Identifying the Heroes in the Equity Market

Life is not a cakewalk! The same applies to investments. As in life, ups and downs are common in the world of investments and one has to constantly ride roller-coaster here too. 

To prepare and equip yourself to face the unexpected, investments have to be chosen in such a way that they emerge winners even after going through unforeseen circumstances. Right from childhood, our parents have always told us about the virtues of having ‘a sound mind in a sound body’. On the same lines, we have to ensure that investments are robust enough to sustain the volatilities of the stock market and they not only offer dividends, but also capital appreciation as they tread towards maturity.

Investments should have inherent qualities to deal with market volatilities and the uncertainties associated with the economy, both local and global. 

The bedrock of the investment should be such that money invested should work for investors. 

Well, that is easier said than done! How should one make an investment that is immune to all the volatilities and uncertainties around? Not an easy task, but it is not too hard either. The basic qualities an investor should have are discipline and a focused approach. One has to have a time-tested methodology to identify an asset class that will ensure outperformance over the long term. Investors must identify the ‘Heroes and Villains’ of the investment story and ensure that the hero outshines the villain, thus scripting a masterpiece.

Let’s identify these supposed ‘Heroes and Villains’. The prime culprit that erodes the value of an asset is inflation, which is the general increase in prices and fall in the purchase value of money. 

For an investment to be value accretive, it should not only beat inflation but should do so by a wide margin, thereby creating wealth. Identify an asset class that would consistently beat inflation. 

Fixed income securities, be it G-Sec bonds, fixed deposits or plain simple bank deposits, somehow match the inflation, and thus have limited scope for wealth creation. Real estate is an asset that is used as hedge against inflation, but has its own issues like illiquidity, opaqueness and limited city-specific opportunity in addition to huge lumpsum investment requirement. 

Gold is also a hedge against inflation, but only on global scale. Gold price in local currency has is often get influenced by currency movement against the US dollar. Lastly, equities have been consistently beating inflation over a long period of time. 

The growth in businesses (which represent equities), in general, involves price and volume growth. The price growth captures the inflation in the economy (assuming that it is passed on to the bottom line without any additional cost) and hence, the return from equities beats the inflation in long run. 

Now let us identify the crucial parameters that one has to focus on while investing in equities. The first and foremost is the management quality. When one invests in equities, he partners with the promoters/ management of business who are responsible for day to day operations. For the business to prosper and offer rewards to the minority shareholders, it is imperative that the promoters are above board, ethical and minority shareholder friendly. It must be ensured that the management is well educated, visionary and understands capital allocation which is crucial to take the business to places. 

The proposed investment should be part of the growing sector thus offering ample opportunity for the entity to prosper. The quality and longevity of earnings growth decide the potential of wealth creation for an investment. The legendary NR Narayan Murthy summed it up aptly, “I’d be happy to have a small slice of a large cake than having a large part of small cake.” To add to it, the business should have an economic moat which ensures that it can command pricing power over longer period. The economic moat is a structural competitive advantage enjoyed by the business over its peers which protects its margins and market share in long run. An expanding business with formidable moat and operating in prospering sector has more than four legs of growth, thus great recipe for investment. 

Lastly, it is always advisable to identify such investment opportunities in its infancy and pay right price. An overpriced entry point always has dangers of correction whenever the growth parameters embedded in the expectation are not met. A way to tide over this issue for a marginal investor (who cannot devote sufficient time to study valuations) is to practice systematic investment approach where the investor invests regularly at different price points. 

Having invested methodically, the investor should give ample time for the investments to mature. Investments made using these tried and tested methodology would survive the toughest of the times ensuring that the health of portfolio is improving as the investor ages!