STOCK PICKING

During the financial analysis of any business, certain factors are prioritized over others. I have always emphasized the importance of profits, profit growth, and sales growth. However, according to the author, growth rates can easily be manipulated by companies. Profit growth doesn’t necessarily ensure the quality of a business, as during high economic cycles, almost all businesses perform well. Even substantial profits do not guarantee real cash flow for the company. Similarly, sales growth cannot ensure shareholder value creation, as it's uncertain how much of those sales translate into cash or whether they add margin. Most importantly, sales numbers can also be manipulated.

The author argues that the major priority should be Return on Equity (ROE), which reflects the efficiency of management and how much profit a company generates from shareholders' money. Personally, the author prefers stocks with improving ROE or companies that maintain an ROE of over 20%. High and consistent ROE indicates a strong "economic moat." However, one should not assume that an extremely profitable company will sustain its profitability in the future. Companies lacking a robust economic moat are likely to falter over time. Economic moats can arise in various ways, such as by differentiating products to command a premium based on features, technology, durability, or branding. A strong brand name can create perceived differentiation in the customer’s mind.

Customer lock-in or high switching costs represent some of the best and most durable economic moats. Identifying what causes customer lock-in can be challenging; for example, switching from Facebook to another social network may be free, but the networking effect of existing friends can prevent users from making the change. ROE provides an approximate view of a company's health, and increasing ROE over the past 5-10 years, along with improved operating margins and cash flow, signals a sustainable economic moat. To gain a comprehensive picture, multiple ratios such as Debt to Equity Ratio, Interest Coverage Ratio, Current Ratio, Quick Ratio, and Debt to Owners' Fund should be analyzed over at least the last three years. The Debt to Equity Ratio, in conjunction with the Interest Coverage Ratio, offers a clearer understanding of the company's financial stability

MANAGEMENT EVALUATION

Management evaluation is a broad and complex process, but certain points can help us gain valuable insights. Attending the Annual General Meeting (AGM) can significantly enhance our understanding of management's mindset regarding the company's growth prospects. While some investors use shareholding patterns as a criterion for assessing management integrity, this metric alone is insufficient for making investment decisions. Promoters may increase their stake for various positive reasons, such as utilizing idle cash efficiently, capitalizing on lower valuations, or acquiring greater control of the company. It's advisable to avoid companies where promoters have small shareholdings or are consistently reducing their stakes by significant percentages. The initial entry of large institutional investors, including pension funds, mutual funds, insurance companies, and investment banks, often signals good times ahead. A higher Foreign Institutional Investor (FII) stake is viewed positively, while a lower stake indicates a lack of confidence in the company. If FIIs are increasing their holdings, it reflects their optimism about the company's future.

Conversely, caution is warranted if individual shareholding is rising while promoter or institutional shareholding is decreasing, as this may signal underlying troubles. Companies with pledging percentages of 2%-8% can generally be overlooked, but those with pledging above 30% should be avoided. Additionally, dividend and tax-related expenses represent real cash outflows that an accountant cannot manipulate. A company that consistently increases its dividend over five years is likely on a genuine growth trajectory. Ideally, companies should report a tax rate between 30%-35%. If a company has reported an average tax rate below 30% over the last 5-6 years, further investigation is warranted, especially for those in special economic zones where the percentage may be lower. Manipulating accounts often involves overstating asset values or inflating expenses, which will typically lead to a lower Return on Equity (ROE). Thus, considering the last five years' average ROE is crucial; an average ROE of more than 20% suggests that the company is unlikely to be manipulating its financials.

VALUATION

In my opinion, this is the single most important financial metric for making extraordinary returns. One of the major ratios under this branch is the P/E ratio, which you can either compare with a stock’s last three to five years of historical P/E or with its industry peers. High-growth companies always demand a higher P/E. The trailing P/E ratio considers the EPS of the past four quarters, while the forward P/E takes analysts’ estimates of next year’s EPS into account. To get a rough idea of valuation, compare a stock’s P/E with the P/E of the Sensex. It is better to focus on the EPS (Earnings per Share) growth rate because, ultimately, it is the EPS that matters most for shareholders, and profit growth doesn’t always translate into EPS growth. One should not pay more than a 20 price multiple for a company growing at 10%. In other words, ensure that the current P/E is not more than two times the last three years' average growth rate.

The Price to Sales (P/S) ratio is useful because the “S” portion or total revenue (sales) is not frequently manipulated. Unlike the P/E ratio, the P/S ratio remains more stable. When judging the P/S ratio, consider the industry in which the company operates; a low P/S ratio is typical for low-margin businesses, while high-margin sectors, like software, typically trade at higher P/S ratios. The P/S ratio is especially useful when analyzing stocks in cyclical industries, such as automotive, cement, and steel, or for companies undergoing a turnaround.

The Price to Book (P/B) ratio is particularly useful for banking and NBFC stocks and capital-intensive businesses that have significant tangible assets. For example, L&T has a strong brand name, making it a dominant player in the construction sector, yet you can't easily quantify the value of that brand. The P/B ratio has little significance for software companies.

If you believe investing in low P/E stocks is synonymous with value investing, you are committing a big mistake. Stocks with low P/E, low P/B, and high dividend yield may look cheap statistically, but many of these stocks represent low-quality businesses, or their future earnings growth is questionable. A business that can grow by 30% annually should command a premium. While these valuation methods theoretically appear effective, they can be impractical in real-world applications.

Comparing valuation with its own historical average provides a clear indication. Over the last 20 years, the average Sensex P/E has remained around 18. Whenever it crossed 25, a market crash followed, as seen at the peak of the dot-com bubble in March 2000 and the peak of the 2007-08 bull run. In both instances, a year-long market crash ensued. Thus, it's easier to identify bubbles and take precautions to benefit from a market crash. Conversely, whenever the Sensex P/E falls below 15, it has typically preceded a year-long bull run. Instances of the Sensex P/E below 15, such as early 1999, 2009, and December 2011, are golden investment opportunities, though such occurrences are rare.

The PEG ratio, calculated as the Price to Earnings ratio divided by the Earnings Growth rate, offers additional insights. A PEG ratio less than 0.5 indicates that the stock is undervalued and could be a great investment. A PEG ratio greater than 0.5 but less than 1 suggests the stock is either undervalued or reasonably valued, while a PEG ratio greater than 1 but less than 2 indicates the stock is reasonably valued. A PEG ratio greater than 2 suggests overvaluation. A P/E in the range of 8-12 (20%-40% discount from average) is considered "undervalued" and may present an attractive entry opportunity, while a P/E between 12-18 indicates the stock is "reasonably valued." If the P/E exceeds 20-30+, it signals overvaluation, especially if it is greater than twice the last three years' average profit growth rate. A P/E below 5 or in the range of 5-8 requires serious scrutiny; such low valuations could signal recent fundamental damage to the company, making it prudent to avoid any loss-making business.

WHEN TO BUY

If a company's fundamentals remain intact and are even improving, investors should not hesitate to add more shares, even after a significant price appreciation of 100% or 200%. If you can identify an extraordinary business with great future potential, it’s often still a good time to invest. However, common misconceptions can mislead investors. For instance, many believe that stocks trading at a 52-week high are unsafe investments, while those near a 52-week low have greater potential to rise. This thinking can lead to poor decision-making, as investing based solely on the 52-week low parameter is not a reliable strategy. In my view, the best time to buy is when you discover a more promising investment opportunity than your current holdings. The author emphasizes that some of the biggest wealth-creating opportunities can be found in quality microcaps and small-cap stocks, highlighting the potential for significant growth in these often-overlooked segments of the market. 

WHEN TO SELL

When investing in stocks, it's crucial to remain vigilant for better opportunities and avoid dangerous practices that can lead to increased losses. For instance, many investors hold onto a stock hoping for a rebound to exit near their purchase price, but this strategy can often exacerbate losses. Instead, selling should be based on a reassessment of whether the investment remains worthy, regardless of price fluctuations. Additionally, it’s wise to sell when a stock's valuation becomes overstretched, particularly if its market capitalization significantly exceeds the overall market size of its industry. A historical example is Bharti Airtel during 2007-08, when its market cap reached around 200,000 crores, far surpassing the entire telecom industry's value.

Another common pitfall is purchasing high-growth stocks and clinging to them simply because they appear cheap; if expected growth isn’t realized, it’s better to seek superior investment opportunities. Establishing a predefined exit strategy can be beneficial, though it's important to recognize that adhering to sound investment principles often negates the need for a rigid selling timeline. Many investors make the mistake of relying on past bull markets, attempting to time the market, or over-diversifying their portfolios—experts suggest that 10 to 15 stocks are ideal for minor diversification.

Misconceptions abound, such as the belief that stocks that have fallen sharply must rebound quickly, or that stocks which have recently doubled have limited growth potential. In reality, a stock’s price movement is more closely tied to the company’s earnings growth than its past performance. The banking sector tends to respond first during economic recoveries, yet investors should avoid dividing their portfolios strictly by market capitalization; instead, focus on the quality of investments.

During major market downturns, maintaining a significant cash reserve for 6 to 10 months can provide essential flexibility. Historical trends indicate that gold and equities often move in opposite directions, making gold a viable hedge against equity market volatility. Finally, be wary of stocks in certain categories: those with high debt, low promoter holdings, excessive promoter pledging, or stocks that have recently hit new lows. Additionally, avoid popular stocks that may have costly acquisitions or show a decline of more than 50% from their recent peak, as these are often red flags for potential investment risks.