How to select a stock - an analysis of the exercise for readers

Before I get into a detailed analysis of last week's stock picking exercise, I would like to extend hearty congratulations to all of you who participated.

Regardless of your answer, the willingness to participate in an open forum indicates a desire to learn and share - which are great qualities for success in life (and in investments). As far as I am concerned, you are all winners.

The information given about the companies was brief. But it was adequate to decide which of the three should be added to a list for more detailed analysis. Thousands of stocks trade every day, and it is not possible for small investors to check the fundamentals of even a fraction of the traded stocks.

One uses short-cuts to create a short list. I start with the cash flows from operating activities. Why? Because a listed company is in existence for one reason only - to generate cash. Cash in a manufacturing business is like gasoline to an automobile. Without a regular supply of it from its operations, a business can run for a while but will eventually come to a halt.

All three companies have positive cash flows from operations and negligible debt. But sales are low and so are the NPMs - an indication that the sector is a profitable one but has low volume and low margin. That is why, it is a bit surprising that all three have outperformed the Sensex by moving above their Jan '08 prices.

The fact that all three have been around for at least 30 years means that the business models are sustainable. The low P/E is an indication that the market is not enthused by the low growth of the sector.

As small investors, we don't have huge capital at our disposal. To make sure our limited resources are not frittered away in chasing multibaggers, the prudent option is to look for companies where internal accruals are sufficient to pay for expansion and investments.

Debt is not bad per se - if it can generate more cash than the debt repayments. But when debt is incurred merely for rapid growth - disaster happens. The sorry state of the high fliers in retail and real estate is a clear example.

So we have three companies - all with good fundamentals in a sector with low risk and low growth. How do we choose one over the other?

Most of you chose Stock 'N' and there were several reasons for doing so. Highest sales, highest EPS, best RoE, strongest technicals. The clinching reason - not mentioned by any one - is that its sales are more than the combined sales of the other two! Even in a low growth sector, one company is growing faster than its two closest and older competitors.

Though it is trading at a much higher price, Stock 'N' is available at a Market Cap to Sales ratio of less than 1. Some of you have mentioned about this ratio (without explaining why it may be relevant). Others haven't. Next Tuesday's post will explain the importance of the Market Cap/Sales ratio.

The exercise was an effort to demonstrate what kinds of stocks can be added to a 'watch list' for more detailed analysis. A 'buy' decision can only be taken after a more thorough look at past performance and business outlook.

Now for the awards announcements.

VJ gets the nod (and applause) for the most logical explanation covering all the important points. Just follow your investment plan, and you will retire a rich man!

sreyO gets an "A" for effort. Though his explanation wasn't brief, he pointed out that a comparison is possible only if all three stocks have the same face value. Pretty impressive for some one who hasn't started investing yet.

A big 'THANK YOU' to the rest of you for taking part in the exercise.