With the markets scaling new heights, it’s easy to ignore quality businesses and fall into the traps of poor quality, low PE businesses with the assumption that such stocks too will get re-rated. Well, in the short term the stocks may get re-rated, however if the business of the company isn’t good or if the business is cyclical, then the fall in prices will be very vigorous and therefore at this point it is much more important to carry out proper analysis of the stocks and establish the authenticity and longevity of the earnings of the company.
Now, as far as long term wealth creation is concerned, in general the human nature is to complicate things and this is especially true of stock markets where everyone participates in order to create huge wealth, while only some are successful.
So, what do successful investors do?
Well, they keep it simple and most of them follow the below 3 rules (as discussed by Pat Dorsey in his book “The little book that builds wealth”):
- They identify few good businesses with competitive advantages that will enable them to grow consistently and deliver above-average profitability for many years.
- They wait for the shares of those businesses to trade at reasonable valuations and then buy aggressively.
- Once bought, they hold the shares until either the valuations become very expensive, the fundamentals of the business deteriorate or if they find other better investment opportunities. Here, it is important to note that holding period for such investors is generally several years and not days/months.
So, just by following the above 3 simple steps you too can be a very successful investor and that too without wasting your precious time and money.
I mean, look at the advantages besides the obvious monetary gains, you have to focus on very few companies, you don’t have to sit for hours in front of the screen, you pay minimal brokerage, you pay almost zero tax (both dividends and long term capital gains are tax free), you lead a stress free life and most importantly you get sufficient time for other productive activities.
In case you are thinking of how to identify good businesses, for starters check the following points:
- Look for companies with consistently high returns on capital/equity (20%+ is good). All things being equal, a company that generates 20 crores of profit on 100 crores of capital employed is any day better than a company generating profit of 10 crores on 100 crores of capital employed.
- Look for debt free companies or companies with low leverage.
- Earnings can be deceptive and easily manipulated, so do check the cash flows of the company for the last 5-6 years.
- High promoter ownership – this ensures that the one’s running the business have their interests aligned with yours.
While a detailed analysis of the business is always helpful (we will leave that for some other post), for those who cannot devote enough time, ensuring that portfolio companies comply with above points will result in above average gains in the long run.
Here again, as you can notice, the idea is to keep your research simple. By narrowing your search for the companies with the above traits, you will eliminate more than 90% of the listed stocks and anyways one needs few high quality companies to be successful than several average companies.