How to Evaluate a Stock in India

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

The BSE Sensex rose almost 33 times during this period. That is compounded returns of almost 12.4% per annum.

But the wealth creation has been extremely polarised. Investors who bought the right kind of stocks and held on for long, made crores out of every lakh invested.

While the rest, failed to get anywhere close.

We can't blame investors for devoting all their effort in trying to discover the next get-rich-quick stock. In bull markets there are stocks that run up too much too soon.

But the real wealth creators, make crores for their investors, over decades.

Take for instance, ICICI Bank. It went up a staggering 5,159% since 1997. A sum of Rs 100,000 in ICICI Bank in 1997 would have turned into Rs 53 lakh in 2020.

L&T has grown 10,200% since 1991. It would have turned Rs 1 lakh into Rs 1 crore, 3 lakh in 2020.

Titan grew 20,016% in since 1995. A sum of Rs 100,000 in Titan in 1995 would have turned into a whopping Rs 2 crores in 2020.

Wealth creation isn't about bagging the highest return stocks. The highest returns tend to be one-off hits that often can't be repeated.

It's all about having a strategy to fetch good returns, consistently, for the longest period of time. That's when compounding runs wild.

Here are ten rules that you must follow to create enormous wealth in the Indian stock markets over decades...

1. Go bottom up unless you are a sector specialist

   Brokers and talking heads on TV often urge individual investors to bet big on the next sunshine sector.

   But doing so is akin to jumping into the pool without knowing how to swim. Most sectors, especially ones like pharma, banking, telecom, and technology have unique characteristics.

   So, unless you yourself understand the sector inside out, it is extremely difficult to predict the turning of the tide. It may be too late before your broker or the experts recommend an exit.

   Therefore, go bottom up on stock picking. Pick stocks based on fundamental merits. Avoid overexposing yourself to a particular sector unless you have specialized insights on it.

   Here are some detailed sector updates.

2. Screen fundamentals over several years

   Judging fundamentals based on performance of a few quarters or based on management's guidance for the next quarter is fraught with risk.

   No one could have predicted that the few quarters, following Covid-19 lockdown in early 2020, will be a complete washout for several sectors.

   Therefore, screen fundamentals of companies based on their performance over at least ten years or at least two economic cycles.

   Here is Equitymaster's proprietary screener.

3. Be skeptical of PSUs and high dividend stocks

   PSUs or government owned companies need not be the pariah.

   Some like defence sector PSUs may enjoy monopoly. Others like Container Corporation may have solid fundamentals.

   There may be ones like Coal India and ONGC offering attractive dividends.

   So, by all means evaluate these PSU based on their specific merit.

   But do note that they are at the mercy of the government when it comes to capital allocation decisions.

4. Take care of regulatory overhang

   Big regulatory overhang can dampen the earnings of companies for several years. Case in point is the telecom sector. Companies with such risks are best avoided.

5. Be wary of intercompany transactions, auditor comments

   Read the annual reports carefully to take note of intercompany transactions, especially in the case of entities with multiple subsidiaries. Auditor comments in the company notes could also offer cues that act as red flags for investing in a stock.

6. Check managements' capital allocation history

   Looking at the return on equity and debt to equity ratios over several years offer good insight on the management's capital allocation skills.

   Check if it has tendency to overstretch the balance sheet. Does it create wealth for minority shareholders?

   Having said that, the cost, nature, and fate of acquisitions should also be studied carefully for companies in high growth sectors.

7. Look for owner operators

   Businesses with managements that are owner operators are the best bets among mid and smallcaps.

   Such managements tend to be not only very passionate about the businesses but also think very long-term. Their interests in creating long-term value is well aligned with the interest of minority shareholders.

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8. Take note of megatrend tailwinds

   Look for stocks that follow megatrends that can act as big tailwinds over a long period of time. The megatrends evolving through Rebirth of India are the most potent ones.

9. Be sector agnostic when looking for value

   Being sector agnostic when screening stocks based on valuation metrics like P/E and price to book helps avoid hindsight biases.

10. Keep a long term perspective

    The key to buying high potential businesses is buying them when there are still some clouds of uncertainty hovering over them.

    The uncertainties maybe with respect to macro challenges, businesses specific temporary risks, execution risks or balance sheet risks.

    The best way to hedge against such risks is to take gradual exposures to the stocks. Doing so, will allow you to buy more of the stocks as your conviction in the businesses goes up.

    As businesses mature, overcome risks, diversify into high growth areas, or change their capital plans, you can always stagger your investment depending on your comfort.

FAQs on How to Evaluate a Stock in India

1. How do you evaluate a stock before buying?

A good way to start is by doing your research. Study the stocks underlying business. Better yet, stick to stocks whose businesses you understand.

Focus on their earnings prospects as the value of a company is determined by its future earnings and assets. Ask the right questions, where is the growth coming from? When can it possibly slow down? What are the main risks that affect its business? Mainly as different companies are at different stages of growth.

The key is to recognise that and work solely towards assessing its future value. However, another important factor is your investment horizon and your appetite for risk. So before you invest in a stock, ensure that it matches your timeline and suits your risk profile.

Equitymaster offers detailed financial factsheet for an exhaustive list of stocks. Moreover, with the help of our screener you can compare the financial parameters of any 2 stocks.

2. Parameters to check before investing in a stock

There are several parameters that you must check before investing your hard earned money. But you can start by cheking the following first:

Does the company run a profitable business with a strong competitive advantage?

Is the Cashflow from operations positive?

Have the earnings grown consistently over the long-term?

Are there any recurring one-time income or expenses?

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

Has the number of shares increased remarkably over the years?

Is the Balance Sheet clean?

Does the management have good intentions towards the shareholders?

If a company ticks all the boxes, it surely deserves a detailed examination. But you must 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.

You can check most of these parameters with single click on Equitymaster. They offer a detailed factsheet for an exhaustive list of stocks.

3. Which ratios should we check before investing

An important part of the fundamental analysis is studying the company's ratios. While there are many, here are some of the most important ones you must check before investing:

• Current ratio: this ratio indicates the liquidity status of a company, showing you whether a company is able to pay its debts and other liabilities.
• Debt to Equity and interest coverage: important ratios that indicates how much the company depends on debt for its operations, and how well they can repay the debt via the money it generates.
• Operating Profit margin reflects on the company's level of profitability and management's ability to generate them.
• Asset turnover: This ratios tell you how efficeintly a company uses its resources such as assets, to produce sales and generate profits.
• Return on equity: An important ratio, it tells you the total return the company generates on the equity that is invested in the company.

All these ratios are available on the company's website in their published annual reports. However, you can also see them all at once on Equitymaster. You can see a sample factsheet of Asian Paints.

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