WHY STOCK MARKETS ARE NOT SPOOKED BY OIL

The single biggest factor influencing the global economy today are surging oil prices. Oil has risen from $ 20/bbl in 2002 to $ 130/bbl now. However this may not affect markets negatively and may in fact even be a bullish signal for stock markets going ahead.

The main reason touted for rising oil prices is the increasing demand for the commodity from growing economies. Therefore the very fact that oil prices are increasing means that the growth drivers are still intact. This is a very significant indicator for the future and it may be one of the reasons why, in spite of a surge in oil prices stock markets around the world are stable.

The second reason for the spiraling prices is the speculative element. Now if oil prices show some volatility on the downside, it could make the oil bulls run for cover. In turn this could trigger a sharper fall in prices intensified by speculators rushing to cover long positions.

The long term reason why oil cannot sustain current prices is that there are huge oil reserves in the form of oil shale, estimated at 2.6 trillion bbl. The only problem is that shale oil requires a different technology to convert into petroleum and new refineries have to be built. The cost of converting shale oil is estimated at $ 35/bbl. Now, as long as oil was in the $ 50/bbl range, this was a problem as it could slip back to less than $ 35 and render these refineries unviable. But at current prices investing in these technologies makes eminent sense and many companies are rushing to set up new plants.

Alternative technologies like wind power, solar power, nuclear energy are likely to get advanced as oil sustains its high prices. Also clean technologies being developed will ensure that demand for oil stops growing even though economies maintain their pace of growth.

When we combine all the above factors, it can be seen that oil is in a bubble zone presently. Whether the bubble goes on to assume larger proportions or deflates shortly remains to be seen. But deflate it will and stock markets across the world are picking up this signal well in advance, as markets have a habit of doing. This is the reason behind their surprising resilience.

REMEMBER THE PAST

Do you remember the stock markets in 2002? The whole world was recovering from the aftermath of the September 2001 attacks. Amidst all the gloom and doom, everyone and his uncle were advising you to sell stocks and get into good old fixed deposits. In fact people were talking as if markets would never rise again and any fresh investments made would fall even further. Further? Think about it now. In 2002, BSE Sensex was at 3200 levels. True, it may have gone down by a couple of hundred points more, but with the benefit of hindsight, just think how ridiculous that advise was.

So do not panic. Treat market falls as your friend. Remember the advise of Warren Buffet who said “ If you are in the market for buying apples and the price of apples were to suddenly fall, would you be happy or sad?” Think about buying stocks as you would about buying businesses. The same solid business that was available at Rs.500 a share barely 6 months ago is now being priced by the market at Rs.300 a share. Consider this. Everything about the business remains the same. Its growth rates, business prospects, quality of management – everything. Only you are getting it 40 % cheaper. In a few days it may fall another 10%. So what? It still remains a great business. If you can, buy more.

Remember, in spite of what the pessimists tell you India is still growing at 8%. Very few economies in the world can match that. Wages are increasing across categories. Millions of people are crossing over to middle class status every year. People are buying new homes, new cars and what not.

Do not let experts tell you that oil is at $ 132/bbl, so we must slow down. We may, but again we may not. We did not slow down when it went from $ 20/bbl to $ 130/bbl. And who knows, oil may come back to $80 levels before soon. These are the same experts who predicted that Indian IT companies would face rough weather because the Dollar had fallen against the Rupee and would fall still further to Rs.35 to the Dollar. And Infosys gained nearly 40 % in this period.

Therefore act with courage. Courage is not the absence of fear. Courage is the ability to act, to move ahead even when you are afraid. After you buy, even if markets fall further, remember the past. Markets have to recover at some point of time. And when they do so you will not only recoup your losses but overall your gains will far exceed interest earned on some stupid fixed deposit. Only remember to invest in quality. Do not buy simply because a stock has fallen sharply from its highs.

Don’t you think India will be a major economic power in the next 10 years? So make the most of that opportunity. Your chance is NOW.

DIVIDEND YIELD STOCKS FOR CONSERVATIVE INVESTORS

Investors who prefer stability in their portfolios and are not comfortable with stock market volatility can look at dividend yield stocks as an alternative to debt based instruments.

Suppose a stock with a face value of Rs.10 is quoting at Rs.100 and giving a dividend of 50% currently i.e. Rs.5 per share of face value Rs.10, then its dividend yield is 5 %. An investor in this stock receives Rs.5 by way of dividend, on every Rs.100 invested. At present dividends are tax free in India which makes it all the more attractive.

Now one might argue that 5 % is low as compared to 8 to 9 % returns available on debt instruments. But one needs to take into account the potential for capital appreciation, that is most likely to accrue over the long run, if the stock has been carefully selected to begin with.

Consider a business with a dividend yield of 5 %. Now take a simplistic scenario where this company is growing its profits at a steady 15 % per annum, year after year. It also keeps on increasing its dividend at the same rate. Now also assume that the market discounts the earnings of the company also at the same rate as on the date of investment. What would happen after 5 years? Growing at 15 % per annum, the profits of the company would double and its dividend will be now raised to twice the original. The initial investors who had got in at 5 % dividend yield would now find themselves earning dividends at 10 % of their principal invested.

Not only that, since the earnings have doubled, the market would now value his company at twice the original price. Therefore our investor stands to gain both ways. One, he is now getting dividends at more than the market rate for debt instruments and two, his original investment has appreciated by 100 %.

An added advantage of such stocks is that their dividend yield protects their market price from falling very much. For instance if the market price of a company with an initial dividend yield of 5 % fall by half, the new dividend yield now becomes 10% based on the current market price. This makes the stock attractive for many investors to buy, thus pushing the price upwards.

A caveat in this strategy being, that companies are not obliged to pay dividends. This entirely depends upon the business environment. If the company encounters a business slump, this strategy might fail. But the strategy is not designed to protect against adverse business conditions in the first place. It is designed to give stability to a portfolio in periods of stock market gyrations, with the basic fundamental attributes of the business staying intact.

Even this risk might be mitigated to an extent by selecting companies which have a consistent history of steadily increasing dividends over long periods of time. Several multinationals and PSU banks fit into this category. Another plus in selecting such companies is that, the very nature of their being profitable over many business cycles gives the investor added conviction in their business models.

This strategy can be used to invest a portion of their assets into equity by conservative investors while investing the balance into debt instruments. It may not give mind blowing returns but will impart a solidity to the investor’s portfolio with returns that at least beat inflation, while ensuring a good nights sleep.

USE OF MARKET CAPITALISATION IN VALUING STOCKS

Market Capitalisation (M Cap) of a company is defined as “ the number of outstanding shares multiplied by the market price of each share”. For instance a company having an issued capital consisting of 1,00,000 shares with each share valued at Rs.100 will have a M Cap of Rs.1 Crore. M Cap of a company changes every day with the change in its market price.

Companies in India are classified into three broad categories on basis of their M Cap.

Large cap companies having M Cap of more than 5000 crore.
Mid cap companies having M Cap between 500 to 5000 crore.
Small cap companies having M Cap of less than 500 crore.

Market cap gives the relative size and stability of a company as compared toother companies in the same industry. An investor can give due weightage to the M Cap of a company before judging its potential as an investment candidate. FII’ and other large investors usually favour large cap companies because of the liquidity they provide and their ability to invest large amounts in these companies without causing wide fluctuations in the price.

Another useful indicator in evaluating a company is its M Cap to sales ratio. This ratio indicates what value the market gives a company as a multiple of its sales. Generally 2.5 to 3 times of sales is considered to be fair valuation for a business, depending on what industry it is in and what is its growth rate.

If a company is being valued by the market at extremely low multiples to sales, an investor can use this as a starting point to investigate why. This can be an important clue to discover undervalued companies. If further investigations into the fundamentals do not reveal any significant problems, it can be inferred that the market has not recognized the value of that particular business and it can be considered as an investment candidate. Like all other ratios, M Cap to sales cannot be used in isolation but should be viewed in conjunction with other fundamental parameters and business attributes.

Another useful hint which the M Cap gives us is that it points us towards the untapped potential of a business model which is in the nascent stage in a country and therefore is not making any profits yet, but the same business model has performed well in other countries where it has had time to flourish and realize its potential.

A case in point is DTH services in India, where companies cannot be valued on basis of existing matrices like earnings, cash flow etc. because they are not generating any profits due to huge upfront investments in infrastructure. M Cap can be a useful parameter to value such companies, by taking into account their number of subscribers and checking what capitalization the market has given to companies with similar number of subscribers in developed nations. If there is a significant variation in M caps, such companies can be considered worthy of further investigation.

Serious fundamental investors should therefore look at the M Cap not only from the viewpoint as an indicator of business soundness, but also as a starting point to spot businesses which are being ignored by the market in spite of being strong investment candidates based on other parameters.