At the time of writing this blog, the absolute return of the Nifty 50 index has been 65% over a 1 year period and 42% over 3 years. Rs.10 lakh invested in a simple Nifty 50 index fund could have fetched you close to Rs.6.5 lakhs in just 365 days. What’s more telling is that this is the return generated by the top 50 listed companies of India. Many people were before this under the assumption that larger companies are generally on the expensive side of valuation and have limited return potential. Well, they are not exactly wrong there either. If you look at the 1-year returns from the Nifty Small Cap index(smaller companies by market capitalization), it generated a whopping 130%.
Such kind of returns in such a short period of time have never been seen before in the history of the stock markets. The stock markets in other countries too have a similar story to tell. While the reason for such a parabolic rally is no doubt due to the liquidity effects of the Covid19 pandemic, the question remains – How will 2021 be for Stocks?
2020 was a period where buying stocks of any company, big or small, would have guaranteed you decent returns. The same certainly looks slim to be repeated in 2021. This year will come down to selecting the right stocks. Hopefully, by the end of this blog, you’d be able to understand the process of identifying the right stocks.
Key Fundamental parameters to look for :
Treat investing in a stock just like you would treat giving a loan to someone. Look at various aspects of a company before buying into their stocks. Don’t just make choices based on what you hear on the television or what your friends are doing.
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Understand the business model of the company and the industry/sector it operates in. Study reports on sectoral analysis. Once you are sure of a sector’s ability to do well in the future, the next step will be to identify a company that will benefit from it.
So, select a bunch of companies from one sector and then compare them on the following grounds:
- Growth Rate – Compare the respective growth in revenues, capital expenditures and profit margins on a yearly and quarterly basis of different companies from the same industry or similar business models. Shortlist the top 4 or 5 stocks based on only this parameter.
- P/E Ratio – PE ratio stands for Price/Earnings ratio which measures a company’s current price to its earnings per share. Never judge a company’s valuation based on its own PE ratio. But look at PE in comparison to a company’s peers. This would give you a sense of what companies in the sector are overvalued. So out of the 5 stocks shortlisted, bring your list to the top 3 by identifying stocks that have more room to grow when compared to others.
- Levels of Debt – After having shortlisted the top 3 stocks from the sector, look at their levels of debt. Ideally, it is better to stick with companies that are ahead of its peers when it comes to CAPEX and are in the process of reducing their debt levels. It’s not like debt is necessarily a bad thing but if I had the choice to pick one company out of two, I would go for the one with lower leverage.
- Analyze the Management – Finally, look at the history of the company’s management and promoters. Here you will look at aspects such as the management’s past experience and performance. So listening to company con calls is a great way to start this process. Listen to past recordings of con calls to evaluate whether the management was able to deliver on its promises.
You should also look at the promoter’s shareholding changes over time. Since promoters are company insiders, them increasing a stake in the company is a positive signal. On the other hand it should raise concerns if the promoter continues to decrease their stake.
Conclusion
Stock selection is an art and takes time to master. It takes years of continuous learning, reading and analysis to finally have it all start working for you. So the biggest lesson of stock selection is to be patient, both with your analysis and investment. So it is better to start the process with smaller amounts of capital. Over time if you find your strategies to be working, you can continue to expand your capital base.
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