I wrote a tweet recently which goes below. A close friend suggested to expand it into a blog post.
I have often come across investors buying stocks purely on hearsay, a tip from a friend and more recently from multiple social media platforms such as Reddit, Quora, Twitter, Telegram & Whatsapp groups. One of the most frequently asked questions tends to be How to pick a Multibagger stock idea.
Buying process of stocks has now become faster than a grocery purchase. In many cases, such investors do not even know which business sector a Company is in. And if this is not enough, such people call themselves as long term investors. After all, does it matter if one makes money and in bull markets people make money even out of junk. Rather in extreme bull market frenzy, junk stocks end up rising faster than quality. Try visualizing a stormy weather and you will see junk flying around in the air versus heavy weight firmly on the ground. When the storm settles, junk becomes reality.
Here I will like to call out following two famous quotes which go hand in :
A rising tide lifts all boats.
John F Kennedy
And then
Only when the tide goes out do you discover who’s been swimming naked.
Warren Buffet
A Stock Is A Business
Basics first –
- I do investments in stock market is a wrong term. Stock markets are a lay man term for ‘stock exchanges’. A stock exchange is a regulated platform which allows people to buy and sell shares in listed Companies.
- A ‘stock’ or a ‘share’ is a proportionate ownership of a Company. If you buy a share, you must congratulate yourself in becoming a part owner of the Company.
- A Company is driven by its motive to make profits. As it makes profits, its value goes up. This is reflected in the price on the stock exchange. An investor in a share benefits from the share price gain and any profits distributed by the Company to its owners, i.e. Dividends;
- There is a difference between investing and trading. A trader may not always look into the fundamentals of a Company. The holding tenure of a trader may be from a few minutes to a few days. At times forever if the trader gets stuck by buying a share and the prices crash (sarcasm intended). For a trader ‘bhav bhagwan che’ or ‘Stock Price is God’ and trend is his friend.
- An investor ideally assesses the underlying business and holds them for as long as the investment rationale hold true. The longer one holds to good businesses, the better it yields owing to benefits of compounding. Trend of stock prices may be considered, but may not have a material contribution in investing decisions.
Outcome of Holding Good Businesses
A good business continues to compound its profit over longer durations of time, eventually resulting in generating multibagger returns. Its management takes opportunities of upcoming disruptions and innovates constantly to stay relevant. As a result, its share price trails its wealth creation journey (as an aftermaths and not vice versa). The image below shows the Top 20 wealth creator between 1995 and 2020. In most cases you would notice that share prices are in close sync with the Profit growth (PAT).
How Do I Shortlist Companies For Investments ?
When it comes to shortlisting good businesses, the best way is to follow elimination technique. There are over 5000 listed Companies in India – so the choices are in abundance. I start applying my quantitative and qualitative filters in identifying good businesses and my eventual shortlist reduces to sub-100. From here I further drill into sectors, managements, growth assumptions, price, quantitative metrics to identify businesses where I would like to stay invested for the coming years (if not decades). In the next few paragraph, I am noting down my thoughts of how I shortlist Companies worth investing in.
What is the business of the Company ?
If I am intending to buy a share in a business, I must know what the business of the Company is and how it makes money. In addition, it should not take tremendous amount of effort for a ‘relatively competent’ person to understand the business model of a Company. If it does, one may be better off to identify other alternative options. An extremely complex business model may often have multiple hidden attributes which an investor may end up missing and these could come and bite back.
This exercise helps me to understand
- The products & services offered by the Company
- Whether the business is scalable in the future
- Competitive advantages enjoyed by the Company
- Upcoming disruptions which could impact the viability of the business
- How does the company makes money, i.e. its profits.
Management
Management of a business is what a pilot to the aircraft or a captain to the ship. A competent management is the key to ensure ongoing success, viability, growth and profitability of the Company. This is a bit challenging area to tread on as many aspects to assess competence of the management are related to their ‘soft attributes’. However, some of the basic checks below could exclude obvious black spots :
- Has the management been charred with integrity issues. It is difficult to hide from Google these days with intelligent search queries;
- Do they hold sufficient ownership in the Company? This may prevent them from acting in a detrimental fashion as their fates are linked to the fate of the Company – skin in the game.
- Have they been innovating and aligning the product offerings in line with changing market needs ?
- Do they have a vision – a read of the annual report will give a fair idea of how the management thinks
- Do they utilize capital efficiently? This would need a good read of the financial statements to check if the return on capital used by the Company is reasonable, over usage of debt, hoarding cash with no plans of utilization.
- Other key areas include organization culture, relationship with their vendors & customers, complaints & law suits, tax disputes, organization structure and succession planning.
Financial Health
It is difficult to make an investment conclusion without having a dip into the financial statements. Hence, an investor should have a reasonable ability of being able to interpret key financial metrics in the Balance Sheet, Profit & Loss, Cashflow & their associated schedules. An illustrative list to look out for may include :
- How much debt does the company have and its ability to service loan payments. Debt is not always toxic, upto a point.
- Does the Company enjoy good and sustainable profitability on its sales?
- Ongoing expansions in its assets may point towards future growth and also the vision of the management.
- Is the Company having a positive operative cash flow? An extremely successful business whose products are in high demand and sell at high margins can go bankcrupt, if it struggles to collect its dues on time.
- Does it pay taxes – low or zero taxation may raise alarm bells of crafty tactics which may invite issues with the tax man in the future;
- How is the working capital need of the business? The nirvana stage is > the Company gets cash from its sales in advance and has to pay its suppliers after a sufficient credit period. A daily example is thinking about Indian railways. You pay months in advance to get a reservation and Railways may pay its suppliers with a credit period of a few months.
ROCE & ROE – the Deadly Ratios
Would you want to do a business which would earn a profitability of say 9% when you can earn the same amount by investing in another low(er) risk investment option?
Return on Capital Employed and Return on Equity effectively captures how much return a business makes upon its money. When used in conjunction with other metrics, these ratios can assist in avoiding dud businesses. A business uses a combination of its own funds + borrowings. The total of these funds are invested to generate profits. ROCE captures how much returns a business makes on its total funds. A subset of this is ROE which captures the returns made by a business only on its own funds, i.e. excluding external borrowing. A poor business would earns ROCE of say 9% where its borrowing cost is 9% or more. A good business would earn ROCE significantly more than the cost of borrowing, e.g. 20% demonstrating that it is profitably employing its capital to generate healthy returns for its owners.
Price
The key to a good investment selection is finding good businesses at a good price. “Good Price” could often be
subjective. As the saying goes “Beauty lies in the eyes of the beholder”.
Computing the value of the business is not an exact science. You will find same Company being valued differently by analysts. Each of the analysts will have different assumptions and how much optimistic / pessimistic they are about the future prospects of the business. Let us assume that you have valued a business at say Rs 1000 per share. If the current price of the share is less than Rs. 1000, you are getting it at a bargain. The more the bargain, the more is your ‘Margin of Safety’ or the cushion against one or more of your valuation assumption going wrong.
It is difficult to make predictions, especially about the future.
Moats and Leadership Position
Good businesses continue to grow owing to a formidable market leadership position enjoyed by them. Becoming a market leader requires a business to build strong moats around its business’s competitive edge. A strong moat prevents new entrants to bleed into the growth of an existing business. Examples of strong moats could include :
- Huge capital needed to establish a business, e.g. setting up a telecom business requires huge capital spends towards telecommunication infrastructure & spectrum license costs;
- Huge country wide dealership or branch franchises to effectively channelize the products at a grass root level;
- Regulatory restrictions preventing new entrants, e.g. establishing of new stock exchanges or depository participants are controlled by the regulator.
- Strong & sticky brand recall, e.g. customers have a preference of a specific cigarette or liquour
- Patents to protect an innovation and prevent competition from copying a successful product;
- Sole selling or manufacturing rights which prevent newer businesses to produce or sell same products.
- Quality & Branding – Parents won’t easily change the brand of milk powders used for their children. People stick to the same tooth paste. This brand loyalty is build over decades of quality centricity and advertisement.
I hope this post gave you some fundamental metrics to identify good businesses for long term investments. Do you want to revisit your stock selection and check how it stacks up against the metrics? And hey, life doesn’t stop here. One needs to regularly monitor to check if the metrics haven’t changed owing to the rapid era of frequent disruptions.
I would like to end this post with a handy reading material which could be of great help in identifying multibagger stock opportunities. Motilal Oswal Financial Services conducts annual wealth study covering a different theme each year. Year 2020’s theme was their investment methodology ‘QGLP’ checklist. It arm investors with an investment checklist to shortlist good businesses. You can find it here > Motilal Oswal 25th Wealth Creation Study – QGLP Checklist