How to buy stocks, carefully

After reading my previous article, some of my friends suggested that I write about technical analysis and how to make money quickly.

There are a lot of people who have made money in the stock market using technical analysis. But I don't understand technical analysis and I am sure most people are like me.

However, what I learned from great investors like Warren Buffet and Benjamin Graham is that if you buy shares of good businesses at a fair price with a margin of safety and good management, you can get reasonable returns over the long term.

I want to emphasise 'long-term' -- typically 3-5 years or more.

In my previous articles I discussed about the importance of:

• Investing in stocks like you invest in a good business;
• Ability to buy the stocks at the right price;
• Integrity of the management; and
• Staying away from stock tips.

In this article, I want to elaborate on the first point of investing in good businesses with specific examples.

What is technical analysis?

What are the key things you need to look in a business to invest? A good business to me is a one that I can understand and has a reasonable history of making money for the shareholders. One should clearly understand how the business runs and how the business makes money.

If you talk about biotechnology, I don't have a clue about it. I don't know which companies have better research or which companies are going to survive after 10 years. But if you talk to me about Blue Dart courier service or Zee Television or ICICI Bank or UB Group or GSK Consumer (owner of Horlicks, Boost, Viva), I can reasonably say that these companies will still be around after 10 years or more.

These companies have significant competitive advantages. So what do I mean by competitive advantage? In plain English, if you imagine that these companies are like kingdoms, then competitive advantage is like a moat (a moat is a deep defensive trench/ditch usually filled with water and probably alligators that surrounds the castle to provide a barrier against attack upon castle ramparts or other fortifications).

The bigger the moat, the tougher it is for the enemy to attack the kingdom. An MBA grad would use this fancy term, calling this a 'competitive advantage'.

The ability to evaluate moats is very important for the long-term investment returns.

Let's see if there are any businesses with that kind of advantage. There are mainly two types of advantages:

1. Cost Advantage: If Company A can make a cell phone for Rs 5,000 and Company B can make a similar cell phone at Rs 3,000, then Company B has a cost advantage of Rs 2,000. This is so because of a number of reasons: volume, supply chain, technical know-how, raw materials, tax advantages, etc.

Most of these advantages are not sustainable unless the company has exclusive rights or some such thing which competitors cannot replicate.

The first company with such advantages that comes to my mind is Tata Steel (Tisco). It has its own ores. When you buy shares of such companies when the industry is down or when every one is shunning the steel industry, like in 1999 or 2000, there is a good chance that you will make reasonable capital appreciation.

One good way to understand is to know which companies are still up and around when most of the firms in that industry sector are shutting down. It's only the ones with a strong competitive advantage and cash flow that survive.

The challenges in these kind of companies are:

a). They should be able to evaluate the competitive advantage

b). They should follow the industry cycle closely.

Let's take another example and compare SAIL with Tisco. Both are steel companies. I know they are a little different on their products, but while comparing we can still get an overall idea whether Tisco has a cost advantage or not.

If you look at gross margins or net margins, you will see that Tisco has better gross margins and net margins compared to SAIL.

2. Brand Advantage (share of mind): Let's take tea. If I were to choose between buying, say, Taj Mahal Tea (Tata Tea) and some street brand tea, I would choose Taj Mahal Tea. I am also even willing to pay a premium up to 20 per cent to buy it.

If someone likes Taj Mahal Tea even more than I do, they might pay a much higher premium than 20 per cent.

Let's say the company increases tea prices by 10 per cent. There is a good chance that I would still buy the premium tea. A product has a competitive advantage if customers prefer it to others even if the company hikes prices by 10 per cent or more.

The other way to look at it is whether you can pass off most of the costs to the customers. If you can and your competitors are unable to do it, then you have a clear competitive advantage.

You can see the difference between Jayashree Tea and Tata Tea. You can clearly see how Tata Tea was able to sustain the margins in the last couple of years where tea prices were really low.

Tata Tea (Indian operations)

Source Equitymaster.com

Jayashree Tea (in Rs crore)

Source: ICICI Direct

I want you folks to think about the airline business. There is a lot of buzz about airlines, their growth rates and IPOs. At least a dozen airlines are going to compete in the next few years.

Can you say which companies are going to have a cost advantage or a brand advantage? If you have seen the history of airlines in the United States, collectively they have lost more shareholder money than most other industries. In spite of logging spectacular growth rates in the last 70 years, they have still lost money.

I have just talked about things I like to see when I invest in a business. At the same time, I don't want to see a few things in businesses like excessive capital expenditure and companies with high debt.

Can you imagine a manager saying, 'Hey, we made Rs 1,000 last year, but can you give Rs 995 so that we can make Rs 1,000 again next year?' As the saying goes, 'You can say a lot about the housewife based on how tidy the house is.' In the same way, you can say a lot about the company based on how they managed their debt.

If a company has an excessive debt, I don't want to be a part of it. It is very important to how much debt the company has.

And yes, you should always ask these questions before you invest:

• Do you understand these companies?
• Are they going to be here for another 10 years?
• Is the stock price reasonable?
• Is the management honest?

In my next article, I will discuss more about reasonable price and management honesty.