A beginner’s guide on how to select a stock to invest: So, you are interested in the stock market and want your money to grow. You have read a number of investment blogs, financial magazines and subscribed to the Stock TIPS and recommendations from different brokers.
However, you are afraid to take the next step. You know that over 90% of people lose money in stock market. Most of them lose because they do not do their homework first and rely mostly on their brokers to select a stock to invest in Indian stock market. Therefore, you decide to take the matters in your hand and intelligently select a stock to invest in Indian stock market. You know that by doing so, either you will win or you will learn. No, a third way.
If you are one such investor and want to smartly select a stock to invest in Indian stock market for consistent returns, then you are at the right place. In this post, I will explain to you 8 steps with questions to be answered to select a stock to invest in Indian stock market to avoid loss and get consistent returns. So, be with me for the next 10-15 minutes to learn the secret to intelligently select a stock to invest in Indian stock market.
8 steps to select a stock to invest in Indian stock market
“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 (or checklist) that you need to follow for picking winning stocks to invest in Indian stock market:
1. Does the company have 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 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:
- Earnings Per Share (EPS) – Increasing for last 5 years
- Price to Earnings Ratio (P/E) – Low compared to companies in the same industry
- Price to Book Ratio (P/B) – Low compared companies in the same industry
- Debt to Equity Ratio – Should be less than 1 (Preferably debt<0.5 or Zero-Debt)
- Return on Equity (ROE) – Should be greater than 20%
- Price to Sales Ratio (P/S) – Smaller value is preferred
- Current Ratio – Should be greater than 1
- Dividend – Increasing for the last 5 years
If you are not familiar with these financial ratios, you can read more here: 8 Financial Ratio Analysis that Every Stock Investor Should Know
Once you are confident that the company fulfills most of the criteria mentioned above, then study the financial reports of the company. Reading financial reports (Profit & loss statement, balance sheet, and cash flow statement) can take a little time. That’s why first make sure that the company passes the 2 min drill before you start investigating further. I have written a detailed post on how to read financial statements of a company, which you may find useful.
These financial results, however, gives the past growth. 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 while evaluating to select a stock to invest in Indian stock market. These factors are discussed in the next steps.
2. Do you understand the products or services offered by the company?
After filtering the companies based on their financial fundamentals, you need to investigate the company. Understand the company first. Learn about its products and services. It’s important that the company is easy-to-understand and has a fairly straightforward business model.
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 which 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 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 take a good 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 Pharmaceuticals’ without knowing what medicines/products it produces.
3. Will people still be using this product or service in 15-20 years from now?
The next step is to ask about the life 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 in 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 a pen-drive or USB manufacturing company? Do you think that people, 20 years from now, will still use pen drives? The answer is no. Overall, select only a stock to invest in Indian stock market that will last for the next 15-20 years.
If you want to learn stocks from scratch, I will highly recommend you to read this book: ONE UP ON THE WALL STREET by Peter Lynch- best selling book for stock market beginners.
4. Does the company have a 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 ‘MOAT’ concept 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, Colgate! It has become such a common name in Indian homes that Colgate is considered as a synonym to toothpaste. Another example is Cadbury– the chocolate producing company. This company is dominating its industry and the people are even ready to pay a lot more to buy its products. Similarly, Tata Motors has got a moat in ‘truck’ sector. Tata Trucks has been in dominating in the Indian automobile sector for the last 5 decades.
In addition, while selecting an ‘unbreathable moat’ look for such companies in which the switching cost is high. For example, Banks. How rarely people change their bank accounts just because the competitor is giving 0.5% more interest rate. Coal India, ITC, Asian Paints are 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 it’s competitors are not.
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 competitors against Maruti in this sector like Tata Motors, Hyundai, Honda, Ford etc.
Nevertheless, Maruti Suzuki is dominating because of the easily available service centers that it provides. 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. 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.
6. Does the company have 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. When you select a stock to invest in Indian stock market, read its financial documents carefully. Avoid companies with big debts. Many times, the accountants use the financial loopholes to hide the debt in their annual results. However, if you read the financials minutely, you will be able to find these debts, as the financial sheet always needs to be balanced.
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. A good management can prosper the company to new heights. On the other hand, a bad management can lead to the downfall of the company. Hence, it’s 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. Hence, 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
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. Nevertheless, the long tenure of good management is the 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 declining 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 it the most, and so does the founders.
In short, the promoter’s buying and share buybacks are signals of good company. However, we cannot judge the company’s future based on the promoter’s selling the 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 workers 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.
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 20% continuously for the last 5 years.
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 give a ‘fair’ quarterly and annual results to its shareholders. Just as the management announces the good results of the company; in the same way, the management should come forward in the times of bad results to explain its reasons to its shareholders. A 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. Consistent news affects the expectations and decisions of the public. Stocks, which are popular in news, can be inflated by the hype of the media. As people expect great results from such companies, even after giving good returns the stock prices of such companies fall. That’s why try to avoid buying stocks of such companies for easy returns. The hot stocks are subjected to market volatility and the boring stocks are the one, which gives the best returns.
A Few Other Quick Tips
Here are a few additional tips to select a stock to invest in 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 P/E 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. For example, Coal and mining sector.
— Invest in mid-cap companies
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 which 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, etc. Always look at both the quantitative and qualitative aspects of the company before investing.
These are the key points to consider while choosing a stock to invest in. Now, let us summarize the 8 steps with questions to be answered to select a stock to invest in Indian stock market:
- Does the company have good fundamentals? 2-minute drill to filter companies using financials.
- Do you understand the products or services offered by the company?
- Will people still be using this product or service in 15-20 years from now?
- Does the company have a low-cost durable competitive advantage?
- What the company is doing that its competitors are not?
- Does the company has a low debt?
- Is the company’s management efficient and qualified?
- Is the company constantly in news and overly popular?
That’s all! 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.
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Let me know what do you think about the steps discussed in this article in the comment box below. In addition, if you have any doubts regarding any step mentioned in this article, feel free to comment. I will be happy to help you out. Keep learning and Happy Investing.
Hi, I am Kritesh (Tweet me here), an NSE Certified Equity Fundamental Analyst and an electrical engineer (NIT Warangal) by qualification. I have a passion for stocks and have spent my last 4+ years learning, investing and educating people about stock market investing. And so, I am delighted to share my learnings with you. #HappyInvesting