How to identify quality companies?
Updated: Dec 29, 2020
There are over 6,000 companies listed on NSE. It is rather difficult to evaluate even a small portion of the listed space. We need to identify 10-15 stocks that are worth investing/evaluating.
The share price is associated with the profit and growth of the company. As long as the company continues to grow its profit, the share price will continue to increase.
There are various other methods to invest, however, a simpler way to grow your wealth is to invest in quality companies.
Now imagine, someone opens a restaurant. You can think of a fancy place or something on the roadside. There are only two possibilities, either it will be successful or it will fail and shut down.
A new business fails because the business is not able to recover its cost of capital.
If the restaurant is not able to recover its cost, sooner or later it will shut down. In fact, a delayed decision will cost more money.
When is a business successful? When it is able to earn a ‘return’ higher than its ‘cost’.
Making a sustainable profit is a business challenge.
If the restaurant is successful (return > cost), it will attract competition. There may be supernormal profits during the early stage. However, over time more restaurants will start mushrooming. If there are many restaurants in close vicinity, customers will have more choices. This will cause customer per restaurant to fall, hence decline in returns.
Think of businesses that continue to earn a high rate of return for a long period of time. These businesses also attract competition but they have a unique proposition (economic moat) that protects them.
If a business is able to protect itself from the competition, it will be reflected in two financial metrics, return and growth.
1. Return on Equity (RoE)
RoE is a measure of the profitability of a business earned by its owners.
RoE = Net Profit / Shareholder’s equity
A business may get loan in India at a rate of around 10%, so let’s keep RoE target of more than 15% i.e. 5% more than the cost.
2. Profit growth
Growing business will not just grow its revenue but its profit too. Business with a unique proposition will grow its profit faster than its revenue (operating leverage).
India’s GDP in real terms has grown around 6% p.a. RBI has an inflation target of 4% p.a. So, we can keep the nominal profit growth target of 10% p.a.
Apply these two filters over a period of 10 years so that business cycle related volatility is absorbed.
When I apply this filter across the top 100 companies by market capitalization, I just get 10 companies.
(only for illustrative purpose and not a recommendation)
Just look at the price charts of these companies and that will validate that share price movement matches the fundamental performance of the company.
Each company has a history to safeguard itself against its competition. A logical next step is to understand what is protecting the business and will that proposition continue in the future.
A professional investor should further evaluate these companies to understand the fair price and accordingly take a ‘buy’ decision.
However, if a basket of these companies is made every single year without evaluation, even that has the potential to beat Nifty 50. There would be a few that will fail but the survivors will be able to cover up for the losses and still grow the capital substantially. The only requirement is patience and long-term (10 years).
These filters can be applied to any company irrespective of the size. However, smaller size companies may not have a long history of 10 years plus. Often quality companies in small-cap and micro-cap are building up their story.
The key is to understand what is enabling the company protect itself from the competition. Once you understand that, investment decision becomes simpler.
Even if you pay a little bit extra for these companies, it won’t hurt because these companies are cash making machines.
Over the long-term, the share price will reflect the underlying performance.
"Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1" - Warren Buffet
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