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  • Rohit Musale, CFA

How to Navigate the Stock Market Effortlessly

There are more than 5,000 companies, listed on the stock market.

How do you navigate such a huge market?

How do you decide, which companies to invest in, and which companies not to invest in?

Here are the steps I follow:

1) Free Cash Flow

Filter out companies depending on whether they are capable of producing a free cash flow or not.

If a company is not able to produce a free cash flow, just stay away from the company.

What is free cash flow?

When you deduct capital expenditures, interest expense and the repayment of borrowings, from the operating cash flow, what you are left with, is the free cash flow.

If that number is positive, then you are looking at a good business, especially if that number has been positive consistently, over the past 10 years.

Why is free cash flow important?

Free cash flow is important because, the company can use that money to pay out dividends, to acquire other companies or do a share buyback, all of which are beneficial for the shareholders.

In step 1 itself, you can reduce the stock market down to the final 10 to 15%.

This means, 85 to 90% of the stock market is garbage.

2) Growth Rate

You have all the companies which are producing a free cash flow.

Not all of these companies are going to have the same growth rate.

Look at the past 10 years of data.

Find out what is the compounded annual growth rate of pre-tax earnings of these companies.

Put that list in descending order of this growth rate.

This is the list of companies which are capable of producing a free cash flow, placed in descending order of growth rate.

3) Target Return

How much return do you want from the market?

Make a decision.

Do you want to make 10% per year, or 15% or 20% or more?

That's your target required return.

The company that you are looking at, should be capable of growing its pretax earnings by atleast this target return, if not more.

Only then will you be able to achieve your goal, right?

Example: if you want a return of 20%, compounded annually from a company, you cannot invest in a company that is growing its pretax earnings by less than 10% or 15% per year, even if it has been producing a free cash flow each year for the past 100 years.

4) Filter Slow Growth Companies

Filter out companies which do not meet your target return requirements.

Now you are left with less than 5% of the entire stock market.

That's a fact.

Try doing it.

Hopefully you expect a return of no less than 20% from the market.

Else why would you be in the market in the first place, right?

If this list is long enough, you will have to do some further filtering, because you cannot track a lot of stocks in your portfolio.

Most professional investors, they either have a 10/10 portfolio wherein you have only 10 companies in the portfolio, and you invest 1/10th of your investment capital in each of those companies.

Or you have a 20 stock portfolio, where you invest 5% of your capital in 20 companies each.

You cannot track more than 20 companies.

By any chance, if you want to be super focused, it makes sense to invest only in the top five companies in your list.

5) Check Valuations

One last step before you invest is: you have to watch out for the valuations.

If the top five companies as per growth rate in your list are overvalued, then you are making a bad investment in a growth company.

Check what is the current value of the company relative to the earnings.

If these stocks are overvalued, it doesn't make sense to invest in them.

You probably have to wait, till the price reaches a level, where you are comfortable investing in, and if at all, it doesn't reach that level, then you have to stay away from the market, because it's not meeting your target return.

Investing is a game of patience.

It is not a game of analysis.

Anyone can do analysis.

Patience is a virtue held by a few.

The ability to sit and do nothing with cash, is the most important quality, that you can possess.

Otherwise, you will make financial blunders.


Rohit Musale, CFA

18 January 2023


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