How to choose good quality stocks for long term investment? An evergreen question in the minds for investors. Both for novice and experienced investors. A book can be written unto itself on this topic. However we have made an attempt to give a sneak peak into the world of investing. We assumed you have the basic introduction to the stock market and how to invest in shares.
Siva is my friend and he recently asked me this question: How to choose good stocks. Many people who know me ask this question. So thought why not write a post on that. Also He had earlier picked penny stocks and made a loss. Now he had bought quality stocks like Reliance, GSK Consumer among others but still his stocks value had gone down. He could not understand why (We will see the simple reason). OK. Let us see how to pick good stocks now….
How to pick good stocks for investments
Criteria #1: Choose the stock of a good business
As Warren Buffet has pointed out “When you are buying a stock, you are becoming a business partner. So if the underlying business is bad, the stock will eventually perform bad in the long run”. You don’t want to be a partner in a bad business. It’s not worth it. A good business has consistent demand for its products/services. People can identify and easily relate to the end product of this business. Low quality stocks usually turn to penny stocks in long run.
Criteria #2: The business has a durable competitive advantage
If you note there are two components here. One is durable. Second is competitive advantage. By durable competitive advantage we mean the business chosen must be able to stand the test of time with good moat. There is no use in choosing a business which will remain competitive for only a short time. It must do well in long term. For eg., Asian Paints. It is very hard to replicate the success of Asian Paints in Indian paint industry. They have continuously innovated with highest technology and have the widest distribution network.
Criteria #3: How strong is the brand and its momentum
It is advisable to choose a company with a strong brand. A strong brand ensures recurring business and stable profits. What do you say when you search on internet. Search Engine? No, mostly you say ‘Google It’. That’s the power of a brand. Also the brand should not have reducing momentum. For eg., remember Xerox. Xerox was the industry leader in photocopy business. Even when one wants to take a copy, the say ‘I need to take a Xerox’. The term photocopy was rarely used. Xerox was such a brand. However, they failed to keep up with the technological advancements and became obsolete with time. The company you choose must be able to adapt and improve.
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Criteria #4: High quality management
This is probably one of the top 3 criteria. As a minority shareholder, you do not have any say on how the company is managed. Nor on where the capital is allocated or how the business is run. If you have a shady management, then your money is in wrong hands. If the management is not transparent, all the other assumptions or criteria can be thrown out the window. So how to check the management quality.Some check points are
- Efficient and professionally run
- Ethically disclose all decisions and strategies
- No unfair issuing of warrants or preferential shares
- No hoarding of cash or capital mis-allocation
Criteria #5: Consistent dividend track record
Dividends are one of the most neglected aspects of stocks. Infact, they are single most important aspect. As a long term investor, dividends provide you with annual cash flow. They reduce the stock volatility and price fluctuation. Warren Buffet bought Coca Cola for $1 billion in 1990’s. Today Coca Cola pays $450million as dividends every year to Buffet. Which is nearly 40% return on investment every year. (not to forget the value of stock is $10billion now). Also dividend ensures, prudent usage of capital and the company does not do costly unwanted acquisitions.
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Criteria #6: Positive and increasing free cash flow
Free cash flow ensures that the company survives and remain profitable. Even in uncertain times. Free cash flow means the company does not need need to make fresh capital investments. Consider infrastructure companies which need to make new investment every year to increase profit. These are not good companies for consumer investment. In times of cash crunch, these companies’ profits take a hit. So does your stock price. But consider a company like Asian Paints. They generate Rs.1200 as net profit each year. They can put up a new plant with these profits if needed. So good cash flow is crucial.
Criteria #7: Check the balance sheet for low debt and high assets
The stock you choose must have low or zero debt on a per share basis. If a company has huge debts, each year the profits are spent on servicing the debt like paying interest,dues etc., There is hardly any profit to distribute back to you.Again infrastructure companies fit the bill. Each year they pay huge interest which will often be more than 50% of their net profit. This is not good for you as an investor. Ideally the debt-equity ratio(total debt of company/equity capital)must be lesser than 1.
Criteria #8: Current valuation of stock price
No stock is worth an infinite price. You have to carefully decide on the price which ou want to bu a stock. Remember Siva. He had made a mistake here. The stocks he purchased had already gone up to higher level. The future 3 years return were already priced in the stock. There was no room for the stock to grow(at least in the next 2 years). You need to buy at a fair or below fair price to make profits. Don’t follow the herd. People often buy at premium prices. Paragh Parikh once said “If you buy a fancy stock at a fancy price, then when the fancy ends you have a fancy loss”
PEG ratio: So how to find a fair value. Check for the PEG ratio around 1.It’s nothing but Price to Earning Growth ratio. If you think a company’s profit will grow at average of 20% in next 5 years, then fair price is 20 times the current EPS(earning per share). Note: You also need to consider the industry the company operates in along with peer valuation. Typically consumer goods have high PE and infrastructure have low PE
Criteria #9: Choose an industry you are familiar with
You have a competitive advantage if you work in a particular industry. Are you a banker? Then you can easily which bank will perform well in future. Are you a doctor? You can easily know from your experience which pharmaceutical companies produce good quality drugs. So you can predict if they will perform well in future. The same is case with IT, bio-tech or other fields. A person working in a particular field can easily identify which stocks will do well in future in his industry and can invest in them
Criteria #10: Observe your surroundings and products you love
Market Research is one of the most important criterion of choosing stocks. Fund managers pay 1000’s of dollars to market research companies. But as a customer you know first hand, how good or bad a product is. Look at products around you and buy their stocks at good price. When Dominoz Pizza(licensed in India to Jubiliant Foodworks) was introduced people loved it. If you had bought Jubiliant in 2009, you could have made a killing(7X bagger).
See around you and observe. I loved ‘Jockey’ underwear when I first used it in 2010.It was comfortable, premium priced and young people loved it. I checked which company manufactures it. Found ‘Page Industries’ manufactures Jockey in India. It was 21 times PE. I bought some shares as it fit all my criteria. Since then it had returned me 12 times return in 5 years(Currently valued at 45 times PE). You can see many companies:ICICI Bank, Axis Bank, SBI, Reliance Communications, Airtel, Castrol, Exide Batteries, Bajaj Auto, Maruti Suzuki etc., Choose companies you see and use daily. If they are available at good price and satisfy the criteria mentioned above buy them.
Conclusion: Stock picking is more an art than a science. It takes courage, discipline, emotion control, rational expectations, little arrogance (to believe you’re right), analysis and patience (above all) to succeed in the stock market. The above list is by no means complete. If you are a savvy investor then you might consider Return On Equity, Return on NetWorth, DCF model etc.,
Hope you got answer to question: How to choose good quality stocks for long term investment. If you do not have the patience or virtue to directly invest, then mutual funds are your best option.Check: Best Equity mutual funds to invest in 2014
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