A rather spectacular rise in Indian stock markets has attracted the interest of potential investors. The Indian economy is booming. GDP growth is expected to be in excess of 8 per cent for third consecutive year. Earnings of companies are increasing at a rapid pace. Even the regulations in stock market have come a long way in last decade and a half, leading to much better standards of corporate governance in general. It seems like best of times for stock market investment. But before we get carried away by general feeling of optimism it will be better to evaluate the investment scenario. Does it still make sense to invest in stock market?

Buying a lottery and winning a multi-crore prize on the same does not make the decision to buy the lottery a good one. If one thinks otherwise and starts buying more lottery tickets with one’s prize money the wealth is sure to be lost. The prize lottery winners get is substantially less than what ticket buyers have paid for. The process here (in case of lottery) is flawed with regard to wealth creation. The key to wealth creation in stock market is following a process that yields results irrespective of fluctuations of market. The results would follow in due course. We will try to define the broad contours of one such process.

We think micro analysis or company level analysis in stock markets makes more sense than looking at broad sector level or market level analysis. It is the companies that do well and aggregate indices are reflection of same. Though the sensex has moved from base level of 100 set in 78-79, fewer than ten companies of the original sensex (formed in 1986) still survive in the current index. Some of the original companies of the sensex like Bombay Burmah or Scindia Steamers are leading a marginal existence compared to their relatively glorious past. New companies have been added to sensex. These companies along with the original ones have taken the sensex to new heights.

So how does one decide whether some company is right candidate for investment or not? We look at the following factors while taking our decision of whether to invest or not:

1. Does the company have potential to grow in terms of revenue from existing and potential products and what are the barriers to entry?

A company whose shares are a good investment should have potential to grow. The potential could be because of demand of current products or from future demand of potential products. Companies with potential for growth belong to two categories: “fortunate and able” and “fortunate because they are able”. Example of first category would be a company like Aluminium Company of America (Alcoa). When it was first started none of its founders would have imagined the potential demand of aluminium. With introduction of airplanes the demand of aluminium increased dramatically and Alcoa was able to exploit the situation to grow using its superior engineering skills. Example of company of second kind is because is 3M. 3M has created a number of products which did not exist before, thus expanding its revenue many times. Companies that are fortunate because they are able create new markets for themselves. In both cases ability is needed. Even when opportunities present themselves only competent companies are able to use them effectively.

Along with the potential for increase in revenue of the company one must also look at barriers to entry in the industry in which company operates. If there is potential for increase in revenue but barriers of entry are low (like in most segments of textile industry) then other players will enter the industry. The entry of newer players would reduce the profitability of the company. If the barriers to entry are high then company’s profits will increase at a pace similar to rate of growth of revenue. Barriers of entry could potentially come from multiple sources, examples would be presence well trusted brands, huge economies of scale or very long gestation period required for introduction of product.

2. What is the operating margin and return on equity/capital?

The margins of the company should be evaluated on both relative and absolute basis. Though relative comparison makes more sense because higher the margin of company relative to its competitor more secure it will be in case of a downturn when pricing power is lost and margins are eroded. A company with lower margin shows a greater fluctuation in profits. In case of upturn, the profits of companies with lower margin grow faster giving an illusion that it is a better investment. However capitalism is case of survival of fittest. A company making lower margin is more susceptible to extinction and earns much lower profits over a business cycle compared to one with a much higher margin.

Any company, which is a good investment option, has to have a high return on equity (that is amount of profit it earns divided the money invested by shareholders in terms of initial capital and reinvested profits). A high return on equity (with Consumer Price Index growing at 6 per cent) would be anything in excess of 20 per cent. The higher the return on equity better it is for shareholders. This parameter should be monitored over a business cycle. Companies having consistently higher level of return on equity should be preferred.

3. Can company finance its growth without too much dilution of equity or substantial amount of debt?

For an average business if one increases the amount of capital used the profits also increase. The shareholders however do not gain from such rise in profits because addition of capital would involve increasing the number of shares. The earnings per share, which is more important metric for shareholders, would largely remain unchanged. A superior business will be one which would generate extra capital through internal operation and use this capital to fund expansion. The expansion in turn would also generate extra (apart from extra cash flow from pre existing business) cash flow which can be used for further expansion and so on. Companies having strong and growing franchises are an example of such business. Typically superior businesses do not require infusion of much capital for expansion. Their most important assets are their well established brands.

4. How is the management of the company in terms of competence and depth?

Any business opportunity requires a certain amount of managerial competence. Company’s management should have the competence to exploit the opportunities. Depth in management is necessary because :

a) Even if a few executives leave the company it would not be adversely affected

b) It shows that the company has a system which produces managers and such a system will ensure that company does not fall short of managerial talent in future.

Though management is an important factor for business success we feel that the economics of business are more important. A good management cannot retrieve the situation if economics of the business are bad. Take the case of airlines industry around the world or any commodity business in times of low demand compared to capacity. In either of the cases good management would not able to do much good. In this sense business is comparable to a horse race. Even a good jockey will do badly on horse with a leg broken. An average jockey will do better with a good horse. The best results, though, will come with a good jockey and a good horse.

5. How is the management in terms of honesty and avoiding institutional imperatives?

Quite often management does not share the enterprise’s prosperity with shareholders. This could be broadly because of two reasons either dishonesty or institutional imperative. In earlier years dishonesty used to be the major cause of shareholders being short changed. Nowadays it is the institutional imperative that is the major cause. Examples of institutional imperatives are:

1) When extra funds are generated in business new projects or acquisition targets come up to utilize the same. This happens even if the returns from such actions are sub optimal or even negative.

2) Any business idea of CEO, however stupid, is supported by detailed return analysis of subordinates and consultants and ultimately executed.

3) The behaviour of peer companies whether they are expanding, acquiring or setting compensation for executive is mindlessly imitated.

Institutional dynamics set businesses on these misguided courses. These acts will ultimately lead to loss of focus, destroying substantial shareholder value. Avoiding these traps can save shareholders a lot of money though it also reduces the sphere of influence of management.

6. At what price the shares are available?

After considering the above factors one has to consider the price at which shares are available. Even the best of businesses with best of management will have a certain value. Buying shares at much premium to that value will lead to suboptimal returns. For an average business, pricing of shares is even more important. Shares should be bought at some discount to their value. The discount would be dependent on how the company fares on the aforesaid five criteria. We would though caution against buying a company that does very badly on above factors but is available cheaply. Time is a friend of good business and enemy of a bad one. The value of bad business gets eroded over time and even at “cheap” prices there is not much of a profit.

Macro condition like how markets are going to move in next few months or even a year or interest rates are going to behave should not be a factor while making an equity investment. Good business when bought at decent prices yield favourable results for investors anytime. These results might not be spectacular always but they ensure safety of capital over the long run yield best returns. The principles of investment have not changed just because stocks have gone up.