fundamentals of stock picking

7/29/2019 Fundamentals of Stock picking

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MAKING MONEY THE OLD FASHIONED WAY

I strongly believe that the single most important number (for me) when considering investment in

stocks, is Return on Equity or ROE. This is essentially the Profit After Taxes (PAT) expressed as a

percentage of the total net worth (or shareholder funds, as the Americans refer to it). In simple

words, it tells me how efficiently the company uses money and how much of a return does it make.

All other things are secondary. Market shares, brand value, corporate governance, competencies

etc., If a company is good, it should ultimately get reflected in superior earnings.

No one wants to invest in a company that makes the right noises, but does not earn enough bang on

the buck, as they say.

One of the first things I look for is that the ROE, in Indian context should not be less than around

eight percent. Eight percent is bare justification for the company to exist. I tend to look for ROE of aminimum of twenty percent per annum, consistently over the last ten to fifteen years at least.

Maybe in a fifteen year span, it could have had one or at worst, two bad years. Anything more than

that and I tend to ignore it (except as low quality trading opportunity should the price be ok).

Once I make this list, then all other things follow. The ROE is the starting point for any long term

investments that I make.

Of course, stocks of companies with no history or those who I think can be capable of improving

their ROE on a sustainable basis fall in to a speculative list of probable investments. Here I am not

on sure ground, since it is my expectation of their improving the ROE.

Once the ROE list is made, from this I also try and focus on companies that pay full income taxes (i.e.

at the maximum rate prescribed by law). This is my wish list of blue chip companies. For companies

that pay lower taxes, the profits need to be adjusted by me for normalised tax payments and then

find out what their position would be.

Anyway, a few takeaways for me whilst doing this analysis:

i) Most MNCs fit in to the list, irrespective of industry;ii) Indian PSUs like to be away from this list ;iii) Indian private sector companies from FMCG, Pharma, two wheelers do make the list; &iv) Those that fit in to the list would be one of the top three/four in the industry.

In an industry, where an MNC makes a fantastic ROE, Indian companies seem to be lagging far

behind. Whether this is due to competency or integrity, one is not very sure. It cannot be for any

third reason, is what my presumption is. I could be wrong, but I choose to be conservative in matters

of faith. This will leave less room for disappointment. Why I say this is that MNCs are supposed to

have higher costs, but if they still show higher profitability, it says something about Indian

companies. Surely they are either incompetent or dishonest. Or it is simply because the MNC has

better brand power (based on reality or perception) that gives it superior profits?


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If look at the last so many years, companies like Colgate, HUL have delivered ROEs of anything

between fifty to over a hundred percent per annum! For a government security of Rs.1000 that pays

a fixed interest of under 8% each year (pre tax) we are willing to pay Rs.1000/- or one time its book

value. So if HUL delivers a ROE of fifty percent year on year, I am willing to pay six to seven times its

book value!. And if I believe that the ROE will continue without falling for the next few years, I do not

mind paying an even higher price in terms of number of times the book value!. The premium I am

willing to pay depends on the extent of certainty I have about the sustainability of the ROE.

It is important that the ROE is sustained by the company not approaching the markets with repeated

offerings (they will generally depress ROE) and not keep too much cash in the bank. For instance, if

Infosys were to distribute its cash pile, its ROE would improve significantly and the stock would be

worth a tad more. So long as there is cash in the bank, it will just give money market returns.

There are also companies like ITC which depress ROE, by allocating capital to businesses that either

lose money or earn very poor returns. The reasons are not relevant here. All a shareholder wants is

the best possible return on invested money and a company like ITC is not doing that.

For me, the ROE as a benchmark provides a ready reference to its price and enables me to take a

quick call. I may miss out trading opportunities on poor quality stocks. Ultimately, it is obvious that

the companies with the best attributes should also deliver the best returns and over a long term,

deliver value in the stock markets.

What we are seeing in the markets over the last two years or so is that there is a clear flight of

investors to the high quality stocks (those with high ROEs) and those stocks have become

expensive. When the bull market rages, these stocks will be forgotten as the markets chase the out-

of- favour stocks (characterised by fluctuating ROEs that trend towards mediocre over long term).For instance we will have companies in metals or infrastructure that fall out of favour, but at some

bullish moment in the market, reach ridiculous levels. We had the real estate stocks trading at silly

values in 2007-08. After that they have perhaps lost sixty to ninety percent by price. Dont be

surprised if these sectors are the ones that will push markets higher.

What I would love to see is a bout of madness that makes people sell off the high quality stocks and

chase the low quality stocks. If that leads to a price correction in the high quality stocks, I will be glad

to buy them. I have seen this happening at least once in a cycle of seven to ten years. Thus, if one

has a life of thirty years of dalliance with the stock markets, there would be three to four big buying

opportunities. The key is whether one has the money and the discipline to capitalise on it.

I have often seen manias where people have chased poor quality (low ROE in my parlance) stocks

using some flavour of the day attribute like eyeballs, Price to Sales (since there is no visibility of

profits), market share etc. How often have we seen stock prices moving up when a company

announces additional issuance of shares, when actually it should fall? These fads and fancies are

temporary and ultimately the markets get out of them soon.

Ultimately, when we invest in stocks, we do so to make money and not for the privilege of owning

some shares in a business for the sake of pride and prestige. Invest in those companies where the

management ensures the highest return on the invested money.


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R. Balakrishnan

([email protected])

January 19th

, 2013

fundamentals of stock picking

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