CategoryInvestment process

I follow a simple approach to stock selection. The first step involves using a stock filter (see links in the side bar under useful links). I typically use a simple filter criteria of PE 10-12%, Debt to equity of less than 0.7 and a market cap of greater than 100 Cr.

In addition to the above source, I add to the initial list based on recommendations on other blogs, analyst reports etc.

The next stage involves doing a quick analysis of the company’s statements such as Profit and loss, balance sheet, financial ratios etc. I end up eliminating almost 70-80 % of the stocks in the original list. The reasons can range from low PE due to one time gains in the previous year (and normalized PE being high) to lack of transparency in the annual report.

I am fairly ruthless in eliminating companies at the above stage. If I am not comfortable with the economics of the business, or find that the level of disclosure is inadequate, I tend to give the stock a pass. I have ended up passing over stocks which have done well later, however I prefer the risk of omission than commission.

Once the numbers check out and I have the necessary AR and other documents, I initiate a deeper analysis. I have a detailed excel document and checklist which I use to analyse the company in terms of competitive position and competitive advantage etc. As a last step I do a 3 scenario DCF analysis ( optimistic, pessimistic and base case scenario) and a relative valuation exercise.

If at the end of the above exercise , the company checks out in terms of the qualitative analysis and the stock price is 60% of Intrinsic value, I initiate a buy on the stock. However I tend not to buy in one shot. I tend to buy in 5-6 orders spaced by a few weeks each. This allows any excitement or irrational attitude towards the stock to cool down. I also try to look at my notes again with a fresh mind and reanalyze my assumptions.

The above takes atleast 4-6 weeks of time. However the above analysis does not involve any peter lynch style study of the company’s products at stores or talking to customers or suppliers.

Most of us know that a stock with a high valuation has a higher risk of loss if the company dissapoints in terms of earnings. However i think there is an additional factor to consider when investing in a stock which is fully valued. A stock which is fairly valued has already discounted a bright future. When i think of investing in such a stock, my due diligence has to be deeper. I should have a strong reason to believe that the company has an even brighter future than what the market believe. What that means is that i am looking into the future farther for the company

Let me illustrate –

Company A sells at 12 times PE. If the ROE is around 15%, then the stock is discounting a mere 3 years of growth of 10 %.

In contrast company B sells at 30 times PE. If the ROE is 15%, then the stock is already discounting a growth of 15% for 10 years.

For me to make money on stock B, i need to have the foresight that the company do better than what the market has discounted. That means the company has to grow faster than 15% or for longer. Both cases for stock B are not easy to forecast .

In contrast company A has to perform only a bit better to give me good returns.

Now all of the above is basic value investing and concept of margin of safety. however my thought is that for high PE stock i should have a deep understanding of the business , its competitive position and other factors. Also my margin of error is smaller for such stocks. If an unknown factor works against the company, then there could be a permanent loss of capital. In contrast low valuation stocks need only a few things to go right for me to come out ahead.

In a nutshell, a low valuation stock protects me from my own shortcomings and sometimes I can get away with lesser research.

Stocks in the real estate business, telecom and retail come to my mind when I think of fairly valued company. When I look at these companies, the thought which comes to my mind is whether these companies will do better than what the market expects and does my own research substantiate it?

I generally analyse a good number of companies before investing in a few. A lot of times i am not able to figure out, with reasonable confidence, the range of intrinsic value estimates for the company. I have had this problem with telecom, retail companies etc. These are companies in a new, sunrise industry. There is a lot of promise and enthusiam around the companies and the valuations may reflect that. I do not have a doubt that these companies and industries will do well. The problem for me is figuring out how well, and how much of that is already built into the stock price.

On the other end are companies which are essentially conglomerates or a combination of businesses such as Reliance, IOC etc. These are in mature industries and are good companies. They may very well be undervalued. The problem for me is that they have a lot of moving parts. IOC has a 400 page annual report, relaince has (or used to have) a lot smaller businesses such as telecom, asset management and now retail etc. So analysing these companies would mean taking apart each of the sub-businesses, valuing each of them separately and then arriving at the whole value. Impossible …no, but definitely tough and a lot of work.

Compare that to the simple (as least to me) businesses such as castrol (lubes), Lanxess ABS(ABS), marico (FMCG), asian paints (paints), concor etc. I could go on and on. These companies are engaged in a single line of business, nationally or in some cases in international markets. They have a decent operating history, dominant position in a stable market, and in some cases attractive valuations. To boot, some even have a small annual reports to analyse (just joking!).

I have invested in both the complex and in the simple businesses (avoided the sunrise type industry as I don’t have a better idea of these businesses). Overall, I found that the simple businesses are easier to understand, to follow on a regular basis and in the end give good returns.

I am clearly influenced by the following quote by warren buffett

“Investors should remember that their scorecard is not computed using Olympic-diving methods: Degree-of-difficulty doesn’t count. If you are right about a business whose value is largely dependent on a single key factor that is both easy to understand and enduring, the payoff is the same as if you had correctly analyzed an investment alternative characterized by many constantly shifting and complex variables.”

So if I have an option between a diffcult to understand, complex conglomerate and a simple business(all else being the same), I generally opt for the simpler business.

I have been doing an analysis of my past stock picks and comparing my notes with how the stock picks have turned out over time.

I have been able to divide my picks into broadly three groups

Group A – The multibaggers. These were picks like concor, marico , asian paints, blue star etc. I had no inkling that these companies would do so well and the stock price would appreciate multiple times over the last few years when I first analysed and purchased the stocks. However on deeper analysis I found that the key reason the pick turned out well was due to a double dip I received. First the gap between the intrinsic value and the stock price closed. At the same time, these companies have been able to increase their intrinsic value through some great perfromance in the last couple of years. As a result of these two happy occurences, I have been able to get good profits

Group B – Good return stocks. These were picks like kothari products, macmillan, KVB bank etc. In case of these picks there was a narrowing of the gap between stock price and intrinsic value. As a result I was able to get decent returns as a whole. However in some cases where I was late in selling the stock, the eventual returns were lower.

Group C – The dogs. These were picks like Larsen and tubro (ouch !! see here), SSI, arvind mills etc. Each pick had its own reason for going wrong from over paying for the stock, poor performance of the business, sloppy analysis etc.

The above analysis is definitely not earth shattering and I have known it vauguely for some time. But after almost 8-9 years of buying, selling and analysing stocks, I thought of doing some analysis so as to improve my future performance.

Ofcourse the logical conclusion would be to always buy stocks in group A. However most of the stocks in that group seem to be fairly or over priced. I am finding more picks in group B. Not too exicted about it, but beats overpaying for quality stocks or picking dogs. Key point for me to remember would be to sell these stocks in time if they do not show promise of improvement in intrinsic value