Generating profits from the stock market is not a child’s play and requires a great deal of patience and discipline, equally supported by extensive research about the market.
The bull market attracts many prospective investors who view the stock market as a treasure, which would provide wealth and prosperity to them. However, generating profits from the stock market is not a child’s play and requires a great deal of patience and discipline, equally supported by extensive research about the market. An investment strategy needs to be prepared for selecting a stock after asking a lot of questions.
The following factors should be taken into account while selecting a stock:
1) Opportunity size: Size of the opportunity is critical for continuous growth and compounding returns. It is important to select the company, which is the leader in an industry having potential and growing at a rapid pace. For example, “the e-commerce space in India is still nascent and has huge potential given the increasing trend of online purchases in the country. Info Edge has many subsidiaries catering to e-commerce model which has huge potential in future,” says Jimeet Modi, CEO & Founder of SAMCO Securities.
2) Competition: Each company faces a risk depending on the competition in the industry it operates in. An investor should look at a company, which operates in an industry having a weak competitive environment and relatively high entry barriers. Such an operating environment enables the company to grow and increase its market share. Telecom is an industry with huge entry barrier as licenses and massive capitals are prerequisite for survival and growth.
3) Regulation: A company operating in an industry, which has low interference from the regulatory authorities, should be preferred over a highly regulated one. The FMCG industry has minimum interferences from the regulator. The amount of wealth companies like Unilever and Britannia have created is huge.
4) Rate of growth: The past financial results of a company are as important as the outlook of future growth. “A company having a history of a high growth rate along with high potential for growth in the future is an attractive option for investment. A growth rate of 20% is generally used as the benchmark for evaluation. In the cement sector Shree Cement has historically delivered huge shareholder wealth because its growth was the fasted compared to its peers,” says Modi.
5) Dividend payout ratio: The quality of earnings of a company depends upon the proportion of earnings distributed as dividend to the shareholders. It is also important to have a consistent payout of dividend. A company with a consistent dividend payout ratio of over 50% should be preferred for investment whereas those having a dividend payout ratio of less than 10% should be avoided. “MNCs rank high on dividend payout ratio. Indian pharma companies are down since last the few quarters due to pricing pressure. However, MNCs pharma companies due to dividend payout ratio have still fared well compared to Indian companies,” says Modi.
6) Debt burden: A high amount of leverage weighs down the growth of a company with a major portion of earnings going towards the finance cost. Therefore, companies operating with minimal debt burden should be preferred over highly leveraged companies. A debt-equity ratio of 1:2 is ideally the upper limit for a sustainable business model to generate returns. Infra companies like HCC, IVRCL etc are in wealth destroyer category due to debt as high as above 10 times their equity and reserves.
7) Capital Efficiency: The Return on Capital Employed (RoCE) is an important parameter to measure efficiency of the capital employed. A high RoCE implies that the company is generating high returns on the employed capital and the profits can be reinvested for the long-term growth. “Companies having higher RoCE are always rewarded by the stock market. In the cement sector, for eg Shree Cement has far superior RoCE at 26% compared to ACC which has ROCE of 17%. Stock price of Shree Cement is up by 50% in two year while ACC is still at the same price,” informs Modi.
8) Promoters’ shareholding pattern: The shareholding pattern of the promoters of a company shows the level of faith placed by them in the future of the company. A high pledging of promoters’ holding implies doubts regarding the management of the company and the likely sale of shares in the market leading to fall in the stock prices. An investor should prefer companies with minimum pledging of promoters’ holding over companies with a high promoters’ stock pledging.
9) Nature of growth: An investor should evaluate the nature of growth of the company, i.e. the source of funds for growth. Growth capital can be either the cash generated from operations or raised from external sources. A constant dilution of equity to raise capital is a long-term disadvantage for the minority shareholders, as the earnings will be regularly diluted.
10) 200-day moving average: 200-DMA is a tool for technical analysis and traders view it as a resistance as well as a support depending upon the direction of breach. “When the price action breaks the 200-DMA in the upward direction, then it is a bullish signal and the stock should be bought. Such bullish price action combined with all the above factors when put together gives a compelling analysis. Only when one thoroughly studies all of the above parameters and rates the stocks in the ascending order, the top-ranking stocks from each sector would an attractive long-term wealth creating portfolio which will be well diversified with strong business fundamentals,” says Modi.