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Sunday, April 24, 2011

How to identify winning stocks – a guest post

The Sensex and Nifty have been quite volatile lately, jumping up and down like a kid on a trampoline. Small investors are not sure whether to buy or sell. At times like these, it may be better to sit back and do nothing.

Niteen has a better idea. Learn how to identify winning stocks using his 12 parameters. If you like his post, please write a comment or query. Your feedback may motivate him to contribute regularly.

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After 18 years in the stock market, I have observed that most small investors are only interested in tips for making quick money. But without exception, they end up losing money. Remember that the reverse of ‘TIP’ is ‘PIT’. ‘TIP’s can take you to the ‘PIT’s. There are no short cuts to making money. The stock market is a place that requires a highly disciplined approach. To make money, investing should be viewed as a long term process.

How to identify a winning stock without depending on tips? What are the parameters that help in choosing a winner?

The most important parameter is the ‘Margin of Safety’. The concept of margin of safety was first introduced by Benjamin Graham, author of investment classics like ‘The Intelligent Investor’ and ‘Security Analysis’.

Graham said: "Margin of Safety is always dependent on the price paid". One should buy a stock when it is worth more than its market price. This is the central thesis of the value investing philosophy, which emphasises preservation of capital. Graham looked at unpopular or neglected companies with low P/E and P/BV ratios.

If you feel that a stock is worth Rs 100, buying it at Rs 75 will give you a margin of safety. In case your analysis is incorrect and the stock is worth only Rs 90, the Margin of Safety provides a cushion against a possible loss. In India, markets tend to be volatile, so it becomes more important to look at each stock through the magnifying glass of Margin of Safety.

Very few stocks make it through the stringent screening process given below, and many potentially investment-worthy stocks can get excluded. If you come across any tips and get tempted to invest, at least you should screen those stocks through these parameters to ensure that you are not overpaying.

There are 12 parameters grouped under four heads.

(I)  Valuation & returns

  • P/E ratio < 40% of highest average P/E ratio over previous 5 years: take the highest P/E ratio of each year for last 5 years and then take an average
  • Earnings yield (E/P) > 2 x (RBI bond yield): RBI Bonds give a return of around 8%
  • Dividend yield > 2/3 x (RBI bond yield): Dividend yield is calculated by dividing the last dividend paid by a company, by the current stock price. Some companies retain earnings and do not pay dividends to maintain growth. But most blue-chip companies that have grown from the time they were not blue-chip, have consistently paid dividends for many years

(II)  Balance Sheet related

  • Current ratio > 2.0. This will give you a positive Net Current Asset Value (NCAV) number per share
  • Stock price < 1.2 x (Book Value)
  • Inventory trend: Inventory trend should reflect revenue numbers. Goods are produced to be sold, and not stored in a warehouse. If inventories increase faster than sales, a problem is brewing
  • Minimum 12% Return on Invested Capital (ROIC)
  • Debt/Profit =<5 and Debt/Equity ratio =<1.5: A company should pay its debt out of its profits, and not out of the equity base of the company. A ratio of 5 means that the debt can be paid out of 5 years profits

(III) Profit & Loss related

  • Revenue and profit should preferably increase consistently during last 5 years. A drop in any one of the 5 years can be considered also
  • Consistently paying dividends, bonuses: This is in line with (I) above

(IV) Governance

  • Published Statements of previous 6 months/Management Discussion and Analysis (from Annual Report): If the management is over optimistic about future earnings, an investor should stay away. Infosys, which is well-known for its transparency, has always been cautious in projecting future earnings
  • Shareholding pattern – Buying, selling or pledging: If management is selling/pledging their holdings, the stock should be avoided

The above parameters are available (or, can be calculated) free of cost from sites like: www.icicidirect.com, www.anagram.co.in or from economictimes.indiatimes.com.

There can be cases where you need to consider some additional parameters. The measurement of one parameter can be relaxed due to the strength of another parameter. This comes through experience and a new investor/analyst should avoid relaxing the parameters.

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(Niteen S Dharmawat is an MBA who has been working with Indian IT companies. A firm believer in long-term financial planning, and an 18 years veteran of the stock market, he likes to analyse the economy, and individual stocks. He also conducts investor education sessions.

Niteen blogs at http://dharmawat.blogspot.com.)

Related Post

What exactly is the Margin of Safety?

4 comments:

LovelyGuy said...

Excellent Post. Thanks to Niteen and Subhankar. I have learned Net cash flow from Subhankar and I have a great respect for providing me with such opportunities to learn. For selecting a stock: The only other parameter I look at is (mainly for small and midcap) greater than 40% of promoter holding. (Minimum) For small caps, I don't choose a stock where DE is greater than 1. (Instead of 1.5)

Thanks and regards

LovelyGuy

Titu said...

Hello Sir,
First Thanks to you both, you have given us an excellent article, as I am a new Investor can you just explain or elaborate why earning yield is important considering we already check PE Ratio, Or we just repeating the same thing again.

Thanking you both in Advance…

-Titu

scorpio said...

These guest posts rock :) Nice idea to have them. I am on and off your blog, but always get to learn from this site.


"If inventories increase faster than sales, a problem is brewing"
and the point about 5 times the profit should be the debt.

Just to be a bit more conservative, we should make it normalized profits (maybe average 3 years profits)

very good points, I learned something and have added these in my list to check :)

Niteen S Dharmawat said...

Thanks LovelyGuy, Titu and Scorpio for your comments. My response is given below.

LovelyGuy:

• In addition to this, I suggest to look for two more additional things. First, the % of share pledged by the promoters and the second, if the promoters have bought/sold stocks in the recent 6 months.

• Instead of debt:equity, you may like to consider debt:profit ratio. The reasoning is already given in the article.

Titu:

• PE and Earning yield are serving different purposes. When we are arriving at PE we are considering the average of maximum PE of each of the last 5 years. This way we are ensuring that we are not overpaying interms of PE valuation. It helps in removing the stocks which are overheated during short span of time.

• While we are taking Earning Yield, we are comparing it against the AAA bond yield. An equivalent of triple A bond in India can be RBI Bond which ensures the highest safety. So in a way we are ensuring the safety of the funds put in the stock. Remember the 1st rule of investing is to protect the investment then think of returns.

• By considering both these factors we are locking the stocks with safety and valuations.

Scorpio:

• Nothing wrong in normalizing the profits but in that case you may have to normalize the debt also for the same duration which may not be the correct way.

• Instead of taking the profit of last year, you can take the profits of last 4 quarters. This number becomes important and more relevant when you are comparing in the middle of the year instead of the beginning of the year.

Trust this clarifies.

Cheers,
Niteen S Dharmawat
http://dharmawat.blogspot.com/