Chart: Buying stocks? Here are 5 things you should know

It would be an understatement to say that things are not going too well for the economy at the moment.

High inflation, low growth prospects, a high government fiscal deficit and current account deficit, and the lack of economic reforms has caused an 11 percent slide in the benchmark Sensex in the past 12 months.

To be sure, India does have some long-term growth drivers intact: a booming consumption story and a growing young population.But that still gives little reason for investors to invest right now, given the tangle of problems it currently faces.

Still, for those interested in wading into this market (hats off to you!), here are some pointers from Ambit Capital.

Politics is hindering growth

Ambit says the biggest change for India has been fragmentation of political power due to a fractured cabinet at the Centre. In addition, power has also been been apportioned between various regulatory bodies, state governments and courts. As a result, pushing through economic reforms has become tougher.

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Ambit also has a “Connected Companies Index”, comprising 75 companies that have long been believed to be receiving favours from senior politicians. Even this index has been underperforming the BSE 500 due to policy paralysis and political instability, indicating the political class is unable to help corporate houses.

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Value investing might not help in today’s times

Value investing refers to a style of investing in which stocks are bought if they are priced lower than their ‘intrinsic’ value. In other words, buy stocks when they are undervalued. The intrinsic value is calculated by assessing either earnings potential, enterprise value or book value.

Lots of long-term investors swear by value investing. However, Ambit says that undervalued stocks have not consistently performed better. In fact, other factors like weak balance sheets or political connections have more effect on how stocks perform.

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Rising competition is lowering returns

Indian companies’ return on assets (RoA) has been on a decline due to lowering profitability and asset turnover. The fall has been most evident in cement, capital goods, textiles, consumer durables, power and steel companies. All of these sectors have been plagued by high input costs and increasing competition.

Asset turnover has fallen especially in auto, steel and metals companies, most of which have acquired assets abroad.

Investors also need to be cautious about power, capital goods, infrastructure and real estate companies because these firms have also undergone structural de-rating, indicating their stock valuations are likely to fall sooner or later. Don’t make the mistake of buying stocks in these sectors without doing your research thoroughly.

India’s cost of capital is high

India has steadily become the most expensive major economy in the Asian regionwhen it comes to cost of capital. The cost has been pushed up because of constant, high government borrowings, infrastructural and labour constraints and restricted freedom of Indian companies to tap overseas debt markets.

In other words, pay attention to corporate cash flows, Ambit says. Companies that are unable to generate free cash flows on a consistent basis are unlikely to outperform.

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Accounting policies of a company matter

There’s no denying that some companies indulge in cooking their books and investors need to be aware of that.Ambit writes, “the most common accounting fudges in India are aggressive revenue recognition, under- or over-statement of expenses in the bull or bear market and cash pilferage (using related party transactions, loans to related parties and over-invoicing).”

Telecom companies have seen the biggest decline in accounting quality recently, warns Ambit; other sectors that consistently face accounting quality issues are real estate, conglomerate, construction, mining and retail.

Basically, it boils down to this: a company should be able to generate healthy cash flows consistently. Companies with good corporate governance or those which are driven by aspirational consumption demand seem to be good bets as well.

Ambit’s top five picks are Bharti Airtel, Tata Motors, Titan Industries, Sobha Developers and Exide Industries.