One common mistake investors make is by asking what to buy? But instead, investors should ask what not to buy! Because by knowing what should be avoided, investors will learn to pick true jewels of the stock market. Simple companies with easy to understand businesses turn out to be wealth creators in the long run. For example, if you would have invested in Nestle (the famous Maggi maker) at the start of 2017 then by Dec 2019 you would have made a compounded return of over 30%.
“The difference between successful people and really successful people is that really successful people say no to almost everything.” -Warren Buffett
Warren Buffett has always focused on quality over quantity and picking quality stocks will come through elimination. Now before picking a stock, you should ask yourself only 10 simple questions:
1) Does the Company innovate? – A company has to keep updating its technology to improve efficiency. Kodak, Nokia are examples of big brands which failed to innovate and ignored the power of technology. When better products came into the market, these companies suffered because they didn’t update themselves.
2) What is the size? – Avoid a small fish in a very big pond such as a JK Tyre. In fact, prefer large companies in a big pond such as MRF because with their scale, networking and brand power they will be able to grow faster when times are good. As seen from the chart, JK Tyre has given -39% while MRF has returned 61% absolute returns to investors in the past four and a half years.
3) Is it a falling knife? – Never put your hands in a stock which is already falling. PC Jewellers, Suzlon are examples to stay away from in order to avoid making losses.
4) Is it a low ROE business? – The sole reason for investments is returns and a company with a history of low ROE won’t improve overnight. Investments in high ROE companies will create value for shareholders.
5) Should you look for cyclical plays? – Cyclicals such as cement, sugar, auto can be loss-making when picked at the peak of their cycle. Timing is everything in cyclicals and requires caution. Therefore, secular companies are safer than cyclical.
6) Are the shares liquid enough? – When a stock suddenly falls, you panic and want to sell it but can’t; it is all because of low liquidity. Lower volumes and liquidity will prevent from finding buyers when you want to sell a stock or vice versa.
7) Does it have poor corporate governance? – Satyam is an example of poor corporate governance. Management and board of directors should be ethical and reliable.
8) How transparent is the Company? – Companies should explicitly disclose their related party transactions to maintain transparency to avoid cases such as the Karvy episode. A qualified auditor’s report is also essential to highlight the authenticity of a Company’s transactions.
9) Is it a penny stock? – High risks can make higher returns but it can also make you lose money if the company goes bankrupt or if a scam surfaces. It is best to avoid penny stocks.
10) How much has the promoter pledged and how much do promoters hold? – Companies with a high promoter pledge or low promoter holding are red flags. To release pledged shares, the Company will have to generate sufficient cash flows. Also, a low or declining promoter holding may imply that the promoters don’t have faith in the growth of their own company. If a promoter himself is invested in his own company, then he is more prone to take unbiased business decisions and will allocate capital keeping the longer objective in mind.
Investors who ask these 10 questions will be able to avoid riskier and default making companies. Additionally, companies with high debt or who are capital hungry and are always looking for regular CAPEX should be avoided. Such companies might provide lower returns on investment as they might not be able to generate returns at the same rate as the capital infused. Airline and infrastructure industries belong to this category.
Safe investing should be your new mantra! Long term secular bets with consistent earnings will prove to be good return generators. Investing in a group of stocks will also help you make money as it will provide sufficient diversification and margin of safety. StockBasket is a product which has baskets curated keeping all the above 10 points in mind. Companies with high debt, poor corporate governance, bad visibility, cyclical, lack of innovation or transparency and illiquidity are excluded from StockBasket which makes it a reliable product for long-term investments.
Begin right and learn to say NO to low quality stocks to create wealth!