The Science and Art behind stock selection
Investor’s selection of stocks is influenced by their risk appetite and the time horizon for which they intend to hold the stock – short term or long term. An investor invests in shares to build wealth in the long-run, whereas, in my view, short term approach is not investment, its rather speculation. Reasoning being, during a short period (less than one year), the market tends to overreact and can remain irrational. The volatility, kindled by everything from an abrupt escalation of border tensions to sudden spike in COVID cases are impossible to gauge or hedge against.
Hence, in my standpoint, selecting and allocating funds to the right shares with a long term investment horizon, ranging from 3 to 5 years, can be more lucrative than returns derived from investing in other asset classes – especially real estate or fixed-income assets.
However, this statement is a mainstream note in all investment blogs and pieces of literature. What potential investors don’t know and they yearn to find is the right stock, that company which has an great growth trajectory ahead and can create wealth for investors..
How can one choose the right stock during the initial stages of investment?
If you are a new investor, you need to become familiar with the basic terminologies revolving around in the equity and investment space, like CMP, PE Ratio, EPS, CAGR, etc. There could be a thousand of such terms. As a novice investor, you can begin your journey by investing in a staggered manner. As your breath of knowledge and experience widens, so will your exposure.
When you decide to invest, it’s essential to have done some research, reviewed stock fundamentals, and identified its potential. The effort you dedicate for the same is what really makes it an investment, otherwise, it would be pure gambling.
I consider gambling to be the allocation of monies upon something the outcome of which is uncertain.
Here are some important guiding principles that a beginner should adhere to whilst investing:
- The management integrity, capability, and history should be good,
- The company should have survived for a reasonably long period of time,
- The company should be profitable with Return on Equity of at least 15pc,
- The Debt-to-Equity ratio should be below 1
- Growth in revenue
- Strong balance sheet
- The company should be paying regular and reasonable dividends,
- Operating margins should be above 15pc,
- The company should be spending on product innovation and brand building,
- The taxes paid should be near the rate prescribed by the Government.
The above-mentioned points are self-explanatory and exhaustively analysing each would rather elongate this article. However, I would like to emphasise on the first point, which I believe is extremely crucial. Investing in a company is like you are giving your hard-earned money to the promoters/management of the company, as the company’s long term performance is a reflection of the intention and calibre of its management. In the last decade itself, big companies have come under scrutiny and made headlines owing to massive scandals, Yes Bank, DHFL, IL&FS to name a few. Along the same lines, big names like Jet Airways and Gitanjali have followed suit to underline how pivotal the management’s calibre and intention is to its performance.
Integrity is impossible to measure. It’s not like PE ratio, Debt/Equity ratio, OPM etc. But still, it can be gauged using various indicators. There isn’t an exhaustive list, but here are some indicators that would raise a red flag:
- Promoters spending on a multimillion-dollar penthouse when their company is navigating with a heavy debt on their books.
- Management remuneration increasing despite the falling performance of the company.
- Handsome profits generated by the company, but nothing goes into buybacks, dividends nor for Capex plans.
- Promoters involvement in illicit acts or acts that are condemned by its stakeholders. If a company are spearheaded by promoters belonging to this class, it would be rather impossible to expect performance as flaws like these are difficult to overcome.
Again, if these factors exist, it does not necessarily mean to avoid the stock, but you should look for counter-evidence. For example, a company which does not pay a dividend each year (RISK) yet comes up with a buyback (RISK MITIGATION), at a premium price and for a decent quantity, every 3-5 years.
All in all, an investor must consider the history and activity of promoters before investing in a stock. A simple google search will prove useful.
Why the finding of right stocks to buy is hard and important?
However, all investors do not act rationally despite knowing all these issues as discussed. They may neither have the time nor the ability to arrive at a perfectly optimal decision. Also, most of the times they are just careless. Investors strive to make good decisions by simplifying the choices available, using a subset of the information available and avoid looking at some other possible alternatives metrics to choose the stock. Some investors select stock without attempting to find the optimal rationale. And they may incur losses.
There are some kind of biases that prevent investors to find the right stock such as cognitive biases (conservatism bias, confirmation bias and availability bias) and emotional biases (loss-aversion bias, self- control bias and regret aversion bias). Sounds like global gyan, but as we know global gyan is always true.
Risks involved in investing the money that an investor must understand:
Financial Risks include – Credit Risk, Liquidity Risk and Market Risk.
Non-Financial Risks include – Operational risk, Solvency risk, Regulatory risk, Political Risk, Legal Risk, and Accounting Risk.
However, to mitigate (partly) these types of risks, Investors must diversify their portfolio. Here diversification means holding a variety of investments from the list below (The right mix will depend on the risk profile) –
- Different asset classes like FD, Equity, Mutual Funds, Real Estate, Bullion etc.
- Different industries in case of equity and
- Different geographies.
Such a diversification will help to smoothen out the ups and downs that an investor will experience during the course of investing.