Steps to choose safer stocks to invest
Disclaimer: This is not a stock recommendation or the process to choose is not full-proof and does not gurantee all-weather stocks. The idea is to understand the underlying concepts. Also this is based on experiences with Indian stock exchanges.
This document focusses on finding out stocks that are safe to invest. Safe-ness is about mitigating risks.
There are various categories of risks:
- Market risk
- Valuation risk
- Profitability risk
- Liquidity risk
- Solvency risk
- Governance risk
There are certain risks that cannot be measured but we can be aware of by lending ears to news:
- Regulatory risk → Governement regulations that might affect the sector or target company.
- Management risk → Change in the management level personnel, might be for good or bad.
- Headline risk → Some news, false or correct, just drive the stock price up or down.
Our focus here should be to mitigate the first set of risks because that is in our control.
And in a longer run, shorter risks do not matter if companies are fundamentally sound.
Tickertape serves as a reliable platform to provide data, stats and filters which we can use to quantify the risks.
To begin with, its safer to invest in NIFTY 100 stocks as they are stable companies.
- Market risk: There is an indicator called Beta which says how much is a stock sensitive to market. It means if market moves upward, by what factor will it move upward. Same applies for downward direction. It is good to have Beta less than 1 to avoid ultra-sensitive stocks.
- Valuation risk: There is always a question when to buy a stock and when to sell a stock. There are concepts like higher-highs, lower-lows, candle stick patterns, chart patterns to decide the timings. But the simpler parameter is to check difference between stock PE ratio and sector PE ratio. This difference should be less than 5. There are some short comings to this, hence to mitigate the shortcoming complement this with PEG ratio. PEG ratio should be less than 3(when overall maket is overvalued) or 1(when overall market is undervalued). PEG ratio filter is not readily available, to calculate this create a custom formula of (Price / EPS) / EPS-Growth.
- Profitability risk: Stocks shouldFolks, if you like my content, would you consider following me on LinkedIn. always be profitable. It does not matter how much revenue they generate if they are not profitable. Question might be that why look for 1 Year parameters, if we are looking at respective 5 Years. The reason is to be sure that no abrupt changes happened in last financial year. Always look at these parameters with no compromise:
a. 5 Year EPS → should be greater than 10 %.
b. 5 Year Average Net Profit Margin → should be greater than 10 %.
c. 1 Year EPS → should be greater than 10 %.
d. 1 Year Average Net Profit Margin → should be greater than 10 %. - Liquidity risk: Companies should always have cash in hand to address few months of operating costs as well as for some fallback safety purposes. Just like we need to have emergency funds in place to breeze through tough times.
a. Free cash flow needs to be positive.
b. Also look at Debt to equity ratio → this is sector specific. Compare with the sector ratio and ensure they are considerbaly lower than industry standards. Look sectors like Finance, Power, Manufacturing are very capital intensive and hence they should not be generallized. - Solvency risk: For this visit Value-Research website and look for Altman Z-Score for that stock.
- Governance risk: For this again visit Value-Research website and look for Modified C-Score. This ensures financial books are not manipulated or altered.
At the end we will arrive at countable safe stocks to invest in to get 10–15% of returns.
Having a smaller bucket ensures we can regularly monitor them.
Also the list will change year-to-year or quarter-to-quarter. Thus invest, withdraw, book-profits, handle-losses according to the time you perform analysis.
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