The primary fact every person interested in stocks should keep in mind is that owning a stock of a company is equivalent to owning the company, which is why investing in stocks is referred to as an “Equity investment”.
Therefore, understanding the basic terminologies of a stock market takes top priority, followed by the knowledge of how to pick the right stock.
The stock market is the central location where people who have excess wealth and companies which are in need of capital meet to fulfill their needs and demands. Luckily, we are in the era where this meeting is routed electronically and is facilitated by the “Colombo Stock Exchange (CSE)”, which is the only stock exchange in Sri Lanka and regulated by the Securities and Exchange Commission (SEC).
The CSE is still at its infant stage in comparison to most of its peer stock exchanges. The GDP to market capitalization, a metric to measure the size of a stock exchange, is still hovering around 28.0% for Sri Lanka.
Factors that drive the stock market
The stock market, like any other market, is driven by demand and supply for the underlying commodity, which in this context, is called a stock. The demand for a particular stock is created due to the attractiveness of the company represented by that stock. In most cases, the movement of the price of a stock is a factor of the underlying fundamentals of the company.
However, in Sri Lanka, various other factors such as liquidity (how fast you can exit from a stock), participation of foreign investors and herd behavior (tendency of individuals to follow a larger group or high net worth Individuals (HNIs)) also help determine the price of a stock.
In addition to the aforesaid market-specific factors, global and local macro-economic and political developments also tend to impact price movements of the stock.
When the overall economy is poised to develop, the companies within the system will start to benefit which in turn will trickle down to the performance of the CSE. Hence, investors should keep updating their knowledge on the developments happening around them in order to be successful.
Equity: a high risk and high return investment
In finance, the amount of risk taken to an investment will be compensated by the return to the investor. Hence, an investor should be cautious about the risk factors associated with the stock market. Risk factors can vary from macro-economic to political risk known as “systematic risk” and individual stock related risk known as “specific risk”. While specific risk can be mitigated through diversification, systematic risk is supposed to be borne by all investors in the market. However, in general equity investments give protection against inflation risk as opposed to a fixed income investment.
Investor checklist
There are various theories and approaches on how to pick stocks; however, not all approaches would suit all investors. Over a period of time, investors should create their own method of picking a suitable stock, based on the experience and knowledge gained along the way. Listed below is a very basic guideline on how to identify a right stock.
1. It is all about the company
At the end of the day, an investor is betting on a company and not on the stock market as a whole. Hence, devote some time on studying the company. For example, Sri Lanka has recorded a 22.4% growth in tourist arrivals every year up to 2015 since 2009 and as a result, the Sri Lankan government has earmarked tourism as a fast growing sector and provided several concessions to the industry. Based on this development, an investor can easily presume that any company which is in the business of tourism (Hotels and Travels sector) is benefiting from this growth. But in the CSE, there are about 38 companies being listed under this sector and not all of these companies will perform well. Hence an investor would still have to analyze the company irrespective of the sector to pick the better stock to invest in.
2. Fundamentals
Using the same example as above, it is not practical to invest in all 38 counters just because the sector is poised to benefit. Thus, the starting point is to screen companies based on their respective financial statements (a company's financials can be freely downloaded from the CSE website). Various financial ratios can be calculated to understand how a company has performed over the years. In order to keep things simple, an investor can start off by calculating a few basic ratios and comparing it with industry ratios. Basic ratios can include, but are not limited to, revenue growth, earnings growth, gross profit margin, net profit margin, interest coverage and debt to capital ratio.
It is not always that a company can repeat its historical performance again and again. Therefore, an investor should be vigilant of any developing story on the respective industry and the company, in order to stay abreast with any new developments regarding the investment.
3. How much an investor pays for a stock will determine the return
An investor does not want to pay more than what a company deserves, that is its intrinsic (true) value. If the market price of a company is lower than its intrinsic value then it is considered to be an undervalued company and vice versa.
Relative based valuation is one of the three main methods used by analysts to derive intrinsic value for a company. The P/E ratio (calculated as the market price per share (MPS) divided by earnings per share (EPS)) is a good indicator to measure how much the investor community is willing to pay for one rupee of earnings of a company.
The usual belief is that the lower P/E stocks (in comparison to their peers and their respective industry) are a good buy. However, an investor should also note that if a company's P/E is trading at a discount for a longer period then investors may be purposefully paying a lower price for that company due to various negative reasons such as ineffective management, stagnant industry, declining sales, higher borrowing costs, etc.
4. Growth stocks
On the other hand, an investor may encounter a stock trading with a premium P/E ratio for a continuous period than its peers and/or industry. These types of stocks are classified as “growth stocks” as investors are willing to pay a higher price, keeping in mind the company's future earnings growth potential.
5. Dividend paying/ value stocks
Investing in stocks, unlike any other asset class, will give an investor a benefit from capital appreciation and dividend income (not all the counters listed in the CSE pay out dividend and they are not obliged to do so as well. It will be at the discretion of the management to decide upon the dividend). Hence, an investor can screen for a company with dividend paying history before investing, in order to ensure a periodic payment, while waiting to benefit from capital appreciation.
High dividend yield (Dividend Per share (DPS) / MPS) companies are often regarded as mature companies and they do not find any suitable investments to be made other than paying out for its investors. These types of stocks are known as “Value Stocks”.
How to be a successful investor
How an investor acts after investing is also as important as picking right portfolio of stocks;
1. Liquidate a stock that achieves the expected return
It is pivotal to determine an expected return before making the investment. The expected return can be based on various measures, but the more popular approach is to add a risk premium (an additional return expected for investing in the stock market) to the T-bill rate. For example, if the one year T-Bill is trading at 10%, an equity risk premium of 5.0% (this may vary depending on the investor's circumstances) can be added for an investor to arrive at an expected return of 15% from his investment over a period of time. Despite any lingering factors, an investor should liquidate a stock once his/her target return has been achieved.
2. Cut loss strategy
Getting out of a losing position at the right time is as important as selling the stock once it achieves the target return. An investor should do away any emotional attachment towards any stock and if prices have fallen below a certain percentage, he/she needs to liquidate the stocks. For example, if a particular stock has fallen by 10% then to recover and to realize profit, it has to rise by over 12%. Hence it is vital for an investor to determine his/her loss bearing percentage after finding the right stocks.
3. Review quarterly results of the stocks in the portfolio
All businesses are in an uncertain and a dynamic environment; which is why the investor community should always be vigilant about their investments. It is recommended that an investor should review quarterly financials published by a company (in a year, four quarterly financials will be released by a listed company) of every stock in their portfolio and if at all there is any major negative deviations in revenue and/or profit, an appropriate decision must be made after talking to their investment advisors.
4. Diversify your portfolio, but don't overdo it
Diversification (investing in different sectors) will act as a resistant of freefalling portfolio value. In the CSE, there are about 20 sectors. So it is important for an investor community to choose stocks from different sectors that will diversify their portfolio. For example, when interest rates are falling, stocks in consumer durables and real-estate are expected to perform well due to increased consumption levels, whereas banking stocks tend to be stagnant.
If an investor over diversifies, then effective management of his/her portfolio will be minimal. In theory, having 30 stocks in a portfolio will provide an investor with a high degree of diversification.
(The writer is currently employed as a Research Analyst at NDB Securities and counts over six years experience in Equity Research, Financial Modeling, Business Valuation, mergers and acquisitions, Industry and Company analysis. He is currently a candidate of the CFA level III examinations).
0 comments: