How to shortlist businesses worth investing in?
Updated: Jul 28, 2021
There are over six thousand stocks listed on NSE. It may not be worthwhile evaluating all the businesses. Each business has its nuances that have to be understood and assessed. Shortlisting a list of companies will help an investor focus his time and effort on a few targeted companies.
“Prior to Newtonian revolution, people explained the world around them primarily in terms of a God that made specific decisions. A child would fall and break his arm, and it was an act of God. Crops failed, it was an act of God. People thought of an omnipotent God who made each and every specific event happen. Then in the 1600s people said “No, that’s not it. What God did was to put in place a universe with certain principles, and what we need to do is figure out how those principles work. God doesn’t make all the decisions. He set in place processes and principles that would carry on.” – Jim Collins, Built to Last.
Just like God has made principles for nature, similarly, some principles would make a business enduring and long-lasting. As far as, the business can grow, the worth of investment in the business will also continue to grow.
Before I explain how to shortlist, I would like to highlight, please DO NOT act on a stock recommendation based on news channels or newspapers. The writing style may influence the outlook of a company, but that may be stale information. When any news is printed, it is usually priced in, and there is no information advantage.
“Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns six percent on capital over forty years and you hold it for that forty years, you're not going to make much different than a six percent return - even if you originally buy it at a huge discount. Conversely, if a business earns eighteen percent on capital over twenty or thirty years, even if you pay an expensive looking price, you'll end up with one hell of a result.” – Charlie Munger
There are various methods to identify mispricing ranging from high-quality franchise businesses to low-quality commodity-like companies. It may be worthwhile to focus on high-quality companies because even if you don’t time it well, you still are positioned well for high returns over the long term.
Criteria 1: Sales Growth
A company must have grown its sales by at least 10% every year for the last ten years. We assume that if the inflation is around 7% in the economy, the company has generated at least 3-4% in real terms.
Criteria 2: Return on Capital Employed (ROCE)
A profitable company will be able to generate cash flows. This cash flow is either distributed to the shareholders (dividend) or invested back (retained earnings). These are the elements of value creation for the shareholders.
Criteria 3: Debt to equity
Firstly, you need to exclude financial stocks, and secondly, you want to invest in companies that are generating cash flows, but that cash flow is not just used to service the debt.
Criteria 4: Market capitalization
You don’t want to focus on less than Rs 100 crores market capitalization of a company —cleaning up companies that are less than Rs 100 crores might be time-consuming and not a worthwhile process.
Here is a criterion you can use to screen companies:
1. Sales 10 years > 10%
2. ROCE 10 years > 10%
3. Debt to Equity < 1
4. Market capitalization > 100