7 Ways to shortlist the right stocks
Equity as an asset class outperforms all other asset classes in the long run. True. But how do you pick the right company?
It’s always important to spend time knowing a company, its business, financial health and prospects. But do you have the time, resources and energy to study 1,400 companies listed on the National Stock Exchange (NSE) and about 4,900 on the Bombay Stock Exchange (BSE) before selecting one to invest in? If these numbers make you uncomfortable, sample this: The market capitalization of these companies ranges from a few lakhs to over Rs2 trillion and the price of shares, from less than a rupee to over Rs12,000 per share.
1. IS THE COMPANY’S MARKET CAP MORE THAN RS250 CRORE?
Setting a minimum market cap floor really helps—it eliminates very small companies, or penny stocks. Generally, small companies have a small revenue base and do not spend too much on investor relations. This makes tracking them difficult. We do not look at companies that have a market cap of less than Rs250 crore. About 500 companies on NSE pass this criteria.
2. ARE THE COMPANY’S TRADING VOLUMES HIGH?
The company should have a reasonable trading volume—at least a few thousand shares per day. If you buy into a stock that has low volume, it can become difficult to get out when the markets fall. Both the rise and fall is sharp in stocks with low volume. Also, the impact cost is high. For example, MMTC, a state-owned company, has a market cap of over Rs62,000 crore, but its trading volume is very thin. The 30-day average trading volume of this stock is just about 338 shares and the stock is trading at Rs12,400 per share. It is always advisable to avoid these kinds of stocks.
3. DOES THE COMPANY MAKE QUALITY DISCLOSURES?
The company should have good quality disclosures. This is an easy test. All you have to do is visit the company website and see press releases and results for the last few quarters. In the results part, you need not get into numbers in detail as of now, but do see how the developments of the last quarter have been explained. For example, see if costs have increased, or margins have declined, and whether there is an explanation for it.
Large companies, especially in the information technology (IT) sector, are generally good at this. Tata Consultancy Services, India’s largest IT company by revenue, has a transcript of analyst conference calls on its website, which may answer all the questions investors have. Availability of information makes tracking easy and decision-making becomes quicker while you are invested in the company.
We dropped Alembic, a pharma company, from our portfolio. The company posted a net loss in the June quarter, but there was no explanation as to why this had happened.
4. DOES THE COMPANY HAVE OPERATING PROFITS?
Sometimes, companies raise money from the equity markets in their initial stages and hope to cover costs by generating profits from later operations. Actually, they are in a stage when they spend money for, say, setting up plants, or research and development facilities. These businesses sound exciting, but can be risky. It is advisable to avoid such companies. New projects involve a lot of regulatory approvals and can get delayed, which can escalate costs. Also, the stock prices of such companies are the first to fall during any broader market correction, as there are no earnings to support the prices.
This is exactly what happened with Reliance Power, which has no plants in operation. Its public issue got heavily oversubscribed (73 times) due to general euphoria in the market, but sentiments changed between issue and listing. The issue went on to become one of the biggest disasters in the markets.
Therefore, it is always safer to be in companies that generate profits from their operations.
5. DOES THE COMPANY GENERATE CONSTANT CASH FLOW?
At times, fast-growing companies may show profits without generating cash. These companies are in their expansion stage. They have to generate cash eventually and create value for shareholders. Companies with a negative cash flow may have to seek additional capital, either through debt or equity. Debt will increase the risk while equity will dilute the earnings, which will get reflected in the share prices also.
6. IS THE COMPANY’S RETURN TO EQUITY (RTE) CONSTANTLY ABOVE 10% ?
RTE is the profit a company generates with shareholders’ money and is calculated by dividing net profits with shareholders’ equity. It indicates how well a company has deployed investors’ money. The RTE is generally low in the case of manufacturing companies and is higher for service companies as the cost of setting infrastructure is low in service companies. Use 10% as the minimum limit for companies to qualify.
There are just about 400 companies listed on the NSE with a market cap above Rs250 crore that generated return on equity above 10% in the financial year 2007-08.
7. IS THE EARNINGS GROWTH CONSTANT OR CYCLICAL?
Cyclical earnings imply that profits move up or down, depending on the business cycle. Businesses generally move in cycles. This is commonly seen in commodity companies, where a shortage or sudden rise in demand helps prices to move up, resulting in super-normal profits for a while.
Sugar is a classic example of cyclical earnings. Bajaj Hindusthan, the largest sugar company in India, saw its share prices soaring from Rs200 in November 2005 to Rs550 in April 2006 on the back of rising sugar prices; net sales for the company went up Rs394 crore in the March 2006 quarter compared to Rs282 crore in the September 2005 quarter. But by the end of the December quarter, net sales went down to Rs286.64 crore and the share price to Rs140. The biggest risk in investing in cyclical or commodity stocks is that you could enter at the wrong time. Once the cycle is reversed, it becomes difficult to get out. Commodity prices are interlinked globally, and any demand-supply mismatch in one corner of the world can disturb prices everywhere. Companies in the pharma and consumer goods space have stable growth in the long term as demand in these sectors depends on business cycles and macroeconomic movements. The services sector also has stable earnings growth compared to commodity stocks.
If you carry out these seven checks, you will, by and large, be able to eliminate companies that are not worth investing in. However, investors must note that these conditions are not foolproof and there can always be exceptions.
CONNECT
BUY
Unit-linked insurance plans (Ulips) are set to become cheaper by 4-5%. According to the latest circular by the Insurance Regulatory and Development Authority (Irda), solvency margins on Ulips have been reduced by about 20%. This would lighten the burden on the insurer in terms of capital requirement.
Solvency margin is the extra capital that a company holds over and above its liabilities. With the reduction in solvency margins, insurers will have more capital to deploy in the market. And it is expected that they would pass on the benefit of extra capital to customers by offering lower-cost Ulips.
KNOW
You can transfer the financial rights of your insurance policy through assignment. This is different from nomination. In the latter, you appoint a person to whom the insurance company becomes liable to pay the claim amount. In assignment, the financial rights of the policy are transferred to the assignee. The nomination stays valid if the insurance company is the assignee (it can happen, for instance, if the policyholder takes a loan from the insurer). In all other cases, it is cancelled the moment a policy is assigned.
DO
You need to steer safely to protect your investments in these tough times. There are some basic rules to remember.
• Pay attention to price: Watch out for the price earnings (PE) ratio. Compare company PE with aggregate market PE or industry PE.
• Sell at higher levels: Use exceptional gain periods to rebalance your portfolio.
• Buy on dips: Whenever there is a sharp reversal, buy strong stocks with low PE.
• Define your own stock-picking strategies: You could watch out for stocks with a market cap of Rs250 crore or more.
• Understand the macroeconomic impact on your stock: Identify changes early. It will help you exit at a good level.
INVEST
If you are planning to invest in debt funds, this is the best time to get going. Falling yields benefit both long-term and short-term bond funds, though the former gets more of it. Stick to long-term bond funds if you are willing to take on some risk in interest rate fluctuations. Else, short-term bond funds should give you modest returns. If you haven’t invested in bond funds already, invest now—this could be your last chance. Stay invested till July, the time when fund managers expect inflation to drop to near-zero levels, and wait for further cues after that.
The views expressed on this page are not the newspaper’s opinion and are provided for information purposes only by Outlook Money. Readers are requested to do their own research. Neither Mint nor Outlook Money will be responsible for any actions and outcomes based on information provided here.