The Study of Stock Market through Fundamental Analysis

Lesson -> Let's understand The Investment Due Diligence

12.2 - Creating a stock idea

Before we can proceed and create a checklist, let's first address a basic question. First, we must choose a stock that interests us. Once we have selected the stock, we need to go through the checklist to determine if it meets all the criteria. If it does, we then invest and look for other options.

How do we choose a stock that is interesting? So, how can we create a list that is interesting enough to explore further? There are many other ways to get it done.

  1. General observationAlthough it may sound basic, this is one the best ways to create a stock idea. You just need to keep your eyes open and pay attention to the economic activity in your area. You can observe what people buy and sell, what products are being used, and keep an eye out for conversations in the neighborhood. Peter Lynch, a Wall Street investor of repute, recommends this method in his book, "One up on Wall Street". Here are the investments I made: PVR Cinemas Ltd. Cummins India Limited. (Because there were multiplexes in the City), Cummins India Limited. (Because most buildings had a Cummins diesel engine.) and Info Edge Limited. Info edge owns, which is the most popular job portal.
  2. Stock screeningStock screeners are used to identify stocks based upon the parameters that you set. They also help investors do quality stock analysis. A stock screener can be used to identify stocks that have a ROE of 25% or PAT margins greater than 20%. If you are looking for investment ideas that will work, a stock screener can be a useful tool. There are many stock screens available. Personally, I like Google finance's stock screener. In.
  3. Macro TrendsGood stocks can be identified by keeping an eye on the macroeconomic trends. This is an example of this: As of today, India is seeing a huge push for infrastructure projects. The cement companies in India would be the obvious beneficiaries of this push. To identify the best-positioned cement companies to capitalize on this macro trend, I would review all cement companies.
  4. Sectoral TrendsThis is sector-specific. To identify emerging trends and companies that could benefit, one must track the sectors. The non-alcoholic beverage market, for example, is a traditional sector. There are three main types of products that are sold: tea, coffee, and packaged water. Most companies only manufacture or sell these three products. There is however a slight shift in consumer tastes these days. The market for energy drinks is expanding and it looks promising. Investors may be able to find companies in the most advantageous sector to take advantage of this shift and adapt.
  5. Special SituationThis is a complicated way to generate a stock idea. To generate an idea that is unique, one must follow companies and company news. Cox & Kings was one of my favorite examples. Cox & Kings, India's oldest and largest tour operator, is probably something you already know. The company appointed Mr Keki Mistry, a representative of HDFC Bank, to its advisory board in late 2013. Corporate India holds great respect for him because he is a transparent and efficient business professional. My colleague convinced me that Cox & Kings would greatly benefit from Mr Keki Mistry joining its board. My colleague was convinced that Cox & Kings would benefit greatly from Mr Keki Mistry joining its board. This alone was enough to motivate him to research the stock further. My colleague was happy to invest in Cox & Kings Limited after further research. He is a good friend. As I write this, I see that he has a 200% gain.
  6. Circle of CompetenceThis is where your professional skills can be used to identify stock ideas. This is a great technique to use if you are a novice investor. This requires that you identify stocks in your professional field. If you're a doctor, for example, your competence circle would include the healthcare industry. A stockbroker or equity research analyst will not be able to fully understand the industry, but you will likely be better equipped than that. You simply need to identify these companies and then choose the best one based on what you have deemed. You will also know more about banks if you're a banker than others. To make the best investment decisions, use your network of expertise.

It doesn't matter where the trigger to investigate stocks comes from. You can add a stock to your watch list as soon as you feel it is interesting. Your 'watchlist' will grow over time. It is important to remember that while a stock might not meet all the criteria at one time, but as the business environment changes, it may eventually match the checklist. It is vital to periodically evaluate stocks on your watchlist.

12.3 - Moat

Once you have selected a stock to invest in, it is important to go through the checklist and investigate further. This is known as "Investment Due Diligence". Due diligence is crucial and must be done with care. Below is a list that I believe to be reasonable. Let us first talk about MOAT before proceeding further.

Warren Buffet popularized the term moat, or economic moat. This term refers to a company's competitive advantage over its competitors. A strong moat ensures that the company's long-term profits are protected. The company must not only have a strong moat but also be able to sustain itself over a long time. A company with a wider range of moat characteristics, such as a better brand, pricing power and market share, will be more resilient. It would be hard for its competitors to take away its market share.

Think of "Eicher Motors Limited" to understand moats. Eicher Motors, a major Indian auto manufacturer, is one of its key suppliers. It also produces commercial vehicles and the iconic Royal Enfield bicycles. Both in India and abroad, the Royal Enfield bikes have a large fan base. It is a well-known brand. Royal Enfield is a specialist in a small niche market that is rapidly growing. They aren't as expensive as the Harley Davidson bikes, nor as affordable as the TVS bikes. Any company would have a difficult time entering this market and shaking up the Royal Enfield brand loyalty. This means that Eicher Motors will need to be displaced from this sweet spot by its competitors. This is Eicher Motors' biggest moat.

These moats are common in many companies. True wealth-creating businesses have a sustainable moat. Infosys was a case in point. The moat was labour arbitrage, Page Industries was manufacturing and distributing Jockey innerwear, Prestige Industries was selling pressure cookers, Gruh Finance Limited was manufacturing and selling small ticket credit, and so on. Always invest in companies with wider economic moats.

12.4 - Due Diligence

These are the stages of equity research due diligence.

  1. Reading the annual reports is essential to understand the business.
  2. Use the checklist
  3. Valuation – To estimate the intrinsic value the business

In 1. i.e., understanding The business We dive deep into the company to get to the bottom of it. It is important to create a list with questions that we want to answer. You can start by asking a basic question about the company. Which business is the company involved?

We don't search Google for the answer. Instead, we look at the latest Annual Report of the company or their website to find it. This allows us to understand the company's internal communications.

My own investment strategy is to prefer to invest in companies with lower competition and minimal government intervention. When I made the decision to invest in PVR Cinemas there were only three players in this space. PVR, INOX, and Cinemax. PVR and Cinemax were merged leaving only 2 listed companies. There are however a few new players in this market. It is now that I need to reevaluate my investment thesis in PVR.

Once we feel comfortable with the business, then we can move on toStage 2Applying, i.e.The Checklist.This stage provides some performance-related information. Here's the checklist of 10 points that I believe is sufficient for a good start.

Serial NoVariablesCommentWhat does it Signify
01Gross Profit Margin (GPM)> 20%Higher the margin, higher is the evidence of a sustainable moat
02Revenue GrowthIn line with the gross profit growthRevenue growth should be in line with the profit growth
03EPSEPS should be consistent with the Net ProfitsIf a company is diluting its equity, then it is not good for its shareholders
04Debt LevelThe company should not be highly leveragedHigh debt means the company is operating on high leverage. Plus the finance cost eats away the earnings
05InventoryApplicable for manufacturing companiesA growing inventory, along with a growing PAT margin is a good sign. Always check the inventory number of days
06Sales vs ReceivablesSales backed by receivables is not a great signThis signifies that the company is just pushing its products to show revenue growth
07Cash flow from operationsHas to be positiveIf the company is not generating cash from operations, then it indicates operating stress
08Return on Equity>25%Higher the ROE, better it is for the investor, however, make sure you check the debt levels along with this
09Business Diversity1 or 2 simple business linesAvoid companies that have multiple business interests. Stick to companies that operate in 1 or 2 segments
10SubsidiaryNot many
If there are too many subsidiaries, it could sign the company siphoning off money. Be cautious while investing in such companies.

A company may meet all the criteria above but the stock will not trade at the correct price on the market. How do we determine if the stock trades at the correct price? This is what we do.Stage 3. We must run avaluation exerciseOn the stock. The "Analysis of Discounted Cash Flow" is the most famous Valuation Method.

In the following chapters, we'll discuss the steps involved in conducting formal research on the company. This is known as "Equity Research". Our discussion on equity research will focus mainly on Stage 2/3, as I believe that stage 1 is the reading of the annual report in a very detailed manner.

To Summarize

  1. Stock ideas can be derived from any source.
    • A great place to start is the Circle of competence or General observation.
  2. It is recommended to keep a watchlist that includes stocks that are interesting.
  3. Once we have identified a stock, we need to look for sustainable moats.
  4. Due diligence involves understanding the business and running the checklist to assess its financial performance.
  5. Understanding the business is only possible if you are familiar with every detail of the company's operations.
  6. As the investor gains more investment experience, it is possible to modify the checklist.
  7. The DCF method is one the most effective methods to determine the intrinsic value of a business.