The rule of thumb says that one must think like a business owner while investing in a company.
Consider a Petrol Pump chain that is up for grabs.
As a potential investor, it is natural that the first number to gauge will be the annual sales & profit figures.
You notice an increasing trend in the numbers. The reported margins are impressive compared to industry standards. The company has been on an expansion spree & plans to add more outlets this fiscal. The entire expansion is funded through equity. All stores are owned which gives the company the dual advantage of rental savings as well as price appreciation of property. Debt is negligible & the working capital cycle does not appear to be stretched.
The best part amongst all this is that the existing owner quotes a reasonable price.
Will you go ahead with the investment?
Well, prima facie, it does appear to be a good deal. Let us now take into consideration some alternative scenarios:
1) Crude Oil prices are expected to go up which is likely to dent retailing margins
2) Automobile companies are increasingly shunning traditional fossil fuel churning cars. There is a clamour in the Electric Vehicles space with market stalwarts such as Apple & Xiaomi joining the race.
3) Business & consumer sentiment in the economy is at an all-time low. The economic growth in the country is lagging & people are shunning purchases of everything under the non-essentials tagline.
4) The entire due diligence process for finalizing this investment will take some time to complete from our end. The board has decided to fund this acquisition by taking a loan from the bank. However, consensus expectations point to a significant interest rate hike in the coming months. This situation will inevitably lead to a higher net outgo & it will take another year for you to break even.
5) Commodity prices are expected to go up. This will lead to a cost escalation for automobile manufacturing firms. The cost-sensitive consumer will put purchases on hold. As a result, demand for petrol & diesel might fall going forward.
6) The Rupee is expected to depreciate. This may push up the cost of imports and impact profitability if pump prices are not increased by a similar quantum.
7) The government is coming up with a proposal to hike taxes on petrol & diesel. It also announces incentives for shifting to greener means of commute.
8) Hardening bond yields in the USA suggest that the government has no choice but to raise interest rates earlier than expected. This would make further investments.
In the light of these developments, an outstanding potential investment might turn out to be a mediocre one or perhaps even a loss-making idea in due course of time. In each of these scenarios, we have highlighted potential macroeconomic risks to the business-
- Crude Oil prices
- Technological Shifts
- Monetary Policy
- Exchange Rate Movements
- Fiscal Policy
- Bond Yields in that order.
Such is also the case with Equity Investments. Just like any other business, equity investing too comes with a risk profile of its own. Therefore, it becomes crucial to have a comprehensive understanding of different risk factors in play with the ultimate objective of maximizing alpha.
Stock returns are a function of many factors other than the fundamentals of the company.
It is a norm for listed companies to disclose their financial performance quarterly. Hence, out of two hundred & fifty trading days in a calendar year, it is only on four days that there is some material information to reflect on. Add to this number a maximum of fifteen noteworthy Corporate Disclosures such as Dividends, Loan repayments, Credit Ratings, Changes in the Board of Directors, Mergers & Acquisitions, Analyst Meets, and so on.
This amounts to a sum total of approximately twenty days in a year. It is on these days that market participants revise their earning estimates on account of the updated information & arrive at a new equilibrium price where demand equals supply.
Some investors also address the remaining two hundred thirty days of trading activity as a random walk or more simply put, noise. A “random walk” is a statistical phenomenon where a variable follows no discernible trend and moves seemingly at random. Otherwise speaking, this theory implies that stock price changes are random & cannot be predicted.
The relevance of such a concept remains widely debated by market experts. Nonetheless, comprehensive knowledge of the different factors moving stock markets will help you decipher if the recent market correction was an indication of complete trend-reversal or just a temporary blip in your journey towards financial freedom.