Stock investing is no big deal in today’s times. Log into your broker’s website, click a few buttons and you can easily buy the stock of almost any listed company instantly. But just because you can buy any company’s stock does not mean you should buy any company’s stock.
Investing in a stock means you trust the company behind that stock to grow in the future and you want a share of that growth. Your money, after all, is your money and you would want to make good (if not the best) use of it. It is common sense that not all companies grow and those that grow do not grow at the same pace. What this means for an investor is that he/she must apply proper diligence before taking any investment decisions. Simply put, there are a few basic criteria that the stock (in other words, the company) must fulfill, for an investor to consider investing in them. I would like to briefly touch upon those criteria in this article, which are:
- The company behind the stock must be fundamentally very sound
- The company must have a great management team
- The industry to which the company belongs must be poised for growth in the future
- The stock must be trading at a value less than its intrinsic value
- The company must have proved its worth in the recent past
- The stock must be suitable to your risk capacity and attitude
- The stock must be suitable for appropriate portfolio diversification
#1. The company behind the stock must be fundamentally very sound
What does that mean, you ask? We often hear that we should invest in fundamentally sound companies. But how do we know if a company is fundamentally strong? Well, there is no fixed criteria for this. But that does not mean you cannot identify such companies. A fundamentally sound company will ideally:
- have a positive working capital
- would be delivering high returns on capital
- have very low debt when compared to its equity capital
- be growing in terms of revenue and profits over the years
- have a high operating margin
- have positive free cash flows
Now, you must know that these pointers are just meant to give you a direction and not necessarily strict requirements to have. What makes a company fundamentally strong depends on a lot of factors like the industry to which it belongs, the competition it faces, whether it is a privately owned concern or is owned by the government etc. This article is not meant to discuss fundamental analysis in entirety but I will be discussing these in upcoming articles. So stay tuned.
#2. The company must have a great management team
A good management is something that is a must-have when it comes to selecting companies for investments. A company’s management team is its heart. It can make or break a company and is crucial to its performance. A company might have all possible advantages, but none of it would count for anything in the absence of competent personnel at the top. On the flip side, an average company can start growing by leaps and bounds if it’s management is handed over to a great team.
An investor should do a background check of the promoters and directors by searching for the company’s name on the internet followed by words like ‘fraud’, ‘dispute’, etc. One should also look at the management remuneration being drawn by the members of the management team (in the annual report) as a proportion of the profits being made by the company. If this ratio is too high one can conclude that the management is using investors’ money to just make themselves richer. Also, if the company is carrying on a whole lot of related party transactions, then those transactions should be scanned well. If the management has taken hasty decisions in the recent past, that should also ring an alarm to potential investors. The general experience and credentials of the members of management should be studied well. Lastly, common sense can save you here as well. For example, if the company is earning profits but neither expanding nor distributing dividends, you should consider staying away from it.
#3. The industry to which the company belongs must be poised for growth
Although I believe in a bottom-up approach when it comes to selecting companies for investment, I cannot deny that no company can sustain its growth for long if the industry to which it belongs is facing problems. For example, if the major revenue of the company comes from export and rupee is appreciating, it is bound to affect the company’s prospects. Again, if the price of raw materials is expected to rise heavily, no matter what other advantages it enjoys, it is bound to suffer. So, the prospects of the industry should be studied well before putting in any money into a company.
#4. The stock must be trading at a value less than its intrinsic value
Price is crucial whenever you buy anything. Nobody wants to pay anything more than what the object is worth, whether it is a cup of tea or a diamond ring. The same goes for stock investing as well. The problem, however, is that in the case of stock investing the ideal price one should be paying is quoted nowhere and depends on the investor’s perception and calculation. Valuation is a big concept in investments and it could take months to learn. Even after learning there is no certainty of getting it right all the time. So what should a normal retail investor do? Well, one good option is to take the help of ratio analysis to get a reasonable idea about whether the stock is currently priced reasonably or not. A few good ratios for this purpose maybe Price to Earnings (P/E) ratio, PEG ratio, Price to Book Value, etc. I would suggest you to learn more about these ratios and these can be very helpful when you are looking for reasonably priced stocks to invest in.
#5. The company must have proved its worth in the recent past
This is one criterion not all analysts have, but I think that it helps to get a certain level of comfort to invest in companies that have done well recently. It is difficult to predict the future of a company that is doing badly. A turnaround is difficult to predict and if it goes wrong the losses can be severe. On the other hand, if the company has been growing in terms of revenues and profits (I prefer earnings per share to absolute profits) recently and still looks undervalued with a good industry outlook and a good leadership chances are that it will continue to grow and will have a limited downside. The results of the last few quarters can come in handy for this purpose.
#6. The stock must be suitable for appropriate portfolio diversification
‘Do not keep all your eggs in one basket’ is a very common advice given in the world of equity investing and there is a reason for this – it makes sense. Imagine investing all your capital in sugar stocks and the sugar industry collapses. The losses, in this case, could be heavy. It can even wipe off a large chunk of your capital and it can take years before you cover your losses. Investing all your capital in one theme or sector is too risky and retail investors are better off investing in a reasonably diversified stock portfolio. If you are bullish on a particular sector, invest a larger proportion in that sector, but keep it reasonable (say 20% of the portfolio size). The markets are uncertain and you don’t want to take unwarranted risks. So, no matter how good a particular company may look to you, if you have already invested in better companies belonging to the same sector, you should move on and look for companies in another industry.
#7. The stock must be suitable to your risk capacity and attitude
Enough about stocks and markets. Now let’s talk about YOU. Not all stocks will suit your risk capacity and risk attitude. You may be earning a limited amount and are in no capacity to lose the money you are planning to invest. Or you hate seeing the value of your portfolio go down too much even temporarily and are looking for relatively safer stocks to invest in. Investing in some stocks are definitely riskier than investing in others. Large-cap stocks are relatively less risky as their movements are limited and are less volatile. Small-caps are more volatile and hence look riskier than large-caps. So, before buying a stock the investor must take into account his/her risk capacity and risk attitude and chose his stocks accordingly.
If you take the above points into account before putting in any money into the stocks of a company, the probabilities of you reaping good profits may rise tremendously. This article was meant to introduce you to the main points you should consider before investing in stocks. I have just touched upon the points here and have not gone in detail about any of these. Books can be (and have been) written about each of these points. There is a lot to learn in the field of stock investing and if you have read this article properly you now know what you need to learn.
If you liked this article, I have one small request to you – share this article with all those you know who can benefit from this. Investing is one subject that is not taken seriously in our country and this results in people losing their hard-earned money by relying on ‘tip-providers’. This is a practice that must stop and I need your help to make an effort in this direction.
The author is a SEBI Registered Investment Adviser and founder of stock advisory portal PaisaPub.in
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