Direct Equity
Investors can invest in equity instruments either in the primary market or in the secondary markets. In the primary market, investors can invest in Initial Public Offers (IPO) and Followon Public Offers (FPO) made by companies. These offerings will be available for a limited period during which investors have to evaluate and invest. Investors can also buy shares in the secondary market on the stock exchange where issued shares are listed and traded. Investing directly in equity market, whether primary or secondary, requires certain skills and conditions to be successful.
Equity instruments come with no guarantee of principal invested or income expected from it. The onus is on the investor to evaluate the operational, financial and management strengths of the company before making an investment. The past performance of the company and the future prospects has to be analysed in the light of micro and macroeconomic conditions and compared with the performance of peer group companies. The shares of the company must be valued based on the expected performance. The price at which the shares are available must be seen relative to the value to determine whether the shares are correctly priced. Analysis and valuation require the necessary skills and the access to relevant data and information.
Constructing an equity portfolio involves selection of securities, determining the right time to buy and sell stocks, decide on the proportion of the different securities and sectors in the portfolio and the trade-off between holding a diversified portfolio or a concentrated portfolio. Investors have to decide on the strategies that they will use to manage the portfolio, such as the strategic long-term allocation and the tactical allocation to benefit from market conditions. Reviewing the investment decisions periodically and rebalancing the portfolio to reflect the current situation of the companies invested in as well as the investor, is also a significant factor in the performance of equity investments of an investor.
Equity investment requires disciplined investing over a long investment horizon so that the short-term volatility in returns are smoothed out. Behavioural factors, such as aversion to loss, herd mentality and others, may result in the investor making the wrong choices and decisions.
Benefits and Risk of Equity
Equity share capital has distinct features which define its risk and return. These features determine the suitability of raising equity capital for the company over other sources of financing such as debt. For the investors, the risk and return in the equity investment determines whether it is appropriate for their needs.
a. Ownership Rights
Shareholders are the owners of the company and have the right to participate in its profits and growth. Since equity shares are issued for perpetuity, the ownership claims are valid as long as the issuing company exists. Shareholders exercise their ownership rights by voting on all major resolutions of the company. The voting rights are in proportion to the number of shares held by the shareholders and allow them to express their views by voting for or against a proposal.
In theory, shareholders can get rid of poorly performing management by voting in a new board of directors which in turn can appoint a competent management team. In practice however, public shareholders are too small or widely scattered and only institutional shareholders have some influence on corporate governance.
b. Residual Claim
Shareholders hold two positions within a company. As investors, they are entitled to a return on their investment. But as owners of the company they are obliged to pay off all the money owed to external (non-owner) creditors first, before taking their return. This problem is resolved by paying shareholders only after all operating expenses, interest costs and taxes are paid from the company’s revenues and depreciation is provided for. Thus the payment made to shareholders is a share of profit after tax (PAT) in the form of dividends. This is the residual profit of the company and belongs to the shareholders, whether it is paid as dividend or not.
Shareholders are ranked last both for profit sharing as well claiming a share of the company’s assets. If a company goes bankrupt and has to be liquidated, the money generated from converting assets into cash cannot be claimed by equity shareholders until creditors and preference shareholders have been paid.
c. Reserves and Net Worth
Companies are not obliged to payout dividends every year, nor are dividend rates fixed or pre-determined. If companies are growing rapidly and have large investment needs, they may choose to forego dividend and instead retain their profits within the company. The share of profits that is not distributed to shareholders is known as retained profits. Retained profits become part of the company’s reserve funds. Reserves also belong to the shareholders, though it remains with the company until it is used in operations or distributed as dividend or bonus. Reserves represent retained profits that have not been distributed to the rightful owners of the same, namely the equity investors. They enhance the net worth of a company and the book value of the equity shares.
If the company is making losses and cannot pay interest (even from its reserve funds) then it is not permitted to declare any dividend for its shareholders. As soon as it returns to profits, it must first clear its interest dues before paying out dividend.
d. Limited Liability
Equity shareholders are owners of the company, but their obligation to the company is
limited to the amount they agree to contribute as capital. If a company falls into bad times and goes bankrupt, and does not have adequate assets to cover its dues, equity
shareholders cannot be called upon to make good the shortfall. Their liability is limited to the amount they have contributed towards the share capital of the company.
e. Returns are not fixed
Investment in equity shares does not come with a guarantee of income or security for the investor. The return to the investor from equity is in the form of dividends, if it is paid by the company and capital appreciation from an increase in the value of the shares in the equity market. At the time of the issue of shares the company does not commit to pay a periodic dividend to the investor or a pre-fixed date for payment of dividend, if any. The investor cannot take any action against the company if dividends are not declared or if the share value depreciates.
Market Indicators
Market Capitalisation refers to the market value of the outstanding share capital of a company. The number of shares times the market price per share gives the market capitalisation. Market cap is an indicator of the size of the company in terms of the current market price of its shares. The largest companies by market cap represent blue-chip stocks that also enjoy a high level of liquidity. Large cap stocks are the top rung of largest and most liquid stocks in the market. Mid cap stocks refer to those that are the next rung, in terms of size. Small cap stocks are those that are smaller in size and therefore do not enjoy much liquidity.
In terms of return performance, large-cap stocks tend to be less volatile than mid-cap stocks. In bull markets, mid-caps tend to run ahead of large-caps, and in bear markets, they tend to fall more than large-caps. If large-cap stocks represent liquidity and stability, midcaps represent momentum and opportunity.
A Stock Market Index tracks the performance of a section or the entire stock market by measuring price movements of a chosen sample of shares. Widely tracked indices are made up of the most actively traded and investible equity shares in the country.
Equity stock indices such as Dow Jones Industrial Average (DJIA) and S&P 500 (for USA); FTSE 100 (UK); Nikkei (Japan); Hang Seng (Hong Kong); and Nifty 50 and S&P BSE Sensitive Index(Sensex) (India) are considered to be representative indices. In addition, sector specific indices that focus on shares from a specified industry; or size of market capitalization or any other grouping are useful for sector analysis and investment. An index usually tracks the price of a chosen set of equity shares. The components are chosen based on the focus of the index. Sensex and Nifty 50 for example, track the prices of 30 and 50 largest and most liquid equity shares on BSE and NSE, respectively.
The simplest way to compute an index is to add up the prices of constituent shares at a point of time and divide by the number of shares to create an average. However, an index based only on share prices would be heavily influenced by large price changes in a single stock, even if that stock belongs to a company that is relatively smaller or less significant in the overall market. To avoid such biases, share prices are weighted by market capitalization of the component stocks. The index then represents the collective market capitalization of index stocks at a point in time.
An index is always calculated with reference to a base period and a base index value. This ensures that trends in index movements are always measured relative to a base level.
A stock market index has several uses:
- Indices are widely reported in the news, financial press and electronic information media and thus real time data on market movements is easily available to the investing public.
- The index value is a leading indicator of overall economic or sector performance and effectively captures the state of financial markets at a point of time.
- A representative index serves as a performance benchmark. The returns earned by equity-linked mutual funds or other investment vehicles are often compared with the returns on the market index.
The most widely tracked indices in India are the S&P BSE Sensitive Index (Sensex) and the Nifty 50. The Sensex has been computed since April 1, 1979 and is India’s oldest and most tracked stock index. The base value of the Sensex is 100 on April 1, 1979. The composition of stocks in the Sensex is reviewed and modified by the BSE index committee according to strict guidelines in order to ensure that it remains representative of stock market conditions. The criteria for selection of a stock in the Sensex include factors such as listing history, trading frequency, market capitalization, industry importance and overall track record.
The Nifty 50 is an index composed of 50 most representative companies’ stocks listed on the National Stock Exchange. The base period for Nifty 50 is November 3, 1995, and the base value of the index has been set at 1,000. The selection of shares that constitute the index is based on factors such as liquidity, availability of floating stock and size of market capitalization. The index is reviewed every six months and appropriate notice is given before stocks that make up the index are replaced.
The SX40 is composed of 40 most representative stocks listed on the Metropolitan Stock Exchange of India Ltd.. The base period for SX40 is March 31, 2010 and the base value of the index has been set at 10,000. SX40 is a free float based index consisting of 40 large cap liquid stocks representing diversified sectors of the economy.
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