Stock Investment is very much like a buying a Mobile phone.
Most of us, at least once in our lives, have racked our brains over which phone to buy. With so many options in the market, and each option characterized by its own special attributes, it is a tough decision. Should you buy the one with a larger RAM? Or should you go with the one with a better camera? Or should you just get the pink one?
Investing in stocks is eerily similar. Should you invest in Coal India which recently posted spectacular profit growth? Or should you go with the safe and stable HUL? Or should you just get something which has been rallying? These seemingly simple questions form the basis of factor-investing or style-based investing.
All stocks in the market can be compared based on some common fundamental attributes – profit growth, leverage, return on equity, price-growth, variability of earnings, valuation multiples, and so on. These attributes characterise factors or styles – the Value factor represents stocks available at cheap valuation multiples; Growth factor, as the name suggests, represents the set of stocks which have been posting high growths in profits; Momentum stocks are the ones which have exhibited recent price appreciation; and Quality stocks represent the safe and stable stocks characterized by low leverage, stable earnings, and decent returns on equity.
Just as in the world of phones, all-rounders are hard to come by. Stocks which fare well on some of the attributes may not fare well on others. For example, if a stock has been consistently posting higher profit growths, it is not likely to be available at a low enough valuation multiple. Similarly, a stock which has been posting relatively slow and stable growth in profits, may not provide a steep enough price appreciation. Basically, there is no stock that has a perfect score on all attributes, and is available at cheap valuations. Thus, arises the need to make a choice.
With phones, if you are a video game junkie, you would choose the one with a powerful processor, great display, and a long battery life. If you are into selfies, you would prefer something that has a better camera and fancy filters. Similarly, in investing, if you are looking for a good night's sleep, you would go for Quality stocks. But if you like the thrill of investing and want to experience the ups and downs of the stock market, you should go with the riskier Momentum investing. No factor fits all. You or your investment advisor should first analyse your risk appetite, investment objectives, and constraints before going for any of these styles of investing.
Another important point to note with factor investing is that factors are cyclical. No style of investing does well all the time. The starkest example of this is Momentum investing. When the market is exuberant, rising stocks keep rising, and if you are a Momentum investor, you keep minting money. But the happy ride stops abruptly when bulk of the investors start getting wary of the heights and book profits.
Needless to say, if you stay invested, you would be in for a rude shock when the rally reverses. Similarly, Value stocks can go years with meager returns before people start buying into them, and only then, would you be able to reap benefits on your Value buys. Usually, it is at the turn of a rally, that people start noticing the quiet Value stocks sitting at the corner. What this means is that Value and Momentum are negatively correlated – in trending markets, rising Momentum stocks are the hotspot of all share market activity, and the unpopular Value stocks are sidelined.
However, as soon as the rally ends and people turn risk-averse, Momentum stocks plummet, and Value stocks take the centre-stage.
This behaviour of factors has given way to multi-factor investing, wherein the objective is to invest in the right factor at the right time. But market-timing is an elusive seductress… in the greed to make money in all market scenarios, you could get the timing wrong and end up losing your nest egg. It is, therefore, usually a much smarter bet to stay invested in a single-factor based portfolio provided you have the stomach to patiently ride out the market ups-and-downs, which can be punishing at times.
In this series, we shall explore the most common factors in considerable detail – the intuition behind them, hypothetical portfolios and their performance, and the pitfalls to look out for.
No comments:
Post a Comment