Before Picking up stocks..

Keep an eye on the factors that cause volatility in stock markets

What moves the stock market?

Hi there,

That question has many answers. Economic factors like GDP and earnings reports, political factors like government policies and political unrest, commodity prices like price of crude oil and gold, social issues like war and terrorism, acts of God such as earth quakes and flood may cause the market to change direction or speed up or slow down its momentum.

Most common of them are listed below.

  • Inflation, Interest rates & Earnings
  • High Speculative activity
  • Demand and supply
  • Oil/Energy Prices ,War/terrorism , Crime/fraud
  • Serious domestic political unrest
  • Uncertainty

Inflation, interest rates & Earnings

To put it in simple terms, Inflation is a sustained increase in the general level of prices for goods and services. There may be a lot of reasons for this. It is measured as an annual percentage increase. As inflation rises, every Rupee in your wallet buys a smaller percentage of a good or service. People living off a fixed-income, such as retirees and salaried class see a decline in their purchasing power and, consequently, their standard of living. Uncertainty about economic future makes corporations / consumers spend their money cautiously. This hurts economic output in the Long run

As inflation increases, Reserve bank increases the interest rates to reduce the money supply and slow inflation down: When interest rates are high, people find it expensive to borrow, and therefore there is less money floating around. When interest rates are high; people require higher returns on stocks. Its not so easy to just increase earnings for a stock, so its price has to adjust downward.

For example : Consider a stock that sells at Rs 100 with earnings of Rs 12, a 12% return. When Fixed deposits pay 8%, an investor may be willing to buy this stock for the extra 4% return. However, if interest rates were to rise, to say 12%, who would pay for this 12% return, when they could get 12% risk-free by Fixed deposits ? Therefore, the stock may drop to Rs 75. With earnings of Rs 12, this now generates a 16% return and is once again at a price where an investor might be willing to take the risk on this stock for the extra 4%.

Mismatch between actual earnings and expected earnings of the corporates may cause the stock markets to fluctuate. That’s because, when the corporates report week results than expected, the investors react by selling of their holdings in that stock resulting in a huge drop in stock prices. The opposite is also true. If corporates come up with better than expected earnings results, more an more investors would invest in those stocks resulting in a surge in stock price.

Speculators and investors

Anyone who owns shares are generally referred to as ‘investors’. However, not everyone is an investor in share market. There is one category of buyers who do not follow the fundamentals – Speculators. Excessive  use  derivative instruments like options and futures to speculate may drive stock prices to extreme levels defying all logic. Speculators are largely responsible in creating  heavy volatility in the stock markets. Since they buy securities based on momentum, it leads to stocks becoming dramatically overvalued when everyone is interested and unjustifiably undervalued when the craze ends.

Demand and supply

The very basic economic theory of demand and supply holds good in stock markets too. When there are more shares available than demand, each of those shares is worth less. The opposite is true when there is more demand than shares available.

Oil prices/fraud /scams and other factors affecting stock markets
There are many other factor like hike in Oil prices (resulting in commodities and services getting dearer) war and terrorism (Example: The sept 11 attack and the uncertainty it created in stock markets around the world) Fraud / scams (Example :- Satyam’s case) serious political unrests which results in certain commodity prices moving up ( or revenues of a particular country decreases) which might result in stock prices crashing down.

CONCLUSION

If you have decided to become active in share markets, it’s important to know what moves the stock market. Events like those mentioned above create golden opportunities to buy shares of good companies at throw away prices.

2 Comments

Using Advance / Decline to spot market trends

ADVANCE/DECLINE NUMBERS

Hi there,

Stock exchanges around the world give out the number of shares that ‘advanced’ or ‘declined’ in a trading day from the last close.

For example, the exchange may inform that out of the 7000 stocks, 4500 stocks advanced while 2000 stocks declined. The balance 500 stocks remained ‘unchanged’.

A/D RATIO

The advance/decline ratio is calculated by dividing the number of advancing stocks by the number of declining stocks.

  • Values higher than 1 show that more issues are presently advancing than declining.
  • Values between 0 and 1 indicate that more issues are currently declining in price.

HOW DOES THIS HELP?

Stock market indexes are very tricky. For example, it is possible for the Sensex to report a gain at the end of the day in spite of many stocks falling, if a couple of heavyweight stocks in the index do well. In such cases, stock indices may not give you that actual picture of what’s happening. To get the real picture, you need the number of shares that advanced and declined out of the total number of shares listed. If too many stocks have advanced it gives us an indication that we are in a bull market.

Another way you can use the advance/decline numbers is in watching trading during the day to spot trends or false trends. For example, if a major index is up significantly, but you find that there is no corresponding increase in advance numbers. So, that increase could be a bubble in a major stock that’s going to burst.

INDEX OR NUMBERS?

If the broad based index conflict with the advance/decline numbers, you have to go with the numbers (and not with the index) to determine what the market really did in terms of direction.

One of the major limitations of the advance/decline numbers is they don’t tell you anything about the size of the advances or declines. It just tells the numbers. It doesn’t tell whether advances were up a Rupee or a 100?

CONCLUSION

Advance/decline is a very simple and effective indicator. It gives you an indication of how the overall market is doing and can add a level of information to indexes for a better understanding of they mean.

0 Comments

Is a stock buyback scheme a good sign?

Hi there,

Stock buy back offers or stock repurchase offers are generally understood to be a good sign. This is one indirect way for cash rich companies to maximise the wealth of its shareholders.

LET’S TAKE A CLOSER LOOK

The idea behind share buy back is simple. The company uses its cash to repurchase it’s shares from the open market. Since the company cannot act as its own shareholder, the repurchases shares are absorbed by the company and the number of shares outstanding is reduced thereby increasing the EPS. So buy backs result in increase in shareholders value.

Another reason why a company would resort to share buy backs is to improve its financial ratios – For example, buybacks reduce the cash component on the balance sheet. Since cash is an asset, it effectively reduces the total assets of the company. Since ROA is calculated as return / total assets, any reduction in the total assets figure will improve the ROA figure. Similarly, re purchase results in a reduction in the number of shares outstanding. Since ROE is calculated as return / number of shares, any reduction in the number of shares will improve the ROE figure. So, if the company is buying back its shares with the sole intention of improving its rations like ROE and ROA, that’s not a good sign.

Another problem stock buybacks seek to cure is the dilution (too much stock on the open market) caused by stock option plans. When stock options are exercised the number of outstanding shares increase. This makes the company’s ratios look weaker – the opposite of what repurchasing does.

The buyback offers however, reduces the book value of the company. ( see the example below)


Advantages to the Investor

  • Buying back stock means that the company earnings are now split among fewer shares, meaning higher earnings per share (EPS). Theoretically, higher earnings per share should command a higher stock price which is great!
  • Improving EPS also means that the P/E of the company is reduced. A lower P/E, higher EPS, ROA and ROE are regarded as positive signals by investors.
  • Buying back stock uses up excess cash which otherwise remain idle.  Buying back stock allows a company to pass on extra cash to shareholders without raising the dividend. If the cash is temporary in nature it may prove more beneficial to pass on value to shareholders through buybacks rather than raising the dividend.

Example:

Lets take the financial figures of company xy ltd-

Before buyback

  • The total assets of the company are 5000 lakhs and the total liabilities are 3000 lakhs. Hence, book value would be (assets – liabilities) = 2000 lakhs.
  • Assuming that the company has 1o lakh shares outstanding, the book value per share would be (2000/10) = 200 per share.
  • If the earnings of the company for the year was Rs 250  lakhs, the EPS of the company would be 25 ( 250 /10)
  • ROE would be 25/200 = 12.50 %

Let us assume that the shares of the company are trading at Rs 250 now and the company proposes to buy back 25% of its shares from the market.

Post Buy back

  • The company would need 625 lakhs to buy 25% shares @ Rs 250
  • The company takes cash worth 625 lakhs and buys back the shares.The assets of the company now get reduced by Rs 625 to Rs 4375 lakhs.
  • The number of shares outstanding is reduced by 2.5 lakh shares to 7.5 lakhs
  • New book value would be Rs 1375 lakhs (Rs 4375 lakhs – 3000 lakhs  ) therefore, book value per share = 183.33 per share
  • EPS = improved from 25 to  33.33 (250 / 7.5)
  • ROE increased from 12.50% to 18 % ( 33.33 / 183.33)

As you can see, figures like price earnings ratio, earnings per share, return on assets, return on equity and others can be pumped up by a stock buyback program. So even if nothing has fundamentally changed about the company, the ratios will give a better picture after buyback. . All weaknesses in the business model before the stock buyback will still be there after the buyback.

CONCLUSION

Stock buy backs may not be a positive sign always.Do not buy a stock as soon as a stock buy back is announced, expecting a rise in prices. Always look behind the scenes and find out the real picture behind the buy back.

4 Comments

Using Beta to gauge volatility.

If your heart has a high beta level, invest in a stock that has low beta!

Hi there ,

Beta is a measure of a stock’s price volatility in relation to the rest of the market. In other words beta is a measure of risk. The ‘rest of the market’ would be represented by any broad index that represents the market. Hence, in India, the broad based index could be the Sensex or the nifty.

Understanding beta is simple.

  • Stocks that have a beta greater than 1 have greater price volatility than the overall market and are more risky.
  • Stocks with a beta of 1 fluctuate in price at the same rate as the market.
  • Stocks with a beta of less than 1 have less price volatility than the market and are less risky.So, if the market goes up 20%,a stock with beta 1 goes up 20%. If the Market is down 10%, the stock comes down 10%. This is, of course, calculated over a period of months and does not necessarily hold true on a daily basis.

NOT ONLY FOR INDIVIDUAL STOCKS..

Not only for individual stocks, beta measure can also be computed for the entire industry.  That would compare the volatility that industry relative to the market.

If you know the industry beta, it would be possible for you compare a stock relative to the industry and the market.

For example, if you know that the beta for information technology stocks was 1.5 and you found a company in that industry with a beta of 0.7, this would tell you that the company is not only less volatile than the market as a whole, but extremely stable compared to its industry.

Beta can be constructed for your individual portfolio also. Beta of a portfolio should be the weighted average betas of securities comprising the portfolio.

Beta measures of a stock is useful in finding the cost of equity using the CAPM method. I ‘ll explain more on that when we discuss about cost of equity in our valuation section.

WHERE TO FIND ?

All financial information web-sites like moneycontrol have information about a stock’s beta.

PROBLEMS WITH BETA.

While the ‘beta’ may seem to be a good measure of risk, there are some problems with relying on beta scores alone for determining the risk of an investment.

Beta is computed with historical data.

Beta suggests a stock’s price volatility relative to the whole market, but that volatility can be upward as well as downward movement. In a bull market, the stock that outperforms all will have  beta that’s greater than 1.

HOW TO USE BETA.

Beta is useful for short term decision making. In short term decisions, price volatility is important. Since beta measures exactly that, it useful for that class of investors.

In a rising market, it’s good to have high beta stocks and in a falling market it’s better to stick to low beta shares.

Later when I talk about risk premium, we will find more applications of beta. For the time being, remember beta as a simple and very valuable tool to gauge volatility.

Bye for now ..

Have a nice day !!

2 Comments