The primary purpose of stock market investments is wealth creation. Share market tycoons like Warren Buffet, Rakesh Jhunjhunwala, Radhakishan Damani, etc., have multiplied their wealth over the years using long-term investment in stocks.
On the other hand, the stock market has historically been the synonym for fear of huge losses borne by relatively new investors. With the onset of online trading in the 21st Century, stock markets have become more & more volatile globally. So, are the stock markets safe for retail investors? Or is it best to altogether avoid it? Well, you can either invest in the stock markets for the short term or instead choose to make long-term investments. Stock markets are highly volatile in the short term, and it is hard to predict the movements. At the same time, long-term investment can provide returns that beat short-term fluctuations. So, keep reading to know the 5 golden rules on how to select stocks for long term investment?
5 Rules on How to Choose the Best Stocks for Long Term Investment
Let’s take a look at some stock-picking tips or rather rules that each investor can follow to select the best long-term investments in stocks.
Rule 1: Always Read the Fundamentals of a Stock
To choose the best share to buy for the long term, you must read the financial statements and the key business ratios. Here is the list of ratios that you should check:
- P/E Ratio: Price-to-earnings ratio is the most popularly used benchmark. It signifies how many times the earnings are the investors ready to pay for one share.
P/E Ratio = Share Price ÷ Earnings Per Share
If a stock has a lower P/E Ratio than the market P/E, it is considered to be underpriced. As a result, investors try to acquire more undervalued stocks.
- Debt to Equity Ratio: Debt is the amount a company borrows, whereas equity is the shareholder’s contribution to the business. The interest cost on debt is fixed, and it doesn’t dilute the ownership.
Debt to Equity Ratio = Debt ÷ Equity Share Capital
Interest is also a deductible expense while calculating profit for taxation. Hence, this ratio also shows the leverage that a company enjoys. Usually, a D/E ratio of 2:1 is acceptable. However, these ratios also differ from sector to sector.
- Current Ratio: This ratio shows the ability of a business to repay its short-term liabilities from the short-term assets. If this ratio is less than 1, the company will need to dilute its fixed assets to pay for short-term liabilities. Usually, 2:1 is an acceptable current ratio.
Current Ratio = Short-Term Assets ÷ Short-Term Liabilities
- Return on Equity: The percentage of net income earned by the shareholders is called return on equity. If a business makes more for the shareholders, it is a good sign. Ideally, ROE above 15% is a healthy indicator.
Return on Equity (%) = Net Profit ÷ Share Capital x 100
Rule 2: Study the Annual Reports
Every company issues an Annual Report which covers the following details:
- Financial & Business Highlights
- Management Discussion and Analysis (MD&A)
- Future Projects & Strategies
- Financial Statements
- Auditor’s Report
You can easily gain all the necessary information and perspective about a company by studying the Annual Report.
Rule 3: Avoid Trading, If You Are Not an Expert
Trading is short-term buying and selling stocks for marginal profits. It requires great skills to predict the market movement accurately. Hence, you should learn how to choose stocks for long term investment in India. Eventually, you can avoid short-term fluctuations and long-term profitability.
Rule 4: Understand the Risk and Diversify Your Investments
The stock market investments carry two kinds of risks:
- Systematic Risk: This is the external risk to the stock market. If the economy faces a recession and the markets fall, all stocks will take a dip. This risk is inherent and cannot be reduced.
- Unsystematic Risk: Unsystematic risk is the risk of the company suffering due to unfortunate events. This type of risk can be nullified by diversifying your portfolio.
You can diversify your portfolio by including stocks from different sectors. Then, if one sector performs poorly, others can cover the losses.
Rule 5: Consider Investing in WealthBaskets
If you do not have time to research and wish to benefit from diversified investments, you can opt for WealthBaskets. A WealthBasket is a pool of Equities, or ETFs, that helps you build low-cost, diversified, long-term and short-term portfolios. These WealthBaskets are curated by SEBI Registered Experts.
With these 5 golden rules, you will be ready to pick stocks for the long term. But remember, there will always be risks associated with the stock market, so invest in safer instruments to reduce risk.
You need to have a thorough knowledge of the stock markets and do extensive research every day to gain from trading. Hence, it is better to choose a long-term investment. Moreover, short-term fluctuations get nullified, and your returns do not suffer.
Fundamental analysis is the best to identify a long-term investment. It refers to the study of key ratios and strengths of the business. Companies provide audited financial statements and annual reports that cover all these details. Anyone can access them in the public domain on the company’s website. Use this data to choose the best long-term stocks.
Never sell your long-term investment stocks at a loss unless there are very adverse situations for the business or a threat to business continuity. Start selling the shares gradually when your gains are in the range of 20-25%. Once you have sold shares and recovered your cost, you can hold the remaining stock for the long term.
Usually, experts look at the P/E Ratio to predict mispricing in the stock. You can compare the stock’s P/E to the industry P/E and pick the undervalued stocks for long-term investment. Once you check that an underpriced stock is fundamentally strong, it is a must-buy.
You should look at the government policies and market scenarios to predict the sector that will enjoy a boom. The future belongs to Information Technology and its integration with different sectors. With the pandemic, the pharma industry can be one of the front-runners. Similarly, the Gati Shakti project of the Indian Government can bring a boom in the transportation and automobile sector.