Tuesday, 24 December 2013

Don’t Mind the Index, Just Pick Your Stocks!

After the state election results were out the Nifty and Sensex reached historic highs (Nifty closed at 6363 after intraday high of 6414 and Sensex closed at 21326 after intraday high of 21483 ) bringing a sense of euphoria in market-watchers but for the seasoned investors, this was just another non-descript day in the market, quick to fade away into distant memory.

Why such extreme reactions? What is the correct mood to have? That of jubilation or that of indifference. We need to understand the indications and limitations of indices more clearly so as to form a correct opinion in the face of market swings.

The Benchmark Indices :

  • The benchmark indices (Sensex and Nifty) constitue of individual stocks of leading companies representing various sectors and having different weightages. The weightage depends on the free-float market cap of the companies (Price * No. of Tradable Stocks).
  • If index stock or sector having higher weightage gathers momentum, it will carry the whole index with it in the direction of the stock/sector. The higher the weightage, the greater the swing.
  • Following is the weightage of some sectors in Nifty as an example :
    • As on 13th December the weightage of IT the Nifty is 11.16%. FMCG is carrying a weightage of 8.68% and Pharma sector is carrying a weightage of 3%.
    • Banking sector alone carries a weightage 21% but presently the valuations in this sector are low. 
  • It is a consequence of the present economic situation that the three sectors (IT, Pharma and FMCG) are able to attract investor preference in the low economic cycle. Consequently each of these sectors is having very high valuations due to their consistent performance and growth. 
  • Even if the other constituents of the index do not participate, still the momentum of these three highly priced sectors are enough to create a considerable swing. Such swings do not always reflect the current economic situation but rather are a reflection of a polarized market.

Limitations of Benchmark Indices :

The present gains of the index are based on a polarized market which does not reflect all the constituent sectors as the participation in any rally is not broad based. If the basis of your investments is the signal from the benchmark indices, then, in the present case, it is futile simply because the indices are not truly reflecting the underlying economy and moreover the stock that you have chosen maybe reacting to different fundamentals than that of the index.

When an economic revival starts, its effect is felt across sectors and results in a true bull-run with the participation of all the sectors in the benchmark indices. The signal from the index then will be a true indication of the underlying economy but any investor waiting till that time will have already missed the bus to gain from individual stocks across the sectors.

Just to get the facts right, in the period from 2006 - 2011 Sensex grew by a CAGR of 12%. In the same period RIL grew with a price CAGR of 21%, TCS grew by a price CAGR of 20%, SBI grew by a price CAGR of 25% and L&T grew by a price CAGR of 22%. It is clearly seen how the topmost companies have easily outperformed the index.

Be a Long-Term Investor - A Class Apart :

When there is an economic downturn, it affects all. Even the best of the companies will feel some lull in activities. But good companies will always have their inherent fundamentals intact, only to bounce back with a revival in the economy. If certain stocks/sectors are not attracting valuations presently, it is because, in the present scenario those sectors are not attractive to big institutional investors which have their own well-calculated time-frames which are not always relevant to retail investors.

The stocks/sectors presently undervalued are not in any way lesser in potential. They are just not attractive at present. This undervaluation presents a great opportunity for any investor looking for good picks with a lesser downside risk and good safety margin. When the economic cycle turns the other sectors will also attract higher valuations owing to the inherent worth of the stocks/sectors.

Finally it is important to remember the following special traits of a long-term investor :
  • Long-term investors base their decisions on a good knowledge and understanding of what they are doing and why.
  • As a seasoned investor, expect reasonable returns and not miracles.
  • Understand that the economic cycles are an inevitability. This awareness will keep you grounded and also present a different set of opportunities in an economic low point and at an economic high point.
  • Acknowledge the fact that investing in equities requires a certain knowledge and access to data which may not always be available readily. So, it is prudent to take the help of a financial advisor or someone who is a specialist.
For the long-term investor, the indices are only one of the many points of reference on which to base a decision. The holy grail for any seasoned investor should be the fundamentals of the individual stock or company in which they are investing. It is for this reason that superficial euphoria or short-term panic does not affect a seasoned investor. For them it is all just part of the game!

This post was originally published in The Indian Republic at the following link : Click Here.