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The Sensex has been recording new highs day after day, although the last two trading sessions have been subdued.
However, given that the index is now trading in un-chartered territory and is within striking distance of the psychological 7,000 mark, we believe that the investors need to look at the markets, more from the bottoms-up approach as against the top-down approach for stock investing.
Let us now look at the two different approaches to investing:
Top-down approach
Looks at the economic performance of the country vis-�-vis the global trend.
Once the economic performance is known, focus on the sectors, which are likely to play the lead role in contributing towards the economic growth. Of these sectors, fundamental factors such as price earning ratio, earning per share growth, and dividend yield can be major indications in terms of investments.
After narrowing down on the sector, the investors need to look at the leading companies in the sector in terms of performance.
Management plays an important role in the company's prospects and therefore, it is important to factor in these factors. Data regarding the management can be availed from the company's annual reports. Management intent is of prime importance when parking your money. It is always better to invest in a market leader like Infosys [Get Quote] rather than have your money in NIIT [Get Quote].
Read our special article: Mr. Market and You
Bottom-up approach
To start with, this approach assumes that individual companies can do well even in an industry that is not performing well. In this case, it is important that investors look at the company's overall strengths and weaknesses in terms of product performance, competition, financial status and the earnings potential.
A part of bottom-up approach is value investing where the idea is to pick the cheap stocks with strong balance sheets. The strategy is to look at the stocks that trade for less than their intrinsic value.
With regard to which approach an investor should follow varies economy to economy. Though there are 6,000 stocks listed on the Bombay Stock Exchange, the BSE-100 index would account for as much as 80 per cent to 85 per cent of the overall BSE market capitalisation!
In such an under-researched markets, there are good investment opportunities available at the company level and therefore, it would make sense for investors to follow a bottom-up approach. Having said that, there are some pitfalls in an under-researched stock market like India:
The risk profile of an auto stock cannot be vastly different from the risk profile of the auto sector, which in turn is governed by economic performance. So, a holistic view is also of significance. The difference arises primarily because of the quality of the management at the top.
Under-researched companies also do not have a proven track record unlike larger companies like Infosys and HDFC [Get Quote]. So, the ability to manage downturns and outperform peers during upturns is extremely critical. Information flow on these under-researched companies is also not smooth. So, one has to be careful to that extent.
During bullish times, there can be significant trading activities in smaller stocks (like it is now). Already, the National Stock Exchange has issued a 'warning statement' to all its members. At times, it is possible that smaller stocks may be rising not because of fundamentals, but someone section of the market participants may be driving prices higher.
Remember, a bull market or a bear market does not change the fundamentals i.e. earnings growth prospects, quality of management and valuations. Time to realise that bull markets do not guarantee easy money!
Equitymaster.com is one of India's premier finance portals. The web site offers a user-friendly portfolio tracker, a weekly buy/sell recommendation service and research reports on India's top companies.
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