Investing in direct equity may not be everyone’s cup of tea, but it isn’t very complicated either. As long as you are aware of the risks involved, following some simple rules and applying a lot of common sense may help you pick the right stocks. The key is to understand the company instead of relying on tips from friends and brokers.
Look around you
Let’s refer to a “Lynchlike” approach (courtesy One Up on Wall Street by Peter Lynch) to investing in stocks, which encourages looking around you for stock ideas. The best place to begin looking is your own home, in your weekly shopping list or among the things you use daily.
Have you noticed how the word “Parachute” has become synonymous with coconut oil and “Saffola” with refined cooking oil? Look further and you’ll find the same company, Marico Ltd, manufactures both the products and also owns a top skincare chain, Kaya Skin Clinic. Havells India Ltd (switchboards and fans), Dabur India Ltd (REAL fruit juice and honey) and Pidilite Industries Ltd (Fevicol, Fevi Stik and M-Seal) are a few more stock ideas you can get from things you see or use.
If you run out of ideas in your house, look out of your window and you’ll find many more ideas staring at you. For instance, Bajaj Auto Ltd (motorcycles and scooters) and Shree Cement Ltd (cement). Stock prices of these companies have increased between 16.9% and 32.26% compounded annual growth rate (CAGR) in the last five years owing to a spurt in consumption and infrastructure investment in the Indian economy. Compared with this, the Nifty index has yielded 10.91% CAGR over the same period.
Look at Bharti Airtel Ltd—15 years ago, few could afford to own a cellphone; today almost everyone has one. A thought about your own cellphone usage over the years will confirm the theory. Since 2002, the stock has risen almost 10 times.
Do some research
Once you have narrowed down on an idea, begin your research. Start by analysing basic parameters such as sales and profit growth over the last few years. The relevant data can be found in the archives of www.nseindia.com or on the official website of the company. Next, dig in a little deeper.
Debt: Taking a loan means interest payment, which can strain the earnings of a company just as a housing loan strains the income of a family. While looking at the balance sheet, compare the amount of debt versus shareholder’s equity; typically, a ratio under 2:1 is considered healthy.
Return on equity (ROE): This is basically a company’s earnings (net profit) divided by the shareholder’s equity. This ratio shows how much profit a company generates on shareholders’ money. It is an indication of the level of return you can expect to make.
For example, Asian Paints Ltd is a high-growth business benefiting from the real estate boom in the country over the last 10 years. The ROE for the company, as per its annual report, has consistently remained above 30% for the last five years and at 56% for 2009-10.
ROE doesn’t necessarily translate into stock returns in a particular year; rather it is an indication of returns to be made over a period of time. For instance, the annual returns of Asian Paints have been positive every year in the last five financial years, except in 2008-09, when even the ROE and net profit declined. Since the business (net profit) has continued to grow, the stock price increased close to 160% in 2009-10. This reflects a consistently high ROE and makes up for the lost returns (stock price) in the previous year.
Typically, stock returns are higher than ROE if growth expectations are high and lower if growth expectations are low.
Cash on books: Looking at this number helps determine the company’s ability to pay back any debt and continue its operations along with managing growth and expansion. Ascertain the cash available with the company and also see if it is being utilized to enhance assets and operations.
Price-earnings (P-E) multiple: An important market-linked consideration, P-E is the net profit divided by the number of shares issued. It indicates whether the stock price is in line with expected earnings growth rate. As a rule of thumb, a high growth company should have a relatively higher P-E as compared with others in the same industry. Further, P-E of a company changes with changes in its earnings perception. P-E needs to be seen in the context of the industry or the company’s own historical P-E.
For instance, Bajaj Auto’s P-E in May 2008 was 11.1 compared with 16 for Hero Honda Motors Ltd. Hero Honda had posted a 32% increase in net profit for 2008-09 versus a decline of 16% for Bajaj Auto. In 2010, the Indian two-wheeler industry grew 23%. Moreover, innovations, product launch and positioning helped Bajaj Auto recover. Subsequently, its stock price increased and so did its P-E—it was 16.9 in April 2010 following a stock price and earnings growth of 200% and 160%, respectively. It was now on par with Hero Honda’s P-E of 17.4. Bajaj Auto was very attractive at a low P-E given that its future growth prospects hadn’t diminished much.
Others: A few more checks to run include the shareholding pattern and dividend history. Additionally, through new and published reports try to track the top management of the company; people are key to businesses.
Go by fundamentals, not trends
While in one quarter, banking stocks could be in favour, metals could take over in the next. But don’t get swayed by the trend and instead keep your focus tight on company fundamentals. By following a trend, you may end up buying close to the peak and selling too soon if the stock shows weakness.
Also, just because the stock price falls doesn’t mean you panic and sell. As long as the fundamentals are sound, you need not sell. For instance, in the second half of 2008, Havells corrected 50% in six months. However, the fundamentals of the company, driven by domestic demand and consumption, had not changed significantly to warrant such a sharp correction. Investing in Havells at that time would have yielded returns of nearly 75% CAGR today.
Track your stock
Once you’ve bought your stock, read up about the company, follow the management’s releases and implications of any new announcements. Also, track other things such as raw material costs, change in products portfolio or prices, changes in the management profile and ownership. Sometimes even the government regulation impacts products and prices. A good source of information is the annual report published at the end of every financial year.
Remember that stock market investment works only in the long term, so you will have to take near-term volatility in your stride. Investing in stocks need not be a daunting task, just apply your good judgement.
Disclaimer: The stocks mentioned in this article are not recommendations. The companies will have to be studied before investing.