How to Select Shares to Buy?

“Long ago, Ben Graham taught me that ‘Price is what you pay; value is what you get.’ Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.” -Warren Buffett

Here are the eight essential steps that you need to follow for picking winning stocks to invest in the Indian stock market.

1. Does the company has Good Fundamentals?

2. Do You Understand the Products/Services offered by the Company?

3. Will people still be Using this Product/Service in 15-20 years from now?

4. Does the Company Have a MOAT (or Low-Cost Durable Competitive Advantage)?

5. What is the Company Doing that Its Competitors are not?

6. Does the Company has a Big Debt?

7. Is the Company’s Management Efficient and Qualified?

 8. Is the Company Constantly in the News and Overly Popular?

1. Does the company has Good Fundamentals?

To find the answer to this question, there is a 2-minute drill to find a fundamentally strong company. Using this drill, you can filter the financially healthy companies so that you can proceed to investigate further. If the company is not fundamentally strong, there is no need to learn more about its products/services, competitors, future prospects, etc.

You can move to the next steps only once you confirm that the company has given good past performance and is worth investing in. For this 2-minute drill, you need to look into the financials of the company. Here are 8 financial ratios and their trend that should be carefully noted in this step:

1. Earnings Per Share (EPS) – Increasing for the last 5 years

2. Price to Earnings Ratio (PE) – Lower compared to competitors and industry average

3. Price to Book Ratio (PBV) – Lower compared to competitors and industry average

4. Debt to Equity Ratio – Should be less than 1 (Preferably debt<0.5 or Zero)

5. Return on Equity (ROE) – Should be greater than 15% (Last 3 Yrs Avg)

6. Price to Sales Ratio (P/S) – Smaller value is preferred

7. Current Ratio – Should be greater than 1

8.  Dividend– Increasing for the last 5 years

To begin your 2-min drill. Once you are confident that the company fulfills most of the criteria mentioned above, you can start researching the company further.

These financial ratios, however, tells us about past performance. You cannot decide whether the company will perform the same or better in the future based on just past trends. Therefore, you need to consider other important factors too while evaluating a stock to buy in the Indian stock market. These factors are discussed in the next steps.

2. Do You Understand the Products/Services offered by the Company?

 You might ask why is it so important to understand the company. Let’s comprehend this with the help of an example. Assume that you have to choose a classmate for whom you’ll be paying for 36 months of expenses. In return for this, he/she will give you a quarter of his/her earnings thereafter for the rest of their lives. Whom will you choose?

While choosing, you must be thinking to select the one who is most likely to have a great income in the future. Further, will you choose a guy/girl randomly, whom you know nothing about? As you don’t know that person, there is no way that you can predict how much he/she will earn in the future. The same goes for stocks. If you can understand the stock, you can easily make an informed decision whether to buy, hold or sell the stock at any time. Hence, always invest in the companies that you understand.

There are a number of companies that everyone knows and understands. From toothpaste, soaps, towels, t-shirts, jeans, shoes to bikes, cars, airlines, banks; there is a company behind every product. Invest in such companies. Do not buy the stock of ‘ABC Chemicals’ without knowing what products it produces.

3. Will people still be Using this Product/Service in 15-20 years from now?

 The next step is to ask about the future of the company. Always look for a company with a long life. Such companies have huge growth potential and the power of compounding applies to such companies. Avoid investing in companies having a life of just a few years.

For example, do you think people will be using soaps 20 years from now? The answer is ‘Yes’. It’s been there for over 100 years and will surely continue in the future. Maybe the fragrance will change, but the soap will be there. Now, take another example. What do you think about pen drives? Do you think that people, 20 years from now, will still use pen drives? The answer might be no. Overall, select only a stock to invest in the Indian stock market that will last for the next 15-20 years.

4. Does the Company Have a MOAT (or Low-Cost Durable Competitive Advantage)?

“I like businesses I can understand. We’ll start with that. That narrows it down about 90% …There’s all kinds of things I don’t understand, but fortunately there’s enough I do understand. You got this big, wide world out there. Almost every company is publicly owned…You got all American business, practically, available to you. Now, to start with, it doesn’t make sense to go with things you think you can[‘t] understand. But you can understand some things. I can understand this. I mean you can understand this. Anybody can understand this. I mean this is a product that basically hasn’t been changed much…since 1886…and it’s a simple business. It’s not an easy business. I don’t want a business that’s easy for competitors. And I want a business with a moat around it. I want a very valuable castle in the middle. And then I want…the Duke who’s in charge of that castle to be honest and hard working and able. And then I want a big moat around the castle, and that moat can be various things.”

Warren Buffet (Source: Warren Buffett On Economic Moats)

 Invest in companies with ‘MOAT’

This concept of ‘MOAT’ was popularized by Mr. Warren Buffet. A moat is a deep, wide ditch surrounding a castle, fort, or town, typically filled with water and intended as a defense against attack. Some stocks have a similar moat around them. That’s why it’s really tough for its competitors to defeat them in its sector.

For example, Maggi (NESTLE)! It has become such a common name in Indian homes that Maggi is considered as a synonym to Noodles. Another example is Colgate– the toothpaste producing company. This company is dominating its industry and the people simply want to buy Colgate toothpaste. Similarly, Maruti Suzuki has got a moat in the passenger car sector. Maruti Suzuki has been in dominating in the Indian car sector with over 50% market share for the last few decades.

In addition, while selecting an ‘unbreathable moat’ look for such companies in which the switching cost is high. For example, Banks or IT companies. How rarely people change their bank accounts just because the competitor is giving 0.1% more interest rate. Coal India, ITC, IRCTC, etc are a few of the other Indian companies with big moats.

5. What is the Company Doing that Its Competitors are not?

Find the unique selling point of the company. Learn what this company is doing which its competitors are not doing.

To understand better, let us analyze the Indian automobile sector. There are a number of automobile companies in India. However, when we consider the passenger vehicles (Cars and SUVs), Maruti Suzuki is the leading company in India. There are a number of Indian and global competitors against Maruti in this sector like Tata Motors, Hyundai, Honda, Ford, etc. However, they have not been able to break the Maruti’s moat.

Maruti Suzuki is dominating because of its cost advantage and the easily available service centers that it provides. Most competitors of Maruti are not able to compete on its selling price. Further, Maruti’s service center can be found on every corner of the streets. It’s really simple and easy to get a Maruti car serviced even in small cities and that too at a little price. On the other hand, try to get your ‘FORD’ car serviced. You will rarely find any authentic ford service center around you. That’s why people prefer buying Maruti cars in India. And hence, Maruti Suzuki is able to increase its sales consistently and give good returns to its shareholders.

Overall, investigate first what the company is doing that its competitors are not before you select a stock to invest in Indian stock market. Whether you’re investing in a banking stock or Tyres, there will be many companies and competitors. Find out the USP of the company in which you’re interested to invest.

 

6. Does the Company has a Big Debt?

Big debts in a company are the same as the big hole in the boat. If the hole in the boat is not filled soon, then it won’t be able to cross the long sea and will definitely sink in between.

Before you select a stock to invest in Indian stock market, read its balance sheet to find out the debts on the liabilities side. Avoid investing in companies with big debts. Further, while investing the companies in the banking sector, look for its Non-performing assets (NPA). Avoid companies in the banking sector with huge NPA’s.

 7. Is the Company’s Management Efficient and Qualified?

This is one of the most crucial questions to ask before you select a stock to invest in Indian stock market. The management is the soul of the company. Good management can prosper the company to new heights. On the other hand, bad management can lead to the downfall of the company.

It is really important to research carefully about the management of the company that you plan to invest in the Indian stock market. First, do some research, and find out who is running the company. Among other things, you should know who its CEO, CFO, MD, and CIO are along with their qualifications and past experience. Next, here are a few points to check the efficiency of the company:

— Strategy and goals

Go through the Vision, Mission, and Value statement of the company. Together, mission and vision guide strategy development, help communicate the company’s purpose to shareholders and inform the goals and objectives set to determine whether the strategy is on track. These defined future statements for the company can help an investor to decide whether to select a stock to invest in the Indian stock market or not.

— Length of tenure of Management

This can help to judge the stability in the management of the company. A long length of tenure of the top management with the steady growth of the company is a good sign. However, sometimes, a change in management is considered an adept signal when the last management was not performing well enough. Nevertheless, the long tenure of good management in a consistently growing company is a sign of a healthy company.

— Promoter’s buying and share buybacks

The promoters of the company have the best knowledge about the company’s performance. The management and the top officials can understand the future aspects of the company and if they believe that the company will outperform in the future, they are mostly correct. Therefore, promoter’s buying and share buybacks are signals that the owners trust in the future of the company and it’s a good company to select a stock to invest in Indian stock market.

In addition, the other scenario, where the promoters or CEO is selling the stocks, is an independent activity and cannot be treated as a bad signal. We cannot judge the company’s future is in the dark just because the promoters are selling a small portion of their stocks once in a while. Maybe, the promoters need money to start another venture, buy a new house or enjoy a vacation. Everyone has the right to sell stocks when they need them the most, and so do the founders.

In short, the promoter’s buying and share buybacks are signals of a good company. However, we cannot judge the company’s future based on just the promoter’s selling little stock. Please note, if the promoters are selling a lot of stocks continuously without explaining the reason, then it’s a matter to investigate further.

— Perks and Compensations to Staff and Workers

If the company is giving good perks to its staff and employees, then again it’s a sign of good management. The results of a company depend a lot on the performance of its staff and employees. Happy employees will give their best performance.

However, if there is continuous strikes or increasing worker union demands, then it means that the management is not able to fulfill the needs of its workers and employees. Such cases are a bad sign for investors in the company.

— Financial ratios ROE and ROCE

The management’s efficiency can also be judged using a few financial ratios. Return on Equity (ROE) and Return on Capital Employed (ROCE) are the best tools to judge the management’s performance and the resulting potential for future growth in value.

ROE is the percentage expression of a company’s net income as it is returned as a value to shareholders. This formula allows investors and analysts an alternative measure of the company’s profitability and calculates the efficiency with which a company generates a profit using the funds that shareholders have invested.

ROCE is the primary measure of how efficiently a company utilizes all available capital to generate additional profits.

A high and steady ROE and ROCE for the last few couples of years is considered a sign of good management. As a thumb rule, invest only in companies with the ROE and ROCE of above 15% continuously for the last 5 years.

— Transparency

This is the last, but one of the most important factors while judging the management. The integrity of the management is the key to the growth of the company. It’s the management’s duty to be ‘fair’ and announce the quarterly & annual results to its shareholders honestly without any manipulations.

Just as the management takes the credit to announce the good results of the company; in the same way, the management should come forward in times of bad results to explain the reasons for its poor performance to its shareholders. Good management always maintains the transparency of its organization. 

8. Is the Company Constantly in the News and Overly Popular?

The stock market is based on the sentiments of the people. Overly popular stocks that are consistently in news affect the expectations and decisions of the public. These stocks can be inflated by the hype of the media. As people expect greater results from such companies, even after giving good returns the stock prices of such companies may fall.

That’s why try to avoid buying stocks of such companies for easy returns. The hot stocks are more subjected to market volatility and the boring stocks are the one, which gives the best returns.

Quick Tips: Apart from the above eight stock-picking tips on how to selfec t shares to buy in India, here are a few additional tips to select a stock to invest in the Indian stock market:

"Cheap isn’t always good, and expensive isn’t always bad"

While investing in growth stocks, sometimes it’s okay to invest the stocks with a high PE ratio. Some growth stocks have huge future potentials and can give multiple times returns. Moreover, while selecting an undervalued stock, you should investigate further why the stock is undervalued. Many companies sell cheaply because they do not have much growth opportunity in the future.

 Invest in Mid-cap companies for Higher Returns

 The mid-cap companies can give the best returns. These companies have the potential to become a large-cap company in the long term frame. They have a high growth rate compared to the large caps that have already reached saturation and the chances of giving multiple-time returns are highly unlikely.

In addition, Mid-cap companies have good capital to stay out of debt and live a long life. Overall, a good growth mid-cap stock can easily become a multi-bagger, i.e. a stock which gives multiple times returns.

Past results do not guarantee future performance

 Do not rely totally on the financial reports to select a stock to invest in the Indian stock market. These reports show the past performance of the companies. However, future growth depends on various aspects of management, competitors, industry, economy, etc. Always look at both the quantitative and qualitative aspects of the company before investing.

Summary: 

These are the key points to consider while choosing a stock to invest in. Now, let us summarize the 8 questions to answer on how to select shares to Buy in India for consistent returns:

Does the company have good fundamentals? 2-minute drill to filter companies using financials.

1. Do you understand the products or services offered by the company?

2. Will people still be using this product or service in 15-20 years from now?

3.Does the company have a low-cost durable competitive advantage?

4. What the company is doing that its competitors are not?

5.Does the company has a low debt?

6. Is the company’s management efficient and qualified?

7. Is the company constantly in News and overly popular?

8. Is the company’s and overly popular?.

That’s all for this post on How to Select Shares to Buy. I hope you have understood all the steps and questions to be answered before you select a stock to invest in the Indian stock market.

By

Ritesh.Sheth CWM^®

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