How do I pick value stocks?
It is in the nature of things that many hard problems are best solved only when they are addressed backward.
“Invert, always invert” – Albert Einstein
Time is a constraining factor for everyone and you can’t expect to perform analysis on all the companies. Therefore, it is important to filter out companies that are relevant for the analysis.
How to screen relevant companies?
There are three pillars of equity investing: profit, cost and growth.
No one knows the future, therefore considering past growth and then assigning a value may defeat the purpose of investing.
Criteria no. 1: Profit
A company that is not profitable is not worth spending time on. I focus on companies that are profitable and have a long history of delivering profits.
Companies that have a history of Return on Investments of more than 20% every year have a potential of creating shareholder value.
Last 10 years Return on Invested Capital > 20% per year
Criteria no. 2: Cost
A company can be funded by equity and debt. A loan requires contractual payment just like you pay EMIs for your car, home etc. Therefore, a company has to make payment for the loans irrespective of the profitability.
Debt to equity measures the relationship between the capital that has been borrowed and the amount that has been contributed by the shareholders.
This can be identified by using a ratio ‘debt to equity’. It simply means total borrowing divided by total equity.
Debt to Equity < 1
I do not prefer investing in commodity or government owned companies.
When we apply all these criteria, we will have around 30 companies from the top 100 companies by market capitalization. Now the task is to focus on those 30 companies and identify 12-15 companies available at a reasonable price.
How to analyze a company?
There are three parts to the analysis:
1. Historical analysis
2. Industry analysis
I break down P&L and Balance Sheet in two parts, core and non-core. This helps in assigning the value only to the core business. Return on Invested Capital (ROIC) helps in performing this analysis.
Return on Invested Capital (ROIC) refers to a measure which is used to calculate a company’s efficiency in allocating capital towards the most profitable investments. Simply put, it shows how well a company’s using its funds to create returns.
The return on invested capital is a fundamental metric which shows a company’s ability to grow from what was invested into it. I also do forensic checks to ensure that the company’s management is not manipulating the earnings.
“When a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.” – Warren Buffet
A company that has consistent record of a long profitability and growth usually have a competitive advantage.
Performing a detailed historical analysis can help investor understand if a company has sustainable business advantage.
Break-up the value of a company as ‘no-growth’ and ‘growth’.
We always want to look into the future and identify investment opportunities. However, there is no way anyone can look into the future and be 100% sure that the forecast will become reality. Another way to look at a company is to assume that the company will not grow. The company continues to exist but the growth is zero (I ignore few months of negative growth, if any).
This is the most unpredictable element of value for a company. Growth in any company comes when new investments earn a return higher than the cost it spends. Unfortunately, only those companies that have competitive edge can earn return higher than the cost over a long period of time.
Benjamin Graham's Mr. Market:
"...Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly. "