We all have heard stories of how people became super rich by investing in the right stock 10-20 years ago. We have also heard about how people lost great amounts of money by picking bad stocks to invest in. This shows that one must be very careful and diligent while choosing the stocks they wish to invest in. But how does one pick the “right” stock? What are the factors that help determine whether a stock is investment-worthy or not?
Here are 12 questions you must try to answer to help you choose a fundamentally strong stock for the long term:
What is the nature of the industry(s) you want to invest in?
Before buying shares of a company, one must consider which industry they want to invest in. For example, Pharma, IT and FMCG (Fast Moving Consumer Goods) are considered traditionally low-risk sectors, and attract investments during times of economic uncertainty. In contrast, industries such as automobiles, real estate and BFSI (Banking and Financial Services Industry) usually perform best when the economy is growing, and hence have higher risk. One must invest in sectors according to the current and future projections of the economy, and according to their risk appetite.
Is the industry a sunrise or sunset industry?
Apart from the nature of the industry, it is also beneficial to analyze whether the industry is a “sunset” or a “sunrise” industry. Sunset industries are industries which are declining and aimed to be phased out in the future, such as coal, oil and gas industries. In contrast, sunrise industries such as green energy, technology and IT are set to grow highly in the future, making them very attractive investments.
Will this industry continue to thrive 10-20 years from now?
When investing for the long-term, one must consider whether the company’s goods and services still be utilized after 10-20 years. Generally, companies from the sunset industries are expected to see a decline in demand for their products, while companies from sunrise industries are expecting high growth for their services. Some industries, such as agriculture, utilities and FMCG, are integral to our society and hence would always be a part of the economy, though they may not grow as much as sunrise industries.
How strong are the fundamentals of the company?
One must now assess the fundamentals of the company they have chosen, which can be done by calculating ratios through its financial statements. Two main factors, liquidity and profitability, must be considered before investing in a firm. Generally, companies with a current ratio higher than 1 and a low debt-to-equity ratio have high liquidity, while companies with a ROCE (return on capital employed) above 15% with growing revenues and/or profits are considered to have good profitability. These ratios must not be viewed in isolation, and must be compared with competitors in the same industry.
Is the valuation of the company appropriate?
Without a doubt, the valuation of a company plays a very important role in deciding which share to buy. If a company’s PE (price-to-earning) ratio and PB (price-to-book) ratio are very high, it means the company has an expensive valuation. Generally, the PE and PB ratio shouldn’t be looked at alone, and be compared with ratios of other companies in the same industry and the company’s ratios in the past 5-10 years. The company’s growth rate and fundamental strengths and weaknesses can also impact its share price, which also affects its PE and PB ratios.
Does the company have a dominant position in the industry?
To minimize risk and increase their chances of getting high returns in the future, investors must invest in industry leaders who have well-defined “moats” or barriers that protect their position in the industry. For example, Pidilite Industries, which produces Fevicol brands in the country, has a dominant position among adhesives makers, and has no competitor that can match its sheer size and scale throughout India, making it very hard to compete against Pidilite. On the other hand, an uncommon approach would be to invest in smaller but fast-growing companies in the industry. This leads to higher return, but also higher risk, as the company may fail to establish itself against existing players in the industry.
How well do you understand the goods/services provided by the company?
Many people often invest in companies whose business they don’t understand, which increases risk and chances of failure. If you don’t know about the goods and services provided by the company, then you won’t be able to understand the company’s business model and be able to predict and react to changes that will impact its profitability. Employees often invest in companies they work with, because they are closely associated with its operations and understand the company’s business model well. As a long-term investor, you must try to understand the business model of the company you are investing in, so that you can predict its future earnings and identify threats that can impact the company’s business.
What does the company do that its competitors can’t replicate?
To develop and maintain a dominant position in its industry, the company must have something unique that its competitors can’t imitate. For example, Apple has its own ios operating system, which cannot be matched by other software developers. Companies that have a unique selling point can maintain a long-term advantage over its competitors, and hence be able to give good returns in the long term.
Does the company have diversification and growth potential?
It is also essential to look at a company’s diversification and growth potential. Reliance’s foray into Telecom led to great appreciation in its share price, as it opened up new growth opportunities for the company. Diversified conglomerates such as ITC and Reliance reduce investors’ risk as they have diversified operations in many different and unrelated industries, though few companies such as Pidilite and Berger Paints achieve growth by focusing on one particular niche product/sector as well.
Does the company have good dividend yield/payouts?
As a long-term investor, you will ideally not be withdrawing your invested funds for at least 5-10 years, therefore companies having a high dividend yield can provide you with additional income every year. Paying out dividends regularly is also a proof that the company has adequate cash reserves, and may have good liquidity.
Are the company’s management and owners efficient and ethical?
While most investors can’t personally contact a company’s management, it is still possible to research about them online and assess their integrity through their actions. Ideally, management should always act in the best interest of the shareholders and the business. Another one key aspect to consider is promoter (owner) buying and selling, as it signals the level of confidence the promoter has in their company, and also impacts the share price of the company in the short to medium term.
What is the opportunity cost of your investment?
One crucial factor that some investors fail to consider is opportunity cost, the cost of missing out on other investment opportunities in the market. While you may have researched about and invested in a “perfect” company, there may still be other companies that are worth considering for investment. An investor must always compare whether their current investments are performing better than the other options in the market, such as the shares of other companies or bonds, index funds and fixed deposits.
These are our 12 tips to help you choose a fundamentally strong stock for long-term investment. We hope answering these questions will help you pick better stocks in your investment journey! If you liked this article, please share and comment below.