The legendary fund manager Peter Lynch rightly said, “Behind every stock there is a company that has a running business. Try to understand that business.” That probably sums up the gist of what investors need to do. When you buy a stock it is not just about the business of the company, it is also about the sector in which the company is operating and the macroeconomic environment that the company is operating. Additionally, you need to also understand the product life cycle. We all know how Nokia literally went out of business within 7 years of the launch of the I-Phone and the Samsung smart-phone. We also know how Satyam and Deccan Chronicle went bust because managements did not act in the interests of shareholders. Here are 6 things that you need to consider before you invest in the stock…
- Does the stock meet my risk/return profile?
This is a fundamental question you need to ask. Your investment in equities depends on your risk-appetite and the kind of risk that you can afford to take. Also, ensure that the stock you select meets your return requirements. If you are looking at stable returns then a large cap stock in a mature industry will be fine. But, if you are looking at outperforming substantially over the next few years then you may have to focus on high growth stories with smaller capital base and nimble balance sheets. Moreover, you need to be clear that the investment is in sync with your long term financial plan, as that constitutes the base document for your financial future.
- Check out the company’s income statement…
If you are an investor, you cannot rely on charts alone. Charts are OK for a short term trade. If you are looking at a long term trade then you need to be clear about the sales and profits of the company. You need to ensure that the company is able to generate growth in sales and profits. Don’t rely too much on a company that purely tries to sell eyeballs to you. At the end of the day, it is earnings visibility that matters. Be cautious of companies that are deriving too much of their incomes through extraordinary items and investments. You need sustainable income from operations and a decent profit margin.
- How is the balance sheet of the company?
This is perhaps more important than the study of profitability. You need to understand what the company owns and what the company owes. If you are looking at high returns then you must be wary of high-debt companies as they are the more vulnerable to macro shocks. The bigger your capital base, the more profit you need to generate to earn positive growth in EPS. That is why you will see the profitable companies with lower capital base always tending to outperform. Also focus on companies that have intangible assets that can be leveraged better without impairing your ROA ratios.
- How are the macros shaping up?
This has nothing to do with the company in question, but it is hard to earn positive returns when the macros are unfavourable. You need inflation to be under control. You also need the GDP growth and the IIP growth to be robust so that the spill-over effects of macro growth can be passed on in the form of micro growth. You must also worry if the economy has a high fiscal deficit or current account deficit as these can led to a run on the currency and foreign portfolio outflows. These macro situations are not conducive to stock markets putting up a good performance.
- How are the sector / industry shaping up…?
This is a very important point. If you are buying a steel/aluminium company you need to look at the prices on the LME as it has an industry level impact. You also need to look at if the sector overall is a victim of negative regulation. You must also be cautious if the sector has large quantum of NPAs to banks. You must also understand what are the new products and alternatives that are emerging for products. For example, how will robotics impact financial services companies? Or, how will low interest rates impact auto and real estate companies. These are questions you need to address.
- What is the company’s management image and public standing?
This can be a fairly subjective measure but is important nevertheless. Historically, companies that have followed transparency and high standards of corporate governance have tended to outperform in the market. We have seen umpteen cases in India where stocks have underperformed because managements have not acted in the best interests of shareholders. In fact, the reason most MNCs get premium valuation is because of the higher standards of disclosure and transparency that they maintain. Public image also matters. Be careful of companies that are embroiled in too many legal and regulatory hassles. These are best avoided. In the modern era, you have access to websites and social media platforms where even the smallest issues get debated fervently. You can use these as a sounding board for your decision.
Remember, investing in a stock is not just about the stock but also about the macro and sectoral trends. But, above all, focus on the big story in the product life cycle and the management quality. They can assure you of a good investment choice.