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.
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.
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.
These are the stages of equity research due diligence.
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 No||Variables||Comment||What does it Signify|
|01||Gross Profit Margin (GPM)||> 20%||Higher the margin, higher is the evidence of a sustainable moat|
|02||Revenue Growth||In line with the gross profit growth||Revenue growth should be in line with the profit growth|
|03||EPS||EPS should be consistent with the Net Profits||If a company is diluting its equity, then it is not good for its shareholders|
|04||Debt Level||The company should not be highly leveraged||High debt means the company is operating on high leverage. Plus the finance cost eats away the earnings|
|05||Inventory||Applicable for manufacturing companies||A growing inventory, along with a growing PAT margin is a good sign. Always check the inventory number of days|
|06||Sales vs Receivables||Sales backed by receivables is not a great sign||This signifies that the company is just pushing its products to show revenue growth|
|07||Cash flow from operations||Has to be positive||If the company is not generating cash from operations, then it indicates operating stress|
|08||Return on Equity||>25%||Higher the ROE, better it is for the investor, however, make sure you check the debt levels along with this|
|09||Business Diversity||1 or 2 simple business lines||Avoid companies that have multiple business interests. Stick to companies that operate in 1 or 2 segments|
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.