Investors can build serious wealth while taking on lower risk by investing in quality stocks
The recent past has seen the stock markets experience volatility due to uncertainty about economic growth, the Coronavirus pandemic and related headwinds. In this situation, stock-picking becomes challenging, with most investment strategies not playing out as expected. The two key investment strategies that most investors follow are value and growth.
When you invest in a stock that is quoting at lower than its intrinsic value (usually called quoting at a discount), it’s termed as ‘value investing.’
Value investing may not pay always
Intrinsic value implies the ‘true’ value of a stock. This can be a subjective decision with analysts computing the intrinsic value in different ways. But value investing comes with pitfalls:
-Stocks are usually available ‘cheap’ for good reason – the company could be in an industry with low/no growth prospects, the company’s financials may be weak, etc.
-You will need to have deep understanding of the industry, the business and the company to assess whether it is a ‘value’ stock.
-You will also need to have knowledge of finance to assess the intrinsic value of the company to decide whether the stock is under-priced by the market.
-You cannot predict when the company will recover/start on the growth path.
-There isn’t sufficient information about ‘value’ companies to help you assess the quality of the stock.
-You may believe the stock price has hit rock bottom; however, it may fall further after you have invested.
What’s the way out? Many fund managers follow a growth investing strategy because it is an aggressive one and can give results faster. This strategy involves investing in companies that are expected to grow at an above-average rate as compared to the industry they belong to or the overall market. Growth investing carries high risk, as growth companies are usually young and don’t have a performance track record.
Shortcomings of growth investing
But growth investing comes with its own pitfalls:
-You need to time your entry; if the stock has already moved up significantly, you may make meagre gains or incur losses.
-You need to closely monitor the movement of the stock’s price so that you can correctly time your exit.
-If the stock price falls, you need to judge whether the company’s growth potential has been adversely impacted or its market sentiment has turned negative, to decide whether to exit the stock or stay invested.
-Most businesses are cyclical. If you enter at a time when the business cycle is heading downward, you will see a fall in the stock’s value.
-Growth-oriented companies may not declare dividends so that they can reinvest the funds in their businesses. This deprives you of cash inflows.
While both these investment strategies work when there is some amount of certainty on how the stock markets are expected to move, during uncertain times, these strategies tend to become riskier.
Greater the uncertainty, greater the risk. In this situation, investors should look for safety in quality. They should focus more on quality investing instead of going ‘value’ or ‘growth.’
What does quality investing mean?
Quality investing, popularly called ‘Coffee Can’ investing was conceptualized by Robert Kirby, considered to be one of the greatest investors, in the 1980s. He used the concept of the coffee can, which Americans used to store their valuables in and hide the can under their mattresses to be left untouched for decades. This concept implies looking for companies that are fundamentally strong with an established track record, quality products/services, leaders in their industry and run by management with outstanding credentials and experience. The idea is to stay invested over a long period, through all the ups and downs that the market may experience. Investors stand to build serious wealth while taking on lower risk by investing in such quality stocks.
Kirby talks about a wife, a client, who requested him to combine her deceased husband’s investment portfolio with hers. Kirby was amused to find that the husband had invested in stocks recommended by Kirby. However, he had ignored Kirby’s ‘sell’ recommendations and continued holding on to his investments. The result was astounding. The husband’s portfolio had grown exponentially over the years. This incident gave Kirby the idea of ‘coffee can’ investing.
10 key parameters to spot ‘coffee can’/quality stocks
-Look for stocks with market capitalization of over Rs 1,000 crore. Market capitalization is the product of the number of outstanding shares and the market price of the stock (Market capitalization = number of shares outstanding multiplied by market price per share).
-The company should have been in existence for at least 10 years.
-Over its existence, the company should have delivered Revenue/Sales growth of at least 10 per cent and Return on Capital Employed (ROCE) of at least 14 per cent consistently over the last 10 years.
-The company’s management should be able to foresee expected shifts in the business scenario and reposition the company to keep its products/services relevant. The company should be a frontrunner in adopting new technologies to make its business more efficient and improve its offerings to its customers.
-The industry/sector the company operates in should have strong growth prospects. It’s preferable to opt for a sector that is on the threshold of sustained exponential growth.
-There are constant shifts in value based on progress made. For instance, with respect to commuting, moving from cycles to cars, and now, to driverless cars. The company should successfully move through these value migration stages while maintaining its leadership.
-Look for quality companies in the B2C (Business to Consumer) market segment. The B2C segment is scalable and offers greater growth potential than the B2B segment. It facilitates building brands, customer loyalty, expanding across geographies and products, etc., thereby increasing the company’s equity valuations. -Look for quality companies you are familiar with based on brands, quality, service, loyalty, etc. Let’s say, you use a particular brand of toothpaste. Check out the company manufacturing this toothpaste; study its business, growth prospects, etc. Additionally, check if it adheres to the ‘quality’ parameters stated above. You may find a quality company worth investing from your analysis.
-Quality companies usually offer products across the price spectrum, thereby increasing their consumer base. For instance, a company manufacturing brown goods (refrigerators, air conditioners, etc.) can offer products at different price points. To make products affordable, quality companies usually get attractive bargains from vendors and pass on the benefits to their customers through lower prices.
- It’s best to avoid PSU stocks and cyclicals such as commodity companies. Also, the 10-point criteria mentioned above is not applicable for the selection of banking stocks. Lastly, selecting quality stocks and staying invested over the long term has the potential to result in significant wealth appreciation.(The writer is the founder & Chief Financial Planner at MoNey MinTing ManTra)