Last Updated: 2nd Mar, 2018
2017 was a great year for Indian markets. The stock market gave returns of about 30% for the year 2017. It’s huge compared to declining interest rates on Fixed Deposits and Retirement plans.
Moreover, there were many top investors who beat the Nifty by generating returns in the range of 35% to 60% CAGR. They bagged big profits because of their years long experience with stock markets.
I am sure most of you must have generated below par returns or may even have lost some money.
Alternatively, you did not even invest in stocks because you were afraid of losing money.
In my initial days of investing,
I did not make any profits because I was investing in stocks after listening to the stock tips from brokerage houses (and so called experts on TV channels).
It’s their business. Everyone from brokerage house to financial websites to experts on TV channels make you believe that investing in stocks is very complex like rocket science. After all, if you know how to select stocks on your own, then how would they make money.
But, what if I tell you that there is an easy and simple way to identify some great stocks!
Indeed there is smart way to make profits from stock market:
.. and in this article I am going to guide you through a step by step approach to select great stocks that you could invest in.
Select Your Favorite Section
- 7 steps to invest in share market in india for beginners
- Types of Investing – Trading vs Value Investing
- Step by Step approach to Invest in Share Market in India
- Step 1. Screening and Filtering the right stocks using Financials
- Step 2. Select only the companies that you understand
- Step 3. Look for companies with sustainable Moat (competitive advantage)
- Step 4. Find Low Debt Levels
- Step 5. Use financial ratios RoE and RoCE to identify the right stocks
- Step 6. Honest, Transparent, and Competent Management
- Step 7: Right Price to Buy the Stock
- Portfolio Construction
- Portfolio Allocation
- Screening and Filtering the right stocks using Financials
- Select only the companies that you understand
- Look for companies with sustainable Moat (competitive advantage)
- Find Low Debt Levels Companies
- Use financial ratios RoE and RoCE to identify the right stocks
- Honest, Transparent, and Competent Management
- Find the Right Price to Buy the Stock
You can learn about stock investments with as little as Rs. 10,000 investment.
If you don’t have demat account, then choose one from the list of best demat and trading accounts in India.
Learn the approach and apply with 10,000 investment, if you make 5000 profits in the first year then the same approach can be applied with Rs. 10,00,000 investment to make Rs. 5,00,000 as profits in the future.
Learning is more important than earning in the initial days.
Disclaimer: The stocks mentioned in the article is not a recommendation to buy or sell. We are taking them as an example. Invest in the stocks after your own due diligence.
You can follow my approach even with minimum or no knowledge of financial statements at all.
Trust me, You can find great stocks with little smartness and basic knowledge of business.
Before I run you through my step by step approach for picking stocks, let’s first understand the two different methods to make profits in the markets and which of the two methods is practiced by majority of the leading investors across the world to create wealth for themselves.
- Value Investing
You are wrong if you think trading and value investing are one and the same thing.
Trading focuses on making frequent profits over a shorter time frame irrespective of the rising(bull) or falling(bear) markets.
During rising markets, trading involves buying at a lower price and selling at a higher price within a short period of time. They make profits in falling markets by selling at a higher price and buying at a lower price, also referred to as shorting.
Since, trading style involves entering and exiting at a shorter time frame, the holding period of the stocks is no more than few minutes or just a day or in some cases a maximum of few days.
People practising trading style make use of tools like technical analysis that makes use of complex indicators such as moving averages, stochastic oscillator to forecast the future price movement of the stocks.
A screenshot below showcasing technical analysis charts to predict the price movements of Axis bank stock.
Trading can be dangerous (heavy loss making) because of the huge volatility in the stock prices. If you do not have a clear strategy and are not fast enough you could end up with huge losses, wiping out all your money.
Market is full of such examples of men who lost money indulging in trading.
I tried trading a few years ago, made a profit of Rs. 10,000 on the first day and end up losing more than 100,000 in next few days. I knew that trading is not my cup of tea.
I focused on my strengths, that is researching stocks and holding for a long period.
Let me introduce the art of value investing.
Warren Buffett says, “If you aren’t thinking about owning a stock for 10 years, don’t even think about owning it for 10 minutes.”
According to him, you should invest in companies that you can hold forever.
The biggest advantage investors gain by holding stocks for such long periods is the advantages of dividends, stock splits, and most importantly dramatic rise in stock’s price levels as the underlying business (of that stock) grows profitably over the years.
Such stocks are referred to as multi baggers for the multifold returns that they generate for value investing practitioners.
The other advantage value investing offers over trading is that one gets to ride out the fluctuations in the stock price caused either by external events or business downtrends with the belief that the stock price will eventually recover and reward the investors with handsome profits.
Warren Buffet, the legendary value investor that every investor looks up to created wealth for himself by investing in good stocks and holding them for a long period of time.
What you are seeing in that picture is the power of compounding at play, which is at the core of value investing. When you hold stocks for long periods of time, it results in exponential growth creating huge wealth.
People practising value investing make use of fundamental analysis to draw conclusions about investing in a stock. In fundamental analysis, you ignore the daily price fluctuations but instead focus on studying the underlying business of the company, the sector in which it is operating in, its financials, the quality of management, and more.
Whereas people who practise trading aim to make a quick 10 to 20% return on a stock and then sell it off to move onto other. This way you might be able to make profits but never create wealth.
Fortunes are actually made by investing in the right stocks and holding on till you make a killing.
Income Tax Benefits
With trading, you end paying 15% short-term capital gains tax on every profit transaction you make since your holding period of the stock is definitely less than 1 year.
Whereas, with value investing, your capital gains tax is 10% irrespective of your profit being Rs 100 crores or Rs 100 when you hold the shares for more than one year.
George F. Baker, an American financier and philanthropist once famously gave the mantra
“To make money in stocks you must have the vision to see them, the courage to buy them, and the patience to hold them.”
There are literally thousands of companies listed on the BSE( Sensex) and NSE(Nifty). Unless you are armed with an approach that you could use to filter out, you would get lost in the sea of companies.
The investing approach that I am going to share with you is the one that I personally practice to filter stocks before investing in them.
Value investing is an ocean in itself and its practitioners go through a tedious process of analyzing stocks by reading through the financial statements, annual reports, and various other information pertaining to the financial health of the company before investing.
But, based on my learnings over the past many years, I have come up with the following simple and practical steps which you use to kick-start your journey of picking stocks even without having a deep financial knowledge.
There are thousands of stocks listed on BSE and NSE and it’s almost impossible to investigate each and every one of them by going through their entire financial information.
Therefore, for your initial consideration, you can use the below easy to implement screening criteria to filter out those stocks whose fundamentals look strong.
- Market Cap > Rs 500 cr
- Sales and Profit growth >10%
- Earnings Per Share(EPS) growth rate is increasing for the past 5 years
- Debt to Equity Ratio <1
- Return on Equity(RoE) >20%
- Price to Book value(P/B) <= 1.5 or low compared to peer companies within the same industry
- Price to Earnings(P/E) < 25 or low compared to peer companies within the same industry
- Current Ratio > 1
You don’t have to scratch your head to get the above financial information. Online screener tools available on financial platforms like Moneycontrol and EquityMaster provide this information readily.
For example, with the help of Equitymaster’s free stock screener tool, I applied the above screening criteria to filter some of the stocks for my initial consideration.
You can then check the other financial ratios as part of the screening criteria by clicking on the company factsheet
To know more in detail about the parameters I have used in screening criteria to filter out stocks you can refer this article on financial ratios.
Now that based on Step 1 you have filtered out stocks with good fundamentals from rest of the garbage, learn more about these stocks by reading about the underlying company as much as you can.
You can do this by visiting the website of the company, tracking updates on media platforms, searching for the company on Google, and getting peer feedback from fellow investors.
Learning more about the company will help you to understand the company’s business and will provide answers to three key questions
- Is the company’s business simple?
- Do I understand the product/service?
- Do I understand how the business works and makes money?
It is important that you invest in companies that you understand, at least in the initial stage when you are learning to invest in stocks. That way you will be ensuring that you don’t lose money.
For example, from the stocks that we filtered in Step 1, I would have looked at technology stocks like Tech Mahindra, Vakrangee, and Mindtree Ltd to begin with.
That is because, I have significant work experience in the IT sector and I am also passionate about technology which makes it easy for me to understand these businesses, the reasons for their growth, and predict how the future could turn out to be.
Similarly, my cousin comes from a Pharma background and therefore it would be easy for him to understand the stocks in that sector.
There could be many businesses that may not require any kind of background to understand at all – think consumer products like footwear, shaving cream, automobiles etc.
For example, your filtered list of stocks has a two-wheeler manufacturing company. You need not to have a background in the two-wheeler industry to know that the two-wheeler sector has always shown growth in India due to increasing demand and better road connectivity.
Similarly, when the real estate sector was growing in India, then the companies which manufacture tiles (Kajaria), sanitary (Cera), and similar supporting companies could be accessed.
The business model of the company should be simple and the company should excite you.
Lastly, if you do not find any stocks (companies) that you can right away understand, spend time studying the company and its sector.
It’s not enough that you identify companies that have passed the test of financial numbers and whose business models are easy to understand.
It is equally important to analyze the company from a qualitative aspect – Moat.
In business terminology, Moat is the competitive advantage that one company has over the other within the same industry. The wider the moat, the larger the competitive advantage of the company and more sustainable the company becomes.
Which means, it would be very difficult for the competitors to displace that company and capture its market share.
Now, that’s a stock(company) you would want to select and invest in.
Examples of this Moat can be brand power, intellectual property rights and patents, network effects, govt. regulations controlling barriers to entry, and many more.
For example – Apple has a strong brand name, pricing power, patents, and huge market demand that give it a wide moat which acts as barriers against other companies.
No wonder that Apple is close to becoming a trillion dollar company and has generated huge profits year after year, making great returns for its investors.
Another simple example of brands with strong moats is Maruti, Colgate, Fevicol which have huge recall value in public memory.
Similarly, out of the 3 IT stocks that I earlier discussed, Vakrangee Ltd has a strong moat. The company runs e-governance service in more than 41,000 digitally connected kendras (outlets) across 18 states that take deposits, offer loans, collect taxes/bills, let people apply for passport, enroll them for the Aadhaar biometric ID etc.
Given its huge distribution network across many states and the push for digitisation from govt, it would be very difficult for a new competitor to displace them off the market.
No wonder that the stock’s price soared from Rs 16 in 2010 to Rs 500+ in 2017. (Note: The current prices may go up and down based on the short-term pain in the markets)
So, look out and identify such companies with strong moats in the initial days.
Large debt levels pose a significant risk to the company. Couple of screening criteria which we used to filter the stocks were Debt to Equity Ratio and Current Ratio.
These two ratios are indicators of how heavily is company dependent on borrowed capital(debt) to fund its growth and whether the company will be able to meet its short-term capital obligations.
So when you are selecting stocks, apart from these ratios, check out how the company is handling its debt over the past many years. The company that is reducing its debt will automatically increase its profits which is a positive sign for the financial health of the company.
Simple Tips to Check Financial Health:
One way to do this is to check the company’s balance sheet where the company’s current liabilities and long-term debt is listed. In general, long-term debt is the debt that comes to due after a period of 12 months. And current liabilities includes the company’s debt that must be paid within the year.
Companies with too much long-term debt will find it hard to pay off these debts since most of their capital is going to interest payments, making it difficult to use the money for other purposes.
This poses a risk of sustainability and may lead to the bankruptcy of the company.
For example, below is the Tech Mahindra’s balance sheet showing the decreasing long-term debt from the year 2012 to 2016 which is a positive sign for the company.
Another way to check whether the debt levels are in a healthy state or not is by looking at the long-term debt ratio.
The long-term debt ratio essentially measures the total amount of long-term debt in relation to the total assets of a company.
A simple formula being
Long-term Debt Ratio = Long-term Debt / Total Assets
Taking values from the above balance sheet of Tech Mahindra, you can calculate the
Long-term debt ratio which comes to 0.008
If the ratio’s value is above 1, that would mean it has more long-term debt than it has assets. This means a high risk of not being able to meet its financial obligations.
In general, you would want to have a ratio which is less than 0.5, which in this case it is, indicating a low risk for the company.
Lastly, a rule of thumb watch out for real estate companies, infrastructure companies, and banks that are notorious for having large debts.
Warren Buffett makes use of these two financial ratios RoE(Return on Equity) and RoCE(Return of Capital Employed) to aid him in selecting the right stocks.
According to Investopedia, RoE is the percentage expression of a company’s net income as it is returned as a value to shareholders. This formula allows investors as an alternative measure of the company’s profitability and calculates the efficiency with which a company generates profit using the funds that shareholders have invested.
RoCE is the primary measure of how efficiently a company utilizes all available capital to generate additional profits.
These two financial ratios put together with help in understanding
- How profitable a company is in terms of investments
- How efficiently it is utilizing its resources
A company with high RoE and RoCE signals the great potential for future growth in value of the company.
Let’s take the example of Avanti Feeds, one of the stocks that we filtered using the screening criteria. As seen below in its balance sheet data, the RoE and RoCE are above 20% for the past 5 years and more or less have been increasing.
Companies that do well on these two ratios by being above 20% and increasing for the past 5 years command premium valuations.
Avanti Feeds stock has risen by over 7000% in the past 5 years creating huge wealth for its investors.
So, when selecting stocks, look whether the RoE and RoCE meet the criteria that I explained above.
Fraud management is one of the reasons some people do not trust the stock market with their savings. There have been many cases in the past where management of listed companies did shady deals, committed accounting frauds, misled shareholders & SEBI, causing a lot of monetary loss to investors.
A famous example being Ramalinga Raju of Satyam.
Therefore, it is very important that the stock and by extension the company you plan to invest in is run by honest, transparent, and competent management. The management includes Promoters, CEO/MD, CFO among others.
One such company run by competent and honest management that has created huge wealth for its shareholders is the one that I discussed earlier – Avanti Feeds.
As an investor, there are few ways to check if the management of the company has its heart in the right place or not
1. Search for fraud and track record
Use Google to search the names of the management and check whether there are any reporting of fraud against the company executives. Also, check their professional qualifications and their track record.
2. Read Annual Reports
Annual reports are a treasure trove of data to get a full understanding of the company and its management. Studying annual reports helps you to understand the management’s analysis, strategy, notice, and future vision for the company.
Ofcourse, on the face of it, everything would look good as the CEO of the company who has prepared the annual report wants to keep the investors interested in his/her stock intact. But, with experience, you will learn to figure out who is genuine and who is bluffing.
Tip: You can get the annual report at the company website as a free download. Alternatively, you can email the concerned investment relations in charge and get the annual report copy emailed.
3. Look out for Promoters shareholding
Higher the promoters shareholding in the company, the more positive signal it sends out to the market. In general, the promoters shareholding in the company may vary over the past many years.
However, if the promoters are increasing their stake in the company, it means that they have trust in the company, making it a good company to invest in.
If you have reached this step, that means you have narrowed down upon a few stocks to invest in. The only question that remains is what is the right price to buy them?
Just want to mention what Warren Buffett said about pricing, “Price is what you pay, the value is what you get”.
Find a maximum valuable company by paying a minimum price.
No matter how good the company is, if you buy the stock at steep value and the stock’s future doesn’t turn up as per expectations, then you would lose money.
Buying at the right price would give you that margin of safety, protecting your investment from any downside risks. Often this right price is the price that is way below the intrinsic value of the stock i.e way below the actual worth of the stock.
When the stock is available at such a deep discount (bargain) to its intrinsic value in the market, you grab it immediately.
This way you are buying the stock very cheap while increasing the chances of generating great returns in the future.
For example, one of the stock that I bought was the Indian Bank. It was trading in the range of Rs 70 to 90. But, its actual worth i.e its intrinsic value was at least Rs 250. That was a great time to grab the stock and people who did so, including me, made good money as the stock hit Rs 300 in less than one year.
One of the best way to calculate the intrinsic value of the stock is through Discounted Cash Flow model(DCF).
Let me also share formula to calculate the intrinsic value of the stock which is based on Benjamin Graham’s original formula to calculate the intrinsic value.
I will not say that the intrinsic value estimated by this formula is absolutely perfect. But for newbie investors, it will give a fair idea about the true value of stocks.
The formula is very simple
V = EPS * (8.5+1*G)
Here V = Intrinsic Value of the Stock
EPS = EPS (earnings per share) for the last 12 months (one financial year)
8.5 = Assumed common P/E ratio for any stock
G = Expected Annual Growth rate (for the upcoming 7 to 10 years)
For example, let’s take the stock TCS(Tata Consultancy Services)
Current Market Price of a Stock = Rs 3118
Expected Annual Growth Rate can be calculated by the below formula
In case of TCS, CAGR = (133.8/71.1)^¼ – 1
Here, I have taken number of years as 4 as I have data only for the past 4 years as seen in the above picture. Ideally, you should take the number of years as 5.
Secondly, we are using the growth rate of the last 5 years to arrive at the future growth rate G.
So, CAGR = 0.171 or 17.1%
Therefore, Intrinsic Value of the Stock V = 133.8 * (8.5 + 1*17.1) = Rs 3425
But, the current market price of stock = Rs 3118
Which means currently the stock is undervalued as it is trading 9.8 % below its Intrinsic Value
You can also think that the future growth G may not be the same as its last 5 years growth rate. In that case, you can assume future growth G = 75% of past i.e 75% of 17.1 = 12.82 %
Now, Intrinsic Value of the Stock V = 133.8 * (8.5 + 1*12.82) = Rs 2852
This way you get a range of the Intrinsic Value i.e Rs 2852 to Rs 3425 which helps you to check whether the stock is available at a cheap price or not.
Now, if the stock is not available at a cheap price, continue to monitor the stock so that when the opportunity arrives you can load it up immediately.
Note: One should not buy stocks on the basis of this formula alone as it would lead to errors and losses. Please always check the true value of stocks by using fundamental analysis tools like the DCF model and then cross verify using this formula.
Portfolio Construction is nothing but building a basket of stocks and allocating a certain percentage of your total investable amount to each of them.
In general, there are two ways in which you can build a portfolio
- A diversified portfolio of many stocks. For example – 15 or more.
- A concentrated portfolio of few stocks. For example – 5 to a maximum of 12.
There are many investors who chose either of the approaches depending upon their capital allocation strategy and succeed.
In my opinion, I would recommend the second approach – i.e building a concentrated portfolio. I would even suggest to just focus on investing in 5 stocks initially and with experience slowly move up to 10 stocks.
The simple reason being, with the diversified approach it becomes difficult to keep track of a large number of stocks and difficult to control risk during bad markets. But with the concentrated approach – tracking the stocks, reviewing the underlying business periodically, and controlling risk is relatively easier.
Note: I read the annual reports of every stock that I track (even without buying).
Also, the concentrated approach is suitable for wealth creation while the diversified approach is suitable for wealth preservation. I suggest you build a small number of high-quality stocks that derive maximum portfolio value.
On the capital allocation strategy, you can start small by building a portfolio of Rs 10,000 first.
On the allocation front, limit the holding of one stock to no more than 20% of the entire portfolio.
For example, if your investable amount(size of your original portfolio in beginning) is Rs 10,000 and you plan to invest in 5 stocks to make up your entire portfolio, then you shouldn’t invest more than Rs 2000 in stock. Of course, you can choose to allocate only 5 or 10% in a stock in which you feel the risk is higher.
Also, once you start investing and your portfolio starts appreciating, you need to allocate accordingly keeping in view the present value of your portfolio.
For example, if your original portfolio is Rs 10,000 and you allocate 20% i.e Rs 2000 in one stock. Now you have a holding of Rs 2000 in stock + Rs 8000 in cash.
After some months, your stock rises by 25% giving you a return of Rs 500, then your present value of your portfolio is Rs 8000(cash) + Rs 2000 + Rs 500 = Rs 10,500.
Now, next time when you allocate 20%, the allocation value has to be calculated on this Rs 10,500. So, 20% allocation would now be Rs 2100.
You don’t need an elite MBA or a Finance degree to know how to invest in stocks. Some of the best investors in India and around the world come from very humble and normal academic backgrounds.
For starters, take the help of this article to kick-start your journey of investing in stocks. In fact, Peter Lynch in his book says that “You need about a 3rd-grade math education to be a good investor”.
And, ultimately, your investing success will boil down to this simple formula
Investing Success = Identifying a Good Company + Buying at Right Price + Holding with Patience