Are ‘Good Companies’ always Good Investments?

Rupali, a software engineer, had recently started working and was looking for avenues to invest her money. She knew from the conversations her colleagues had in office that investing in stocks could give her great returns. But she had no idea which stocks to invest in. She hence discussed with her colleagues about which stocks she should invest in. Her colleagues advised her that investments in well run companies always give good returns and hence she should invest in such companies.

They also discussed how to find such companies by looking for some important characteristics.

So, what are the characteristics of a Good Company?

1. Good financial performance

A good financial performance allows a company to raise capital at lower rates as compared to others, thus increasing the profit margins and helping the company to deliver higher returns.

2. Efficient management

Only the companies having credible and efficient management will be able to achieve stellar growth rates year after year.

3. Good Corporate Governance practices

Corporate governance is a measure of transparency, accountability and responsiveness to stockholders of the management. Companies with good corporate governance practices are willing to cede more power to the board. Look for factors like relatives/friends being appointed as Independent Directors, Promoter shareholding, compensation of directors etc.

4. Social responsibility

Companies with awareness of their responsibility to society are perceived to be good companies. It is believed that such a company, not only creates wealth for its stockholders but also creates benefits for its employees, customers and the society at large.

5. Reputed companies

Companies like Tata, Birla, Reliance etc. have grown considerably over the years and today draw value just from their reputation and brand name. Customers place a lot of faith and trust in these firms and their products.

A year later, Rupali found that the companies in her portfolio had not delivered the returns she expected. She was confused. These companies were some of the most well managed companies and yet had not performed. She could not understand what the problem was and decided to find it out.

So are ‘Good Companies’ always good investments?

No! Not always. After some research, Rupali found that there can be times when we can get carried away by a ‘Good Company’ tag and ignore the fact that it may not be a good investment. She penned them down:

1. Overpricing

The market usually prices stocks of these companies higher; this premium is for the high quality of management and the firm. They are traded at hefty PE and PBV multiples. But, if the market exaggerates this value, the stock could lose its luster over time, thereby leading to a drop in the price. Rupali checked the stocks in her portfolio and found that she had indeed invested in them at very high prices.

2. High Expectations

Whenever Sachin Tendulkar walks out to bat, the country expects him to score a century. Even if he scores a half-century, we are disappointed and the media has a field day with reports of how Sachin could not live up to the expectations. Similarly, investors expect a well-managed company to consistently deliver higher growth than its peers. If the company fails to live up to these expectations, it is penalized by the market by a reduction in the stock price.

3. Mature Business

The fact that these companies have earned a reputation for themselves indicates that the companies have been around for some time. With age, the company may face stagnancy in business prospects and this may lead to a stage where it cannot sustain such high growth rates in the future. Such stocks will thus have low growth prospects unless the company can innovate or do something to revive its growth.

4. Sector Impact

The industry to which the company belongs to also plays an important role in determining the stock prices. If there is positive news for the sector, all companies in that sector will trade at a premium. Similarly negative news like regulations that may hamper growth can send the stocks plummeting downwards.

Rupali now had a very clear understanding. In order to put her knowledge to best use she decided to invest in the good companies only after necessary checks. Let’s have a look at what these were.

How to best utilize the ‘Good Company’ filter

The best strategy to buy a good company is when it is undervalued by the market. Sounds ironical, doesn’t it? If a company is good and can give superior financial performance compared to its peers, how can it possibly be undervalued?

The answer lies in short term problems like fall in demand, fire in factory, cancellation of projects, recent acquisitions, etc. When such companies are at the center of some negative news, market may sometimes overreact even if the news might not affect the company over a long term. At such times the stock will usually trade at a low P/E, P/BV multiple, thus giving us a golden opportunity. What we need to check, however, is whether the company can overcome the short term problem and grow well in the future.

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