We all know that it is just a handful of stocks that outperform the market over longer periods of time. These are the wealth creators of the Indian market. Over the last 20 year we have seen tremendous wealth creation by companies like HDFC Bank, Infosys, Hero Moto, Eicher, Escorts, and TTK Prestige etc. There are stocks that outperform and then tend to lose all their gains over the next cycle. That is not what you are looking for. What is it that defines a good stock? What are the value stock characteristics that we need to understand? What is a stock that can withstand the gyrations of the economy and the market and yet put up above-normal performance? What is a good stock to buy in the market? Let us look at 5 characteristics of good growth stocks that really set them apart.
Consistently growing within a growth industry
It is not just enough to be in a high growth industry, but you need to grow faster than the industry average. You achieve that kind of performance over a period of time by constantly reinventing your business. Most good stocks were perhaps lucky to have been in the right place at the right time. Hero Moto was early to see the huge opportunity in fuel-efficient two-wheelers. HDFC Bank was lucky to synchronize its growth with the growth in Indian banking. But the bank was also early to realize that good asset quality and sound margins will create value in the long run. Bharti also created tremendous value by virtually inventing the mobile industry in India. So the first condition is that it is not enough to be in a high growth industry. Your business model must bring in that extra something that differentiates you from other players in the industry.
Great margins and great efficiencies
We have all seen the limitations of eyeballs and footfalls approach. It is good to have people visiting your website or walking into your stores across India. But how much of all this translates into revenues and profits? When we talk of great margins we talk of margins at two levels. First is the margin that your business generates on the total volume of business. OPM and NPM are good measures and they need to be healthy. But more important is the need to reward your shareholders with solid ROE and ROCE. Companies that focus on both these aspects turn out to be great stocks in the long run. If you are also able to churn your assets efficiently, then that is icing on the cake.
Management that under-promises and over-delivers
You do not want the company top management to promise you the moon. On the contrary, you want companies that actually deliver the moon. We are not just talking about guidance here. We are also talking about the implicit performance that is in-built in the expectations of stakeholders. When a company is consistently able to better these expectations; that is when you get good stocks. In the Indian context we have seen companies like Maruti, TCS, HDFC Bank, IndusInd Bank, Motherson Sumi and many such companies that have consistently under-promised and over-delivered. Not surprisingly these stocks have also been stark outperformers.
Makes products that are either innovative or addictive
We have all heard of a moat or an entry barrier that a company needs to create. Most businesses can be literally commoditized. It is the ability of companies to create that one unique advantage that sets their business model apart. These are the questions that investors need to ask. Has the company created an unbreakable bond between its products and the customer? Has the company created a brand or value proposition that is almost addictive for customers? Is the company constantly able to innovate (something like what 3M does globally) to keep customers on their toes and meeting expectations before they are able to crystallize the same. That is what separates really good stocks from ordinary run-of-the-mill stocks.
Available at a reasonable valuation..
That is the last and the most important factor. A good company need not necessarily be a good stock. Remember, every stock can be good at a price and bad at another price. Even if you have all the above four factors in your favour and the stock is quoting at a ludicrously high valuation, then you can really rate it as a good stock. For it to be a good stock, it should be available at reasonable valuations. We are not just talking about P/E ratios but the margin of safety that is available. When we are talking about valuations, we are not just talking about the P/E ratio but also about the comfort of a reasonably broad margin of safety in the stock.
A good company is not necessarily a good stock. A growing company with all the fundamental appurtenances also needs to be available at a reasonable valuation. That is the acid test of a good stock!
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