19x right now. As a result, the company’s market capitalisation is down nearly 25 percent in the period despite nearly 30 percent rise in its annualised net profit during the period.
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Re-rating or de-rating of a stock happens when markets become bullish or bearish about the long-term growth prospects of the company.
Conversely, a stock is likely to get derated if its valuation becomes too high either compared to its historical average or in comparison with the prevailing industry valuation.
So keep a close watch on the valuation ratio of your stocks and don’t shy away from buying or selling it if you believe it to be out of sync with the long-term trend or industry average.
3. Stock valuation varies greatly from one industry to the other. There is no standard measure of a stock’s fair valuation and it varies greatly from one industry to the other.
As a general rule, stocks in defensive sectors such as FMCG, pharma and IT or technology always trade at a premium to the broader market or Sensex or Nifty 50 valuation ratios. Here is the current valuation ratio of BSE sectoral indices.
See the extent of variation in the valuation ratios from one sector to the other. As such always compare the valuation of a company from a similar company in the same sector. And never compare the valuation of two companies from two sectors with different dynamics.
Valuations are also a function of the company’s financing policies and its balance sheet composition. For example, companies’ with no debt on their books get premium valuation in the market compared to those that make frequent borrowings to fund their operations.
4. Know the correct valuation ratio for your stock. The right valuation ratio to assess a company varies from industry to industry. So while IT, FMCG and pharma companies are typically valued on the basis of P/E ratio, companies in capital intensive industries such as banks, non-banking finance companies, metals and oil & gas are usually evaluated on the basis of price to book value ratio (P/B Ratio).
This is because earnings or profits can be very volatile in these sectors, making P/E ratios unreliable. This is especially true when the sector is going through a cyclical upturn or a downturn.
In contrast a company’s book value or net worth changes at a slower pace than its earnings or revenues. This makes P/B ratio a more reliable means to find fair value of stocks in cyclical industries.
5. Check a company’s dividend paying record. A good company with a competitive and profitable business should reward its shareholders with equity divided commensurate with its reported net profits. Everything being equal, always invest in a stock with a history of dividend payment than one without it. There can be exceptions if the company is too young or is investing heavily in business expansion
As a matter of prudence, stay away from companies that report fast growth in their revenues and profits but do not show matching growth in dividend payout.
A close track on these five factors will help you avoid costly mistakes and greatly improve the chances of making money regardless of the underlying market conditions.
(Advice: This article is for information purpose only. Readers are advised to consult a certified financial advisor before making investment in any of the funds or securities mentioned above.)
(Karan Deo Sharma is a Mumbai-based finance and equity markets specialist).