Let’s say you recognize the corrosive nature of inflation, doff your hat to the marvel that is compounding and realize why equities are critical to wealth-building. Good going already. You’d now like to build your very own stock portfolio that you hope will grow your wealth manifold over the years. Fantastic! So, how do you find your first stock?
Where to look
One way is to flip through the pink papers or to CNBC to see what stocks the talking heads are eagerly touting as the next big thing. It is also probably the worst way.
Reading the Financial Times to prepare for markets is equivalent to reading a spy novel to prepare for a mathematics exam.
— Nassim NicholنTaleb (@nntaleb) February 2, 2015
The other downside of buying your first stock based on a tip is that it doesn’t become your stock. It’s just something you clicked and bought.
For the Calm Investor, your first stock should:
- be something you know and preferably use extensively
- have a simple enough business model
- not be bought as a potential “10-bagger” but as a learning tool
Buy what you know
Peter Lynch, probably, the 2nd most-famous investor in the world, said “Buy what you know”. The anecdote supporting this strategy was how his wife raved about L’eggs, the new line of pantyhose launched by Hanes, that was available at local supermarkets as opposed to only high-end department stores. Following further research and analysis, he bought Hanes for his portfolio which went on to give him great returns.
Since then, the strategy has been misconstrued and therefore criticized to such an extent that in the latest edition of his best-selling book ‘One up on wall street‘, he updated the introduction to say “Peter Lynch doesn’t advise you to buy stock in your favourite store just because you like shopping there”. He probably meant to suggest using “buy what you know” as a starting point to identify potential investments, which, if you think about it, offers significant possibilities.
So, what do you know?
Typical weekday morning: Wake up – Check time on smartphone (Apple iphone / Galaxy S4 / Micromax Canvas) – brush teeth (Colgate / Closeup / Vicco) – Change into running gear (Nike / Reebok / Adidas): Run – have a cup of tea or coffee (Brooke Bond / Tata tea / Nescafe / Amul) – turn on the water-heater (Bajaj / Crompton Greaves) – shower (Cinthol / Fiami-di-Wills) – shave (Gillette) – dress for work (Jockey / Zodiac / Arrow / Raymond / Hush Puppies) – quick bite to eat (Quaker oats/ Kellogg’s / Britannia) with a glass of fruit juice (Tropicana / Real) – ride/ drive to work (Hero / Bajaj / Maruti Suzuki / Hyundai)…
Turns out, you already know a lot. Keep track for a few days and some products will strike you as being nearly irreplaceable in your daily life.
Look out for products-brands that:
- evoke an age-old emotional connect
- you have a hard time even thinking of competitors
- you wouldn’t consider replacing because they’re the best at what they do
Each of those should make it to your “first-stock potentials” list. Identify the parent companies of the brands you identify. Filter out those that aren’t easily accessible to Indian investors; international companies not listed in India (Apple, Samsung), private companies (Micromax). Looking at the role real products and companies play in your life will make this exercise fun.
An illustrative list could look something like this:
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It’s apparent that this approach leaves out broad sets of companies not involved in consumer-facing industries. But that’s ok since this exercise is to pick your first stock and not an entire portfolio.
Five traits of your first stock
Now that you have your short-list of potential stocks, you need to dive deeper to identify the stock most fitting to be your prized first buy. There are hundreds of possible things to look at in a company, but the idea of this site and this article in particular is to identify those key aspects that allow you to be reasonable confident in the strength of a company.
1. Size & Longevity
Size because the largest firms by market capitalization have the most eyes on them, tend to be among the leaders in their industry and longevity because you want to be sure the company has been in its chosen business for long enough to be able to run it with its eyes closed.
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They’ve all been around for a decent length of time, with Godrej and Bharti Airtel being the babies of the group at under two decades so that shouldn’t rule anyone out. However, there’s a big range in market capitalization between HUL and Colgate.
Let’s draw a line at ₹10,000 Crores (~$1.7Bn) which eliminates Bata India.
2. Extent of borrowing
The debt-holder gets his share of the companies profits – a pre-determined amount, before the share-holder does. In a year where the business doesn’t do well due to any reasons, the shareholders get proportionately less, but the lenders are due the same amount. So, a company that isn’t able to pay lenders can go bankrupt, even if the decline is temporary. This makes any company that borrows a lot of money (relative to what it makes in an average year) a risky equity investment.
Corollary: A company that doesn’t need to borrow is better at funding it’s own growth from what it makes, thus indicating its probably better at running a business than one that needs to borrow a lot.
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None on our list is a “big” borrower. Page Industries with a Debt-Equity ratio of 0.49 (including short-term debt) could raise an eyebrow. But, it has a healthy interest cover, which means for every ₹1 it needs to pay it’s lenders, Page Inds makes ₹23.6 in earnings before interest and taxes. The other company that’s a question mark is Bharti Airtel because of it’s interest cover of just 7x and a sizable debt burden. Let’s remove Airtel but leave Page in for now.
3. Profitability & Growth
An ability to run a business profitably and to grow those profits over time is essential for a company to be a good stock investment. Therefore, we prefer businesses that are consistently profitable and also show some growth over time.
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Some credit is due to our initial method of identifying strong brands that they’ve all been consistently profitable. However, earnings growth (adjusted for stock splits) suggests some underperformers. Gillette India, Colgate and Maruti Suzuki lose out and can be eliminated here.
4. Quality of earnings
Which is better: A company that uses ₹1,000 of capital to generate ₹10 in earnings or one that uses ₹100 to do the same? The second company is able to make more productive use of its capital and is therefore a better investment.
Note that this metric tends to vary across sectors depending on their capital intensity. Can the company generate earnings at a rate much better than a regular bank FD could (In the above example, putting ₹1,000 in the bank would get you ₹90 in pre-tax interest at 9%, obviously better than the ₹10 the fictional company managed)
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A wide dispersion in how effectively companies utilize their invested capital. We can now remove Godrej Consumer products because of the relatively low RoIC and the decline in the latest financial year. Britannia has the 2nd lowest 5 year average but with a sharp increase while Bajaj Auto has a healthy average but a decline. Let’s also remove Britannia for now from our consideration set.
5. Management quality and other qualitative stuff
We started with 10 companies and whittled them down to three; Hindustan Unilever, Page Industries and Bajaj Auto, all in different businesses. Now comes the hard or the fun part depending on your bent of mind.
One makes branded packaged foods, one is the exclusive licensee of a known underwear brand and one makes two-wheelers. Assuming you do not have a clear preference on which sector will do better, your decision will need to take into account which management you have most faith in.
There are several ways you could approach it, but no clear-cut metric will help here. Why not? After all, the three key ratings agencies in India have something called a corporate governance rating (CRISIL, CARE, ICRA). Because, on 22nd Sep, 2008, a global corporate governance ratings agency awarded the ‘Global Peacock Award for Excellence in Corporate Governance’ to this company, and on 7th Jan, 2009, the founder wrote a letter to its board of directors admitting to accounting fraud.
Some things to think about when considering the management of your shortlist:
- Is the promoter (founder) still involved? Has (s)he maintained or reduced ownership stake?
- Their tenure and track-record, have there been many changes at the CXO level?
- Do they talk up the company and make lots of optimistic statements or do they try to temper expectations? (Consider this, a research paper in the US found an average +1.6% jump in stock price when CEOs appeared on CNBC. This gain then receded over the next 10 days)
- Any radical departures in strategy, like going on an acquisition spree, buying back stock at historic highs, investing in an unrelated business…the list goes on
Now its time to make your decision and buy your first stock. Notice how there is no mention of price until now. That is deliberate. While price is a critical element of the stock-buying process, its secondary to buying quality companies, especially as you begin.
The objective of buying your first stock should be more to learn about your reactions to the vagaries of Mr. Market as the price of your stock fluctuates soon after you buy. That urge to check on the price every 5 seconds, the elation when the price ticks up by 1.1% and the rising dread when you see it go the other way. All are stimuli that tell you about your temperament as an investor. Over time, as the stock either gains or loses, you learn to revisit your assumptions about the company and refine your method.
And above all, stay calm and enjoy the process.
Disclosure: Of the stocks mentioned, Colgate is currently part of my portfolio
‘Buy what you know’ is a seriously flawed investment strategy – Business Insider
Buy your first stock – Motley Fool