Equities by nature are dynamic and complex, with multiple qualitative and quantitative factors impacting their value. This requires active investors to spend a lot of time in deciding on how to choose stocks, and then staying on top of their investment decisions with regular monitoring and adjustments as needed. In such a scenario, while it is difficult to come up with a rigid set of rules to select right stocks, here are seven best practices that have stood the test of time.
Understand the business model of the company: A business model is a description of how the company will operate to generate revenue and profits. You should invest in stocks that have an easy-to-understand, straightforward business model, as you can only monitor and assess what you understand. You may consider stocks of niche industries if you have an advanced knowledge about the space and can understand what other investors might find difficult to comprehend about the company’s business.
Get to know the industry: To pick good stocks it is important to understand the industry in which the company operates in. While studying the industry, you should try to gain a good understanding of the economic/business forces that drive the industry, its attractiveness with respect to market size, profit pool trends and key success factors.
Know why this company will succeed: Companies generate long term wealth due to the competitive advantages they build over their peers. Examples are network effect of Microsoft in enterprise software, distribution reach of ITC in FMCG, innovation of Apple in consumer electronics etc. A smart investor must know about the competitors of the company, understand why a particular company has an advantage over its competitors and if the advantage is sustainable.
Analyze Company financials: Leverage financial reports published by the company along with any available analyst reports to get a clear picture of current financial health of the company and its performance over time with its competitors. Ensure that you have evaluated the balance sheet and are comfortable with companies existing assets and liabilities. In the end, do check upon common financial ratios that signals company’s financial fitness (e.g. Valuation ratio - P/E, P/BV).
Invest in strong brands: Overall it is best to go with eminent and highly regarded brands for long term gains. This may mean that you can miss out on few brands of tomorrow (as they may be small brands now) but historically big brands have delivered sustained profits over long term. If you are moderately aggressive you may consider including emerging brands growing rapidly and offering innovative new niche solutions.
Weigh in Management and Corporate Governance: Strong and capable senior management is the backbone of any successful enterprise. Check upon details of top officials - how long they have been with the company, their credentials, roles and responsibilities and industry credibility. Also ensuring that the management follows right corporate governance practices and safeguards the interest of the shareholders (e.g. ITC, Infosys, L&T).
Stay on top of events but do not worry about everyday volatility: As a long term investor, once you have invested in a stock, you should dig in for the long ride. You must make yourself comfortable with short term price fluctuation which is natural for stocks. Having done your research, continue to keep yourself educated and be confident about the quality of your company. Do not chase hot tips and react on word of mouth information coming from any source. At the same time, it is important to understand where your early call may have gone wrong, and correct it by a timely exit if you see things moving differently than you expected for a few quarters, or any serious management issues.
Given the complexities in picking the right stocks for long term value creation, there can be exceptions to every rule laid out above. However, employing these simple principles will help you identify good set of stocks that are worthy of your investment for long term wealth creation. That said, if you are a common investor with limited understanding of these complex variables, and not enough time to devote in studying and regularly tracking these variables, then you may be better off investing in professional managed ‘Equity mutual funds’ and let the experts do the job for you at a small cost, which anyhow pays back with the advantages it delivers!
The author, Amar Choudhary is CEO & Co Founder, FinAskus.