Sunday , 25 June 2017

Chapter 4: Why Equities are a Must

As explained in Chapter 2, asset creation starts with the objective of achieving a financial goal. The factors driving asset creation may be future financial requirements or meeting any distress in future. A dilemma commonly faced by investors in the process of asset creation, is assigning investible surplus among various available options. Excess income over expenditure results in creation of disposable income, which must be invested to generate future returns.

To channelize savings in right asset classes, it is essential that you scan all the possible investment options available in the market:
1) Fixed Deposits (FDs)
2) Insurance Policies
3) Mutual Funds (MFs)
4) Equities
5) Gold and Silver
6) Real Estate and
7) Others like post office savings and Public Provident Fund (PPF).

Understanding return expectations
While some investments like PPF, FDs and post office savings deposits are categorised as fixed income securities, others such as equities, MFs and real estate are variable income assets. Fixed income securities offer a fixed return, which largely depends on government policy. For example, PPF fetches a return of 8 per cent per annum, as of now, which has been fixed by the government. In case of variable income securities, the rate of return is market determined. Hence, the returns continuously change with market dynamics.

You, therefore, need to examine the pros and cons of both, variable and fixed income securities, to create an asset mix based on your risk profile and return expectations. Empirical evidence shows that among all the asset classes, equities provide the maximum return. The table below illustrates exactly that.

Returns from Investment Assets: A comparison

Last 5 years Last 10 years Last 15 years
Equity 34.72% 16.11% 9.7%
Gold 10% 7% 15%
PPF 9.5% 12% 12%
Bank Deposits 6.39% 12.55% 13.00%

The above table proves that equities have outperformed all other popular assets in the last ten years. The reason why equities lag in the last fifteen years is primarily because of a series of scams in the stock market between 1992 and 2000 and also because the level of participation in the Indian securities market was nowhere close to what it is today. It is also important to note is that the Sensex is not a static value and its composition continues to change. Hence, returns generated by the index may not always talk about the same company.

Performance of the Sensex in the last 15 years:

Sensex (Closing Value) Year
3561 May, 1992
4305 June, 1997
3244 June, 2002
4795 June, 2004
10609 June, 2006
14400 June(22nd , 2007)

The case for long term investment in equities:
The movement during these fifteen years shows that it is rewarding to stay invested in equities for the long term. The following factors justify this:

1) Industries and businesses, to which companies belong, mature over a period of time. As industries grow, so do the profits of companies belonging to them. The best example of this can be found in the Indian telecommunications industry. Hence, investors start reaping the benefit of their investment over a period of time.

2) While markets undergo cyclical phases, which follow a series of peaks and troughs, over a period of time these factors get negated and returns from stocks present a valid picture. So, although you may incur some losses in the short term, if you are looking to invest in equities you must always think long-term.

3) Equities are the only investment asset, which are exempt from long-term capital gains tax, which means that you own all the returns generated. All other investments, excluding PPF and life insurance, are taxed for the gains made. This reduces the overall return in investment assets like NSC, bank deposits etc.

4) An investor can ill-afford to ignore that India is a fast growing economy and it is widely perceived that this robust growth would continue for many more years to come. The biggest beneficiary of this growth story would be the industries and service sector. It is almost certain that the Index of Industrial Production (IIP) would grow at a rate of over 10 per cent in the next few years. This would enhance profit growth of companies and it would get reflected in the upward movement of their share price.

Stock Market Indices:
A stock index represents the change in the value of a set of stocks, which constitute the index. More precisely, a stock index number is the current relative value of the weighted average of the prices of a pre-defined group of stocks. For example, if an index is assigned an arbitrary base value of 100 on a given date with a certain number of stocks assigned to it, this date onwards, the change in index would be measured in terms of changes that the base value of 100 acquires.

A good stock market index is one, which is well diversified and is adequately liquid. Some of the prominent indices in India are:
1) Sensex
2) Nifty
3) Nifty Junior
4) BSE 200
5) Nifty Bankex etc.

Among all these indices, BSE Sensex and Nifty deserve special mention. Brief details about these indices are as follows:

1) BSE Sensex: The Bombay Stock Exchange is the oldest stock market of India. “Sensex” stands for sensitive index. It was created in 1978-79 with a base value of 100. It comprises of thirty stocks of leading Indian companies and is well diversified with representation of almost all the sectors of the economy like Banking, Information Technology, Cement, Autos, Manufacturing, Capital Goods, etc. The Sensex is revised from time to time to incorporate companies belonging to emerging sectors of the economy. The movement in Sensex values on working days is computed on a real time basis.

2) Nifty: Nifty is the stock market index of National Stock Exchange. It comprises the stocks of 50 of the largest and the most liquid companies from about 25 sectors in India. It was introduced in 1995 keeping in mind that it would be used for modern applications such as index funds and index derivatives, besides reflecting the stock market behaviour. NSE maintained it till July 1998 and subsequently it has been managed by IISL (India Index Services and Products Ltd.)

3) Sectoral Indices: Sectoral Indices are those indices, which represent a specific industry sector. All stocks in a sectoral index belong to that sector only. Hence an index like the NSE Bankex is made of Banking Stocks. Sectoral Indices are very useful in tracking the movement and performance of particular sector.

What Makes Indices Move: Newspaper reports state on a daily basis as to how Sensex or Nifty went up or down. The indices close at different values compared to the previous day’s value. What causes an index to move up or down? Let us look at some of these factors:

  • Economic Indicators: Economic indicators are one of the most important drivers of an index. GDP growth, balance of payments position, interest rates etc. are some of them. These have a direct bearing on the movement of indices. Hence, news related to strong trends in GDP growth would normally lead to an upward movement in an index primarily because any news related to growth of the economy is likely to positively impact almost all industries. If the Sensex has shown a CAGR of around 35 percent in last five years, it is because Indian economy has grown at more than 8 percent.
  • Sentiment: Sentiment is a critical factor in the stock market. While it cannot be quantified like GDP growth, it makes a big impact on the index movement. Sentiment is nothing but perception of an economy, industry or maybe even a company. As there are several categories of investors including foreigners, Indian institutions and retail investors, each of them perceive the market to move in a particular way. Therefore, even though economic indicators may be positive, the index may trend downwards due to prevailing sentiment. Sentiment is purely psychological and in the short term, a positive sentiment helps the market to move upwards.
  • Industry Specific Factors: Sometimes, an index like the Sensex may go up, but a sectoral index may show an opposite trend. This is primarily because of news related to that sector. For instance, post budget, the cement sector went in for a sharp correction because pricing restrictions were imposed on cement companies in the budget.
  • Inflation: Inflation is perceived to be a villain of the stock market. With a rise in the inflation rate, the government takes measures to control money supply. Taking liquidity out of the economy means hiking interest rates. This drags the indices down as on one hand increase in interest rates makes fixed income instrument attractive for the investors and on the other hand, reduced liquidity means lesser trading in the stock market. This double-edged sword curbs the growth in rate of return, which an investor would expect from stock market.
  • Other Factors: There are several other factors, apart from those mentioned above which have an impact on an index. Government policies, fiscal environment, global factors etc. can all cause a serious impact. Due to larger foreign participation, Indian markets are no longer insulated from global risks. Any change in the international environment can affect movement in the stock market. It has been said that our markets are largely driven by overseas investments. While there may be no way to prove it, the fact remains that you need to keep track of the global environment.

The most important lesson that an investor in equities needs to learn is that equity investment is very rewarding provided a prudent approach is adopted. This includes investment with a long term horizon in a selection of good companies which have past record of performance.

Now that it is clear why equities are a must,

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