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How should I select a stock?

In this video, Dhirendra Kumar shares an essential checklist to understand a business before investing in it

What are the essential checklists for selecting a stock (especially for retail investors)?
- Mandagandla Nagesh

There are too many checks. Firstly, I would say that a company should have been generating a good return on equity or good return on shareholders' fund measured by a good decent ROE but not just for one or two years. It should be doing that for many years. Generally, we look at all the other alternatives or all the options before recommending for Values Research Stock Advisor. The quantitative filter is that we try to look at companies that are generating high returns on equity over the last eight-10 years in a sustained way. Of course, it will not happen every year. But generally speaking, above-average return on equity is a very important criterion. If a company doesn't make money, it won't be a great long-term performer.

Then comes - how is it doing it? Is it coming in at random or is it coming by the design of a product or service or customers' experience or the company's culture, which looks difficult to replicate. So, we look at how it is being done. What is the product? What is the service? And what is the competitive advantage of the business?

Then one should consider the people who are running this business. Are they credible enough? Do their actions align with the business? That is one of the biggest risks. While investing in stocks, you are effectively becoming a long-term investor, i.e. you are becoming a partner in the business. If the owner or the dominant partner of the business misbehaves or if the dominant partner of the business does not treat you equally, you are at a huge disadvantage. That translates into shareholders' value destruction over a period of time. There are plenty of jargons around it, but commonly referred to as corporate governance i.e. the people running the business. Where do they come from? Do they have enough skin in the business? For a large company, we generally look for promoters as owners who have at least 25 per cent stake in the company. For some small-sized companies, we would be very happy if they own 50 or 60 or 75 per cent of the business. This is because they will work hard to succeed with that business and they will be a key beneficiary and you would also be a great beneficiary alongside.

Then comes looking at an investment option that is scalable. Will it get bigger in size? Is it a large enough business with future potential? Or is that business completely exhausted or is it getting into any dimension of obsolescence? Is the company nimble enough to change its strategy, change its complexion and get bigger? Any change in the attitude of customers and things like that? So, there are many things to look for. Of course, we also look at all the downsides of investing in a business. When you subscribe to our Value Research Stock Advisor, there are about 30-35 questions on determining risk. These are standard questions. Most companies should actually be qualifying with 80-90 per cent of positive or favourable answers to them because that is actually a reflection of the riskiness of the management of the underlying business.

And then comes in the basic financial analysis wherein we see that the company is not indebted or not bought into a manner that it will land into trouble. There are companies which grow very fast but that could be because of borrowed money and whenever the tide turns or whenever the situation is not very favourable, their cash flows dry up and those companies struggle and many a time, they die. We have seen in the last five-seven years that some good and rapidly growing companies have completely disappeared during tough times.

So, there are a number of essential checks. There is a joy in exploring and decoding these nuances about a company, knowing about them, knowing new things about a company, knowing about their future plans and judging that company based on the likelihood of its success or the scale of its success. And most of the time, you'll be wrong. But if you are right a reasonable number of times after following the entire cycle of exploring, decoding, understanding and finally betting your money on that, it translates into a very rewarding and enriching experience.

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