“A correction is a wonderful opportunity to buy your favourite companies at a bargain price.” - Peter Lynch
A sale is going on for you if you are a value investor or a growth investor. This Market Crash has allowed us to buy some great businesses at a deeply discounted price.
So, what makes a business great? And, how to identify them? We are happy to break this down for you. Here is a list of 5 things to look for before buying a stock.
1. All that glitters isn’t gold
Most financial frauds by the companies are done through inflating profit and revenue. Remember, the Satyam Scam! It happened by booking false revenue and profits. Therefore, to check if gold is gold, you have to take the help of the Cash Flow Statement. Check the percentage of Cash Flow from operations with EBITDA to find if the company has booked genuine profits or not. This percentage should be better compared to its peers. It is a good sign if the company can convert its profit into cash.
2. Growth Potential of the Industry
While picking a stock of the company, check whether the industry in which the company operates has high growth potential and a large market size. You can get industry insights from the Annual Report of the company. If the industry has entry barriers, the company will enjoy low competition and thus have high profitability. An industry also becomes unattractive if the business is highly regulated by the government.
3. Management Quality
Save yourself from investing in the next Yes Bank! The Board of Directors takes all the major decisions to run the company. The Board contains both promoters and non-promoters. In the case of Yes Bank, the promoter controlled the business decisions and the Board couldn’t do much about it. As an investor, you need to check whether the Board of Directors can protect the interest of shareholders. If the majority of the Key Managerial Personnel are related to the promoter, it is most likely that the company is used for their benefit. One common trick seen in such companies is that they give high amounts of loans to either promoters or their companies or other subsidiary companies which are controlled by promoters and these loans are never repaid.
4. Valuation of the Company
PE Ratio is generally used to evaluate whether the company is overvalued or undervalued. The PE ratio cannot be measured as low or high in absolute terms. It is a relative concept and has to be compared with the industry average to find out about the valuation of the company. This ratio shows the confidence of investors in the company. Hence, a low PE does not necessarily mean a company is undervalued. You have to check for other reasons as well. For example, if the promoters have pledged their shares, then the PE of the company could be extremely low. This shows the low confidence of investors and the share is not undervalued.
5. Sustainable Competitive Advantage
Competitive Advantage is what gives a company an edge over its competitors. But, this edge should be sustainable. Suppose you go to a shop only because it is near your house. If another shop opens that offers the same goods with better quality, you will shift as a customer. So, here the location of the shop was a competitive advantage but not sustainable. Companies can have different competitive advantages like having a unique business model, Intellectual property, monopolies, Pricing power, etc.
Conclusion