“I would like to start investing in stocks, how can I get started?” This is a common question in any forum involving money/finance. If I were to ask this question, I expect to find specific answers that will get me going: “How to choose a stock?”, “how to make a list of stocks never to touch?”. The last thing I want to see is some reference to Buffett or Munger or “intelligent investor”. Boy, are such references those annoying! In this post, I discuss a simple way to get started with direct equity investing – a shortlist of stocks to get started with and a method of selection to begin with – all using the new NIfty multi-factor indices.
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The first and foremost rule of equity investing is that for any given stock, there will always be someone who will claim it is good and someone who will claim the exact opposite. It may be confusing, but it is necessary. Unless someone sells a stock, we cannot buy. Unless someone buys, we cannot sell. So whatever method of stock selection you adopt, it is important that no matter how much you analyze, you will always have to take a chance and buy/sell. The same applies to what follows below too. Someone might like it, someone might hate it. It is important to not get affected by both reactions and have the guts to go ahead. Without guts, there can be no glory.
Although I am not a direct equity investor, I am a student of stock selection and rejection and over the years have developed some resources for the same in collaboration with some of the brightest young investors I have ever met. Here is a selection of some of the most popular freefincal stock investing resources:
Readers may recall that in a couple of posts we have been searching for alternatives for the Nifty Next 50 – better returns with lower risk. So you might want to read those first to get a better perspective: Warning! Nifty Next 50 is NOT a large-cap index! and Are Nifty Smart Beta (strategic) Indices better than the Nifty Next 50?. This post is part 3 of this series. We shall consider the new NIfty multi-factor indices that are built by combining two or more strategic indices.
We have already found out that the NIfty 100 Equal Weight and NIfty Midcap indices are strong contenders to do better than the Nifty Next 50 (see part 1) and that the nifty strategic indices based on value, growth, alpha and low volatility are also good choices (see part 2). A nifty multi-factor index combines alpha with value, growth with volatility and so on. So they too should do well when compared to NN50. We shall deal with a detailed comparison in part 4 of this series. In this post, let us look at how each index is constructed and how new stock investors can quickly learn the essentials of the trade and get going with a short list of stocks.
Nifty strategic index or a smart beta index is one in which stocks are chosen by one or more methods of stock selection instead of simple picking stocks by market capitalization. So by investing in a smart beta index we combine both active and passive methods of investing. Although it would not be a bad idea at all to construct a portfolio of such stocks on our own and manage it passively (change only when stocks in the index changes), that is not a practical way for most investors as some of the smart beta stocks can be pretty expensive to buy (eg. each stock of MRF is about Rs. 75-76K).
Instead, I would recommend two things: (1) use smart beta indices to learn stock selection and (2) use the current stocks in smart beta indices as a shortlist and either investigate more or simply buy a few that you can afford each month and gradually build a portfolio. Please note that I have no plans to do this and my skin is not in the game. So this post is merely food for thought. All I can say is, if I did want to invest in direct equity, I will simply pick a few from the index mentioned and start in a small way. Without further ado let us look at each index.
I have discussed strategy indices and made tools for using them to analyze mutual funds earlier. So what follows is only a brief introduction and methodology behind the index construction. Those who are serious about this should read the whitepaper and index construction document from NSE. The images below are sourced from these. The multi-factor indices are sources from NIFTY 100 and NIFTY Midcap 50 and are based on the following four single-factor indices:
1. NIFTY Alpha 30
Alpha is a measure of risk-adjusted outperformance with respect to NIfty 50 and the MIBOR* 3-month bond rate representing the risk-free return. Higher the alpha, higher the weight in the index.
MIBOR = Mumbai Interbank Offered Rate (a benchmark rate for one bank to lend to another)
Jensen’s alpha = (excess return of index wrt risk-free instrument) – (a measure of relative volatility wrt nifty 50) x (excess market return wrt risk-free instrument)
excess return of index wrt risk-free instrument = index return – MIBOR return
excess return of market – nifty 50 – wrt risk-free instrument = nifty 50 return – MIBOR return.
relative volatility wrt nifty 50 = beta.
The idea behind alpha is simple: higher the excess return + lower the volatility the better. The last one year is considered for calculation.
This index has 30 stocks with the highest alpha with a weight proportional to the alpha.
2. NIFTY Low-Volatility 30
This has 30 stocks with lowest fluctuations in daily returns for the past year. This is a simple and amazing way to get good returns with low risk. Just this index alone is enough for new stock investors to get started. Read more: Nifty Low Volatility 50: A Benchmark Index to watch out for
3. NIFTY Quality 30
This index calculates three metrics: Return on equity (ROE), Debt equity ratio (D/E) and Average change in Profit After Tax (PAT) in previous 3 financial years. Only those companies with positive PAT in the last 3Y are eligible. Then it creates a quality score.
Quality score = 40% ROE – 40%D/E+20%(PAT increase). Then 30 such stocks from NIfty 100 + NIfty Midcap 50 are chosen.
4. NIFTY Value 30
This is based on high ROCE (Return on Capital Employed), low PE, low PB and high Dividend yield (DY) in the last financial year with positive PAT in the same period.
Value score= -30%PE -20%PB +40%ROCE +10%Div. Yield
These four methods are more than enough for the new stock investor to discard bad stocks and create a shortlist.
NIfty Multi-factor indices
So now the following multi-factor indices are built
1. NIFTY Alpha Low-Volatility 30 = 50% alpha + 50% low volatility
2. NIFTY Quality Low-Volatility 30 = 50% quality + 50% low volatility
3. NIFTY Alpha Quality Low-Volatility 30 = 1/3 Alpha + 1/3 Quality + 1/3 Low Vol
4. NIFTY Alpha Quality Value Low-Volatility 30 = 25% Alpha + 25% Quality + 25% Value + 25%Low Volatility
Here are the current constituents. You can get them from here
That is a pretty good shortlist by any yardstick to begin with. All that a new stock investor needs to do now is to have a clear asset allocation and slowly start accumulating a few of these stocks keeping in mind their market cap, sector, nature of business and moat. What about the right price to buy? Personally, I am not a fan of finding the right price as a huge dip in price does not happen when we want it to, but then again, I am not an equity investor. So it is up to you.
Note: I have no problems with those who swear by WB or Munger or Graham. Just that I prefer learning basic stock picking skills first, put my money in the market and then enjoy the lessons from these experts. It would be easier to process such information then Anyway the learning never stops.