Knowledge Centre

How to identify the right stocks to invest in?

Actually there are no hard and fast rules for selecting the right stock. Marquee investors like Warren Buffett, Ben Graham and Peter Lynch have followed a very methodical approach to gauge if the stock has the potential to generate above-market returns. Remember, investing in stocks is all about the future. Therefore you must invest in stocks that have a strong potential. The past really does not matter much; at best it is an indicator of how the future could reasonably look like. Here is a 5 step process to identify the right stock to invest in…

1. Get the sectoral story right:

For a stock to outperform, it must be in an exciting industry. You must focus on industries and sectors that are showing promise over the next 5 years. Attractiveness keeps changing. Take the case of the IT sector. For over 15 years, the sector was a consistent outperformer. However, in the last 2 years, the IT sector has underperformed due to shift in tech spending and a greater focus on digital business. Hence, do not get too focused on past performance.

2. Go after growth; that is what really matters:

It is hard to get good returns unless the stock is on a high growth trajectory. Take a basic comparison between PSU banks and private banks in the last 5 years. Private Banks have outperformed because they have managed to sustain growth in top-line and bottom-line. The stock market always rewards companies that are growing at a rapid pace and are likely to sustain growth. Focus on growth in revenues and profits. A situation where the revenues are growing but losses are mounting is not a sustainable situation.

3. Look at key ratios; they matter a lot:

The next step is to delve into ratios. You need to look at profitability ratios to ensure that the company is profitable on an operating basis and on a net basis. You also need to look at solvency and leverage ratios to ensure that the company has kept its debt within manageable limits. Quite often high debt is the biggest bane for companies. Finally, you need to look at efficiency ratios. Is the company using its fixed assets efficiently? Is the company locking too much funds in working capital? Is the company able to generate adequate ROE and ROCE? All these matter a lot.

4. Look at the valuation metrics of the company:

Don’t just look at the P/E ratio in isolation. Look at it with reference to growth and also to the peer group. Also look at ratios like P/BV if the stock you are considering is a financial stock or if it has a long gestation period. Also check if the stock is giving you comfort in terms of the dividend yield.

5. Does the company offer margin of safety and a moat?

These are two different issues. Remember, even the best of companies can be a bad investment if purchased at a very high price (like buying DLF at the peak in 2007). You must look at the margin of safety, which measures how much of comfort level you have over and above the valuation of the stock. Greater the margin of safety, the better it is. Also look at the moat. Has the company built some unique advantage that cannot be easily replicated? Buffett looks at the moat regularly and it is one measure that can result in outperformance.