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The Best Stocks to Buy

I can just hear people screaming “tell me the best stocks to buy right now!” They want to know, and they want to know in this instant. They not only want to know before anyone else, but they want to buy the stock the minute after you or someone else tells them. My friends, this is not the way to buy stocks. You cannot rush out on some hot tip and make money on a couple stocks to buy now; there are rules to be followed, “Golden Rules”.

Golden Rules

Future prospects of the industry/company

The past is dead. It’s over. When you are buying a stock with an expectation to make money in the future, it’s the future that is important.

Will you invest in a company that makes Video Cassette Recorders (I hope you remember them) or the one that makes DVD players? Will you invest in a cement company in India/China or a cement company in Europe? I think the answers are quite self-evident.

Quality of the Promoter/Management

OK, smartphones is a growing sector and you can invest in it. But, will you invest in Apple vis-à-vis Blackberry? Again, I think the answer is quite self-evident.

You all know that not everyone can run and manage businesses. It requires great entrepreneurial and management skills to run successful businesses. A bad entrepreneur will ruin even a good company, whereas a good entrepreneur could turnaround even a bad company into a profitable one. Secondly, one can expect good entrepreneurs to grow their companies and even enter new upcoming businesses. Thirdly, good entrepreneurs may also show good corporate governance and not siphon away your money.

Group strength

Single companies, of course, enjoy undivided attention of the promoters and management. Besides, the allocation of the resources viz. men, material and money can also be done possibly more efficiently.

But there is a risk too! Adverse developments could pose a serious threat to the company. Therefore, if a particular company were part of some group, it could look for some support and possibly survive the crisis.

However, the converse is also true. You can see many examples of excessive diversification in the past. This divides the management’s time and resources across too many areas and dilutes their effectiveness.

Therefore, you must also study the group, if any, carefully and assess its strength. A good group will add some points in favor of the company; a bad group will reduce some points; while no group could mean zero extra points.

Sales and Profitability of the company

Fine, the industry may be growing and the management may be good! But does it all finally reflect in hard cash and that too consistently?

Typically, only financially strong companies will make money for themselves and for you. Weak teams may notch a few wins here and there, but only strong teams will be consistent winners.

Some key parameters about the company could be:

  • Size
  • Sales
  • Net profit

Are the profits genuine?

Cooking up the accounts book is almost as old as the concept of account books itself. Given that profitability is the key to success, it would be prudent to study the financial statements – profit & loss account, balance sheet and cash flow statement – very carefully.

Some of the ways of manipulating the books of accounts include among others:

  • Fake sales
  • Change in depreciation policy
  • Overstating Revenues
  • Understating Expenses
  • Off balance-sheet transactions

Instead of looking at just the book profits/EPS, you should concentrate on the cash-flow statements, which are relatively difficult to manipulate. Further, start with the foot notes, fine print and auditor’s comments. A lot of jugglery can be uncovered here.

Other financial parameters

Apart from operational performance, the balance sheet’s strength is also very important. A strong balance sheet not only gives the company the opportunity to grow, but also makes it less vulnerable to shocks.

Some key balance sheet numbers would be:

  • Debt/Equity ratio
  • Dividend record
  • Price/Book Value
  • Current Ratio
  • Return on Net Worth

Share Price

Finally, the price that you pay really matters. A good company’s share bought at a high price can become a bad investment, while an ordinary company’s share bought at a huge discount can become a good investment.

But beware – don’t look at price in the absolute sense. It is quite natural to think that a stock at $20 is cheaper and better than a stock trading at $100. Nothing could be far from truth.

People usually prefer low-priced stocks assuming they are cheap. However, many of these have poor business models and hence very low (or even negative) value. So despite being low-priced they are a bad stock as they have no value.

Therefore, look at ‘relative value’ in terms of PE/PEG ratio and not the ‘absolute price’.

PE/PEG ratio and the Margin of Safety

The most common determinant of a share price’s reasonableness is its PEG ratio i.e. PE/Growth Rate. In very simple terms, a PEG of 1 means the stock is fairly valued, less than 1 means undervalued and more than 1 means overvalued.

The principle behind Margin of Safety is to buy when the Price is at a discount to Value. If the value of the business works out to $150/share and the market price is $125/share, you are effectively getting something at a discount of $25.

While there is no guarantee that the price will not go below $125, the probability is low. Further, sooner or later, the market will realize the true value of the business and the chances of the price moving beyond $150 are high. In other words, the risk of losing money is low, while the odds of making money are high.

Trading Volume

Don’t forget to look at the floating stock and the trading volume. It may so happen that the prices do go up after you buy the stock. So, even though you are having huge profits on paper when you go to sell you may not find any (or sufficient number of) buyers. Moreover, the lack of sufficient volumes makes it difficult to value the stock fairly. And third, even small purchases could have a large impact on the prices.

This is particularly true of small and medium-sized companies. Not only is the capital size small in such companies, but the promoters have a very large share-holding, making such stocks usually very illiquid.

Further, the prices of small/medium companies are low and thus you tend to buy higher volumes. With low trading volumes, selling even 100 such shares is difficult, so selling large quantities is virtually impossible.

Does it match your financial profile?

Last, but not the least, you must not forget yourself. Remember, any investment can be good or bad only in relation to the investor.

Therefore, it is not as if a stock that meets all the above criteria, necessarily becomes a good buy for everyone.

There could many reasons for not investing despite the stock being fundamentally good:

Perhaps you already have a high exposure to the particular industry

Perhaps the time frame for company’s growth potential to realize does not match with your investment horizon

Perhaps the risk level is higher than your own risk appetite

Hence, apart from being good per se, it is equally, if not more, important for the share to match your financial profile too

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