How to identify winning stocks

“You must value the business in order to value the stock.” — Charles Munger

Equity is one of the best asset classes for making money over the long term, but a lay person generally finds it quite tough to decide where to invest.

Most investors do not have adequate knowledge of the stock market and therefore fall prey to ill-advised recommendations and burn their fingers.

But, if investors have to create wealth, they cannot afford to miss the equity bus. Investors must carefully choose companies for investing. For doing this, lay investor hunts for information in various media such as newspapers, TV channels, magazines and internet.

Then they pray and hope that the investments become profitable. The proper way to select stocks should be to study the sectors and the companies in which one wishes to invest.

STOCK SELECTION

So what goes into the process of stock selection by professional investors? A stock price represents the understanding by the markets of the future profit prospects of a company.

For doing this professional money managers broadly follow two approaches — bottom-up approach or top-down approach. In the top-down approach, the stocks can be selected by first identifying the broader economic trends and factors that affect specific sectors.

The other approach is to focus only on the strength of the company’s business model, balance sheet, management and earnings visibility over the long term. This is called the bottom-up stock selection.

How can a top-down approach be put into practice? A top-down investor first studies the macroeconomic conditions.

Where to invest

For example, if the economic cycle is slowing it would make sense to look at sectors that would be affected the least, such as FMCG or pharma. At the same time, if economic growth is beginning to pick up, one can focus on sectors that will directly benefit from improved macro-economic conditions, such as banks and capital goods. One must also understand the key drivers for a particular sector. These drivers include the demand environment, level of competitiveness in the sector, long-term growth prospects, among others.

Let us consider the two wheeler industry in India. A large part of our population is fairly young, with working age population being 52 per cent of the overall population, one of the highest in the world.

Also, with Indian families becoming nuclear, shortage of public transport, better roads and rising disposable incomes are leading to higher demand for personal vehicles.

In 2000, 43 lakh two-wheelers were sold while currently the number has shot up to 1.5 crore vehicles a year. The two-wheeler market is dominated by two main players, namely Hero Honda and Bajaj Auto with close to 80 per cent market share between them.

This sector also requires significant capital, technology and distribution reach which serve as strong entry barriers for newcomers.

BUSINESS MODEL

To identify winning companies involves studying their business model and the position that these companies enjoy in their sectors. Any business is subject to myriad market conditions, which could be in the form of competition, change in the technology environment or lack of pricing power.

These could affect a company’s profitability, growth and even survival. Eastman Kodak Company of US invented photographic film, taking photography into mainstream usage by the world. The company barely exists today as it was unable to adapt to changing technology environment. Among the other invisible factors that affect the prospects of shareholders the most pertain to taking a call on the management of a company.

Having got the broader picture about the stock right, investors should focus on the financials of the company. This involves focusing on profits and cash flow generation by the company. A business model which consumes less money and generates lot of cash is a sound investment.

The last question to ask oneself before investing in a stock is whether all this is coming at a good price and if valuations are attractive enough? If valuations are attractive, judged on the basis of ratios such as price to earnings, price to book or dividend yield one should go ahead and buy the stock.

But, buying the stock is not the end of the story. In fact, it is just the beginning of it. It is easy to get into a stock and difficult to get out of it in troubled times.

To avoid getting caught on the wrong foot, investors should aggressively monitor the performance of companies they invest in on a regular basis.

So focus on the long term and remember you don’t have to be brilliant, only a little bit wiser than the other guys, on average, for a long, long time.

(The author is Head-Research, Capital Markets (Individual Clients), Edelweiss Financial Services.)

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