(This article appeared in Moneylife – November 2014)

Here is a beginner’s guide

 

Often, people ask me for a list of books to read on the topic of investments with a view to being able to pick up stocks. I casually mention a few books and they write the titles down. Maybe they buy and read those books; maybe they do not.

 

However, I am not so sure that it makes the task of stock-picking any easier. For those of us who are not professional analysts, identifying a stock is akin to the story of blind men and the elephant. Where to start is itself a daunting task. And in this fear, we are happy to profess our willingness to bow to ‘superior’ knowledge or ‘leave it to the professional’. We are ready to do anything to get out of this pickle—of having to choose a stock.
Of course, everyone says that he is putting money in stocks to ‘make money’; ‘beat inflation’; ‘asset allocation’; ‘portfolio diversification’, etc. The knowledge gap starts here. Why do we think stocks help us achieve any of these outcomes?
All of us know that buying a share is like buying a piece of that company. We put our faith in the existing promoter/manager to run his business in a manner that it remains profitable and keeps getting better (or at least not worse) over time.
As the business keeps growing whilst remaining profitable, we expect that the stock markets will correspondingly give a higher value to the shares that we own. Thus, it is most important to know the business prospects of the company that we target for investment.
If a business is doing well, the numbers will reflect that. The first step is to understand the business. If we can get a handle on that, we will know whether or not to invest in a company. The number-crunching is not so important. Numbers help us to identify and put an ‘estimated’ value on the share and help us make a decision about whether we should buy, or sell, at a particular price.
And this number-crunching is also just one aspect of the stock price. There are other factors like liquidity, state of the economy, mood of the investors, etc, which can move prices.
If we have to make a beginning, let us say, through a systematic investment plan (SIP) route, into direct equities, understanding price and its components becomes less important than understanding the business of the company. Thus, we can break down analyses into two parts—business analysis and price analysis.
I would say, let us leave the price analysis to the experts. If we choose SIP, we are not so concerned with prices. Hence, the business analysis becomes important to us. The main comfort we have to derive is whether the business will remain prosperous for the next 10 years or so and whether its products continue to find favour with customers. This is perhaps the most difficult question to answer. For instance, who would have thought that a Nokia handset would lose its dominance or that in a simple product like a shaving aid, Gillette will continue to dominate the market for years?
One of the things we learn early (leave it to those who can time the market) is to avoid products, or services, where there is some seasonality (sugar), cyclicality (shipping, capital goods), or governmental interference (oil & gas, electricity, etc).
Of course, there could be more factors in our ‘negative’ list (infrastructure, real estate, etc, due to mistrust factor). The main idea is to understand all the factors that can impact a business. Right from demand & supply to consumer preferences, competition, etc, everything plays a role in the longevity of a company.
One factor to bear in mind is that if we like a business, we should try and pick the leader/s. There are different views on whether an industry gets dominated by three or four players. Anyone who is fifth or sixth or 19th is simply an also-ran (or a ‘me-too’) who is doomed to extinction.
So, if we think that chocolates are an undying market, do not chase a small unknown brand.
Cadburys, or Nestlé, it is, if you want to bet on chocolates. Then there are ephemeral things, especially in the technology space, where the life span is measured in a few years. If I do not understand it, I will keep away.
It can happen in commodities also. For instance, aluminium was once a much-used commodity. However, plastics replaced it in many applications and aluminium is now a pure commodity play.
There are companies like a Hindustan Lever or an HDFC that demonstrate longevity from which we can learn. There will be companies or businesses where we are not so sure and, somewhere, we end up making guesses. There are many, where we are unsure. It is part of the game.
I believe, it is important to understand the business of the company and its scope for longevity as much as possible. And, while there may be separate success factors for each company, we can surely find one common basis to evaluate companies. Financial analysis can wait. If we are pursuing a SIP strategy, financial analysis becomes less important and we need not feel inadequate, or challenged, because we do not understand ratios or prices.
If I were to recommend just one book that helps you understand a business, or an industry better, I would urge you to read Competitive Strategy by Michael Porter. I have found the framework for analysis given in this book outstanding and timeless.
The author takes you through general analytical techniques, industry environment and understanding strategy. I will not spoil it for you by giving a summary or a perspective. Suffice to say that I still discover gems from this book as I keep reading and re-reading it.
As you get into the book, you will start matching companies in real life with what he talks about theoretically. This book gives you enough tools to dig deeper into a company and understand a company better.
The book is written in simple English. It does not demand any knowledge of accountancy or book-keeping or economic theories. To me, this book is a MUST OWN and MUST READ for anyone who is interested in stocks for the long haul.
There are many ‘classics’ on investment. Of course, people will recommend two books by Ben Graham and David Dodd (Ben Graham was the inspiration and guide to Warren Buffett).
However, to a non-finance person, I would push a book titled Common Stocks and Uncommon Profits by Philip Fisher.
This book (please read it, after you read Michael Porter) will give you a checklist for stocks. He lists 15 attributes that you would like to run through. He also tells you what to avoid.
So make a beginning in financial literacy with just two or three books. Hopefully, they will lead you to finding good stocks. And, in case you are interested in some basic understanding of a balance sheet, profit and loss account, etc, please get a very easy to understand book How to Read a Balance Sheet.
There are more than a few books with this title and the one I am referring to is published by ILO (International Labour Organisation). An Indian edition is available on Amazon and costs Rs380.
This book is easy to understand and will help you overcome your fear of financial speak. This is one book which has to be in print or hard copy format. An e-copy will not do. Get rid of your fears; be systematic and disciplined, if you want to make money from stocks.
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7 thoughts on “How to Select Shares

  1. may be Bala sir can share his wisdom on what to select and why. From reading on the guide lines of his past posts it seems he is very risk adverse and choses stocks where there is surety ex. Cummins, CRISIL, MRF, HDFC Bank, Colgate

    One the second note he keeps some small corpus on side for total gambling for cyclical stocks ex. cement,steel etc. situation specific stocks ex. MCX at given time

    Bala here likes to talk about idea and let you figure out stock and he works hard to get the framework right rather then discussing stocks.

    ( I may be totally wrong on the stocks i have put here, As this is my pure assumption as i have been a silent admirer of Bala sir, I have only read his post and never seen/meat him in person. Please don’t think that i am advising the above stocks. )

    Like

    1. one day. The problem is that I cannot do any specific recommendations, thanks to SEBI. I am not a registered adviser. I do not make any money to pay the fees there.

      Like

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