Beginners’ guide to stock research

Stock research is all about understanding the company behind the stock in elaborate detail.

The legendary Warren Buffett once said that every investor can be a research analyst. All that they need to do is to ask some very probing questions about the company. When you buy a stock, you actually buy a part of the company behind the stock! So you buy the company’s products, its strategy, its management quality and its future prospects. Stock research is all about understanding the company behind the stock in elaborate detail. Here is your guide.

How good is the future of the business?

That is where it all begins. When you buy a company’s stock, you buy for the future. As Buffett put it, “If the past is all that mattered, then archaeologists would be the wealthiest persons in the world.” As an investor, you need to ask some tough questions. Does the company operate in a high-growth business or stable business? Is the demand for the products cyclical or round-the-year? What are the big ideas the company has to increase profits?

A company is as good as the cash flows it generates 

In warfare, a victory that comes at a huge cost is as good as a defeat. The same is true of growth too. If the company is paying top dollar to buy market share, the question is what happens after three years. Burning cash round-the-clock cannot go on forever. At some point, eyeballs and footfalls must translate into profits for the company. Again, profits are not reflective of the actual cash flows of the company, so focus on the operating cash flows generated.

Does the management of the company have a good market image?

This can be qualitative in nature but it is normally the difference between successful and unsuccessful companies. Business groups like Tata, Birla, and Mahindra enjoy a premium image in the market. They have taken pains to maintain the highest standards of disclosure, transparency and corporate governance. This is a great valuation supporter.

Look at the risks in terms of existing and future competition

Not all competition is visible. Telecom in India was disrupted by an oil and gas company. Sometimes competition comes from disruptive products. Hero Honda disrupted the two-wheeler industry with focus on motorbikes and fuel efficiency. Look at the way ecommerce companies and discount brokers have disrupted retail and financial services respectively. As an investor, watch out for such potential risks.

Prefer a company that is transparent about its performance

Mr. Narayana Murthy famously said: “When in doubt, disclose.” While it is essential for companies to effectively communicate in good times, it is a lot more important to effectively communicate in bad times. Beware of companies that keep shareholders in the dark about their actual performance. You do not want to invest in a company that throws up negative surprises out of the blue.

Has the company created a moat?

This is a concept pushed by Buffett and even Ben Graham, long before that. Moat is a sustainable advantage that can come from high margins, unique patents, market leadership etc. Moats ensure that the company is able to sustain growth and operating margins even in tough market conditions. Companies with a moat get attractively valued.

Will future plans be funded by debt or internal accruals?

This is relevant for companies with massive expansion or diversification plans. If the funding is through equity then there will be dilution of earnings. Funding via long term debt means greater financial risk. Expansion and diversification are integral to future growth. You just need to ensure cash flows to service the debt.

How much of the promoter’s stake is pledged

In the last few years we have seen sharp correction in many stocks due to this very reason. When a large percentage of shares of the promoter are pledged, it makes the stock vulnerable to selling by financiers in the event of a margin call. Prefer companies where the promoter pledges are low. These can escalate at any time.

The model mentioned above is the framework of research. Of course, you still need to look for a detailed analysis of income statements, balance sheet, cash flows and ratios. But all that would come as the next step once you have zeroed on your preferred stocks. The framework is simple and entails a lot of common sense questions. Asking these questions can help beginners to really get a hang of their investors via practical research.

Disclaimer:

Investments in the securities market are subject to market risk; please read all the related documents before investing.

Past performance of an investment asset does not guarantee future returns.

Companies mentioned in the article are purely for illustrative purposes and are not meant as a recommendation to buy or sell any security.

The above article is purely academic in nature and aims to provide knowledge about basic trading concepts & should not be construed as an opinion or advice to invest or trade.