Decisiveness and patience are key to stock market success
Seeking to explain complicated financial hindsight in the most comprehensible way, here is a list of 17 questions to research before you invest your hard-earned money in Equity. Stocks can give the best returns over the long term. If you don’t need your capital for some other trusted business that can ensure you higher returns, then invest in stocks.
I definitely recommend everyone park little funds in the stock markets. You need to ensure your financial future by bringing in cash flows from different sources. Investing in Equity is in a way investing in the economy. Public companies also capitalize on their equity to increase borrowings and grow.
If you have cash lying around and don’t know anything better to do with it, then you should consider a well-diversified index fund. Investing passively across a diversified ETF should definitely ensure steady returns over the long term.
However, such schemes do come with a cost. Hence if you have no intentions to research your stock picks, you may have to find the cheapest and most reliable index fund out there. Vanguard index funds are very popular as they have a very minimal cost structure. The passive fund requires no active managers and thus is much cheaper.
Remember to stay long in the equity markets
But if you really want to have fun in the equity markets and would like to save that extra fee that you pay for an index fund, you can construct your own stock portfolio.
You need to purchase great companies with strong fundamentals at the right price. Based on my personal experience, simple financial knowledge can make you big money in the stock markets.
In spite of the recent March 2017 gains in the Indian equity markets, I have chosen to remain long. Maybe, I should be booking my profits now, but I prefer to wait it out. I would have to pay loads of transaction fees and short-term gains taxes. But I would like to stick around and collect dividends for the next 20 years or more.
My personal preference here is to stay long. I believe that it is impossible to predict the direction of prices in the short term. But the trend is always up in the long term if nothing drastic affects the company with strong fundamentals.
Therefore, considering these 17 points before you go long should help you make a better decision. Alternatively, you can have a look at these 3 additional advanced multibagger stock investing concepts.
17 things to consider before buying stocks
- Diversify your investments for long-term growth
- Basic company research is key to buying equities
- How does the industry perform?
- Is growth in sales for the company steady?
- What is the current and historical profitability of the company?
- Basic and Diluted Earnings per Share (EPS)
- Market Capitalization may indicate risk of equity
- Valuation is art and science
- Dividends and the Dividend Discount Model (DDM)
- Volumes are an indicator of liquidity
- Historical Volatility or Beta
- Historical excess returns or Alpha
- Cash Flow is king
- Promoters and Shareholding Pattern
- Current Ratio for balance sheet liquidity of the company
- Debt to Equity Ratio is key to see to where the EPS goes
- Price to Book ratio for determing undervalued stocks
Though the checklist may work for short-term gains, it is aimed at the long-term investor.
Diversify your stock investments for long-term growth
Is the Investment less than 5% of your total investment portfolio? This is me diversifying against hate comments post Blog publish. Your money is very important also for me. The markets are too erratic for anyone to predict accurately. Hence, always diversify.
Most of my stocks have fallen after purchase. Eventually, after a time period, most of them do rise.
Basic company research is key to buying equities
What product or service does the company provide?
How big do you think is the market? Is growth sustainable in the long term?
A great understanding of the company and its business is crucial before you decide to buy its shares.
What are its short-term and long-term missions?
How does the industry perform?
Market shares of competitors?
What are the Industry trends? How are the peer company stocks performing?
What are the Industry headwinds?
The key is to make sure that the stock chosen is the best among its peers. To make sure that whatever the reasons you were interested in it were not just Industry-specific.
Hence it is important to analyze in detail all the peer companies too.
Is growth in sales for the company steady?
Does the company have steady Sales growth? If not why?
What is the current and historical profitability of the company?
Operating Profit Margins (OPM): This can be tricky to analyze in financial sectors like Banking. But nonetheless, the higher the profit the company makes after paying for the cost of goods sold the better. Who wouldn’t invest in a product with high margins?
Net profit margin: The profits the company makes after paying out everything including the taxes. Pre Tax margins should also be looked.
Return on Equity: The net income a company makes over its shareholder’s investments. i.e. (Net Income/Shareholder’s equity)
Return on Assets: The net income a company makes over its total assets. i.e (Net Income/Total Assets)
Basic and Diluted Earnings per Share (EPS)
Positive earnings per share followed by consistent growth is desirable. The absolute value of a company’s EPS should increase annually, but the rate of increase of EPS should also accelerate. Stock buybacks, splits, share issuance etc all help in manipulating the Earnings Per Share (EPS) value as the earnings get divided by a different number of shares.
Potential shares outstanding due to convertible debt and employee stock options lead to a more conservative EPS called the diluted EPS.
Market Capitalization may indicate risk of equity
If you are here for the long haul, you should diversify your portfolio across company sizes.
Market Capitalization = Number of outstanding shares X Price of each share
Important to check if your company is listed in any of the popular indexes. If you are invested in a company listed in popular ETFs then you are ensured of steady inflows.
Based on the capitalization levels, you have Large-Cap, Mid-Cap and Small-Cap companies. Large cap companies are expected to have steady conservative growth and may be better for risk averse investors as the ownership is well distributed among a larger base of investors. Small cap companies on the other hand may be concentrated in fewer hands and hence may be riskier. But this risk also means that you may also more likely make huge returns on a good small cap in the short term.
Valuation is art and science
Finding a good company is not a challenge. The real challenge is finding its shares available at a great price. The key is to buy great stocks at the cheapest price.
Price to Earnings: The ratio of the share price over its per share earnings is a great valuation metric.
Higher P/E ratios could indicate a growth potential in a stock. Investors are hopeful that the earnings will rise so high that the P/E ratio will eventually decrease. Most great blue chip companies trade at significantly higher P/E ratios. Picking some of these at lows can be a great idea.
But on the other hand, companies with low P/E can be great investments for short-term returns. Considering that markets always overreact, a stock trading at low P/E for temporary reasons makes great investments. An investment in an Indian oil stock has yielded over 150% in returns in less than a year. I found it to be trading at a historically low P/E only due to Industry headwinds.
Look at historical P/E ratios to pick stocks at the right time.
Dividends for stocks and the Dividend Discount Model (DDM)
The key here is to find companies paying consistently increasing dividends over a long period.
Apart from the Dividend yields, you need to look at the Dividend payout ratio. It is the percentage of earnings paid out in dividends, which should ideally be around 20-30%. This would mean that the company still keeps 70-80% of the earnings to reinvest in itself. If the Industry has huge growth scopes, this would be justified. More saturated cash cow companies would tend to give out a higher payout ratio in the range of even 50-60%. But remember, this means that they have lesser money to reinvest in further business.
My suggestion is to get a mix of companies, but make sure that 90% of your portfolio has a long dividend history. Dividends make a big difference in the long run. A sign of a healthy business.
The Dividend Discount Model is a conservative valuation model that is based on the assumption that the company’s valuation is based on the current and future discounted dividends.
Volumes are an indicator of liquidity of stocks in the market
Often ignored, but you can learn a lot from traded and deliverable volumes.
If the stock price is going up and you have a higher percentage of equity delivered in Demat accounts after trade, then investors are bullish.
If the stock price is going down and you have a higher percentage of equity delivered in Demat accounts after the trade, then investors are bearish.
Historical Volatility or Beta
An indicator like the Beta of your stock indicates how volatile its price is in comparison to the market. The calculation of a beta is done by dividing the covariance of the stock and market returns by the variance of the market returns.
Beta values can be easily found online for listed companies. Stocks with higher beta tend to give higher returns in a bullish environment while lower beta stocks are companies whose sales do not get much affected by market sentiment.
Pharmaceuticals and FMCG usually have a beta lesser than one as their sales tend to not be correlated with the overall market. Whereas Banking, Financials and Materials tend to have a beta higher than one.
Historical excess returns or Alpha
Like Beta, Alpha helps you to compare your stock returns with a benchmark. The Alpha is the excess returns over a benchmark index.
An indicator to measure investor performance, it is important to pick an appropriate benchmark index for your stock.
Cash Flow is king
While earnings can always be manipulated, the cash flows paint a more clear picture. Steady positive operating cash flows are a good sign.
Free Cash Flows i.e Operating cash Flows minus Capital Expenditure, is a good indicator as it shows the ability of the company to enhance shareholder’s value.
Discounted Cash Flow method of valuation of a company utilizes these Free Cash Flows.
Who are the Promoters and what is the Shareholding Pattern?
Who are the Promoters and what is the Shareholding pattern?
How is the Shareholding pattern changing over time?
Current Ratio for balance sheet liquidity of the company
The ratio of current assets and current liabilities from the Balance Sheet is a popular indicator of the liquidity of the company.
Comparing historical values of all the ratios is recommended.
Debt to Equity Ratio is key to see to where the Earning Per Share goes
Dividing the total company liabilities with the shareholder equity enables a better understanding of the financial leverage of the company.
It is important to understand how much Debt and Shareholder Equity go to finance the assets of the company.
Price to Book ratio for determing undervalued stocks
The book value of a company is the shareholder’s equity (Assets-Liabilities) that excludes also intangible assets.
A low Price to Book ratio makes a stock attractive as you get ownership of more tangible assets for a lesser price.
Analyzing your stock picks based on the above seventeen points should make you a smarter investor. Additionally, it is useful to visit investor forums to further your company research.
Finally, correct decisions and long-term patience is needed to make huge gains in the stock markets. Investing in equity is only a wealth generation tool and should not be looked upon as an alternative to making a regular income until you have a huge portfolio that guarantees adequate dividends. Hence, keep saving and investing a little regularly till you achieve this goal. Short-term volatility can cause massive losses if you are not careful, so always diversify.
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