5 factors that can help to pick right stocks for long term

Kartik Mehta Correction in stocks markets makes most investors worry about the downside. However, the focused lot that keep searching quality stocks for long term, use such corrections to load up their portfolios with right picks. To identify stocks that deliver over medium to long term, one must employ a healthy mix of qualitative and quantitative factors that influence shareholder returns in long term. Here are five factors that one must focus on to reap rich dividends in the long term.

Management Quality: -If promoters raise fresh capital regularly it means they are not competitive enough to generate sufficient cashflows to sustain or expand business. Companies like Colgate, Asian Paints, Infosys, Sundaram Finance are never required to do so. Sometime promoters issue warrants to themselves at lower levels and later on at higher price they dilute stake to others.  Lower dividend payout despite of good profits or higher payout despite of poor earnings both requires scrutiny because later would be funded through borrowings and dividend distributed will be largely flowing to promoters. Salary issued to directors should be seen carefully. There should not be any abnormality between their salaries as compared to salaries paid to their counterparts in peer group. Salary should be compared as percentage of net profit of the company.Aggression vs. Passion: -Aggressive promoters are desirable but not at the cost of business. Sometimes in extremely good business conditions they make aggressive expansions or diversify to unrelated businesses. For ex. Tata Steel acquired Corus at the peak of steel cycle or acquisition of RE Power by Suzlon. While TCS being the same Tata group company never tried to use surplus cash unnecessarily and yet they remain extremely passionate and growing much higher than industry growth.Business Risk: -Business is designed at the given point of time considering customers’ requirements and solutions that cater to those needs in the most efficient way. However, consumer priorities keep on changing with time but business designed earlier may not necessarily change, which puts business into risk. For example, Bajaj Auto moved out of scooters and focused on bikes. It was very wise decision as customer priority was changing then. But later on Bajaj couldn’t get the feel of change in customer needs and growing acceptance of scooters (27% penetration in 2 wheeler space). No wonder, the market was absorbed by Honda. Hero Moto however understood the consumer pulse and changed business model to accommodate scooters in the portfolio despite being bikes manufacturer. Another classic example is Nokia & Blackberry losing out to other smart phones manufacturers.Quality of Financials: -Sometimes your revenue and profits are growing but yet your debt on balance sheet does not go away despite of no major capex. This is because there is no control over working capital. Your receivables are growing faster than sales or inventories are piling up quickly. Gross margins of businesses are seen under pressure due to spike in raw material prices in a quarter. However, the company can still maintain EBITDA margins by cutting down on other production related costs such as staff costs, advertising spends. This can be accepted for a quarter or two. In the long run, gross margins and EBITDA margins should show similar movements. If it is not the case, one should be careful with such businesses. Investors should study Operating Cashflow to PBT ratio carefully. Ideally cashflows should meet working capital needs, capex and dividend. In decent companies at least two out of three parameters are met. Most of the infra or real estate companies failed to meet above criteria and gave red flags much earlier.Capital Reinvestment & Valuations: -Each businesses is expected to generate cash and cash so generated is expected to be further deployed in the same business to earn even better returns. If a business generates, say 18% return on capital employed (ROCE) in a year then the company should redeploy it to generate at least 18% in the subsequent year. This is tough to achieve and if achieved for long run, such businesses are seen as high quality businesses . Ideally investors should look at ROCE for the longer tenure on average basis because sometime due to extreme business conditions, ROCE may get skewed. Valuation is another important aspect. A good business should be bought in bad markets and a bad business should be sold in good markets. Any business which is scalable in nature without compromising balance sheet strength and has an edge over competition should be eyed upon constantly. Value investing is an art which may not be mastered by everyone. Similarly investors are not able to buy growth stocks due to expensive valuations or fear of failure. Best way to pick up the stock is growth at reasonable price (GARP). However, most investors try to buy value stock which often becomes value trap. For example, PSU Banks or Infra stocks have been always seen value buy in the last 5 years but they have been proven value trap mostly. Whereas, private banks were available at reasonable valuations then and have given phenomenal return.Current fall in stocks can throw open opportunities wherein investors can pick up mis-priced bets in quality stocks provided they do not panic and stick with their mandate of buying quality stocks.