Classroom | Where should I invest and how? (Equity: Part 7)

In Part 7 of the Classroom, CNBC-TV18 Consulting Editor Udayan Mukherjee explains how to go about building an investment strategy.

Q: How do I finalise an investment strategy?

A: The first two things to arrive at are one's investment horizon and return expectation. Some people may have shorter time frames in mind, but with equity investing, the longer the time horizon the better the chances of success. The minimum investment horizon should be three years and the ideal is 8-10 years. Therefore patience is the key.

Also, return expectations should not be too high. Investors should understand that even a 15-16% compounded growth over a 10-year horizon can create significant wealth. People often buy very risky stocks in the hope of multiplying their principal quickly, which is totally avoidable. The best strategy is to buy stable stocks with proven track records and hold them over long periods.

Q: My broker recommends a set of stocks daily. Is it a good idea to follow that?

A: Daily stock recommendations are usually trading ideas. The probability of success with such ideas is 50%, which is the flip of a coin. The truth is that there is no way to predict the short term movement of the market or individual stocks.

Sometimes, brokers can get lucky but over a period of time, their success rate will come around to one in two. That is almost as good as a random guess. So, while it may be exciting to think that a recommendation from a broker can lead to quick gains,  it is actually a futile pursuit. This is not the way to wealth creation.

Q: My friends follow recommendations of experts on business channels. How do I know which expert is good?

A: Experts who appear daily on business channels are themselves, with very few exceptions, not very successful investors. Almost none of them have created significant wealth for themselves with their own trading ideas. Sometimes, though, thoughtful investors appear infrequently on these channels who speak about the long term prospects of some good quality businesses. That can be a cue to doing some research on these names before taking an investment decision.

But generally, the path to success does not lie in blindly copying the picks of investment experts on TV. If, over a period of time, a particular expert identifies wealth-creating stocks consistently, an investor can take his advice more seriously but still never invest without personal due dilligence.

Q: How do market analysts predict price targets for stocks.

A: Trading experts make price forecasts based on technical analysis. This, as discussed above, is a game of chance and therefore not very scientific or reliable. The future direction itself of stocks is inherently unpredictable in the short term, leave alone their price levels.

Fundamental analysts make future predictions of the earnings per share of a particular stock based on various assumptions about growth. Then they multiply these assumptions by the likely valuation (usually PE multiple) of the stock, based on growth and historic valuation patterns, to arrive at a price target.

But this exercise too, is fraught with uncertainty and therefore investors are better off focussing on the general business trajectory and competitive strengths of any company, leaving the future price levels to the market.

Q: How do market analysts predict the earnings of companies?

A: Analysts try to gauge the intrinsic demand outlook of a particular company, within the context of the overall sector it is in. They also keep in mind the historic growth trends of the company under various business cycles. Using these, they try to arrive at a revenue projection for the coming one or two years, which they update regularly with every passing quarter.

Based on these revenue numbers, they then make assumptions of profit margins and try to arrive at an Earnings per share or EPS. The future EPS is the basis of all projections and targets of stocks prices but it is an imprecise science and often prone to significant errors. The last 5-6 years have been testimony to how significantly analysts can overestimate earnings projections.

Q: I want to identify winning stocks myself, how can I do that?

A: The process of identifying stocks is never easy. The first step is to work within one's sphere of competence, i.e. exclude complex industries, which are difficult to understand. While most analysts try to predict the future, the key to stock selection often lies in the past. Try and identify market leaders in a few chosen sectors, who have consistently delivered high return on equity (RoE) over long periods and many business cycles. Keep your universe small, so as to not spread yourself too thin.

Using the above methods, arrive at a set of 12-15 stocks, no more, which fit the criteria. Now, dive deeper into them, read reports, talk to smart investors and fine tune the list further. All you need finally, is a set of 8-9 stocks which you know and understand well, and hope that 5-6 of them deliver the goods.

Q: What is a multibagger stock? Is it possible to identify one in the making?

A: A multibagger stock is one that generates a return of several times the purchase price over a period of time. If a stock purchased at Rs 100 becomes Rs 900 over a seven year period, it is a multibagger. Many investors think multibaggers happen within short periods, and while that may be so on a few occasions, generally stocks take time to multiply.

The trick is in the power of compounding - if a stock grows its profits by 25% every year for a decade, it will become nearly ten times its value, or a 10 bagger, in that period, even if it only keeps pace with its earnings growth. Chances are that it will appreciate more than that. So, the effort should be to try and identify companies that are growing profits at 20-25%+ and have a reasonably good chance of sustaining it over many years. That is the recipe of finding a multibagger stock.

Classroom | Why markets exist, and should I invest in stocks? (Equity: Part 1)

Classroom | Starting your stock market journey (Equity: Part 2)

Classroom | Can I get rich fast by investing in shares, and other questions (Equity: Part 3)

Classroom | How to open a demat account and select a broker (Equity: Part 4)

Dealing with the stock broker (Equity: Part 5)

Classroom | Placing orders (Equity: Part 6)