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Why to do your homework before investing in stock markets

05 Jan 2023

Many investors often wonder if they need to do their own research and homework on the stocks they invest in it. "My financial advisor identifies the stock and I just invest" is the standard refrain. But it is always advisable to be well-informed about the stocks that you are investing in. Remember, a little bit of homework can go a long way.

Why to do your homework before investing..

First and foremost, it is your money after all. Irrespective of what you are advised to do, you have to take 100% interest when it involves your money. When you have done your homework and ask pointed questions to your advisor that will also bring the best out of the advisor. Remember, when you are the investor, the buck ultimately stops with you.

Every investment that you make has to fit into your eventual financial goal. Only you know your long term goals and aspirations. The advisor may recommend a stock for a 5-year period on a fundamental basis, but your perspective may be limited to just 3 years. That mismatch will not be evident unless you have done your homework.

Contrary to what most people believe, doing your homework before investing is not as complex as you may imagine. You have a universe of stocks on which you can set alerts which will act as triggers. These alerts may be in the form of news, corporate actions, quarterly results etc. You can also use screeners provided by your broker to do your own limited research on the stock.

What are the checks that you need to run before investing in a stock..?

Irrespective of what your advisor may tell you, it will add a lot of value if you do your own limited homework on these stocks. As an investor, who is not exactly an investment professional, you can apply 6 critical tests before investing in a stock..

1.  Do a quick check on the indebtedness of the company. Typically, companies with a high debt/equity ratio have run into trouble in bad times. Compare steel and software. The reason steel companies have got into solvency issues are due to the high levels of debt in their balance sheets. As a matter of policy try to avoid high debt companies.

2.  Look at the quantum and quality of the profit that the company is making. Eyeballs and footfalls are great top-line ideas. But whether they are actually translating into profits is the question that you need to ask. Quality of profits also matter. If the profits of the company are driven by treasury operations or by cyclical factors, then you need to take it with a pinch of sale.

3.  Be cautious of companies that have seen promoter stake falling consistently. This shows lack of interest on the part of the promoters. Normally, promoters who are serious about the long term sustainability of the business will be loath to reducing their stake below a point. Sharply falling promoter stake is the first red herring that you should snap up.

4.  Check if the business model pertains to the past or to the future. The current model of IT outsourcing is undergoing a shift. You do not want to invest in a company that is basing its future projections on models that are not valid any longer. Also be wary of companies that are likely to have a very long gestation period. That is not your cup of tea as an investor.

5.  Always chase growth because that is where you get valuations and that is where you get upgrades. The market always pays a premium for growth. Value buys may be great ideas in specific phases of the market but it is growth that assures you of sustenance. That explains why people love retail sector stocks despite their steep valuations.

6.  Finally, don’t fall into the high value trap. At the peak of the Bull Run it is very easy to sell and buy ideas. But remember, that stock prices eventually gravitate towards their intrinsic value. In the past we have seen fancy valuations for sectors like cement, IT, telecom and real estate. Eventually, all these stocks came down to earth.

What does Ben Graham have to say?

As the legendary value investor, Ben Graham rightly put it, "Investing is a simple exercise if you ask the right questions." There are basic rules pertaining to cash flows, business models and leverage which any lay person can easily understand and apply in practice.
The next time you are doubtful about doing your homework before investing, remember the famous words of the legendary Peter Lynch. According to Lynch, "If you take trouble to understand what you own and why you own it, then you have already won half your investment game". There surely is a case for doing your homework before investing, the next time around!

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