Investing in the stock market and deciding to buy a particular stock are two different decisions. The latter requires proper analysis.
Equities have historically been the best performing asset class, and hence the best bet for wealth creation. But deciding to invest directly in stock market and deciding which stocks to buy are two very different decisions. The first one is fairly easy and depends on your risk-appetite. The second one, however, is not that easy.
Since equities are the units of ownership of a company, the fate of an equity investor is directly linked to the company's performance. So, it is important to invest in right companies which offer consistent growth opportunities. This calls for fundamental analysis, which is the backbone of investing. Let us understand important factors, related to fundamental analysis.
Macroeconomic and industry outlook: Irrespective of the strength of the stock, it will get impacted by the overall macroeconomic scenario in the country like inflation, interest rates, liquidity, political stability, foreign flows and so on. Global macroeconomic outlook also has a bearing on equity returns due to capital flows into equity markets. The stock's performance also depends on the latest developments and industry outlook in terms of growth, demand-supply, regulatory changes amongst others. One should know if a company is in a growing or saturated industry. Even weak stocks in a strong sector may give better returns than a good stock in a sector with weak fundamentals. Lastly, market leaders always command premium.
Promoter, management background and quality: Once you are convinced about the positive economic and industry outlook, you need to analyse stocks in that sector. It is important to check the background of the people at the helm of affairs in a firm - the promoters and top management. Being in the driver's seat, their ideology, vision, integrity and execution capabilities will impact the business. It will also have long-term bearing on the shareholders’ interests and stock returns. This is especially important for start-up or mid- and small-cap firms as right leadership is very essential for their growth.
Dividend payout policy: Knowing that equity is a high-risk-high-return asset class, it is prudent to safeguard a portion of your investments and get it back periodically as dividend. Dividend yield shows the return you can expect as a percentage of the stock’s current market price. The higher the dividend yield, the better. One must keep in mind that companies in a growth phase may choose to redeploy the earnings in the business itself instead of paying dividend. This should not undermine the attractiveness of these companies.
Leverage - debt to equity ratio: This ratio indicates what proportion of equity and debt the company is using as finance. If the ratio is greater than one, assets are mainly financed with debt and less than one means equity provides a majority of financing. It displays the financial strength of a firm and assumes greater importance during market downturn as huge borrowings will have fixed obligation in the form of interest payment.
Annual report, director's report, auditor's report & management discussion: The best place to get information about a company is in its annual report. There is a wealth of information in all annual reports. The management discussion and analysis will tell you about the company's future plans. The directors' report will tell you how the company performed in the preceding year. The auditor's report also assumes great importance as it is an expert's certification stating if the company management is telling the truth or not.
Corporate profitability and valuations: One important measure to gauge the profitability of a company is its returns-on-equity (ROE). Higher the ROE, more profitable is the company. Once you are convinced about the fundamentals, look at the valuations. The most common valuation ratio is the price-to-earning (PE) ratio. It is the ratio of the current market price and the expected earnings per share (EPS). Typically, stocks with expectations of higher earnings growth will have higher PE and vice versa. One should compare the ROE and PE ratios of companies with its peers and with the company's past performance.
After having invested in the stock, it is important to keep a track of the developments on the above parameters. Active trading is not recommended. One should always invest with a long-term view. However, if there is a structural shift in the underlying fundamentals and it is important to reassess the stock.
With some research on the above mentioned variables, an investor can reduce the risks inherent in equity investments. Relying on advice from friends is not a good idea. It is necessary to do some groundwork yourself. Wealth creation is not just luck. A continuous learner can create great wealth by following a disciplined investment approach.
The writer is chief investment officer of Birla SunLife Insurance
