Undervalued shares recognized with dividend yield

Oscar Wilde described a cynic as a man who knows the price of everything and the value of nothing. Alas, the same description applies to many investors. Recognizing true value and being able to identify quality are two of the greatest forces investors can have behind them in the stock market.

How to Identify Quality

There are many ways of measuring the quality of a share, but the most persuasive characteristic of all is a company’s standing as a blue-chip operation.

To save time and turmoil, to pave the way to profits and, most of all, to minimize risk, the dividend-yield theory should be applied only to the most prosperous and progressive corporations on the stock exchanges — the blue chips.

Why concentrate on blue-chip stocks when searching for quality? Don’t some young, growing companies have high-quality characteristics and potential for paying outstanding dividends? Aren’t there good values to be found in formerly troubled, turnaround companies under new and better management?

Perhaps. Sometimes the company on the brink of disaster does save itself. Small companies do sometimes break clear from the pack and achieve spectacular success.



But with such companies, risk too runs high. There is no way to be certain they will achieve their goals. Talk comes easy; evidence is harder to produce. A lot of young companies in growing industries have not been able to survive the competition. Even a chief executive with a brilliant record may not be able to pull a sinking ship out of deep, dark waters.

The world of blue-chip stocks offers fewer unpleasant surprises. These companies are managed by the best, the most experienced leaders that money can buy. Their products and services are well known and widely distributed. They often are sold on international markets, especially in the lesser-developed countries, where growth potentials still are extraordinary. Blue-chip companies have the most sophisticated research centers, the most elaborate advertising programs, the largest sales organizations and the longest histories of profitable progress.

They are the most willing to share profits with their stockholders, paying dividends that can help investors keep pace with inflation and provide a safety net under the prices of stocks.

Secondly, understanding the cycles of blue chips will help you be positioned at the right place in the market at the right time. Blue-chip shares are generally in the forefront of every major market move. They are among the first stocks to rise in a bull market and nearly the last to fall when the market declines.

In good times, blue-chip companies outperform both their lesser competitors and the economy. In bad times, they resist adversity best. Time and time again, experience has shown, there is no profitable substitute for quality.

What is a blue chip?

Clearly, though, not every share that goes up is a blue-chip stock. To some investors, any share they own is a blue chip!

Confusion over the definition of blue chip in the stock market abounds. Maybe it is the term itself that gets our thinking off track. Originally, the expression comes from the blue chips used in a poker game. The blue chips are the highest denomination of money. They are the most expensive tokens — the most valuable chips in the game.

In the stock market, however, price has little to do with value, and even less to do with the definition of a blue-chip stock. Only as it relates to the dividend, to earnings, or to book value is price an important measure of blue-chip quality.

The term really refers to the quality of the company on which the stock is issued. A blue-chip company is one that has a long history of corporate excellence.

How to Identify Value

But recognizing quality is not enough to guarantee profits in the stock market. Even a top-quality share can be overpriced.

Without conscious effort, we automatically measure relationships of price and value every day of our lives. It doesn’t take a genius to realize that Rs. 1,000/- is an undervalued price for a new car, but an overvalued price for an umbrella.

Once you have identified a high-quality blue-chip share, investors should apply the measures of good value. In this way, both safety of capital and total return are maximized.

If concern about value persists, it makes sense to buy stocks as if buying a company itself — as close to its net asset value (book value) as possible.

Thus, the linking of quality and value in the stock market can help investors select timely — and undervalued — stocks. Close attention to fundamental investment precepts may not be the most glamorous approach to equity investing, but it is the safest and most sane way to ensure long-term investment success.

How Put/Call ratio reveals market’s future

The Put/Call ratio measures the sentiment of speculative option traders. A high Put/Call ratio indicates that option buyers favour puts, and are bearish. Historically, their pessimism has been ill rewarded, as the market has instead forged higher. A low Put/Call ratio signifies a relative dearth of put buying and a preponderance of bullish call buying. The record shows that option buyers’ optimism is usually shortlived, as the market declines instead.

A call is an option to buy common stock; a put is an option to sell common stock. A call buyer hopes prices will rise; a buyer of a put option wishes prices to fall. Both calls and puts receive their value from the price of the stock itself and option speculators’ judgments of the future course of the stock’s price movement.

Consider, for example, the valuation of a call option. If a stock sells at $25 and a speculator owns an option to purchase that stock for only $20, the value of the option is $5. Any price less than $5 would prompt a massive purchase of call options, an immediate payment of $20 and a resale of the acquired stock at $25, for a profit. Hence the theoretical value of the option is $5. Actually, because of a variety of other factors, the option price will usually be somewhat above $5.

One of these factors is the possibility of large percentage gains. If, in our example, the stock rises in price to $30, the option to buy it at $20 is worth $10. (Paying $10 for the option plus $20 for the stock by exercise of the option is akin to paying $30 for the stock in the first place.) Note that while the common stock has advanced 20%, from $25 to $30, the option value has doubled, from $5 to $10, a 100% gain and five times the percentage stock gain. This is obviously a highly leveraged and profitable situation.

Of course, there is a corresponding risk. If the stock declines from $25 to $20, the call option would be theoretically worthless. While a common stock investor would lose only 20% of his original investment, a call buyer would lose his entire investment. (Put options are diametrically opposite to call options. The space will not be devoted here to explaining their reward and risk opportunities. Suffice to say that the buyer of a put option only makes money when the stock declines in price, whereas the call option buyer makes money when the stock moves up.)

Option buyers are plainly a special breed. They shoot for large, highly leveraged profits. In return they risk catastrophic loss of capital. It often seems to be the case that the sentiment of extreme risk takers yields valuable clues to future market behavior. Option buyers are no exception.

If the volume of call options in a given period is greater than the volume of put options, one may logically assume that option speculators as a group are expecting higher prices and are bullish on the market. On the other hand, if the volume of put options is relatively greater than that of calls, these same speculators hold a generally bearish attitude.

Option traders lose money on balance. Their judgments of the direction of individual common stock prices, and of the market as a whole, are usually wrong. Therefore, a high Put/Call ratio (a large volume of puts relative to calls) usually precedes a period of rising prices, not falling prices as the option speculators would prefer. Conversely, a low Put/Call ratio (indicating relatively little put buying activity and greater call buying activity) is invariably followed by declining prices instead of rising prices as the preponderance of option buyers desire.

In the US from 1945 to 1976, the Put/Call ratio was computed using volume in the over-the-counter options market. In 1977, the options exchanges began trading both puts and calls on 25 stocks, and from 1977 to 1982 the P/C ratio was based on that volume. By 1983, the Ratio was expanded to use put and call volume on every stock with listed options.

To stabilise the indicator, we utilize contract volume only for those puts and calls with a striking (exercise) price within 10% of the current market price of the underlying stock. This eliminates far “in the money” options and far “out of the money” options from the tabulation.

First, a Put/Call ratio is computed for options in which the stock price is greater than the strike price but not more than 10% above it. A second P/C ratio is computed for options in which the stock price is below, but not more than 10% below, the exercise price. The two ratios are then simply averaged to derive the overall market logic P/C ratio.

Low readings (20% to 35%), signifying excessive call speculation, are bearish. High readings (above 140%), indicating excessive put speculation, are bullish. Bearish readings tend to be a bit early relative to market turns, but bullish readings frequently coincide to the very day with market, troughs. The market logic Put/Call ratio is one of the most sensitive and valuable of all market indicators now in use.

Option activity ratio: A derivative statistic of the put and call data is the so-called option activity ratio (OAR) calculated by dividing total put and call volume by NYSE volume. A high OAR is bearish for it signals the excessive option speculation that frequently accompanies market tops. A low OAR is bullish for the opposite reason: if there is a dearth of speculation, the market should be depressed and near a major trough. Recently the indicator has lost its usefulness. The sharp decline in over-the-counter option business during the last few years has thrown the OAR into a severe downtrend, rendering interpretation next to impossible. Several more years’ development of the registered option exchanges will be required to furnish sufficient data to construct the OAR anew.

Impact on investments when interest rate changes

That changes in interest rates affect returns from fixed-income investment avenues is obvious. Equally, changes in interest rates have profound impact on the direction of the stock market. In fact, interest rates are a key driver of the stock market

Unfortunately, many individual investors miss the many signals that the debt market offers the more astute investor. These signals can present opportunities — or serve as warnings — in a wide variety of personal financial matters, ranging from home loans, credit cards, personal and car loans to investing in the stock market, and, of course, fixed income investments.

The Indian debt market comprises broadly of government securities (G-Secs) and bonds — PSU Bonds, bonds issued by financial institutions such as ICICI and IDBI, and corporate bonds and debentures, with G-Secs being the most dominant. Unlike in developed countries such as the US where the debt markets are significantly larger than the stock market, in India the situation is the reverse. The reason: interest rates in India were till recently strictly regulated and the number of players in the debt market relatively few.

The de-regulation of interest rates, however, is now changing all that. A freer interest rate regime, with frequent changes in interest rates, obviously leads to fluctuation in the returns from fixed income instruments. Indian investors have of late discovered this to their dismay as the lowering of interest rates offered on ever-green instruments such as PPF, NSCs, bank deposits has eaten into their income returns.

How interest rates affect share prices

The impact of interest rates on your personal finances extends well beyond your debts. Interest rates affect your equity portfolio, too. There is plenty of evidence. Indeed, in history to prove that interest rates can have a profound impact on the stock market. As a result, the stock market watches the bond market like a hawk. Stock market professionals respond predictably to the RBI’s periodic raising or lowering of interest rates.

By gaining a better understanding of the debt market, you can recognise the potential risks and opportunities that movements of the debt market present for equity investment. A clear grasp of the goings-on in the debt market will help you understand how it affects the stock market and refine your investment decision-making process.

There are basically six ways in which changes in interest rates affect the stock market investor :

1. Changes in interest rates directly affect corporate profits. Companies need to borrow funds to finance expansion programmes, meet working capital requirements, purchase equipment and maintain inventories of raw materials and finished goods. Low interest rates lower the cost of money and increase the profit margins of companies. Since share prices are directly linked to corporate profits, the lowering of interest rates always has a bullish effect on the stock market.

2. Changes in interest rates affect the general demand for goods and services in the economy. When interest rates are lowered, people tend to spend more and save less. When interest rates are raised the reverse happens. Increased consumer spending as a consequence of lower interest rates leads to an expansion in the demand for the goods and services provided by the corporate sector.

3. Changes in interest rates have a direct effect on the sales of automobiles, commercial vehicles, two-wheelers, tractors, agricultural equipment, consumer durables (television sets, washing machines and kitchen appliances) and increasingly housing since the demand for these products is significantly dependent on borrowed funds. Lower interest rates also spur to construction activity through a reduction in the cost of housing finance. Therefore, falling interest rates are good for automobile, two-wheeler, tractors, farm equipment, cement, construction, steel, consumer durable and housing finance companies.

4. Changes in interest rates also alter the relative attractiveness of competing financial assets like shares, bonds, and other fixed-interest investments. Lower interest rates generally tend to cause a shift of investible funds from bonds, bank and company deposits to equity shares and vice versa.

5. Changes in interest rates affect the way companies finance their operations. During a high-interest-rate regime, companies prefer to raise funds through issue of equity shares rather than through bonds and high-cost bank loans. When interest rates fall, bank loans become a cheaper source of finance than equity, and companies prefer to borrow money from banks and raise their debt-equity ratios. In short, lower interest rates are bad for the primary market and good for the secondary markets.

6. Lower interest rates also reduce the cost of borrowing money for the purchase of shares. This is another way in which the lowering of interest rates has a bullish effect on the stock markets.

In sum, a lowering of interest rates generally lifts the stock market. Conversely, stock market tend to slip as interest rates rise. This is not to say that this happens in perfect co-ordination. It takes time for changes in interest rates to work their way through the markets in the manner described above. For an alert investor, though, changes in interest rates offer pointers to switch from debt investments to the equity market when interest rates fall and vice versa.