Identify a few long-term growth stocks and invest small amounts in these each month to create wealth
Systematic investment plans (SIPs) of mutual fund houses are currently the flavor of the season. According to fund managers, retail (small) investors have entered equity funds largely via the SIP route in the past two years. This new, and possibly savvier, generation of investors is not making one-off bets on equities when the markets are at or near their peak. They are focused on long-term wealth creation and don’t stop their SIPs even when the markets witness a temporary downturn. All of which leads to a question: Can direct investors in equities also employ the SIP strategy to their advantage?
Merits of the SIP approach
SIP allows investors to create wealth over the long term, owing to a number of factors. One, it does not require them to time the market. The approach instead requires investors to keep investing small amounts, irrespective of market levels.
Second, an SIP allows investors to buy more units of equities when the markets are down and fewer units when the markets are up. Over time, this results in averaging of the cost of units purchased.
Third, the SIP approach works because it matches investors’ cash flows. Most investors, especially those from the salaried class, don’t have lump-sum amounts to invest. They can, however, salt away small amounts each month to build a substantial corpus over time.
Long-term growth stocks
Over the past few decades, many long-term growth stocks in the Indian markets have given fantastic returns. A recent book by an expert mentions a company that exhibited 10 per cent annual revenue growth and 15 per cent return on equity (RoE) for 70 years. This is none other than Asian Paints. HDFC is another stock that has delivered annual growth of 30 per cent for many years. Over time, high earnings growth translates into higher stock prices.
The “FERA dilutions” of the 1980s, when multinationals were forced to reduce equity holdings in their Indian subsidiaries, or exit India, offered investors the opportunity to buy blue-chip stocks at attractive valuations. Later, companies such as Infosys, Wipro and many other information technology and pharmaceutical majors provided retail investors with golden opportunities for wealth creation, provided they identified and entered these stocks early.
SIP approach in stocks
By picking a select group of about a dozen stocks and applying the SIP approach in these, even ordinary investors with a small monthly surplus can participate in the growth story of top-notch companies and build a portfolio of massive value by adding only a few shares each month. Many broking houses nowadays even offer investors an automated facility for making SIP investments in stocks.
The SIP approach in direct equities will, however, work only for investors proficient at stock picking. They must be able to carry out fundamental research on stocks, and pick those that have sound growth prospects and are currently trading at attractive valuations. This approach will only suit investors with a long investment horizon of five years or more.
The difficult part of this approach is to be able to identify stocks, early in their growth curve, that will be able to grow their earnings consistently over the long term. It involves a study of past performance, while rewards come only if the company is able to generate profits in the future. Companies face several risks. Even the best are exposed to competition, changing government policies within the country and outside (which affect importers and exporters), technological and process obsolescence, and so on. The magnitude of the challenge involved in sustaining earnings growth for decades should not be underestimated.
Ten SIP tips
If you believe the SIP approach to direct equity investing is for you, here are a few suggestions that could improve your chances of success in this endeavour.
- Before picking a stock, do adequate research. A lot of data on the financials of a company and its industry are available online. Spend some time studying it.
- Pay heed to management quality. Look for management that has displayed adequate vision and execution capabilities in the past. Avoid management that is known to cheat investors, workers, or tax authorities.
- Take into account financial parameters such as sales growth, profits and profit margins. Also, see if the firm pays income tax, a good sign, as it means the profits declared are unlikely to be falsified.
- Make use of financial ratios. Warren Buffett suggests that ‘Return on Capital Employed’ (RoCE) is the most important factor to consider, followed by price/earning (P/E) ratio. Peter Lynch advises using PEG (price earning/ growth) ratio as a measure of valuation.
- You could also use Peter Lynch’s approach of examining your shopping basket for investment ideas. Many of the brands you buy could belong to companies that have strong growth prospects. This is especially true of consumer products like toothpastes, soaps and cosmetics, paints and other items of regular consumption at home. A brand that has attracted you may well be popular with many others.
- Diversify among sectors and companies. Putting all your eggs in one basket, or all your money in a single company or sector, can be hazardous. Let your portfolio have at least a dozen stocks spread over five segments or more.
- Do not panic if some stocks lose value. Any portfolio will have its share of winners and losers. In a market crash, which happens every few years, the entire portfolio will lose value. But, even in normal markets you will have laggards. If you are confident about your stock selection, give the laggards time to perform.
- Keep the SIP on even during market downturns. Only by doing so will you reap the full benefit of this approach.
- Remember that leaders rotate. Many of the frontline stocks of only two decades ago, now part of the Sensex or Nifty, are forgotten heroes. They have lost money or have even been shut down. Review your portfolio periodically and get rid of stocks whose prospects appear to have got irreparably damaged.
- Put your market earnings back in the market. Do not spend the dividends or proceeds from the sale of any of your stocks. Reinvest the money to make it grow.
By Anil Rego – CEO, Right Horizons
Source: Business Standard