The Ultimate 10-Minute Guide to Pick the Right Stock

Indian stock markets have seen a phenomenal rise in the past three decades.

Investors who bought the right kind of stocks and held on for long, made crores out of every lakh invested.

However, this is easier said than done. In the vast sea of companies listed on the stock exchanges, spotting a good one can be a bit of a task.

That is why, you need a checklist of some sort which can eliminate the stocks which don't fit your criteria and eventually turn out to become the biggest wealth destroyers.

This simple 10-minute test can help you drop the stocks that don't deserve more of your time and energy. It can narrow down your search to quality companies for the next stage of your in-depth analysis.

Let's get started...

#1 Does the company pass the level 1 quality test?

A good start is to rule out any initial public offering (IPOs). They are rarely ever a bargain. Think about it. A company goes public only when the owner thinks he can get a higher price for the shares.

Moreover, most are young, inexperienced companies with a short track record. This makes them a poor candidate for further analysis.

Investors looking to speculate on IPOs should not be surprised to find some of them are making losses. This is bound to happen when loss making companies seek steep valuations.

But there is an exception.

If an IPO is a spin-off of an established company with long operating history, you may consider it. Like when L&T and HDFC spun off L&T Technology Services and HDFC Life Insurance Company.

#2 Has the company ever made money (generated an operating profit)?

There are various types of companies in the market. Often, the most exciting ones have never made money. They are yet to:

• start operations or
• run unproven businesses or
• are developing fancy products and services.

No matter how exciting their prospects may seem, avoid them. History tells us that most of these go down in the initial years of operations.

Usually, these companies have businesses that depend on a single product or service. This can be very risky and has a low success rate statistically.

Relying on unproven loss-making businesses, hoping they will turn around, rarely works out.

For instance, look at Dish TV. Offering a Direct to Home (DTH) service, the business looked attractive with the digitisation of cable TV on the horizon. But the company had no history of profits and didn't turn a profit for the longest time, eroding investor value.

This is relevant now more than ever when new-age companies are coming out with their IPOs.

It's important that you evaluate the business model very carefully to identify some key metrics you would want to keep tracking. Poor performance on those metrics should be taken as a warning.

So unless you want to gamble, stay away from unproven businesses with no history of profits.

#3 Is the cashflow from operations positive?

Growing companies can sometimes report profits without generating actual cash flow from operations. But this cannot last long as the company will need cash to function. The company may borrow or issue shares, diluting your shareholding in the company.

So before you consider investing in a company, study the cash flow statement in the annual report. Check to see how long the cash flow from operations has been positive. The longer the history, the better it is.

#4 Have the earnings been growing consistently?

Consistent growth in earnings is always a good sign. Not only does it imply that the company is well-established, but it is also a sign of capable management.

However, an erratic growth in earnings can mean different things:

• the company is in a cyclical business
• they aren't responding well to competition

A cyclical business model does not raise a big red flag. But you must only invest if it is available at a discount to its fair value.

For instance, companies in the commodity sector often undergo cycles. They make good money when the economy prospers and lesser during economic downturns. In the wake of the pandemic, as the economy recovered, metal companies outperformed most sectors in the market.

#5 Any recurring one-time income or expenses?

One time income and expenses are excellent tools for hiding bad times and bad decisions. Often used by companies, it usually reveals the intent of the management.

Look into the details of the one-time income or expenses. Check to see if they are recurring in nature.

A large chunk of other income or expenses (more than 10% of the total income or expenses), recurring in nature, raises a big red flag. It also makes company analysis cumbersome, further implying that the management is up to something.

#6 Is the return on equity (ROE) consistently over 15%, with reasonable leverage?

The Indian stock market has clocked a 15% rate of return over the long term. So you must expect a similar rate going forward. Anything lower than that is not worth your time.

Companies in the non-financial sector must clock a ROE of 15% or more. Financial companies must generate a higher ROE. However, there are two exceptions to this rule:

For companies with debt, ROCE is a better indicator. This ratio factors in debt along with other liabilities a company may have.

For companies operating in cyclical sectors, like shipping or commodities, the ROE will vary with the cycle of the business. In this case, a better strategy is to look at a 5-year average.

#7 Has the number of shares increased remarkably over the years?

A consistent jump in the number of outstanding shares over the years is worrying. A company issues shares for two primary reasons:

• It needs money for acquisitions.
• It is granting options to its employees.

Statistically, new acquisitions and mergers don't always work out. There are only a few success stories, but most go down in the initial years of operations.

Look what acquiring Corus did to Tata Steel back in the day. Even though the domestic business was doing well, they marked a massive non-cash write-down on its foreign business. The US$12 bn Corus acquisition turned out to be a value destroyer for the company.

In 2009, Hindalco Industries had to write down US$1.5 bn, concerning the acquisition of the Canadian aluminium producer Novelis.

Granting options to employees is not the worst thing but it does dilute your share in the company.

While a consistent increase is worrying, a shrinking number of shares is usually a big plus.

Usually, the company buys back shares to return money to shareholders, which is a plus. But it also means the owners are confident of the company's potential and find the stock price undervalued.

#8 Is the Balance Sheet clean?

A quick check on the balance sheet is to assess the debt in the company. Companies with a lot of debt need extra attention.

But how do you define 'a lot' of debt? A good measure is to calculate its debt-equity ratio. If it's higher than one, dig deeper.

Assess how soon the debt is due. Go through the terms and conditions for re-payment. If it is complex, the company is not ideal for further analysis.

Companies in stable sectors, like the Fast-Moving Consumer Goods (FMCG) or Healthcare, are more likely to service the debt promptly than companies in cyclical businesses (like shipping and commodities).

Now some of you might wonder, why we didn't mention dividends.

Generally, older more mature companies pay dividends. Their well-established businesses generate more money than the company needs.

Whereas most companies in their initial stages of growth don't pay dividends. They put their profits back into their own business for expansion. Especially if they see strong growth opportunities.

So, if you avoid such companies purely due to lack of dividends you will miss out on some great growth stories.

Some of the top-performing companies in the world have never paid dividends. These include Berkshire Hathaway, run by Warren Buffett and Charlie Munger. Apple didn't pay any dividends for the longest time. Google still doesn't pay a dividend to its shareholders.

Last words

If a company passes the entire test, it deserves a detailed examination. Think of this as a stepping stone to spotting the next Infosys or Bajaj Finance.

Sure, the research process that follows will take time. But knowing the company has passed this test assures you that your time and energy will be well-spent.

Happy Investing!

Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such. Learn more about our recommendation services here...