10 Important factors & ratios to consider as stock filtering criteria
Contents
Industry structure
Focus on core business or overdiversified
Moat or Competitive advantage
Management quality
ROCE > 15% ( at least for last 5 years)
Debt / Equity ratio < 0.5
Simultaneous sales and profits growth
Stable EBITDA margins
CFO/ EBITDA > 60% & CFO/ PAT >80% & Free Cashflow
Presence of strong hands > 70% ( PROMOTER/ FII/ DII Holdings
It's only when the tide goes out that you learn who has been swimming naked
- Warren Buffet
While it is true that money can be made in any kind of stocks, but that is true for only experts ( top 1-2%) . If you are relatively new, sticking to the factors laid out will help in avoiding mishaps wrt stock picking in your initial years of investing journey. There will be good companies/stocks which fall outside these criteria- those can be learnt once you dabble with foundation and become more interested. After all, market, like river, is free spirited, intuitive- always keeps surprising all of us.
Oversimplification is to make the journey easier for starters.
1.INDUSTRY STRUCTURE
More emphasis should be given on INDUSTRY STRUCTURE ( number of competitors operating, unorganised sector vs organised players % , size of the industry and its growth potential, % of business coming from exports ( high exports contribution makes it more difficult to analyze as global factors to consider increases a lot )).
If the industry is fragmented, meaning too many players, each with low market share, there will be high competition in terms of pricing of products, poaching of distributors and dealers, offering of more margins and credit limits, credit periods to dealers to lure them to stock the products, continuous high expenses on marketing and branding- all these leading to profit margins getting thinner and thinner. If the industry has high unorganised sector presence, and positive triggers are there ( like demographics, improving gdp/capita) , there may be shift happening from customers shifting from unorganised to organised players which will result in faster growth of organised players in the industry.
Size of the industry determines the scope of growth of business, if a company is already a big fish in a small pond, its scope of further growth is limited, hence stock price growth also becomes limited. So big fish in a very big pond, or even a small fish in a big pond are better choices. In an industry with considerable size, industry should also be growing one with time, rather than stagnant industries where further scope of industry size growth is limited.
For companies whose significant portion of business depends on exports, consideration of global factors becomes important. If you are not an expert in determining the global risk factors associated with the export, possible changes in export norms, forex currency factors, better to avoid such companies to start with.
There are other considerations of cyclical vs non-cyclical industries, regulated industries. To read more, check out this article.
My idea of a great business is one that has shortage of competitors
-Peter Lynch
2.FOCUS ON CORE BUSINESS or OVERDIVERSIFIED
Companies focussing on 1 core business are known to generate better returns rather than companies doing 5 different businesses together. Simply put, in the age of high competition, if a company deploys its resources ( profits earned) to a single business , keeps on doing it for years, it deepens its presence, reach, market share, expertise in that sector , thus reflecting in superior profits, cashflows and returns.
On the other hand, a company which has 3 different unrelated businesses has to deploy the capital in 3 businesses, so scope of RATE of growth and expansion often of all businesses gets limited.
Unless, the core business is generating huge excess cashflows (free cashflows) which cannot be deployed anymore in existing business as market is already penetrated and monopolistic market share is already achieved, therefore limiting any scope of business growth through deploying excess capital, in that case, diversifying to related businesses makes more sense, as that way company can capitalise on its expertise and brand positioning in the market fruifully.
3.MOAT or COMPETITIVE ADVANTAGE
If a company operates in an attractive industry with good returns, it will sooner or later attract attention of bigger players of other industries with excess capital to deploy.
Moat is one of the most important edge a company can possess which protects its business from getting disrupted by such new entrants ready to invest high capital.
Moat can be the brand power or reputation company has created over the years through its demonstrated results, investment in branding, promotion resulting in a higher product market share and a distinctive position of its brands in customer mindspace through proper positioning.
Or Moat can be in the form of some strategic assets company possesses- some proprietary technology ( like google's search engine) / patents ( in case of pharma companies patented drugs can be sold by the patent holder for fist few years before it is allowed to sell by competitors) /some assets ( like a steel manufacturer having captive iron ore mine)/ license ( like 4G, 5G spectrum license for telecom players).
Moat can be extensive distribution reach/franchisee strength throughout the country deepened and strengthened by further layers , which cannot be replicated by a new company even after trying for years.
Moat can be long term contracts/ relationships/ exclusive rights enjoyed with OEs in case of B2B Supplier companies strengthened by technological edge of products.
Moat can be internal structures , operational excellence and intricate relationships across the entire network of different functions of the company encompassing suppliers, customers.
Moat can be network effects- where bigger gets bigger and top 1-3 players eventually sweep entire market, for new age platform businesses. Think about facebook- how people stopped using other networking sites as it got bigger and added more features, and killed competition by acquiring competing networks like whatsapp, instagram.
Identifying whether a company has a distinctive moat becomes one of the focal point of choosing a company while investing.
A truly great business must have an enduring moat that protects excellent returns on invested capital. -Warren buffet
The only duty of a corporate executive is to widen the moat. I can see instance after instance where that isn't what people do in business. One must keep their eye on the ball of widening the moat, to be a steward of the competitive advantage that came to you. - Charlie Munger
If you gave me $100 billion and said take away the soft drink leadership of Coca-Cola in the world, I'd give it back to you and say it can't be done.
- Warren Buffet
4.MANAGEMENT QUALITY
Single most important job of promoter or management is efficient CAPITAL ALLOCATION. Warren Buffet is involved in only capital allocation for his companies, rest all decision-making has been delegated to his managers. So checking the history of company getting involved in unrelated capital allocations through acquisitions unrelated to core business, whether the company repeatedly redeploys part of cashflows/ profits generated again into core business.
This can be combined with whether promoter/management is
1. long term oriented - long term goals (clear 3-5 year goals spelled out in 1 slide)
2. internal practises like talent management/ employee retention/ work culture
3. whether they spell out new goals every year or talk about achievement status of earlier goals spelled out in concalls last year
4. consistency of meeting earnings guidance
5. Whether CEOs changing every 2-3 years or CEO tenures longer ( longer the better)
All these talk a lot about quality of promoter/ management
Another factor to check is whether the company involves in a lot of transactions from the listed company to other unlisted companies owned by promoter. Or the companies which has too many subsidiaries, resulting in a complex organisational structure. Such companies are better avoided.
There are many other accounting red flags that is a subject in itself. Simple things that can be considered are auditors changing very frequently, whether company is doing earnings call after quarterly results.
5.ROCE > 15% ( Return on capital invested)
ROCE is an important measure to check how efficiently company is generating returns on capital invested in business.
ROCE = EBIT / Capital Employed
EBIT - Earnings before Interest and Taxes
Capital employed- Fixed assets + Working capital
ROCE becomes an important measure as in order to generate consistent returns the business must deliver more that the cost of capital ( depends of risk free rate, which is government bond returns, plus equity-risk premium ). A company generating consistently high ROCE for long periods demonstrates it ability for prudent capital allocation and utilization. In India, few companies are able to generate ROCE > 15% consistently for long periods.
Experts have found high correlation amongst ROCE and stock price returns. Give preference to companies with ROCE > 20% while doing final selection.
6. DEBT/ EQUITY RATIO < 0.5%
It is the ratio of debt vs company's own equity ( shareholder funds+ Reserves).
The more debt the company takes, it will affect the profits in terms of interest payments. During rising interest rate cycles, and contracting business cycles, companies with high debt are more prone to go bust. Unmanageable debt combined with business going down is the most important reason that companies fail or go bankrupt.
Avoiding high debt companies is the best thing a conservative investor can do. After little more experience, you can tweak factors like debt without lease liabilities ( as current accounting standards require lease liabilities to be accounted under debt), net debt etc.
7.SIMULTANEOUS SALES GROWTH & PROFIT GROWTH
Health of a company is considered good when its sales increase every year and profits also increase over long time- say 10 years. There may be few years ( 2-3 years) when business ( sales and profits) can remain stagnant ( in times of crisis), that can be ignored unless profits are decreasing or fluctuating in nature. It is a red flag if a company is continuously increasing profits with sales figures remaining constant, as in that case company is possibly doing that by increasing the price of the products and not by increasing the sales. Such growth is not sustainable and healthy.
8.STABLE EBITDA MARGINS
Stable EBITDA margins denote company has pricing power , meaning in the face of significant raw material price hikes, company can take price hikes to protect its margins. Stable EBITDA margins increase the predictability of earnings of the company. Such companies get good valuation ( P/E ) from the market. Compare the margins of commodity companies and that of consumer retail companies, check their P/E ratios.
EBITDA = Earnings before Interest, Tax, Depreciation, Amortization
EBITDA = Operating revenues - Operating expenses
EBITDA margins % = EBITDA/ Revenues X 100
9.CFO/ EBITDA > 60% & CFO/ PAT >80% & Free Cashflow
CFO ( Operating cashflow) to EBITDA ratio is a measure of whether company is able to convert its profits into actual cashflow generated.
Cashflow generation is the single biggest operating metric of a company. A company generating good revenues but not enough cashflow will not be able to take up further capex (capital expenditure) plans through its internal accruals and has to depend on debt to expand operations.
B2B businesses where sales happen but payments are received after 2-4 months will have lower CFO. B2C businesses where sales happen upfront in terms of cash or shorter credit periods(30-45 days) to dealers are usually high cashflow generating businesses. Companies operating with low working capital or negative working capital are also high cashflow generating. 1 or 2 odd years can be ignored, but a company growing its profits but consistently scoring lower on CFO/ EBITDA and CFO/ PAT are better avoided.
Free cashflow (FCF) compounding is perhaps the most important thing in long term, but evaluating free cashflows is tricky considering it will be less for companies in its high growth stage, there will be erratic FCF in companies with seasonal and high working capital businesses, so park it for learning in future.
FCF= CFO- Capex
10.Presence of strong hands > 70% ( PROMOTER/ FII/ DII Holdings)
Strong hands are big players who are professional investors , who have much more resources and expertise in taking decisions, so a stock backed by good presence of strong hands reduces chances of risk of losing money compared to a stock where strong hands holdings are low. Weak hands are retail investors holding, retail holding > 30% are better avoided.
Stocks without the presence of FII/ DII ( institutional investors) are better avoided ( though Peter Lynch talks about picking these stocks ahead of big players are interested- you can explore that later) There are other technical reasons of supply/ demand why lower retail holding and lower free float stocks have a higher chance of price appreciation.
Overall, combining these principles, one can develop an investing framework and avoid impulsive buying of any stock that looks attractive through some recency bias caused by some news, new development, hot trending stocks, trending themes, recommended by someone on news channel. There are other things, but these can be used as a starting point to look at Nifty 500 or Nifty 100 stocks.
Once you know more, you can always tweak rules, and find excellent opportunities violating these rules, as mentioned at the beginning.
You may like the following related posts-
How to avoid companies like Brightcom (BCG) ? Investing red flags
12 Things to consider before starting investing
Mistakes to avoid while starting to invest
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