Reblog: 3 Guidelines for Selecting Stocks Ideal for Retail Equity Investors
Equity markets are one of the key avenues for investors to create wealth for themselves. However, despite the significant return generating potential of equity markets in India, the participation of retail investors in direct equity markets remains very low.
Many a times, the factors assigned to low participation of retail investors in equity markets focus on the characteristics of markets like share price volatility, poor corporate governance, stock price manipulations, corporate frauds etc. These issues make it essential that a retail investor spend sufficient time while making her equity investment decisions.
It is advised that an investor should select any stock for investment only after doing her own assessment, which is sufficient to provide her the conviction about her investment decision. Investor’s own research & conclusions independent of general market opinion & sentiment are key essential for an investor to overcome the above mentioned issues.
However, retail investors, which many a times have a full-time day job to meet their financial needs, face peculiar problems while conducting stock research and monitoring of the stocks in their portfolio. Let’s see what are the key issued faced by retail investors everywhere and what are the guidelines by which retail investors can overcome their limitations.
Key Issues Faced By Retail Investors
A) Day-time job takes most of the time:
Most of the retail investors have jobs, which consume most of the time of the day available to them. With increasing time of commutation to office, especially in large cities, a retail investor finds that her almost entire day (7AM to 9PM) is consumed in daily office rituals.
B) No time to monitor/track companies during weekdays:
During weekdays, retail investors hardly get time to effectively monitor companies in their portfolio. Retail investors are not able to spare time to study the quarterly results/annual reports/company filings during working weekdays whereas these activities are essential for monitoring of the performance of the companies in the investor’s portfolio.
Most of the time, during the working weekdays, a retail investor is only able to track the price movement of her portfolio due to wide penetration of smartphone apps and mobile internet availability. However, only tracking of share prices is not sufficient for effective monitoring of portfolio performance.
C) On the Weekends:
The only time when a retail investor has some time at her disposal when she can analyse companies, read their annual reports, quarterly results filings, exchange disclosures etc. is on weekends. However, it is the same time, which she and her family expect to spend with each other after 5-6 days of exhausting working week.
Weekend is the only time available with the retail investor & her family for recreational, entertainment & bonding activities. Therefore, the retail investor finds it difficult to devote time to her equity investments on the weekends as well.
Therefore, it would be evident to retail investor that the key issue faced by her is lack of time. All her equity investing strategies should be centred on this key parameter so that she is able to devote sufficient time to her family, equity portfolio as well as other commitments.
However, it should not be assumed that a retail investor is at a disadvantage to full time/institutional investors. There are quite a few aspects, in which a retail investor despite her time consuming day-time job, is at an advantage when compared to full time and institutional investors. Let’s see:
Advantages of Retail Investors
A) No dependence on equity portfolio/markets for day to day living expenses:
A retail investor does not have to depend upon her earnings from equity portfolio to meet her day to day expenses like rent, EMI, children school fee, kitchen expenses etc. Her salary from the day time job is most of the times sufficient for these expenses. She does not need to get under stress if a company in her portfolio does not declare a dividend in any quarter. Whereas a full-time investor might face cash shortfall in meeting her household expenses, if her portfolio earnings are not as per expectations.
B) Gets investible funds at every month-end
A retail investor, if she manages her household expenses well, is able to save some surplus funds at the end of every month from her salary. This surplus or savings provide her regular source of funds, which she can invest in her equity portfolio. The fact that these funds are not dependent upon the performance of equity markets, empowers the retail investor to have the discipline of investing regularly irrespective of market performance. She can easily invest this additional money in new opportunities, without unnecessary churning in her equity portfolio.
A full time investor, whose only source of income is from equity markets, does not enjoy this benefit of regular source of funds every months for deployment in her equity portfolio. A full time investor might have to churn her portfolio i.e. sell existing stocks to generate funds, in case she finds an attractive opportunity in the equity markets. This portfolio churning might or might not prove to be a successful decision every time.
C) Can take long-term investment views:
A retail investor does not have to prove her portfolio performance to anyone. She is not being judged by markets/third parties based on the performance of her equity portfolio. As a result, a retail investor can afford to stay calm and behave in a peaceful manner irrespective of equity market results. She can easily focus her aim at the long term performance of the companies in her portfolio as she is not being questioned about her portfolio on a regular basis.
An institutional investor does not enjoy such freedom. The fund management team is continuously under scrutiny for the performance of the funds that are under their management. Most of the institutional investors, mutual funds (MF), private equity (PE) funds etc. have to disclose their performance to their investors regularly (daily for MFs, quarterly for PE etc.). The fund manager is continuously under pressure to showcase good performance whenever she sends out the periodic performance report to the investors. Even otherwise, large investors of the funds keep on calling/enquiring the fund managers about performance of their money.
Such continuous monitoring of performance, many a times, leads to short term defensive investment approach by fund managers, which is focused on avoiding tough questions from investors.
D) Can benefit from bear phases/lower stock prices by buying more:
As mentioned above, a retail investor is not answerable to anyone for her investment decisions. She can take her portfolio decisions without the need of such decisions looking justifiable to others. This ability gives an immense power to the retail investor to benefit from bear markets when she can add on to her favourite stocks, which are available at cheap prices. She can keep on buying stocks despite a continuous decline in stock prices.
An institutional investor does not have this unrestricted freedom. As mentioned above, all her decisions have to be approved by a board of trustees and have to be justified to large investors. In such a situation, institutional fund managers, most of the times avoid buying stocks when prices are falling as the fund manager might have to face tough questions on underperformance of the fund if the stock price of her newly bought companies does not recover soon enough.
E) Hold back buying when stock prices are high:
A retail investor does not have an obligation to invest her surplus funds in the equity markets as and when she get the salary. The retail investor can hold back the buying decision and sit on cash until she believes that the stock prices are available at attractive levels.
Many institutional investors like mutual funds, do not have such freedom. Mutual funds have to invest a certain portion of their funds in equities, which is determined by their fund guidelines/prospectus. E.g. if a mutual funds has the mandate of investing 90-100% of its funds in equities, then it has to keep at least 90% of funds invested in equities all the time irrespective of valuation levels of stocks in the markets.
Such mandated guidelines create hard times for mutual fund managers, who face fund movements at precisely the wrong times. Most of the mutual funds see higher investment by investors in bull markets when stock prices are rising. As a result, to maintain the minimum equity investment proportion, the mutual fund manager has to invest the fresh funds in stocks despite high valuations.
On the contrary, many a times investors withdraw their funds from mutual funds in bear markets. The fund manager to meet the fund requirement of redemptions has to sell the stocks when the stock prices are falling.
As a result, the mutual fund managers end up buying stocks in rising markets and selling stocks in falling markets. This is buying high and selling low, which is against the key principle of equity investment, which says that investors should buy low and sell high.
A retail investor is spared this forced buy high and sell low situation faced by mutual funds, as she does not have any obligation to invest funds available to her as she does not have a mandated equity allocation to be followed all the time irrespective of market valuation levels.
Until now, we could observe that a retail investor enjoys a lot of advantages over institutional investors when it comes to equity investing. The only issue which puts her at the back foot is the paucity of time at her disposal to analyse & monitor stocks.
Therefore, if a retail investor is able to find solution to the problem of lack of time, then she has all the abilities to perform well in equity markets and even match/outperform her institutional peers.
We believe that with careful planning, a retail investor can solve her problem of shortage of time to devote to her equity investments. If she takes care of some key guidelines while creating her portfolio, then she would be able manage her equity investments within the time at her disposal and also devote sufficient time to her family and other commitments.
Let’s see the key guidelines that a retail investor should follow while investing in stock markets and while creating her portfolio:
Key Guidelines for Retail Investors
Always invest in companies that won’t require intense/close tracking
A retail investor should try to invest in companies and create a portfolio, which do not require much tracking/monitoring. She can achieve this objective by following two key principles:
A) Only choose stocks with high margin of safety (MoS):
A retail investor should invest only in those companies, which enjoy a high margin of safety.
1) Margin of safety built in the purchase price of the investor:
It is determined by the earnings yield of the stock. The higher the earnings yield than the ongoing treasury/G-Sec yield, the higher the margin of safety.
2) Margin of safety built in the business model of the company:
- Self-Sustainable Growth Rate (SSGR): Higher the SSGR than its achieved sales growth rate, higher the margin of safety. Read more about SSGR in the following article: Self Sustainable Growth Rate: a measure of Inherent Growth Potential of a Company
- Free Cash Flow (FCF): Higher the proportion of cash flow from operations (CFO) available as free cash flow (FCF) post meeting all the capital expenditure requirements, higher is the margin of safety.
An investor would notice that the companies which have higher margin of safety in their business model have higher ability to successfully face tough economic times. This is because, in case of economic downturn, these company can safely:
- reduce its profitability (i.e. give discounts) to generate higher demand
- reduce dividends to conserve funds to make additional investments and
- invest in fixed assets to improve its plant & machinery/technology (leading to lower NFAT)
- and are still able to maintain their current sales growth rate.
Therefore, if an investor focuses on investing in companies, which have good margin of safety built in their business model, then she need not worry a lot about such companies, even if the economy faces a downturn as these companies can withstand downturns successfully and the investor would not face any negative surprises.
It is also essential that the investor purchases these companies at a reasonable price to equity (P/E) ratio levels, which ensure that her investments enjoy a reasonable margin of safety in the purchase price as well. The investor can follow the guidelines in the following article to determine the investable P/E ratio of the stocks:
B) Invest in as low number of stocks as possible:
Every new stock in the investor’s portfolio mandates her to follow certain key events to monitor the stock & company effectively. In a year, every new stock would require the investor to read:
- 4 quarterly results
- 4 shareholding pattern disclosures with pledge details
- 1 annual report
- 1 credit rating report
- Regular stock exchange filings and
- Monitoring the internet for news related to the company (Google Alert)
An investor would notice that a portfolio would 25 stocks would require the investor to read every year 100 quarterly results, 100 shareholding disclosures, 25 annual reports, 25 credit rating reports, about 250 stock exchange filings (assuming 10 exchange filings by each company in a year) and about 5,000 news items (Google alerts) related to these 25 companies.
Therefore, the time & effort required in regular & effective monitoring of each stock should lead the investor to have only that many stocks in her portfolio, which she easily monitor. It is advised that an investor should have as low the number of stocks in her portfolio as possible. This would ensure that she spends minimum amount of time monitoring her stock portfolio. In any case, the number of stocks should be such that she can sleep peacefully without worrying about high exposure to any individual company.
C) Choose stocks only after very high due diligence:
An investor should choose her stocks only after doing sufficient due diligence. This is to ensure that she has analysed the stocks from all the relevant perspectives of financial, business, management and valuation perspectives so that there is no weakness in the company that might have missed her analysis.
Once an investor has done sufficient analysis while initially buying the stock, then she might rest assured that the company would not give a lot of negative surprises to her during the regular monitoring. This would, in turn, reduce the time & effort needed from the investor in monitoring the stocks in her portfolio.
Until now, we have noticed that a retail investor is well placed to match & outperform her institutional counterparts because she does not have to face continuous scrutiny of portfolio performance. She can take a long term view, can benefit from bear markets and can deploy additional money every month into attractive opportunities irrespective of market conditions.
The only constraint that the retail investor faces is the scarcity of time at her disposal to effectively analyse and monitor her stocks because, after a hectic day job, she has to meet other commitments on her time related to family, recreation, entertainment etc.
We also noticed that a retail investor can counter the constraint of the lack of time by being very selective about her stocks. She should invest in very few companies, which enjoy high margin of safety in business and purchase price and select these companies after sufficient due diligence in terms of financial, business, management and valuation analysis.
By being very diligent in her stock selection, the retail investor would ensure that her portfolio companies do not put a lot of time requirement on her for regular monitoring and at the same time do not present her with negative surprises with their business performance.
Over time, we have noticed that there are certain type of companies and certain key guidelines, which if a retail investor follows diligently, then she would have higher probability of finding ideal stocks for her portfolio, which would be fundamentally sound as well as would not put a lot of pressure on her time for continuous monitoring/tracking.
Ideal Stocks for a Retail Investor
An investor should focus on investing in stocks of companies which are:
- growing at a respectable pace,
- have sustained profitability,
- are generating free cash flows,
- are conservatively financed [very low debt to equity (D/E) ratio: preferably debt-free] and
- are run by competent & shareholder-friendly management
Investing in stocks of the companies, which meet all the above criteria would ensure that the investor would invest only in the companies that have:
- a competitive advantage depicted by sales growth with sustained/improving profitability
- Presence of free cash flows would ensure that:
- the sales/profits are genuine and the company is not doing aggressive sales recognition, fictitious sales recognition without cash collection as well as
- ensure that the company does not have capital intensive business model because the company is able to meet its capex requirements from its cash flow from operations
- Debt free status/low D/E ratio would ensure that:
- the company has fundamentally sound capital structure
- low/nil bankruptcy risk
- low/no incentive to management/promoter to cook its books by doing accounting juggleries
- low probability of the company facing liquidity constraints.
- Management assessment is the most important factor as management/promoter is the person standing between the fruits of the business and the retail shareholder. If the management does not have interests of minority retail shareholders in its mind, then, unfortunately, the retail shareholder would not be able to benefit from the good business performance of the companies in which she has invested.
Therefore, we believe that if a retail shareholder focuses on being highly selective in her equity investments and invests in very few companies meeting the criteria of high margin of safety in their business and invests in them at an attractive price, then she has a very high probability of managing her time requirements between day time job, family and equity investments as well as she has high probability of matching/outperforming her institutional peers.
It is essential that the retail investor puts in sufficient due diligence before investing in any company and that she keeps the number of stocks in her portfolio to the minimum without losing her peaceful sleep.
It is also essential that she should invest only in companies, which meet the key parameters of sales growth with sustained/improving profitability, which are generating free cash flows, which are conservatively financed (preferably debt free) and are run by a competent & shareholder friendly management.
Once an investor has invested in such stocks, then she would be happy when the price of her stocks goes up as she would enjoy the feeling of building up wealth. Moreover, if the prices of her stocks goes down, then also she would be happy as she can buy more of such fundamentally good stocks.
If a retail investor is able to keep in view these guidelines while creating her equity portfolio, then we believe that she would be able to generate significant amount of wealth from equity markets without putting a lot of strain on her personal and professional life and with minimal risk of facing negative surprises in her stocks thereby ensuring the safety of her hard earned money.
Effectively, if the retail investor follows these guidelines, then she can sleep peacefully at night despite investing significant amount of her money in stocks.
With this, we have come to the end of this article in which we discussed the various key aspects, which we believe that a retail investor should focus on while investing in equity markets.
It would be a great pleasure if you could share your inputs about the additional factors and the guidelines, which you believe are essential for retail investors while dealing in stock markets.
You may write your feedback and inputs as comments to this article.
All the best to each one of us for our investing journey!
The original article is penned by Dr. Vijay Malik and is available here.