ASKUS

Q. I have never invested in the equity market. However, in the belief that it will rise over time, I am considering investments in it but for the long term. I just want to know whether this kind of belief is helpful or should I still refrain from investing in the equity market?

Kavya Vijay

A. Before you decide to invest in equities, it would help to understand how equity returns are generated. Shares are said to outperform other assets over the long term because when you buy shares (equity) in a company, you become a part owner of a business. Any successful business must generate profits that are higher than its borrowing costs and compensate its owner for the risks he takes, which is why equity returns over the long-term are believed to be higher than debt returns. Whether you make high returns from equity in practice, though, depends on whether you are able to select companies that can grow their earnings or profits at a healthy pace over time.

Selecting the right stocks to invest in involves taking a long-term view on a sector and business, and gauging whether it can generate strong returns on your invested capital. If the business turns loss-making, suffers a downturn or fails due to its inability to repay debt, you, as an equity shareholder, will have to suffer losses too. Successfully investing in equities therefore requires not just understanding the key drivers of a sector’s prospects and profitability, but also the sources of competitive advantage for a company within a sector. Stock prices in the long run reflect a company’s earnings or profits on a per share basis. If these are rising, stock prices will rise; if they fall, stock prices will follow suit.

Now, while stock prices do broadly track a company’s profits per share over long periods of five or 10 years, in the short run, there’s no saying how they may move. While companies certainly don’t experience any changes in their business fundamentals or financial position on a daily basis, the stock markets constantly mark up or mark down the valuations that they’re willing to pay for a business based on how a majority of investors view the sector or business growth prospects over the next 1, 3 or 5 years.

Such a valuation is commonly measured by the price-earnings, or PE ratio, which captures the market price for every rupee of earnings generated by the company on a per share basis. To ensure that you make good equity returns in the long run, it is essential not just to identify good businesses to invest in, but to also to enter them when their valuations are reasonable.

Therefore, there are two factors that decide whether you make good equity returns in the long run. One, your ability to pick successful companies that deliver long-term profit growth. Two, your ability to buy them at the right price or valuations, so that you don’t overpay for that growth.

If you aren’t an expert at analysing businesses or stocks, you can solve the first problem by buying into equities through an index fund owning the top 50 or 100 stocks in the market (say a Nifty50 or Nifty Next50 index fund) or any of the actively-managed equity funds offered by mutual fund houses, where a professional manager picks stocks that he thinks will outperform.

Addressing the second issue though, is left to you. If you invest a lump sum into equities when stocks are expensively valued, your long term returns can suffer. Today, the PE ratio of the Nifty50 is above 30, which is well above the long-term average of about 18 times.

Investing a lump sum into equities or equity funds at this time is therefore not ideal for a first-time investor. At the same time, waiting for valuations to correct (which can take months or years) can lead to missed opportunity to make a start on your long-term equity portfolio.

To get around this, you can make a start on your equity investments for the long run by starting an SIP (systematic investment plan) in either a broad-based index fund (Nifty100 or Nifty 500 fund) or in a multi-cap equity fund with the help of an adviser. An SIP will help you invest a small sum each month into a select basket of stocks (held by your fund) so that you can participate in their growth over the next 7-10 years. Do not invest any funds that you may need within the next five years, in equities.