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Future Glitter

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On the stockmarket, as in life, there are two scarce commodities. Unbiased investment guidance and time. Ask any fund manager, and you will be cautioned against two dangers: venturing out into equities directly, and timing the market (when to enter and exit) all by yourself. A person who dares either of those activities, you'll hear over and over, is either very brave or very foolish.

If a binary choice it must be, go ahead, press the buzzer for 'brave'. A fund manager's job is two things: making money for clients and preserving his job. Yours? Making money and preserving your independence of judgment. Whatever be the eventual difference in performance, your job, dear investor, sounds a lot more exciting.

Timing Pays

First things first. Market timers make more money than passive investors. This is self-evident. Markets go up and down, both, and the classic investment fantasy is to profit from the ups and stay away from the downs.

Still, if you're in the habit of questioning anything touted as self-evident, simple calculations show that if you had bought an entire Sensex-worth basket of shares every month since 1991, your would have made a paltry return of about 5.5 per cent-which, dear investor, is worse than a bank deposit. On the other hand, had you picked up shares on the dips (low valuation periods) and sold on the highs, you would have enriched yourself quite a lot more (See charts). This kind of active investing, indeed, is the reason that the equities excite investors so. Speculative? Sure it is. That's business. A reward for money risked.

Ten On Ten Efficiency

Almost without exception, investment theorists are fans of the so-called 'efficient market theory', according to which, capital markets are self-corrective in nature, and so to the extent of all distortions getting balanced out over a reasonable span of time. Reasonable enough, that is, to incorporate all the information relevant to the future business prospects and value of stocks.

Conceptually, the theory is elegant. When things are out-of-whack, it posits, good sense will filter through to the trading floor and adjust prices upwards or downwards to attain an equilibrium.

As with all things elegant, the theory also serves as a tool to justify all sorts of actions and advice. Fund managers, for instance, are known to use the theory to suggest that hunting for 'undervalued' or 'overvalued' stocks to bet on is a futile exercise, since what you know is already known to thousands of better-informed players, and so your information (unless you happen to be privy to something very very special), has already been taken into account and is already reflected in the prices.

Well, the fact is that most fund managers make lots of money on this supposedly futile exercise themselves, and there's no reason why you should not.

Today, even the strongest fans of the efficiency logic admit that price overshoots are common-and often for extended periods, too. This shouldn't be a surprise. Just close one eye and try bringing your two index fingers into alignment with one another... see?

If nothing else, the very volatility of the market should make you think, and think hard.

Barely half a year back, the bse Sensex was stuck at the 3,000 level. In fact, when BT wondered aloud about the prospect of Sensex 4,000, some readers thought an overworked editorial staff was in desperate need of a vacation. But by the time this magazine wrote that "valuation parameters are just right for another major rally" in its editorial of May 11, 2003, FII money was ready to gush in. And so it was. The Sensex has gained nearly 2,000 points since, enriching a lot of people out there, especially those who timed their bets well. Rarely have equity portfolios appreciated so fast in the history of Indian stock trading.

At the time of writing, the Sensex was in the region of 4,900, and now this is being touted as the index's appropriate level. So have you missed all the action? Are you too late already? Not at all. So long as volatility remains volatility, and change is a bankable concept, the timing game is open to everybody. Read on.

Trigger Watch

What you saw earlier in the year was a rally 'trigger'. It wasn't the first and won't be the last. The big players on the bourses know this only too well. Timing the market, to them, is mainly about keeping their trigger-detection sensors sharp enough to swing into action. This turns them into obsessive information junkies and opinion tracers, but also highlights the importance of background study. Data often needs the processor of prior knowledge for conversion to usable information.

As a retail player, it's scary to contemplate the sheer magnitude of the big players' scale, be it in terms of investment corpus or research resources. Since all you have, in contrast, is that head on your shoulders, take this advice: don't underestimate it. There's much use you can put it to. You can still study companies, their source of profits, their strategies, their business environments and their performance, and then take a call on whether a stock is undervalued.

Stock valuations are complex. "Whether the market is cheap or expensive can't be decided just based on a specific price level (or an index level if one considers the whole market)," elaborates Ajay Bhatia, Head of Research, Enam Securities. This is because the price is dependent on the company's earnings. The stock price can double and still retain its old valuation-the P-E or price-earnings ratio-if earnings also double. Other valuation parameters are the p-b ratio (price/book value per share) and the dividend yield (dividend per share/price). The BSE posts updated values on its website every day, so the internet can save you all the miserable arithmetic.

Yet, the very choice of a valuation parameter can be a head-scratcher. Historical calculations show that investors who used p-e ratios would've fared the worst, and dividend yield ratio, the best. But don't be misled by this. The reason for the difference is simple. The BSE's posted ratios are trailing ratios-calculated with past records of earnings, book value and dividends. What matters is the future. "A company that grows faster deserves a higher p-e compared to a slow growing one," says Ashim Syal, Chief Investment Officer, ING Vysya Mutual Fund. Dividends, being corporate decisions, are often declared with a view of future prospects-and so this ratio already includes the management's take on the future.

You, of course, will have your own views. The smartest way to operate, then, is to use expected earnings as your input for P-E ratios, and go by these. Fast profit-growing companies, naturally, ought to have higher p-e ratios. An old rule of thumb: if you expect a company's earnings growth rate to be higher than its current P-E, it is undervalued. If lower, it is overvalued.

Anyhow, back to the timing part. If you find an interesting undervalued share and expect a trigger sometime not too far in the future, you could 'buy and hold'. The trigger could be market related or stock-specific.

What you must be extra sensitive to is a crash trigger. Bad news must always reach you faster than good news. Diversify your information sources. You will, of course, mis-judge some triggers along the way-but that's part of your learning curve.

Join The Dots

Now to the point. What does the BSE look like right now? Our calculations show that on all parameters, valuations of the mainline stocks are no longer 'cheap', but are still 'low'.

The newspapers, in the meantime, are filled with glowing corporate results. These, however, are no guarantee that the rally is likely to resume. This is because the results have already been 'discounted' by the market. In volatile times, what matters most is 'market sentiment'. Even a trigger is often a big turning point in sentiment. But that's an event. The trick is to watch sentiment as it slowly accumulates. To do this, technical analysts use a whole set of price charts. "Investors should not try to forecast the future, but just try to understand the emerging trends and act only when the trend actually changes," advises Deepak Mohoni, an independent technical analyst.

Anyway, start with a simple chart. Use statistical graph paper, put value on the vertical axis, days on the horizontal axis, and plot the closing price of a stock (or Sensex value) every day. After a fortnight or so, join the dots. Look at the jagged pattern, and if successive peaks are higher, the trend is upwards. Or vice versa. Sit down, study the chart, and ask yourself what caused the turns.

Once that has been mastered, get into 'moving averages', which condense longer-period trends neatly into smooth curves. "The computation as well as the rules for buying and selling are simple here," says C.K. Narayan, Technical Analyst at ICICI Securities. It's easy, really. Junior school arithmetic. Take the last fortnight's average closing price, and plot it against today's date. Tomorrow, take the past fortnight's average again (dropping the earliest day's data and adding tomorrow's data), and put it down. Keep plotting it to get a curve. Now take just the current day's price. If this is above the moving average line, it signals a market turning bullish, and vice versa. If you're plotting two different moving averages, then the shorter-period trend going above the longer one is a bull signal. It's all about putting volatility in perspective. At the moment, for example, the technical charts are pointing up.

In And Out

The generic strategy is to move in at the start of a bull incline, and exit just as the market reverses (or before it does so). The exit decision is critical, don't forget. Be clear: timing is about buying and selling to book profits. You mustn't get out-timed by the market.

Your job is to maximise returns, and there will never be a 'best time to sell' or any such thing. Even what constitutes a market reversal depends on your time horizon. What you need, therefore, is a clear time-frame for your play (calculate moving averages accordingly). Depending on your perspective, a short-frame reversal-if you zoom out and look at the longer period charts-may be just a blip. You could play a quarterly game on volatile stocks, while keeping a separate portfolio of longer term bets. Otherwise, a year's investment horizon would be just fine, which is long enough for some equilibrium-seeking mechanisms to do their work.

Once you start correlating price trends with other information, you're in the groove. To enhance your understanding of the interplay of different factors, tune yourself in to varied arguments-after all, someone's boon could be someone else's bane-but don't let them dominate your mind. As a solo retail investor, you should value your independence above all else.