Choosing Stocks - for low risk investors - Playing Safe

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Choosing Stocks - for low risk investors - Playing Safe

Postby executive_2010 » Mon Jan 05, 2009 6:02 pm

During the past few years, many changes have taken place in India. As a result, the rules of investing have changed considerably. Until year 2000, a typical Indian family would invest major portion of its savings in fixed deposits and government securities, which yielded a decent 10-15 %, relatively risk free returns. Stocks and mutual funds were unknown to most. But, things have changed now. The IT and BPO booms have caused a heavy inflow of foreign funds to India. The interest rates plummeted. Due to this, and many other factors, Indian businesses have prospered multifold. Barring a few hiccups, the stock market has made an impressive growth over past 4-5 years. While this doesn't mean that everyone should dilute their fixed deposits and other assets, and head towards the Dalal street, shunning stocks completely and totally relying on fixed income instruments wouldn’t be a wise decision anymore. Here’s why I feel, everyone should have a place for stocks in their portfolio: -

1. History repeats itself.
Research has shown that, in long term (10 years), stocks yield the best returns compared to other asset classes - such as debt instruments, gold, real estate or bonds. Stocks of well managed, growth companies have yielded over 15% return pa, compounded.

That means, Rs. 100 invested in stocks, back in 1994, would have grown 4 times.
And, gold in 1994 was trading at 3800 Rs/10 gm, hardly 1.7 times lower than its present value.
A 2BHK apartment, which today costs Rs. 16 lakhs (Rs. 1.6 million) in Pune, was available for Rs. 6 lakhs (2.7 times lower).

So, even if we let go of the depreciation, property taxes etc, real estate in a high-growth city like Pune, has yielded a disappointing 10.5% pa return. (Okay... this doesn't take into account the rental income from the property or savings in rent which you would otherwise have paid, but real estate requires one-time lump investment. You can’t buy a tiny play-house for Rs. 1000 and expect it to sell for Rs. 3000 after 10 years, can you? )

2. Your shield against inflation.
Again, history has proved that stocks somehow manage to do well in inflationary times. No doubt, inflation hurts everyone, but slowly businesses pass on the costs to the consumers and live on.

With increasing direct and indirect influx of foreign money in India, rising oil prices, increasing strain on global resources like iron and other commodities, inflation is bound to be a cause of concern for investors. And, you should note that no debt instrument offers protection against inflation. High inflation doesn’t necessarily mean high interest rates. Interest rates are simply dependent on demand and supply of money.

Alright. The bottom line is - stocks are good. But not all of them. There are many examples of companies going bankrupt and being delisted from the market. The censored can loose anywhere from 200 to 1000 points in a single day! While regular investing is a sure-fire way to beat the volatility, one can also reduce the risk considerably by picking a good quality stock. While none can invent any magical procedure or formula, I’ll try to give you some tricks you can follow to reduce your risk. The trick I play is, in fact, very simple. A few of you might know that banks lend you loans against your shares. Certainly, the bank wouldn’t lend you money if you own ridiculously overpriced shares of a sinking company. So, they have a set of guidelines that the loan officer follows before lending the money. My idea is - we can use the same guidelines to identify the "safe" stocks in the market. Typically the guidelines are -

1. The share/ debenture should be of a company listed in BSE 100 Index (list of BSE 100 Index companies is available on http://www.bseindia.com/about/abindices/bse100.asp).

2. The market price of the security should not have fallen below par for preceding 52 weeks. This might indicate a serious trouble with the company or the sector. But, if you are sure that all is well with the company, and the price has simply fallen because of market sentiments, you should go ahead and buy the stock.

3. The market price of the security should not be as variance with the arithmetic average of preceding 52 weeks high and low by more than 25% in downward direction. Also, security where the market price 52 week high is 4 times of the 52 week low is not be accepted. This ensures that the stock isn’t volatile.

4. P/E ratio of the company should not exceed 40. A high P/E ratio indicates over-priced stock. Earnings are the main fuel that drives stock prices. While, a high P/E ratio might indicate high expectations from the company, buying a stock on such expectations is very risky. Just a few days back, L&T, a leading infrastructure company missed its earnings expectations, and its stock fell by over 17% over 3 days. Such is the risk associated with investing in companies with high P/E ratio.

5. The total number of shares of the company traded on NSE and BSE should exceed 25,000 on the day of financing and on each preceding 2 days. This ensures that the stock is actively traded in the market. Should the bank decide to sell it, it won't be too difficult.

So, these are the ways to determine how safe your stock is. Needless to say, these tips only ensure that your losses would be minimum and do not guarantee phenomenal returns. Some of the stocks that qualify these criteria are - SBI, Bank of India, Punjab National Bank, Tata Iron & Steel, etc.

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