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Investing: What matters! - Views on News from Equitymaster
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  • Aug 31, 2006

    Investing: What matters!

    With the Indian indices on a strong footing, we feel that this is a good time to 'get back to basics' and focus on the major factors that investors should consider when taking a decision on investing in equities. There are different participants in the stock markets, ranging from speculators, day traders, long-term investors, short-term investors and hedge funds. All these players have differing objectives for buying/selling stocks. Our focus in this write-up is the factors that longer-term investors (2 to 3 years and more) must look at while taking an investment decision.

    Business model
    Undoubtedly, the very first thing that any investor must look at is the business/sector that the company is operating in. The sustainability of the business model, scalability and robustness are factors that every investor must consider before studying the stock any further. To give a simple example, the top-tier software companies' business models are focussed on the 'Global Delivery Model', a totally new paradigm that has changed the face of the global software industry. The key to the strength of this model is seamless co-ordination between centres across the globe and excellence in execution. We have seen these companies seamlessly execute projects from different geographies with the help of this model. Thus, these are factors that point to the long-term sustainability of the offshoring model.

    The management is another extremely important factor to consider before investing in any company. At the end of the day, it is the management that will be the driving force behind the future direction and success (or failure) of the company. As an investor, you must take a long, hard look at the past track record of the management, it's ability to steer the firm through difficult times, it's focus (or lack of it) and future growth plans as well as the sustainability of these plans. Just to give an example, Satyam has been guilty in the past of buying into unrelated businesses. When these failed, the company wrote off these investments, incurring huge losses in the process. While the company and its management have improved significantly over the past 3 years, such past mistakes must be seen in perspective and one must be on one's guard to avoid a repetition in the future.

    Competition in the industry
    Undoubtedly, the company's competition is a major factor that you as an investor should look at before deciding to buy (or not to buy) that company's stock. It should be understood that most industries are highly competitive in today's free market environment, unless that industry is highly regulated (such as energy) or is characterised by artificial entry barriers. Therefore, not just the competition, but also the company's place in the industry (market leadership) should be assessed before taking the plunge.

    Financial analysis
    This, of course, is one of the major factors that most investors look at. It includes doing a detailed study about the company's financial position and performance over a reasonably long period of time. Studying its sales growth, trends in EBITDA margins, net profit growth, return ratios and other such number crunching is pertinent in order to understand as to whether potential is being transformed into performance. Such a study is commonly known as 'Fundamental analysis'.

    Dividend yield
    This is another factor that is often considered by investors. Dividend yield is basically the trailing 12-months dividend per share divided by the current market price. The dividends are a form of income from shares and regular dividend-paying companies do provide some comfort that their profits and cash flows are stable enough to enable them to keep on paying dividends each year. High dividend-yielding stocks could provide some cushion against any potential downside. Typically, it has been observed that companies with stable cash flows and not too high valuations, such as power and fertiliser companies, trade at relatively attractive dividend yields.

    And finally, the last step in deciding whether or not to buy a stock - the valuation phase. While the business model, management, fundamentals and market positioning of the company may be the best, if the stock is trading at valuations that are not warranted, then it is not worth buying the stock.

    A good example here is cement stocks. There is significant potential for the cement sector in India, given the infrastructure boom and the SEZ Act passed recently. The Indian government needs to ensure that the country develops better infrastructure, such as better roads, airports, ports, railways, power and telecommunications. Thus, a strong focus on infrastructure development is essential, and cement is a major commodity that is used in most of these activities. However, in our view, valuations of most cement stocks are far beyond their historical average and beyond what should realistically be accorded to them. So, while the future growth prospects for all these companies are undoubtedly strong, it is on the valuations front that there is cause for concern.

    Thus, to conclude, we believe that every investor must consider each of the above factors and possibly do more analysis as well, before making an investment decision in any stock. However, at the end of the day, we believe that investing in shares is all about conviction - if you yourself are not convinced about the company, then you should not stake your hard-earned money.



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