Secret of Stock Buying

Mint, 9/2/11

Secret of stock buying: lots of homework

A little research about the firm before buying its shares can fetch you rich dividends. Here are some of the key areas

In August 2009, the National Securities Depository Ltd (NSDL) crossed the 10-million mark of demat account holders through various depository participants. Another depository, Central Depository Services (India) Ltd has around 7.4 million investors on its platform. The NSDL website also says that as on 31 October 2010, the average number of accounts opened since November 1996 has been 3,663 per day.

Since the introduction of dematerialized form of stock trading, the ease with which shares can be bought and sold has attracted many to join the bandwagon of market investors. However, everyone is not equipped with the knowledge and expertise required to pick up the right scrips, which can outperform the market or at least not give negative returns. “For most people who do stock picking themselves, it is a part-time activity. They may not understand balance sheets, business scenario and government regulations. Sometimes, even if someone understands fundamentals, it may not be enough,” says Prithvi Haldea, chairman of primary market tracker Prime Database. So how do you go about picking up stocks if you are a newcomer? Is there a set of rules to be followed? Is there a magic formula? No, there is none.

However, there are some parameters that one should definitely look at before investing in a company. One of the core principles of Benjamin Graham, the author of The Intelligent Investor who inspired the likes of Warren Buffett at a very early age, was: “A stock is not just a ticker symbol or an electronic blip. It is an ownership interest in an actual business, with an underlying value that does not depend on its share price.”

First of all, differentiate yourself from traders. You should have a long-term investment horizon. Here’s a word of caution for you: “There is a difference between investing and daily trading. Traders enjoy markets as gamblers in the casino and eventually lose a lot of money,” says Haldea. Here are some of qualitative (fundamental) and quantitative (technical) parameters that may prevent you from losing money in the stock market.

Management: A good management will ensure that the interest of the shareholders is safeguarded. The experience of the management, especially in that particular industry and at similar companies, is a way to measure its dependability. However, do remember that “longer experience is obviously preferable but only if the performance of the company has been good”, says Tom Robinson, managing director-education division, CFA Institute, US.

If management has been there for a long time but performance is poor, it is an indicator that management may be entrenched and a change may be needed. If members of the management have been in the company for a short time, then look at the performance of the prior companies they worked with.

“Also for key positions, see that they have experience in their functional area. For example, it is more important for a chief financial officer to have a great deal of experience in the financial function rather than the industry,” adds Robinson. The exception, however, would be very specialized industries in the financial area, such as banks and insurance companies where both financial and industry experience are important.

Ajay Parmar, head (institutional research) at Emkay Shares and Stock Brokers Ltd, a Mumbai-based brokerage, says, “If the sector is facing issues, the way the management of a company reacts to get out of the problem can be a reflection of how good the company is. Take, for example, Tata Motors Ltd and Tata Steel Ltd. They were under huge debt after acquiring Jaguar-Land Rover and Corus, respectively, and people thought these were expensive buys. But both these acquired companies have started giving good numbers. The managements showed courage in these cases.”

Also while investing in the primary market, i.e. subscribing for an initial public offering, an individual should do a proper research about the management. “Track record of the promoters is crucial. Whether they were involved in some irregularity at the earlier company or how the company was doing when these promoters were there can give you a fair idea,” adds Haldea.

One can also look at awards and accolades that the management received in their earlier ventures.

Leadership position: The leadership position of the company among peers can also tell you whether it is investment-worthy or not. “See if the company is a leader in its industry and able to charge premium prices— for example, Apple. Also whether it is creating strong product demand or is a low-cost producer,” says Robinson.

However, if the company is not a leader, check how does it plan to earn above average returns for investors. This information can be obtained from company filings to the exchanges or any other statement releases.

Investors should, however, not always go by the leader—sometimes the market price reflects the leadership position but there may be better value for investors in other companies in the industry.

Haldea, too, has a word of caution: “Good shares at high prices is a bad investment. Good shares at low prices is a good investment. However, dips are not always good. It may be that market sentiment is not bullish but it is also possible that the company is not doing too well compared with peers. Look out if the price is falling due to change in the business scenario, management change or any regulatory change.”

Understanding the business: Peter Lynch, one of the most successful stock pickers in the history of US stock markets, always preached—“buy what you know”.

Back in school, our teachers asked us to question if we did not understand anything taught in the class. Reason: they wanted us to know exactly what a particular lesson meant or otherwise we would flounder while answering questions on that topic. The same applies when you pick a stock. If you do not understand the business and it does not make sense to you, better stay away.

Robinson adds: “Ask yourself, is this a business that should do well in the current economic environment and the environment expected in the next 5-10 years?” One should look at the foundation of the business and consider what the future can offer to that particular company.

However, an investor may not have insight to understand the business or time to do so. Haldea offers an alternative: “Check whether any venture capital or private equity firm is invested in that particular company. They screen the companies thoroughly via various rigorous tests before investing in them.”

Financial statements: At the end of every quarter, companies come out with their financial statements. These statements, if read carefully, can give you enough insight about the financial health of the company. You can deduce the key ratios and cash flow of the company from these statements. However, remember that understanding financial statements is not easy and is a specialized job. Also, companies at times play around with numbers to make the books look healthy.

“Focus on the income statement and cash flows first. See if the company is profitable. Check whether profit margins are improving or decreasing over time. Read the footnotes carefully to understand before investing. Then focus on cash flow. Lastly evaluate the liquidity and solvency of the balance sheet using metrics such as debt-equity ratio,” says Robinson.

Cash flow: Another way to gauge the strength of a company is through its cash flows.

“A company should not borrow money every now and then. It should have cash to finance small projects,” says Parmar. Strong cash flow is important to pay suppliers, employees, creditors, investors and others. “Investors should particularly look at operating cash flow. For a young company operating cash flow generally lags behind net income. For a more matured company, you would like to see operating cash flow on average exceeding net income (which includes non-cash charges such as depreciation),” says Robinson. However for all companies, as an investor you would like to see operating cash flow growing. It may fluctuate from year to year but there should be an upward trend over time. Lastly, check whether there is sufficient cash flow to pay for needed capital expenditures. If the cash inflow is not sufficient, where is the cash going to come from and how and when is it going to be paid back. Such information can be obtained from the financial statements and announcements made by the company.

Key ratios: Though many investors would not understand ratios or what they mean, there are a couple of such figures which are crucial and easy to understand. These ratios give a picture of the operating efficiency of the company.

Return on equity (RoE): RoE is a key ratio for investors. It enumerates the amount of return in the form of profit the company is generating from the money invested by investors. The ratio looks simultaneously at profitability, leverage and efficiency of the company. Generally an RoE of 15 is considered good for companies across various sectors but it may vary. For example, it may be low for companies which require heavy capital infusion for operations and expansion. One would prefer an RoE that is higher than other companies in the same industry but the same caveat from leadership position above applies—if RoE is high but the stock price is also high relative to earnings, the company may not be a good value.

Debt-equity ratio: Debt-equity ratio is a measure reflecting the proportion of equity and debt that the company has employed to finance its assets. An investor should look out for the level of the ratio. A high debt-equity ratio at one particular point of time is not bad, but an investor should look at the trend. A high ratio over a period of time may not be good. “Some debt is good if RoE is strong but if RoE is low, it may be unwise to take on debt. If debt to equity is very high relative to other firms in the industry, then the company has more risk,” says Robinson. Investors may still invest but they need to understand that risk is high and a higher return would need to occur to compensate the investor for higher risk.

If you can take the pain of looking at the above-given parameters, then you can surely shortlist a bunch of best deserving shares for your money. But do remember to diversify—the dictum “don’t put all your eggs in one basket” is sacrosanct.

Also, apart from keeping a long-term horizon, it is important to check your greed. Says Haldea, “You should know the target and should exit when achieved. On the other hand, do know your stop-loss and exit at the same.”

And, of course, don’t be a gambler but an investor and do value your money.

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