How should one invest in the stock markets?

By - IndianMoney.com Research Team     20 November 2013

One of the trickiest things in life is making a decision when to enter and exit the stock market. Investing in the stock markets is all about timing. Yet the timing is never right .Stocks never seem to reach the optimum price one wants .When share prices are expected to fall down to abysmal levels they rise and are soon out of one’s price range. When share prices are at low levels one keeps waiting for them to hit rock bottom and when they rise one has missed the bus. Stock markets are all about keeping one’s emotions in check. One must stand the true test of time.

What are interest rate sensitive stocks?

When interest rates rise consumers who purchase expensive items such as cars on credit might postpone them. Discretionary spending is cut .Customers might postpone the purchase of a new home or a car which affects the loan segment of the banks. The number of customers opting for a car or a home loan might come down which affects the net interest margins of the bank. Stocks of certain Companies such as banks, automobiles and infrastructure are affected by the change in interest rates in the economy. A cut in interest rates leads to a rise in prices of the shares of banks and automobile Companies based on the hope that a higher percentage of loans will be taken and net interest margins of banks will rise.

How does one purchase interest rate sensitive stocks?

The rise in the prices of goods and services with time is called inflation .When inflation goes to high levels measures need to be taken to bring it under control. One of the common methods used is an interest rate hike. In an economy in recession most of the industries take a hit. This affects their ability to service debt. The net result is a loan default. This increases the non performing assets of banks. When interest rates rise costs of deposits increase. A higher interest rate needs to be paid by the bank on the deposits parked by the customers. Ultimately this affects their lending rates which also rise. This results in a reduction in loans taken by borrowers who prefer to postpone their purchases on credit owing to higher loan rates.

This affects the net interest margins which is basically the difference between the interest income earned by banks on loans and advances minus the interest paid to customers on their deposits divided by the average earning assets of the banks. This results in banking stocks being badly beaten down. However the larger banks in the public and private sector with a long track record in operations and sound fundamentals are able to weather the storm and can be purchased at lower prices .These tend to be value buys as their fundamentals are strong but owing to macro economic conditions beyond their control they can be purchased at bargain rates. These banks should have good capital adequacy, strong loan books and negligible restructured assets.

The real estate sector takes a severe beating due to rise in interest rates. With the rise in interest rates lending rates of banks also rise. Customers postpone the purchase of their dream home or apartment .This results in a huge unsold inventory for the developer. Developers borrow heavily to fund their constructions. This increases debt in the real estate sector .The real estate sector is further hit due to high land prices. Buyers would not purchase land at such elevated levels .Infrastructure and real estate stock prices tend to fall under such conditions. Infrastructure stocks having sound fundamentals are a good buy at lower prices. However Infrastructure Companies with a huge debt on their balance sheets need to be avoided.

The automobile sector is also heavily hit due to rise in interest rates. With lending rates of banks being high customers who purchase on credit will postpone discretionary spending and car loans would be the first to take a hit .Inflation results in high fuel prices. This coupled with high interest rates is definitely a put off for customers which results in stock prices of automobile Companies coming down. Stocks of Companies having sound fundamentals can be obtained at bargain rates.

What would happen to these stocks if inflation were to come down? A fall in inflation would lead to an interest rate cut. The share prices of automobiles, infrastructure and banking would spike. This rise would be so fast that fence sitters would be caught off guard. Stock markets were not made for those sitting on the fence.

How do defensive stocks safeguard ones portfolio?

Stocks of FMCG, Pharmaceuticals, and consumer durables are considered defensive stocks. These stocks are in high demand when markets are in a recessionary phase. These stocks provide a cushion or a fence around ones hard earned investments and this helps to protect them in times of volatility. This prevents a hard landing on rocky ground. One should always invest part of one’s portfolio in defensive sectors such as Pharmaceuticals and Fast Moving Consumer Goods. An investment in these stocks leads to very less fluctuations in periods of drastic fall in the markets as is what is happening a lot in recent times. Similarly in periods of a spiking in stock market indices the rise is not very high.

This is a trade off which one has to make. So when should these defensive stocks be purchased? When markets are in recession and there is negative sentiment around the prices of defensive stocks tend to soar. Many investors purchase these shares are very high prices .When markets boom the price of the defensive stocks tends to come down .The best time to purchase these stocks is when the economy is booming. When consumer confidence is high the defensive shares are available as a value buy. Their true value is reflected in times of recession .Stocks having sound management, good fundamentals and whose products have huge demand should be at the top of one’s list.

Should one purchase stocks which give a high dividend?

The management of a Company might set aside a part of its profits for an acquisition or to expand the business. The Company might decide to distribute the left over profit among its shareholders during the year. A dividend is a payment made by a Company to its shareholders out of the profit after tax of a Company and distributed to the shareholders according to the class and number of shares held by them. The dividend yield is given as the dividend per share divided by the price per share. So are Companies with a high dividend payout good for its investors? This would depend on the risk profile of the investor. Dividends are tax free in the hands of the investors .

For investors looking for a steady income on a yearly basis this route can be followed. Even if the share price does not rise to high levels the dividend can be an earning to the investor. Stocks which give high dividend payouts are preferred by conservative investors. Care must be taken to see that a Company is consistent with its dividend payouts. The Company should have a good revenue and growth. If the Company does not have a strong balance sheet and good profits it might not be able to provide dividends in the future. So what about an aggressive investor? In India many large Companies sit idle on huge cash piles and aggressive shareholders question them on the use of these funds. The Company might choose to return this cash pile as dividends to the shareholders. This displeases aggressive shareholders who want growth rather than dividends.

If a Company declares a dividend of INR 10 per share and the share is trading at INR 500 the yield would be 2%.If the share is trading at INR 1000 then the yield would be 1% where we divide the dividend per share by the share price. These are very low returns for an aggressive investor who expects the Company to grow perhaps using its cash pile to make an acquisition in line with its current business. The Company can make an acquisition abroad and increase its profitability and size of operations expanding on a global scale. This results in a growth in profits and a high appreciation in value of the share price .Aggressive investor’s focus on Companies which follow this line of thought and are not interested in dividends.

What are the factors one should note while investing in the stock market?

  • One must focus on the Company growth and fundamentals rather than on the state of the macro economy or the stock market. Always purchase shares of good Companies rather than only maintain a focus on the stock markets.

  • Always study the Beta value of stocks. If Beta=1 then the stock moves in line with the market .Stocks having low Beta value are defensive in nature and are not too highly affected in a recession .Stocks with high Beta value tend to give very high returns in periods of a boom in the economy and are severely beaten down in times of recession. These stocks especially if they have sound fundamentals and a good management are value picks during a recession .Infrastructure stocks are a prime example.

  • The eternal rule of investing in stock markets is to be greedy when others are fearful and fearful when others are greedy. Investors tend to blindly follow the herd based on investment patterns of relatives and friends. This is a trend which can result in severe losses in the market. Always study the fundamentals of the Company one is investing in. If necessary take the help of a financial adviser. Always invest in a Company whose business you understand. One must always be ruled by the mind rather than the heart and not let emotions cloud sound decision making.

  • Always invest in a systematic manner in the market .Follow a disciplined approach in order to make a killing in the market. After making a decision on the shares one would like to invest in after through research, understanding of the business and making sure of sound fundamentals, one must fix a target price range of the share he is comfortable investing in. One must then accumulate sufficient quantities of these shares and over a long term make a killing in the market.

  • Always be realistic when investing in the share market. Set a target expectation of 10-15% rate of return per annum on the investment. If more is obtained consider this a bonus. Stocks can give 50-60% return in a few months or even 300% returns in a year. If one is lucky to get such a high rate of return consider it good fortune .However always stick to a realistic rate of return and one will not come to grief in the stock market.

  • One must never invest living expenses or emergency medical funds in the stock market. Always invest out of the excess funds set aside such that a loss should not put one in a desperate situation .One has to sleep at night and a severe loss can surely rob you of this necessity.

I would like to end this article stating that investing in the stock markets is not a flash in the pan approach and one has to monitor the investments to check and see if the intended target is being reached. If not churning of the portfolio to cut losses might be necessary. Making a timely decision on churning of the portfolio might be more important than actually investing in the market. This yields a high rate of return in the future.

Under : Financial Planning