How do you pick stocks that are likely to beat the market?
When it comes right down to it, the answer is simple.
Invest only in stocks that treat you well and let you sleep peacefully at night.
And just how do you do that?
Well, the answer varies a bit from person to person, but here are 10 specific tactics that help you identify businesses that satisfy both criteria.
1. Avoid complicated companies
Stick to companies that you understand. Even better, buy only companies whose products you use regularly.
Shoprite, for example, has a straightforward business model. It sells groceries through a large network of supermarkets. Kenya’s Safaricom sells wireless phone service and operates a popular mobile payment platform, M-pesa. Dangote Cement, makes … you guessed it … cement.
Understanding a company’s business model and products gives you a clearer view of what factors contribute to its success.
2. Don’t stray from established businesses
It can be tempting to buy that fast-growing community bank or to participate in that hot IPO that’s all over the news. Resist the urge.
Investing in unproven companies can yield out-sized returns, but they often also come with a high risk of catastrophic loss.
Focus instead on companies that are known quantities, that have proven they can prosper through good economic times and bad. They may not make for scintillating conversation material at parties, but they stand a better chance of building your wealth over time.
3. Sniff for scandal
Have company executives been charged with paying bribes? Has a parent company been caught running a Ponzi scheme? Does it dump toxic sludge into waterways?
Malpractice like this is insidious, and it can take years for a company to live it down. Distrust of such companies will weigh on their share prices like a ton of bricks. There are better places to put your hard-earned money to work. You don’t need to be associated with businesses like these.
4. Revenue growth is crucial
If a company isn’t selling an increasing amount of stuff to an increasing amount of people, there’s trouble on the horizon. A company can boost earnings for a year or two by cutting costs and becoming more efficient, but if sales are stagnant, profits will eventually stagnate, too.
Look for companies with long-term revenue growth rates that exceed your local rate of inflation. That’s 7% in Kenya, 18% in Nigeria, and 6% in South Africa.
5. Insist on profitability
Take a look at a company’s profit history. Has it reported negative earnings at any point in the past five years? If so, do not buy the stock unless you thoroughly understand the reason for the loss.
Everybody loves a good redemption story, but turnarounds and cyclical stocks are tough to analyze. Stick with a business that earns money year after year, and sleep better at night.
6. Look for consistent dividends
Good companies rarely reduce their dividend, and great companies boost them every year. When you buy a stock, you become a part owner of that company. As an owner, a mature, healthy company should be able to pay you a portion of its earnings in the form of a dividend every year.
If the amount of this dividend is cut, or remains stagnant for several years, there better be a very good explanation for it. If there isn’t, there are plenty of other, more profitable places to invest your money.
7. Watch out for debt
Companies with heavy debt loads suffer disproportionately during tough economic times and have fewer resources available to them when expansion opportunities arise. What’s more, they also have less flexibility to issue dividends or buy back shares.
KenolKobil is one formerly debt-strapped company that got serious about paying off its loans in 2013. The stock’s stellar performance since then speaks for itself.
8. Shun high P/E ratios
The price-to-earnings ratio is a blunt instrument, but like a hammer, it’s nevertheless one of the most valuable metrics in your analytical toolbox.
As a general rule, stocks that are priced at a low multiple to their most recent twelve months of earnings (below 15x), will outperform stocks with high P/E ratios. The market expects stocks with high P/E ratios to grow their earnings at high rates. And high expectations often end in disappointment.
9. Take CEO share purchases seriously
Who knows more about a business than its CEO? Pretty much, nobody. So, if you see a CEO buying a large amount of shares of her own company, you can be pretty confident that good things are in store for the stock. Calgro M3’s Wikus Lategan and James Mworia at Centum are two CEOs who’ve recently made big purchases of their own shares.
10. Beware rising share counts
When a company increases its number of shares outstanding, it’s rarely good news for shareholders.
Issuing share options to employees dilutes existing shareholders’ stake in the business. Acquisitions funded by the issuance of shares dilute shareholder value and expose the company to the risk of a new venture. Rights offers dilute shareholders who don’t have additional cash to invest in the business, and indicate that the company that may be over-leveraged. And bonus share issues are essentially an attempt to weasel out of paying a dividend.
Favor companies whose total share count remains level, or, even better, reduces from year to year.
So, there you have it. The stock market offers no guarantees, but if you can identify a company that passes this checklist with flying colors, there’s a good chance you’re looking at a long-term market-beater.
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