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How to Evaluate a Stock in India

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.

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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.

  8. Discover Now: One Stock for Potentially Life-changing Gains

  9. 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.

  10. 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.

  11. 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.

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