Table of Contents
12.1- Basis for stock selection
In the last few chapters, we have understood how to read financial statements and how to calculate some important financial ratios. Using all this, we can start making our own stock-picking positions based on fundamental analysis. We have talked earlier also that before investing in every company, it has to be seen whether it is a company worth investing in or not. Any company which fulfills the conditions of the investible company can be invested in it.
The most important thing is which is a company worthy of investment. It may be that the company which is worth investing in for me may not be worth investing for you and the company which is worth investing for you may not be worth investing for me. For example, I may choose to choose companies with a strong focus on corporate governance. But there may be another investor who does not pay attention to corporate governance and may say that there is something wrong with all companies, as long as the company’s results and other numbers are looking good, I am ready to invest in them.
What this means is that there is no fixed checklist for picking stocks. Every investor has to make his/her own preferred terms on the basis of which he/she will invest. Every investor sets these conditions based on his experience. But it should be noted that these conditions should be based on some logic. Well at the end of this chapter, I will show you my checklist. If you are just starting to invest, then you can use this checklist of mine and choose the terms of your choice from it.
12.2- How to start picking stocks
Before we make a checklist for investing in stocks, some important things should be taken care of. At the beginning of the process of stock picking, we should first find some stocks that we like. After shortlisting some stocks, we should see whether they fulfill the conditions of our checklist or not. If it fulfills the conditions then we should invest in it and if not then we should look at other stocks.
So the very first question is how do we choose those stocks which we can say we like and which we want to check on the terms of our checklist? There are a few ways to do this:
- General Observation means keeping an eye on economic activities. This may sound like a very simple thing but it is a very important method for stock picking. All you have to do is keep an eye on the economic activities happening around you and keep your eyes and ears open. See what people are buying, or selling? Which type of product is in high demand? What products are people talking about in your neighborhood? Peter Lynch, a very well-known investor in the American stock market, has discussed this method in his book “One up on Wall Street”. Personally, I have also used this method. I chose to invest in PVR Cinemas stock (as I could see PVR multiplexes opening very fast around me) and Cummins India stock (I saw Cummins diesel in every company building around me generator is on)
- Stock Screener – You can consider it as a filter through which you can extract good stocks from many stocks. This means creating a process for picking stocks that you will decide on your own. Through this, you can choose good quality shares. For example, you can create a screener in which you have put a condition that the ROE of the stock should not be less than 25% and the PAT margin should not be less than 20%. In this way, you can choose some useful stocks from a large number of stocks. Though there are many stock screeners available online personally I prefer Stock Screener by Google Finance and screener.in.
- Economic signals – One of the best ways to pick good stocks is to keep an eye on the state of the economy. Let us understand this with an example- You will see that these days a lot of emphasis is being laid on creating infrastructure in India. New bridges, roads, and all such things are being built. Cement companies working in the country will get direct benefits from this. So I will look for more cement companies that fulfill my checklist and can take advantage of this new trend.
- Sector trends – In this, you try to identify those sectors where new trends are visible. Then try to identify the companies working in those sectors which can get benefit from this trend. For example, we know that 3 types of beverages are widely sold in India, coffee, tea, and bottled water. But if you look carefully, a new trend has started recently in energy drinks. This market has grown very fast and there is a lot of potential in it. Now you can try to find companies in this sector that are involved in the energy drink business or are preparing to enter in it.
- Special Event or Special Situation – This is a bit tricky way to get a share ideas. For this, you have to keep an eye on companies, news related to companies, and such events of the company, which can benefit the company in the long run. I remember one example. In 2013, Cox & Kings, one of the country’s largest tour operators, inducted HDFC’s Keki Mistry into its advisory board. Keki Mistry has a lot of respect in the business and industry, it is believed that he has a good understanding of business. A friend of mine said that Cox & Kings would benefit from Keki Mistry’s entry. So he started doing more research about the company to see if it met the other investment criteria. He then invested in that stock and today he is sitting on a profit of 200%.
- Circle of Competence / Use of your ability – This is the way to extract stock ideas where you take advantage of your knowledge or your ability. This is the easiest and most reliable way for a new investor. For example, if you work in a bank, then you will have a good understanding of the banking industry. If you look around you or talk to your colleagues, you will come to know which bank is in a better position and can earn big profits in the future. . Similarly, people working in the medical industry have better information about the companies related to health care than others. All they have to do is see which are the listed companies in their industry and which of them have the potential to generate profits in the long run. In this way, you can use your potential to extract stock ideas.
It means to say that stock ideas can be found anywhere. Whenever you like a stock, add it to your list and keep an eye on it because that stock may not be fulfilling your investment conditions at that time. But if you keep an eye on it, then it is possible that in the coming time, it will meet the conditions of investment and can become a good investment idea for you. You should always keep a list of such stocks which you are keeping an eye on.
12.3 – The Moat
After identifying the stocks, the next step is to see whether the stocks are meeting the conditions of the checklist or not. This important pre-investment work is very important and you should be very careful on every part of it.
Before revisiting the checklist, there is another principle to be understood called The Moat. It has been popularized by Warren Buffett. It tells how far the company is compared to its competitors and how long the company can maintain this position. You must be aware that Moat means a moat which was made outside the fort in ancient times so that the enemy could not reach the fort by crossing it. Warren Buffett has said on the basis of this that companies should make such a moat that there remains a gap between them and their competitors and their profits are not affected. The wider the gap, the better it is for the company.
Let us take an example to understand Mot. Eicher Motors Limited Company manufactures commercial vehicles and also manufactures Royal Enfield bikes. Royal Enfield bikes are very popular both in India and abroad. A special kind of customer like this bike very much. This bike is neither very expensive like Harley Davidson nor very cheap like TVS bikes. It will not be easy for any other company to bring a new bike and compete with Royal Enfield. This means that Eicher Motors’ moat is very wide, so it will not be easy for its rivals to compete with it.
Today there are a lot of companies that have such MOTs. Every company that makes money in the stock market has such a fat somewhere. For example, look at Infosys which had this opportunity to provide the same service from India which was available in America at a very high cost. Page Industries made this moat when it got the India license for jockey innerwear. Prestige, a company that sells pressure cookers in India, also has a similar motto. You will find many such examples.
12.4 – REQUIRED WORKS AND PRECAUTIONS
The most important thing to do before investing and researching the stock market is
- Understanding of business including the reading of Annual Reports.
- Look over the terms on your checklist and test each investable company against that criteria.
- Valuation of the company so that it can understand that business completely.
To know about a company, we have to know and identify each and every aspect of it properly. We have to make a list of our questions for which we have to find answers. The first question would be what does the company do? We do not have to search for answers to these questions on Google, the answers will be found in the annual report of the company or on the website of company. This will also tell us what the company has to say about itself and its business. Personally, I prefer to invest in companies in which there is less competition and less chance of government interference. For example, when I invested in PVR Cinemas, at that time there were only three companies working in this field, PVR, Inox, and Cinemax. Later Cinemax merged with PVR leaving only two companies in the market. Now, many more new players have come in this market. So it is time to take a look at my investment in PVR and decide what to do next. After knowing the business of the company, the next step is to see how many conditions the company is fulfilling from our checklist. Take a look at my checklist which has 10 conditions.
|serial number||condition of work||Comment||it’s meaning|
|1||Gross Profit Margin (GPM)||> 20%||The higher the GPM the better, the bigger the company’s moat or moat|
|2||increase in income||should be in the direction of profits||should grow at the same rate as profits|
|3||EPS||EPS should grow at the pace of net profit||If a company is issuing new equity, it is not a good thing. The share of existing shareholders will be reduced|
|4||debt level||The company should not be heavily in debt||High debt means that the company is dependent on debt for the business. This increases the finance cost and profits go into it.|
|5||inventory||Applicable to companies engaged in manufacturing or production||Inventories and PAT margin growing together is a good sign. Must check inventory number of days|
|6||Sales vs Receivables||Sales growth based on receivables is not a good sign||This means that the company is only trying to show more sales figures.|
|7||cash flow from operations||Must be cash flow positive||If the company is not getting cash from its business, then it is clear that there is pressure on the company.|
|8||return on equity||>25%||The higher the ROE, the better for the investor, but also check the level of debt.|
|9||business diversification||The company is engaged in only 1 or 2 types of business||Avoid C companies that have a wide range of businesses. A company with only one or two lines of business is better|
|10||subsidiary||should be less||If the company has a lot of subsidiary companies, then it can be an indication that the company is withdrawing money on the pretext of them. Avoid investing in such a company|
If a stock fulfills these conditions then you should look at its price. If it is not available at the right price then there is no point in buying the stock. How do you know what the right price means? This will be stage 3 or the third phase for us. We’ll have to do some valuation experiments. The most well-known method for valuation is Discounted Cash Flow (DCF) analysis.
In the next few chapters, we will see what needs to be done to do equity research on a company. Equity research which we will discuss will be a part of Stages 2 and 3. I think in stage 1 we should go through the annual report properly and in detail.
Main points of this chapter
- A Stock Idea Can Come From Anywhere
- You can also get ideas by keeping your eyes and ears open or using your ability
- Keep a watch list i.e. such a list in which you keep those stocks on which you have an eye.
- Once you have selected the stocks that you are eyeing, then see who has the Moat in them.
- After this comes the process of investigation i.e. the process of necessary work in which we see about the company’s business and fulfill the conditions of its checklist and also we find out how the company’s performance has been so far. Has been and how much is its valuation?
- When we are trying to understand the business, we must examine every aspect of the company’s business.
- Keep tweaking and improving your checklist as you gain experience in the market.
- The DCF i.e. Discounted Cash Flow method is considered the best way to find out the valuation of a company.