You have just about learnt that equities can generate tremendous profits for you over the long term. But you cannot jump into any stock. You need to take a well thought and calibrated investment decisions. Broadly, you need to consider fundamental factors and technical factors before zeroing in on the stock.
Fundamental factors to examine in a stock
Fundamental factors have got to do with the core business of the company. These factors can be quantitative or qualitative. Here are some key fundamental factors to examine…
- Growth is the primary motivation. After all, you want to invest in a company that grows. We are talking about growth in business volumes, growth in revenues and also growth in profits. It is only when these 3 combine that you have an attractive proposition. Higher growth means higher valuations in the market.
- Profitability is the key. Eyeballs and footfalls can only take you that far. Your business needs to be profitable. What is the net profit margin and what is the operating margin. This will tell you how good are the business. Check the ROE and the ROCE of the company. That will tell you how well the company deploys its capital.
- Efficiency is the binding force. You have up cycles and down cycles in a business. What holds a business together in tough times is the efficiency of operations. How efficiently the company churns its total assets and fixed assets? How well is the working capital of the company managed? All these add up to efficiency.
- Brand image is what will give you the advantage in a competitive market. Companies like Hindustan Unilever, Britannia, HDFC Bank and TCS have built a formidable brand in the market. That is why they get premium valuations in the market. Brand image is an intangible factor and cannot be seen or felt, but it can be experienced and monetized.
- Management quality separates the wheat from the chaff. A good management can make a success out of a mediocre business but a mediocre management can make a mess of even the best of businesses. Generally, companies with solid managements tend to outperform their peers as well as the index overall.
- Business moat is the unique advantage that you have created in the business. It could be a unique product, a special distribution channel, some key entry barrier or a brand that cannot be replicated. The value of the business comes from the moat and it is companies with moat that are better equipped to handle disruptions in the business.
Yes, you will have to examine some technical factors too…
No investment decision is every complete by just looking at the fundamentals of the company. You need to look at the technicals too. Here are a few technical factors to examine…
- Price patterns are largely technical factors. You can compare the price chart with the 100-DMA and the 200-DMA to get cues about the stock. You can examine the supports and resistances on the technical chart and also whether there are any double bottoms, double tops or serious breakouts. These are the key to your investment decision.
- Volumes can be seen either in terms of number of shares or value. Normally, the number of shares is a better indicator of volumes, especially in smaller stocks. Volumes show whether the interest is building or waning. Volumes are useful in ratifying whether the price trends you see are credible or not.
- Spreads and basis risk is a case study on how easily you can enter and exit a stock. Volumes are only one side of the story but these volumes must come with narrow spreads and low basis risk. If an order for 10,000 shares is going to take the stock up by Rs.1 then you are running a huge basis risk on the stock.
- Volatility represents the standard deviation or the risk of the stock. Prefer stocks that show movement and sensitivity to news flows but are not too volatile. When stocks are too volatile, they become hard to predict and the stop loss risk becomes too high in them. Such stocks are better avoided.
Even after you consider all these fundamental and technical factors, you must examine whether the valuation offers a margin of safety to you. That is the last test. Only then, a final decision must be taken.