Stock Selection: A few more metrics

In a previous column, I had written about the importance of return on equity (ROE) and the fact that most MNCs have delivered on this front. The ROE approach helps us filter and identify high-quality stocks. It does not mean that investors should rush and buy without looking at the price. If I make a list of stocks and buy them at any price, it is senseless. Price is a critical component; although I cannot comment on stock returns from one point to another.

Timing is difficult, especially when it comes to purchasing high-quality stocks. In a bearish market, there is a flight to quality which pushes the prices higher; whereas in a bull market, such stocks are mostly neglected. I have observed that sometimes there is an overreaction to negative surprises which opens up buying opportunities. For instance, in 2007-08, there was an opportunity to scoop up high-quality stocks but they were ignored, by and large. This happens when there is a disappointment about earnings due to a slowdown or companies’ inability to pass on cost increases to customers which lowers their margins and, hence, profits.

My approach tends to get too conservative. I like to look at how many times a stock trades over its book value. I believe that around 7%-8% of ROE represents a fair price that equals one-time book value. This is because I assume that the long-term risk-free return is 8% per annum. So, if a company earns 24% ROE, I do not mind paying three times its book value. If a quality stock is available at this level, it is a juicy buy. Growth, generally, has two components: inflation and volume. Even if a company is not growing by volumes, it can still show some growth on account of inflation. In nominal terms, the ‘average’ growth in sales and profits should equal the growth in GDP plus inflation. If investors pick up investments that beat the average, they are fortunate. An interesting analysis of the past 20 years of profits showed that only 11% of the total listed universe, in India, delivered returns better than those of the index. This means that almost 90% delivered returns equal to, or poorer than, the index. The probability of picking up winners is just over 10%!

If a company delivers a consistent return of 50% on shareholders’ funds and pays out 40% of the profits as dividend, each year, shareholders’ funds triple in five years! At 25% returns, returns would less than double. At 10% returns, there would be an increase of only 20%. 

Whilst there is no immunity against a perfectly structured fraud, the following points should help to mitigate the risk:

i) A track record that is at least 10 years old. I prefer 15;
ii) As far as possible, no issuance of new equity or convertibles;
iii) Tax payout at the highest corporate rate of taxation;
iv) Consistent dividend payout;
v) Promoter holding of at least 30% is ideal;
vi) No pledge of promoter holdings;
vii) Low debt. I prefer total debt to be less than half of shareholders’ funds;
viii) As few subsidiaries as possible;
ix) Not more than one acquisition of another company in a 10-year span. If there are more than that, I’d examine each, on a case by case basis;
x) No merger of wholly-owned promoter companies;
xi) Increase in year-on-year turnover should exceed the increase in fixed assets;
xii) A stable business should not demand much capital expenditure on an ongoing basis;
xiii) No change in auditors.

However, these are only broad checks and should not be construed as the be all and end all for stock picking. After all, there are nearly 2,000 data points in analysing a balance sheet! In addition, there is management reputation and history to be considered. All of us instinctively sort companies into categories of trustworthiness.

I strongly believe that profits in the books should be demonstrated by the cash flow. To gauge the efficiency of business, a company’s profit after taxes minus dividend plus changes in working capital should be a positive number, for at least eight out of 10 years. If not, then it calls for a more detailed analysis. The difference between current assets and current liabilities is called ‘net working capital’. As the business grows, it is natural that both the numbers expand. However, when the expansion of this need is greater than the cash generated by the business, after paying dividends, it means that the company is going to suffer a decline in profitability. I do not deliberately consider depreciation as a cash flow for my assumptions, since that cash is always needed to refurbish the assets.

In addition to cash flow analysis, I like to read the auditors’ comments and search for clues, including changes in accounting policies, differences in valuation methods or any divergences that are stated to be in conflict with accounting standards. I do not bother to read the directors’ report or other voluminous speeches or comments. It is hardly ever that a company will put in writing anything bad about itself, so why waste time reading it?

My approach to stock selection tends to be ultra conservative and may not be suitable for everyone. It tends to work where there is predictability about the business and the industry. It may work better for industries that gain from consumer spending rather than from industrial customers. Further, my framework limits my stock picking universe to a rather small number but it does not mean that there is no scope outside of it. I buy stocks with expectation of value appreciation and not to meet a specific spending goal. It is not money I put by for building a house or meeting education or marriage expenses (for this, I prefer to be into fixed-income investments). Money in stocks is for wealth-creation and not a savings instrument. Only after 10 or 20 years will I pause and see what I have made out of my investment in stocks and maybe think about what I want to do with the money.

Understanding of fundamental, market technicals and patience are required as well, to invest successfully. Stocks shouldn’t be bought simply because one has money to invest. Keep the money in a liquid fund until you spot opportunities. If you do not have the patience and ability to pick stocks on your own, then it is better to stick to mutual funds and take the systematic investment planning (SIP) route.

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