How to pick a stock: What to invest in and how

Saturday, October 26th, 2019 00:00 |
How to pick a stock.

In the first instalment of investing in the stock market, PETER KAMAU takes us to throw the fundamentals of what shares to buy

With so many shares listed on the Nairobi Securities Exchange, how do you choose which stock to invest in? 

Before we go further, it is imperative to understand that behind stocks are real businesses with real performance issues.

We must, therefore, adopt the philosophy that when we buy stocks, we are buying businesses. 

Now, forget about stocks for a moment and imagine you want to buy an ongoing business from a choice of many. Assume you will hold it for some years, say five or 10, and then sell it.

Imagine you want to buy the whole business, including the employees, so that the business will continue running as per normal; only ownership will have changed and as such, you will not be involved in the day to day running of the business. 

What will be your criteria for choosing that business that is likely to be profitable over that 10-year period; criteria that will give you the confidence to label that business wonderful?

There are four main criteria that we need to consider in choosing a business. Do you understand the business you are buying? Can the business withstand competition for long?

Can I trust the current management to continue to grow the business for the next 10 years? Is the price of the business fair?

If we proceed from this understanding, then we will approach the choice of stocks more logically as opposed to doing guesswork. 

Do you understand the business you are buying?

If you do not understand the business you are going into, what are your chances of success? Zero! Why? Because you have no idea what forces affect it and therefore, no way to measure its quality.

Naturally, businesses you are likely to understand well will usually fall within your circle of competence.

When you understand a business well, you will invest with minimal risk. When choosing stocks, therefore, this should be the first question you ask yourself. How well do you understand the business behind the stock?

Can the business withstand competition?

Competition strangles or kills businesses. The chances of a business to continue operating profitably for long in a highly competitive market are slim. If you are buying a business, you want one that has a high probability of being in existence for a long time to come.

That kind of a venture has to have some unique products or ways of doing business that is unique or not easily duplicated. This is usually referred to as a moat or competitive advantage. A business with a wide moat will keep competitors at bay.

This moat can be in the form of a strong brand, dominance in the market, patents, high switching costs and more. Like coke with its powerful brand; Toyota with its economies of scale in the vehicle market; or Microsoft with its high switching cost. 

Consider a commodity business like selling sugar. Such a business has little or no pricing power. Profits from this kind of business fluctuate unpredictably as the market dictates price. Commodity business have highly unfavourable economics. 

The business you chose should have favourable economics for it to be sustainable. Investing is about future returns. If the business will not be there in the future, you cannot expect returns.

Therefore, in choosing stocks, you must choose businesses that have a wide moat. This is especially critical for long term investors.

The writer is the author of The Ultimate Framework for Success in Shares

Email: [email protected]

Next week, the writer will give additional pointers to what a good share is. 

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