6 tips to pick great stocks

Starting your stock market adventure? It might feel like diving into the unknown, but fear not- I've got your back.

Only 3% of Indians invest in stocks, compared to 13% in China and 55% in the US. If you're gearing up for your first stock purchase this new year, kudos on taking the plunge into the 3% club.

Now, with over 5,000+ stocks out there, deciding where to put your money can be daunting. So, let's cut to the chase and focus on the good stuff- picking the right stocks. Remember that nervous excitement from your first investment? Yeah, I've been in those shoes, too.

I've crafted a concise checklist of 6 key tips, plus a bonus, to guide you through the stock selection process. Stick around till the end, and let's make your first investment journey smoother.

Now, the first few tips might seem elementary, but as Ralph Waldo Emerson wisely said, "It's in the ordinary that we find the extraordinary, and in the simple things that the most important messages are whispered."

So, without further ado, let's jump into Tip #1.

1. Company's Track Record

I'm sure you've come across headlines like this one, 👇

“RBI slaps penalties totalling ₹10.34 crore on Citibank, Bank of Baroda, and Indian Overseas Bank for non-compliance.”

“RBI imposes fines on Union Bank of India, RBL Bank, Bajaj Finance over regulatory lapses”

These are common occurrences. Stock exchanges, regulators, and government bodies often slap fines on certain banks or companies. If you're venturing into the stock market and eyeing your first company, here's a crucial tip: check if the company frequently faces fines or warnings from government agencies.

How do you do that? It's simple. Just type your company's name on Google followed by terms like "fraud" or "scam"- you'll quickly uncover its history. Keep in mind that if one mistake surfaces, there might be more lurking beneath the surface. 🤫

Now, think about reputable companies. Have you ever heard of Asian Paints in a scandal? Or is Pidilite in the news for the wrong reasons? What about Colgate? No, right?

Quality companies tend to steer clear of controversies. If one does pop up, it could be a red flag for more to come. It's wise to stay away from such companies. This insight revolves around a company's track record.

Now, let's shift focus to the track record of those running the company.

2. Management's Track Record

Imagine you're all set to invest in a company, but a nagging fear creeps in: 

What if the company shuts down tomorrow? 
What if the owner takes off with my money? 

Could the same happen to your chosen company? If the promoter or owner faces trouble, will they bail on you? To dodge this potential headache, especially for beginners, go for companies with highly reputable owners.

Ask yourself, can Pirojsha Adi Godrej or Ratan Tata vanish with your money? It's highly unlikely. As a novice investor, it's safer to opt for companies that have a long history of positive reviews and owners respected by both the market and the country. This way, your money stays secure.

Let's move on to the third point with an example.

3. Debt Scenario

Consider this scenario: you have the choice to become a partner in two businesses. Which business would you choose?

I'm anticipating your answer is Business 1- the one with no debt. When there's no debt in our personal or business life, it naturally leads to a stress-free existence.

Whether in the stock market or our lives, it's advisable to steer clear of companies with high debt. The more debt-free a company is, the lower the risk of going bankrupt. The less debt, the safer your investment.

Now, here's an interesting tidbit. Ever wonder why there's "Limited" (Ltd.) in every company's name? Take Colgate-Palmolive Limited, Tata Steel Limited, or my company, Finology Ventures Limited. It signifies that your responsibility for providing money is limited.

Even if a company has a debt of ₹100 crore, its owners and shareholders don't need to sell their homes to repay the loan. A company is distinct from people- its debt is repaid by the company, not its owners. The term "Limited" is there to emphasise this point.

Rest assured, if the company you've invested in falters, the creditors won't come knocking at your door. As a shareholder, you're not personally responsible for repayment.

However, this doesn't grant you the green light to invest in a company with any amount of debt. Why? Because your share's book value indicates the company's assets against your one share. For instance, if the book value is ₹100, it means the company has assets worth ₹100 for each share.

As the company sells assets to repay loans, your share's value will decrease proportionately. So, investing in a highly indebted company may not jeopardise your house, but it won't lead to an increase in your share value. 

Instead, your share price will keep falling, mirroring the ongoing sale of the company's assets. This is another reason to steer clear of companies with excessive debt.

4. Sales and Profit

Take a visit to Ticker by Finology and ensure that the stock you're eyeing has consistently increased sales and profits. Growth in both is crucial- merely one on the rise won't cut it.

Scenario 1: Sales are increasing, but profits are stagnant.

This isn't an ideal situation. It suggests the company is more focused on boosting sales than on growing profits. While anyone can increase sales without a substantial profit or even at a loss, truly exceptional companies, the big players, are those that expand both their sales and profits. 

Take Eicher Motors or Page Industries, for example. Their products soared in popularity, yet they never compromised on their profit margins, delivering impressive returns to shareholders.

Scenario 2: Sales are not increasing, but profits are on the rise.

Here, the red flag is that the demand for the company's products is limited. If they're selling 100 units, that might be their cap. While any company can boost profits by selling 100 units, the key questions are about efficiency and cost-effectiveness. 

There's a limit to how much they can enhance efficiency or reduce production costs. Without a continuous increase in sales, profits can't sustain growth for years. Saturation is inevitable. This is why it's vital for both sales and profits to keep growing. As a beginner, spotting this is easy, so keep it in mind.

5. Return on Capital

Sure, having a high margin in a business is appealing- you sell a ₹100 product and pocket ₹20, a 20% margin. But here's the catch: determining whether a business is good or bad depends on the amount of money invested in it.

It's not just about the margin from sales; it's about assessing the total investment required to run and sustain the business. Consider a scenario where you set up a large cement plant. The net profit margin would indicate how much profit you make on one bag of cement, factoring in costs like plant operations, labour salaries, and what's left after covering all these expenses.

However, the crucial aspect is understanding the total expenditure. How much did you spend on raw materials, salaries, building the plant, acquiring land, and obtaining government licences? This holistic view, compared with the resulting profit, is what defines Return on Capital.

Return on Capital reveals the profitability relative to the total investment in the business. So, it's not just about the net profit margin; Return on Capital is the key metric to gauge whether a business is good or bad.

6. Customer Satisfaction 

Consider this: a product, initially marketed as new and innovative, may experience a surge in sales for a short period- say, one or two years. During this hype, it's easy to be swayed and buy into the company, impressed by the immediate success.

But here's the critical question: 

1. Will the company's products maintain popularity in the long run? 
2. Will they continue to sell? To answer this, it's crucial to assess customer satisfaction. 
3. Are the people buying these products happy?
4. Will they be repeat customers? 

The best way to gauge this is by investing in companies whose products you use yourself. As a customer, you can provide firsthand insights.

Now, onto the most important and special tip- Tip #7.

7. Think Like an Angel Investor  

Imagine you're about to make a substantial investment in a company, almost buying it out entirely. Let's say you have ₹5,000 crore (Because, you know, who's just casually handing out ₹5,000 crore anyway?), and you're exploring companies in India within that budget. 

Consider two examples: KPI Green Energy Ltd. and Wonderla Holidays Ltd. Both have market caps below ₹5,000 crore, meaning you could acquire all their shares for that amount. Now, the decision-making process kicks in.

Firstly, examine their profits. KPI Green Energy Ltd. earns ₹23.77 crore annually, while Wonderla Holidays Ltd. makes around ₹13.52 crore. The comparison reveals that for the ₹5,000 crore investment, one company yields about ₹24 crore per year, while the other brings in ₹13.52 crore.

Now, the critical question: which is the better investment? Consider additional factors like future profit growth, overall growth potential, and competitive landscape. After crunching the numbers, your brain will guide you toward the better option.

When selecting a company, start by looking at its market cap. Does it have a ₹1,000 crore market cap or a ₹2,000 crore market cap? Then, within that market cap, explore other companies. Imagine if you were fully buying one company from this group- consider 4-5 similar-sized market cap companies. Your preferred choice becomes the company whose shares you should invest in.

For an outline of the basic filters you need to apply to help you identify strong companies, refer to the article: "The Ultimate 7-Step Guide to Screen Top Stocks." 

The Bottom Line

In stock picking, I always abide by these tips- it's been my go-to for selecting the best, not just the second best. 

Check out our numerous articles on Insider by Finology for more insights. Until then, this is Sakshi signing off. Bye-bye! 👋

*Disclaimer: The stock discussed above aren't recommendations from Finology, and shall not be construed as a replacement for professional advice. Consult a professional or conduct the necessary research before making an investment decision.