What to Look For While Investing in Stocks?

Introduction

This article is for those who have made up their mind to invest some money in the stock market directly. They do not prefer mutual funds. They are going to be in the market for the long haul and are not going to speculate. They are looking for a method to identify good businesses and become their partners. What they expect from this undertaking is to preserve their capital, be able to beat inflation effectively, and also compound their wealth at a decent rate. In due course of time, when their portfolio has grown to become big enough, they might have an option to live off the dividend income during their retired life.

For those who have come looking for stock tips, a hidden opportunity, or an easy way of making quick money, my confession is that I don’t know of any.

This article is going to have three parts. Firstly, I will give some suggested pre-conditions for investing in the market. Secondly, I will explain a few generalities and lastly, we will discuss the specifics.

The Pre-conditions

If you want to invest in the stock market, you have to develop a personal approach or a process. It may be an orderly system of thinking or a list of DOs and DON’Ts. It is preferable to have it in writing. First of all, you should outline a few pre-conditions for yourself that you will not violate. Some suggestions, in this regard, are as under:

Be very clear in your mind that you want to invest and not speculate as these are two very different styels and mindsets. You cannot make the same preparations for winters and summers.
Make a distinction between risk and volatility. Volatility is the measure of periodic gyrations in the market whereas the risk pertains to the quality of a particular business and your expecations from it.
Work on your risk profile. See at what stage you are in your financial and professional life, how many dependents you have and what are your major financial goals. The risk profile will not determine whether you should invest or trade in the market. Instead, it will help you decide on your style of investing which I will come to a little later.
Pre-commit to yourself that any money that you are likely to need in the next 5 years, you will not invest in the stock market.
Know that stock market is a platform for long-term wealth creation. You cannot possibly churn out regular income from it through trading. However, it can be turned into a regular income generating machine through dividend-based investing but that would need a lot of capital: roughly 20 times of your annual expected income from dividends.

Some General Points

The stock market is a ferocious animal if approached casually. Therefore, one must have a basic know-how of the market operation. You may read a few books and watch some Youtube videos to develop a basic understanding of the market. To read my blog post on this subject, please click here.

Here, I will give some general principles of investing and an overview of the market, before going into the specific details of how to analyze a company and select a particular stock.

Specifically, in the stock market and generally, in investing, it is advisable to figure out first, what is not to be done and then gradually narrow down to what should be done. It is an essential part of the system of thinking that you are trying to develop while you invest in the market. In other words, first finalize your DON’Ts and then gradually work towards your DOs. If you don’t do this, your investment decisions will become erratic and the overall efficiency of your portfolio will deteriorate significantly. Let me quote Warren Buffett here. He said, “What counts for the most people in investing is not how much they know, but rather how realistically they define what they don’t know. An investor needs to do very few things right as long as he avoids big mistakes”.
Stock market is organized into various sectors of the economy e.g. autos, infrastructure, commercial banks, insurance, oil and gas exploration companies, oil marketing companies, food and personal care, IT and communication, fertilizers, pharmaceuticals, and many others. Every sector has its own perculiarities. Study each of them to know what it offers in terms of opportunities and challenges.
No effort should be made, especially in the beginning, to time the market. Decide a date on which you are going to put a fixed amount into the market every month and follow it strictly. This is called dollar-cost averaging or systematic investment plan (SIP).
Have a deliberate strategy with regard to diversification of your portfolio. Stock market offers the best possible opportunity to deversify like no other asset class does. There are multiple ways you can diversify in stock market. Make use of various sectors of the economy to ensure horizontal diversification and dollar cost averaging to achieve vertical (time) diversification. There are some other parameters across which you can diversify. Keep your risk profile, major financial goals, the time horizon and the peculiarities of various businesses in mind while diversifying. Don’t overdo it.
To ensure proper diversificatioin, how many stocks you should have in your portfolio is an important question and merits a thoughtful consideration. Although many permutations are possible in this regard, here is a suggested one:
- From across the stock market, shortlist 7-10 sectors for investment, keeping in view their peruliar characteristics and your expectations from each.
- Select 1-3 companies from each sector after thorough research and comparison.
- This should give you a list of 20 companies, roughly.
- You should invest in 10-20 different stocks. 15 is a good number.
- Consider two market leaders in the shortlisted sectors for investment. Evaluate them on multiple parameters. Details, in this regard, will be covered in the next part.
It is very imortanl to know and implement your own style of investing, in line with your risk profile. In stock market, you come across many types of businesses, however, following are more relevant. This is going to help you make your choices and refine your investment strategy.
- Growth Stocks. These are relatively small size companies at an early stage of their life cycle where they are going to need a lot of cash for development. Whether these are going to become successful businesses or not is not clear. Most of the start ups fall in this category. From investment point of view, these are suitable for young investors and unsuitable for those who are over 50.
- Value Stocks. These are those companies which are fundamentally strong, fairly old and well established but are out of favor in the market due to some temporary reason and, according to your research, are available at lower earning multiples or discount. You tend to believe that when the market “wakes up” and corrects its mistake, the price of these companies is going to go up significatly. From investment perspective, these may be considered by the investors of any risk profile.
- Yield Stocks. These are mature and stable businesses with predictable earnings. Since they don’t have any big plans to grow further, they have a lot of free cash which they keep dispensing in the form of dividends. From an investment point of view, these companies are most suitable for senior citizens or retirees but may be considered by other categories of investors.
- This categorization is bit of an oversimplification and is only for the purpose of giving a basic understanding, otherwise most businesses are much more complex and don’t neatly fit into one of these categories.

Specific Points

In this section, I will discuss the process of individual stock selection and what percentage of your total investment you should allocate to a particular stock.

While your portfolio is like a building, the individual stock is the basic brick. Hence, the overall strength of the building will depend on the quality of each brick that you are going to select.

With regard to the size of each investment, you should, first, decide on a priority within your shortlist, according to a criterion. Then allocate capital to each shortlisted company. Your best selection should get a maximum of 10% and the minimum you allocate to a company should be 5%. This is only a suggested solution and there can be other ways of doing it as well.

Suggested Stock Selection Criterion

Now we come to the crux of the matter: the stock-picking which, you may say, is the core of investing. The bottom line should be to buy good quality businesses, with a fairly long track record, at reasonable prices. A suggested criterion is summarized here. It is better to analyze numbers, wherever applicable, for the last 5 to 10 years.

Analysis of Financial Statements

Basic knowledge of accounting is necessary for stock selection. You should know how to interpret numbers given in the balance sheet, income (aka profit and loss), and cash flow statements.

Price to Earnings (P/E) Ratio

This ratio gives you a sense of how expensive or cheap a particular stock is, relative to its earnings. Good quality stocks at low P/E are preferable but quite rare to find. The average P/E ratio varies from sector to sector. For example, pharmaceutical, technology, and consumer goods will have a higher P/E than cement, steel, banks, and insurance. Therefore, P/E ratios of various companies should be compared within the sector.

Earnings Growth

If the earnings of a company are growing consistently, it is a very good indicator. If you can find such a company at a relatively low P/E, you should consider buying it. If you are able to predict the growth trajectory of earnings with some degree of accuracy, you may even pay more for such a company.

Earnings and Cash Flow

It is very important to see the cash flow situation of a company while seeing its income/ earnings. While the income is shown in the income statement, cash flow is what the company actually receives. Therefore, if cash flow is, more or less, equal to the income, it is indicative of good financial health of the company.

Return on Capital Employed (ROCE)

This ratio, expressed in percentage terms, shows how much the company earns on the capital employed, including debt and equity. Obviously, a company that makes 10 on 100 is better than the one that makes 5 on 100, in a given period. ROCE has nothing to do with the share price. A similar ratio is return on equity (ROE) which compares only the equity with the return.

Dividend Yield (DY)

If a company has a good track record of paying dividends, it ought to be a good company. If you can see steady growth in the dividends, it is even better. The dividend yield is the ratio, expressed in percentage terms, between the dividend and the share price. You may also factor in the payout ratio, which shows how much the company is paying in dividends and how much it is retaining for other purposes e.g. 60% payout ratio implies that 60% of the income is going into dividends every year and 40% is being retained by the company. Now, obviously, a 10% DY for 50% payout ratio is better than a 10% DY for a 90% payout ratio.

Debt to Equity Ratio

The company with a lower debt is better than the one with higher debt. Therefore, the companies owing higher amounts of debt should be avoided.

Brand Equity and Pricing Power

The companies owning some strong brands should be preferred. Such companies will invariably have a pricing power which is an important prerequisite for a good company that will continue to make money for a long time. For example, you can’t have a strong brand in the cement or steel industry. The companies in these sectors don’t have pricing power because all cement or steel is alike and the sole consideration for the buyer to buy is low price. Such businesses are called commodity-like businesses and they compete by lowering their prices rather than on the strength of their brands. On the contrary, Apple, being a strong brand, can dictate the prices of its products.

Public/ Government Sector Entities

Avoid investing in public sector/ government-owned entities due to their inherent inefficiencies, political/ bureaucratic interference, and sluggish business practices.

Cyclical Businesses

Avoid cyclical businesses for these are not good compounders of wealth. Examples are autos and infrastructure (cement, steel, and real estate) companies. If you must invest in these sectors, consider the market leaders only.

Recession-Proof Companies

Some companies continue to perform well even when the economy goes into a recession. Identify such companies and invest in them. For example, a good company making soap or toothpaste. A recession in the economy might hit auto and infrastructure companies very badly but since people will continue to buy small items of daily use in the same way even during a recession, these companies will continue to perform well, earning a lot of cash for the shareholders.

Market Share

See the market share of various companies in the sector under consideration. Only consider the top 2-3 companies in market share for a deeper analysis. Go further down only if a particular company looks exceptionally promising due to some other factors.

Bonus Shares

Give zero importance to a company issuing bonus shares. Only a rudimentary knowledge of accounting is enough to understand that issuance of bonus shares or splitting shares is only a book adjustment or a non-cash transaction and is neutral from the investor’s point of view. It is only an accounting gimmick and doesn’t say anything about the performance of the company.

Conclusion

I have tried to put together a way of going about investing in the stock market. These are mere suggestions for consideration and, by no means, the only way of doing it. However, I will re-emphasize one thing here. The stock market should be approached systematically. It is an assortment of different businesses and gives you an opportunity to become equal partners in good businesses to the extent of your shareholding. Expect from your investment as much as a particular business is earning. If the company continues to perform well consistently, earning multiples re-rating will also happen eventually, however, no time frame can be given for that. Therefore, stay invested in a good company. Approaching the market with some other ambition can be perilous.

How did you find this content? Please comment and give suggestions, if you have any.

My other articles you may find useful are:

How to Make a Personal Financial Plan – Basic Considerations

Personal Finance – A Suggested Checklist

Investment vs Speculation

A Brief History of Money

Why I Started a Blog on Personal Finance

Anatomy of Financial Risk

Debt, Equity, and Real Estate: An Overview

Retirement Planning

How to Compare Equity and Real Estate as Investment Options

How Stock Market Works and How to Work in Stock Market?