Choosing the right stocks to invest in

Investing has always been considered a complex process. Especially when it comes to financial assets it is considered further more complex as it is supposed to be an expert domain. No wonder the equity penetration has been comparatively lower in India despite India enjoying a good saving rate. It is true that some amount of traction is visible over the past two years, the pace of increase is yet far away from what the bank fixed deposits and other physical asset classes enjoy.

However equity as an asset class has many advantages – transparency maintained by regulators like Securities and Exchange Board of India (SEBI), great amount of liquidity, high speed of transactions and lowest brokerage costs. With all such advantages comes another big advantage – one of the best returns generated over a long period in terms of compounded annual growth rate (CAGR). Following tables gives estimated returns generated from different financial asset classes. With equity expected to generate between 14-16 percent CAGR over a long period, it is considered as a better investment opportunity.

One should remember that Equity investing can be rewarding for those who have adequate knowledge of the stock markets and have the ability and appetite to take risks. But more often than not, retail investors lack the knowledge and even the time to research and educate themselves about the nitty-gritty’s of stock market movements. In such cases, it is best to leave your hard earned money in the care of professional money management experts or fund managers of mutual funds. Reason being, Investing in equities can be complex. When investing in equities, you have a lot of factors to consider such as industry, sector, size and structure of the company and management track record. It requires a lot of Economy, Industry and Company analysis before investing. This is as far as fundamental analysis is concerned. However we opine, stock market is simple and hence the approach of investment should also be as simple. Always remember equity investment is all about common sense and hence it is good we try to avoid simple or silly mistakes. Rather in the stock market it is important to understand ‘what to not to do’ than knowing ‘what to do’.

With a lot of new equity market participants entering the markets (especially during the Covid-19 pandemic period) we feel it is better if we provide a simple ready-reckoner for the new entrants to sort or filter quality investment ideas.

Remember, when we invest in a share we are investing in a business idea. So if the business does well, even the share price does well and vice-a-versa. Better the investors understand the business and few other qualitative parameters to sort down a list of good investment ideas. To help our readers through the same, we have prepared a few questions. And finding an answer to the same is a very simple process. To make it simple for our readers, we have categorized the questions in four different segments containing five questions each. It is segmented as 1x, 2x, 3x and 4x factors.  In simple terms, in the case of 1x factors – if the answer to the question is positive – the scrip scores one point. Similarly in case of 2x – if the answer to the question is yes then the scrip scores two points for each question. So the maximum points scored (including 3x and 4x) would be 50. At the end of the process one can get an answer to if he needs to buy that share, hold it or exit from the same. Let’s understand those 20 questions.

Understanding and answering the – 1 x factors

Q1. Brand: 

Does the company’s business rely on recognizable branding truly valued by its buyer base?

While the Brand holds its own value, it also has its own impact in terms of sales growth, pricing power and repeat business. One must understand what kind of Brand they are investing in. Google, Apple. Coca Cola and Microsoft are a few of the examples of global equity markets. In India the likes of Pidilite (Fevicol), Asian Paints and Page Industries (Jockey) are few of such examples. There is a long list of such brands with Tanishq, Royal Enfield and even Bata are brands recognized by even common people. If the company you are analysing has got a brand name – it is advantageous.

Example – Pidilite Chart

Example – Asian Paints Chart

Q2. Raving Fans: 

Does the company, on the whole, receive positive word of mouth from its customers?

While advertising is normal, it is the word of mouth that makes the product and its business sustainable in the long term.  We have seen how a particular consumable or product is well accepted and its new launch is always sought after. Apple products have such a fan following and in India we have seen how the royal Enfield has managed to create its own niche. Raving fans is also applicable to brands such as Titan, Burger King, Domino’s Pizza and McDonalds. Most of such franchises or companies are listed in Indian equity markets.

Q3. Diversification:

Has the company diversified its buyer base so that no single customer accounts for more than 20 percent of revenue? Apart from this the segment wise diversification and geographical diversification also plays an important role. We have seen such diversification in larger companies like IT and FMCG sector. For them diversification is the key. Else a dependency on a single product or a single customer leads to slower growth or erosion of market share.

Q4. Disclosure:

Does the company maintain a high standard of disclosure, consistent with SEBI guidelines and other regulators? Compliance may be a subjective and qualitative factor. However if the compliances are followed righteously, such companies enjoy a premium over the peers on bourses.  In the past we have seen how a non compliance companies like HDIL, Manpsand Beverages, Suzlon, DHFL and Satyam Computer have eroded wealth of investors. Hence if the company management gives right kind of disclosures, it should command better valuations as well.

Q5. Transparency:

Would an intermediate investor find the company’s financial statements and management ownership disclosures relatively easy to sift through and understand?

If the answer is yes here – provide one brownie point. If we analyse the Annual report of companies like Tata Group, Infosys, Asian Paints and even the other companies like Hero Motors, Bajaj Group, etc. there is a transparency in every action of management. Over the years such groups have been wealth creators for the investor fraternity.

While here we end the 1x parameters, let’s understand the 2x factors now.

Understanding the 2x factors

Q6. Insider Stake:

Do any key insiders have at least a 5% stake in the company? Especially in the case of mid-cap companies or small cap companies. There are few large-cap companies where the insider’s stake is lower than five percent. However, such companies score better in other parameters and hence it is not necessary to put it in the insider take category. As regards where to find such data? The exchanges website is the best way to find that data on the shareholding column. It is updated every quarter on the BSE and NSE website.

Q7. Not an Underdog: 

Is the company free of any direct competitors that have substantially greater financial resources? If there is a competition with deep pockets it not only affects the pricing power but also affects the margins severely. Reliance Jio and other Telecom players is a recent example of the same. Over the past few years we have seen how the telecom companies have suffered and now only few players remain on the canvas. The significant under performance of Vodafone Idea, Bharti Airtel and closure of few other service providers indicates the same.

Q8. Goliath: 

Is the company free of any disruptive upstarts visibly challenging its business model? Here one must understand if the business model is easily replicable and technology can disrupt that segment.

Q9. Moat: 

Would potential new competitors face high economic, technological, or regulatory barriers to entry? Such Moat makes business not only sustainable but also scalable. Lesser the number of new entrants in the business, higher is the sustainability of margins. A few companies like Concor, ITC (Cigarette Segment), Page Industries and even few of the Pharmaceutical & Research companies enjoy such Moat. Such moat means additional points to the kitty.

Q10. Ownership:

Does the promoter/promoter group hold more than 33 percent stake for the past 6 quarters? In simple terms, the promoters holding it gives confidence to the investors. Any recent selling by promoters would mean, some news might be in the offing. Higher promoter holdings show the confidence of promoters in the company. Further the volatility is usually lower in such share prices as the majority of the stake is with promoters who have restrictions in terms of exiting suddenly. Now the 25percent minimum holding by public rule is in place and hence there are many companies where promoters hold 75 percent.  Earlier many of the promoters had a higher holding than 75 percent.

We have till now discussed the 1x and 2x parameters, in our next continuing blog we should explain the 3x and 4x parameters to analyse a company.

Answering the 3x factors

Q11. Cash Flow: 

Was the company cash flow-positive during the previous quarter and past 12 months? It is stated that top line (revenues) is a vanity, Bottom-line (Net Profit) is sanity and the only reality is Cash Flow. Check how the company scores here. Here as well, focusing on the cash generated from operating activities is important. If the operational cash flow is not generated the financials are expected to be on the weak side.

The following chart shows how the operating cash flow (amount in Rs Crore) of ABG Shipyard was affected since FY13 and eventually the company went bad.  It was focusing on the financing activity and as the operating cash flow stopped the debt trap led to a historic fall of the counter on the bourse. Hence cash flow generation always shows a true picture. Hence always focus on operating cash flows while analysing a company.

ABG Shipyard – Cash Flow Chart

Q12. Experience:

Does the top management have more than 15 years of combined leadership at the company? This helps the company endure the different economic peaks and troughs. It is the management vision and capability that helps a company grow and create wealth for the stakeholders. A simple rule suggests that if the management quality is good the scrip enjoys a good premium on the bourses. The likes of L&T, HDFC Group, Pidilite Industries and Tata Group always had very good and experienced management teams. Even Infosys has been having a very good strong management bandwidth in terms of the founder members. However even a company like Infosys had to witness hiccups when promoters gave charge to professional management and markets gave a cold shoulder to the scrip then. Eventually the scrip witnessed a lot of volatility during mid of 2016 till the mid of 2017. So, experienced management is a prime factor one must look at.

Q13. Market Cap: 

Does the stock have a market cap of more than at least 1000 crore?

Simple reason being, anything less than that would mean there is not enough liquidity to either enter or even exit the counter. The basic rule of investing suggests one should enter a trade keeping exit in mind. SO unless there is no higher liquidity in the scrip it is difficult for us to exit. Especially in the midcap and small cap counters. Hence one must enter the trade keeping exit route in mind. In the past we have seen how many of the small cap companies providing good returns hardly provide an exit route. Eventually the transaction cost increases and hence the returns also get affected.

Q14. Beta:

Is this stock’s beta less than 1.3 for the past 12 months? Beta in simple terms means – if the index moves by 1 by how much the stock would move either way. Just to put it in perspective, a beta of 1.3 means – if Index moves up by 1 percent, the stock would move 1.3 percent. It is applicable to decline in index also. When we look at market movement usually the Benchmark Indices are tracked. Even the returns generated by those benchmark indices are also considered as returns to compare with. Beta plays an important role here. Higher the beta higher is the volatility of the stock.

Q15. Self Sufficiency: 

We have already discussed cash flow generation and its importance. However there are times when liquidity becomes scarce and companies have to be self-sufficient. One must look at the parameter; can the company operate its business in the next three years without relying on external funding? If the company has the ability to fund the expansion on its own funds it is a major positive. While others may find it difficult to expand when interest rates are higher, self-sufficient companies would go ahead with expansion. If the answer is yes to this question we should provide 3x points to the company.

Answering the 4 x factors

Q.16 Profitability:

Was the company profitable during the previous 4 quarters? While sales growth is important, consistency on the bottom-line is also essential.  Following chart shows how HDFC Bank has not only stayed profitable for the past 10 quarters but has managed to show growth on Y-o-Y basis for the past five quarters. Despite the pandemic the company has been showing growth and such

Q17. EPS (Earning Per Share):

Is EPS growth visible in 4 out of 5 immediate preceding years? EPS is calculated as (Net Profit / Number of outstanding shares). Earnings are important as it shows growth. Sales growth is necessary but if it is not profitable there is no point in growth. Hence if the earning per share is better the stocks trades at better multiples as well. As the EPS increases along with it the valuations also witness improvement. If the growth is consistent on a quarterly basis – the company should be seen as a good investment opportunity.

Q18. P/E Ratio: 

Price to earnings ratio is calculated as (Market Price / EPS). Try to find out if the stock has a positive price-to-earnings multiple that is 10 percent above or below it’s 5 year average? While there are theories that suggest that P/E nowadays is not relevant. However it is still relevant and holds value. Always remember, 75 percent of the time it is the P/E expansion that leads to stock price up move. Hence if the share price trades at lower than the average of the past five years, it is a good opportunity to invest.

Q19. Growth: 

Did the company increase its sales in the range of 10 percent to 30 percent annually in the previous three years? Growth is the only constant in terms of business. Unless and until the sales volumes increase – it would not be taken as a consistent growth. Following chart shows how Pidilite Industries has posted Sales growth over the past few.

Q20. Well-Managed: 

Did the company report a return on equity (RoE) of more than its 2 year’s average in the previous year? In simple terms, return on equity means how much the business is generating on the invested capital by equity share holders. If it is on a declining path – it is advisable to avoid such investment.

Conclusion:

Here we have given higher points to quantitative parameters and comparatively lower points on qualitative parameters. However, most of the questions would be answered in a clear Yes or a No. While subjective questions could be answered easily the financial data is available in the open domain. Now it is important to take the right call based on the above parameters.