How to find under-valued stocks (even when a stock market is trading near its lifetime high)

The Indian stock market has rallied almost 30% from its Feb '16 low and is within hand-shaking distance of its lifetime high touched back in Mar '15.

Many stocks are touching 52 week highs on a daily basis. Some have touched their lifetime highs. 

Small investors are in a quandary. Should they jump on to the bandwagon and ride the bull market, or should they wait for a correction to enter?

The answer is: Neither. Instead, they should do their homework. Try to find undervalued stocks. 

Are there any undervalued stocks left in the market? Haven't all of them been bought already?

Those are valid questions - specially when a market is near its lifetime high. The truth is, there are undervalued stocks available under all market conditions. They are more difficult to find near market tops.

So, what is the 'secret formula' for finding undervalued stocks? There isn't any. 
Finding undervalued stocks requires methodical, 'grunt work'.

The following five metrics will get you started on your quest:

1. P/E (Price to Earnings) ratio
2. P/BV (Price to Book Value) ratio
3. Debt/Equity ratio
4. Free Cash Flow
5. PEG (P/E to Earnings growth) ratio

The first three ratios are readily available from any finance website. The last two may need to be calculated from Annual Reports.

Read more about the five metrics from this article.

Not interested in doing grunt work to find undervalued stocks? Leave the job to experienced fund managers. Invest in equity or balanced funds.

Related Post
How to pick Stocks for Investment - Part III

Stock Chart Pattern - Great Eastern Shipping (an update)

These were introductory comments in the previous post on Great Eastern Shipping 7 years ago: "Fundamentally strong, with very good profit margins, strong cash flows from operations, low P/E ratio, regular dividends - all the hallmarks of a stock that should adorn any long-term portfolio."

The shipping sector has been facing a pressure on freight rates for quite some time due to an excess supply of vessels - compounded by a slowdown in the Chinese economy and low oil prices that have affected offshore drilling business.

In spite of such headwinds, India's largest private sector shipping company has produced stellar results. Consolidated net profit of Rs 1039 Crores with NPM of 25.5%; diluted EPS of 68.8 giving a P/E ratio of 5.3; net cash flow from operations of a massive Rs 2047 Crores; debt/equity ratio at a manageable 0.55; dividend yield of 3.7% on CMP.

Yet, the chart below shows the stock price has been in a 2 years long down trend (marked by blue down trend line). Is this a value investing opportunity, or what? 

The stock price had touched a 2 years high of 460 on Sep 15 '14 only to drop into a long correction-cum-consolidation phase. After forming a 'rounding bottom' reversal pattern, the stock rose to touch a high of 399 on Aug 13 '15 but retreated after facing strong resistance from the blue down trend line.

Continuing with the consolidation within a 'rounding bottom' pattern, the stock price breached the down trend line and touched a high of 420 on Nov 10 '15, but formed a 'reversal day' pattern (higher high, lower close) that triggered a sharp correction below its three EMAs into bear territory.

The stock price formed a small 'double bottom' reversal pattern at 275 on Mar 2 '16 and rallied past its 20 day and 50 day EMAs, but failed to overcome strong resistance from its 200 day EMA. Another correction-cum-consolidation ensued.

After forming another 'rounding bottom' reversal pattern (clearly visible on the 20 day and 50 day EMAs), the stock price rallied past its 200 day EMA into bull territory and has breached the blue down trend line once again.

Daily technical indicators are looking overbought. That means the upside may be limited in the near term. Those who understand the nitty-gritty of the shipping business may consider gradual accumulation.

8 Signs of a Doomed Stock

Let me assume that you have been following my posts regularly, and are no longer swayed by stock market cacophony and 'expert tips' sent by SMS to your smart phone.

You have been doing due diligence and picking stocks based on solid research. Already some of them have moved higher since you bought them.

But there are these one or two exceptions that are refusing to move up. In fact, they may be gradually sliding down despite apparently good track records.

As a long-term investor, what are you supposed to do with the laggards? Hold on, and hope for prices to improve? Buy more as the stock is now available at a price lower than your 'buy price'? Get rid of it?

In a recent video posted at investopedia.com, you can check out more information about the '8 Signs of a Doomed Stock':

1. Negative cash flows from operations
2. High debt/equity ratio
3. Low interest coverage ratio
4. Sustained decline in price
5. Profit warnings issued before or during quarterly results
6. Large selling by owners/directors
7. Resignations by key executives/managers
8. Investigations by SEBI/Enforcement Directorate/Income Tax department

Any one of the above signs may not be enough to warrant selling. But several of these signs taken together is almost a guarantee that the stock's price will crash.

Related Posts

What does the Debt/Equity ratio indicate?

What does the Interest Coverage Ratio signify?

Fundamental Analysis: Solvency ratios and Liquidity ratios

Selecting a company for investing is not a trivial task. Many small investors get into trouble because they buy a stock without doing adequate homework. 

A stock may be in the news as a potential multibagger, or may be approaching its 25th or 50th year of existence or has a reputation of distributing large dividends.

Those may be good reasons for someone to buy the stock in the hope of making some quick gains. But for building wealth for the long-term, more detailed analysis is necessary to determine a company's staying power.

Ratio analysis is a good way to differentiate a company from its peers and competitors. But there are so many ratios to analyse - where should you start?

The state of financial health of a company is one of the first things you should evaluate. If the financial foundation is strong, many other shortcomings can be overridden.

Solvency ratios - like debt/equity and interest coverage - indicate the ability of a company to meet its long-term financial commitments.

Liquidity ratios - like current ratio and quick ratio - indicate how well a company can meet its short-term financial obligations.

To learn more about solvency and liquidity ratios - how to calculate and evaluate them - visit the following links at investopedia.com:

Link 1

Link 2

Stock Chart Pattern - Balrampur Chini (An Update)

Sugar stocks are not really my cup of tea - though I do add a spoonful of sugar to my evening cuppa. 

The sugar business is cyclical and weather dependent. To make matters worse, policies and prices are subject to frequent interference by the government.

That makes the business unpredictable, and I stay far away from it. But a young, risk-taking trader interested in making quick gains may find sugar stocks attractive.

The 2 years closing chart pattern of Balarampur Chini clearly reflects the cyclical nature of the sugar business. How cyclical? A look at the net profit figures of the past 5 years should suffice.

For year ending Mar '11 and Mar '13, net profit crossed Rs 160 Crores. For year ending Mar '12 and Mar '14, net profit was Rs 6.6 Crores and Rs 3.6 Crores respectively. For year ending Mar '15, there was a net loss of Rs 58 Crores.

Debt/Equity ratio is 1.43. High interest expenses continue to affect the bottom line. In other words, fundamentals do not warrant long-term investment.

But have a look at the returns that a trader could have made. From a low of 36.80 touched on Jan 31 '14 to a high of 85.15 touched on Jun 23 '14, the stock gave 130% return in less than 6 months.

A 15 months long bear phase followed (marked by the blue down trend line). The stock dropped to a closing low of 38.90 on Jun 16 '15 - giving up almost all its gain in one year, but providing good trading opportunities.

After forming a 'double bottom' reversal pattern (marked B1 and B2), the stock price embarked on another bull rally, touching a 2 years high of 87.85 on Jan 13 '16 - giving 120% return in less than 5 months from the low of 39.60 (B2) touched on Aug 31 '15.

The stock is trading well above its rising 200 day EMA in a bull market, but such a sharp rally is unsustainable. 

All four daily technical indicators are looking overbought and a couple of them are showing negative divergences by failing to touch new highs with the stock price.

Get ready for another stomach-churning roller coaster ride. Like I said, not really my cup of tea.

Technical updates – Container Corp and Indraprastha Gas

Stocks of PSU companies have never been my favourite because too often, management decisions have been dictated by government prerogatives and their bulging cash balances have been used to fix problems arising from faulty fiscal policies.

But if some one pointed a gun at my head and forced me to pick two PSU stocks – these two would be at the very top of my list. Why? Their near-monopoly status, and consequent strong fundamentals.

Container Corp is debt free, with RoE of 14%, and net profit margin of 18.4%. Indraprastha Gas has a debt/equity ratio of 0.18, RoE of 20.4%, and net profit margin of 9.1%. Therefore, it is no great surprise that the former has a P/E of 26.6, while the latter has a P/E of 17.6.

The charts below show that both stocks are trading in strong bull markets. But the general public holds just 1.3% of Container Corp’s equity and 6.5% of Indraprastha Gas’ equity. Two excellent investment-worthy stocks – and the public doesn’t seem to care about them!

Container Corp

The stock price of Container Corp. consolidated sideways within a ‘rectangle’ pattern for a year before finally breaking out upwards on a volume surge. As often happens, a pullback towards the breakout point gave investors an opportunity to enter.

The stock closed at a new high of 1483 in Nov ‘14, but negative divergences in all four technical indicators - which failed to touch new highs with the stock (marked by blue arrows) - led to a correction. The stock dropped below its 20 day and 50 day EMAs, but has recovered since then.

Technical indicators are looking bullish. Some consolidation can be expected before the up move resumes. 

Indraprastha Gas

The stock price of Indraprastha Gas consolidated sideways within a bullish ‘falling wedge’ pattern before breaking out upwards with a volume surge. It has been a strong up move since then, with intermittent corrections that ensured that the stock didn’t become too overbought.

The stock touched a new closing high of 465.40 in Dec ‘14, but negative divergences in all four technical indicators, which failed to touch new highs with the stock (marked by blue arrows), have led to a correction that is continuing.

Any drop below its 50 day EMA will be an adding opportunity.

Technical updates – Gayatri Projects and IRB Infrastructure

Stocks from the construction sector have emerged from long bear phases in anticipation of growth in the economy that may lead to revival of stalled projects and awarding of new contracts. The ground reality hasn’t quite lived up to the expectations – though there are some signs of increasing construction activity.

Gayatri Projects and IRB Infrastructure are two companies from the construction sector that have similar looking chart patterns (below), but looks can deceive. While the former has gained a considerable 270% from its bear market low to its 2 years high, the latter has gained an even more impressive 365%.

On the valuations front, Gayatri has a debt/equity ratio of almost 2, and its financial expenses are three times more than its net profit. IRB’s debt/equity ratio is a more manageable 1.06 and its financial expenses are marginally less than its net profit. No wonder Gayatri is trading at a P/E of 9.4 while IRB is trading at a three times higher P/E of 29.3.

Does that make one a better buy than the other? Or, should both stocks be avoided? You tell me!

Gayatri Projects

The stock price of Gayatri Project went through a long ‘double bottom’ bear market reversal pattern formation that took 7 months to complete. The subsequent rally was sharp, and was supported by strong volumes that launched the stock into a bull market.

Such sharp rallies are difficult to sustain. All four technical indicators reached extremely overbought conditions that led to a correction and then a small ‘double top’ pattern with a higher second top. But none of the technical indicators touched a higher top. The combined negative divergences was followed by a sharp correction that bounced back before testing support from the rising 200 day EMA.

For the past 4 months, the stock price has been consolidation sideways within a triangle pattern from which the break out can occur in either direction. Technical indicators are in bearish zones, but the 200 day EMA is still rising and the stock is trading above it in a bull market.

IRB Infrastructure

The stock price of IRB Infra dropped to a bear market low of 54 on a sharp volume surge, which was a sign of selling exhaustion. A ‘V’ shaped recovery was followed by a drop to a higher bottom – forming a small ‘double bottom’ pattern that preceded a gradually rally.

The rally faced resistance from the 200 day EMA and dropped to a higher bottom that indicated the start of a bull phase. The next leg of the rally was sharp and accompanied by strong volumes. But overbought conditions and negative divergences (marked by blue arrows) in three of the four technical indicators led to a sideways consolidation within a ‘rectangle’ pattern.

The consolidation within the ‘rectangle’ has consumed more than 5 months. Since rectangles are usually continuation patterns, the eventual break out is likely to be upwards. But rectangles are unreliable patterns, so one needs to wait for the break out to initiate any buy/sell action. Technical indicators are in bearish zones. The consolidation is likely to continue for a while longer.

Stock Chart Pattern - Balrampur Chini (An Update)

The previous technical update of the stock chart pattern of Balrampur Chini was posted back in Jan 2010, with the following concluding remarks: “Existing holders may stay invested with a strict stop-loss at 115, with the hope that a white knight will appear on the scene soon. The risk-averse can book profits. Fresh entry is not recommended.”

The owners had been trying to sell the company, but the high asking price had deterred potential buyers like Bajaj Hindustan and Shree Renuka Sugar. No white knight appeared. After touching a high of 167 in Oct ‘09, the stock dropped into a prolonged bear phase. It received brief support at 115, but soon dropped to 70, where it received stronger support – in May ‘10 and then again in Dec ‘10 (marked by blue up arrows on left of chart below).

Once the support at 70 got breached in Feb ‘11, the stock made a couple of valiant efforts to climb back and stay above 70 but failed and dropped all the way down to a low of 33 in Dec ‘11 – just above its Oct ‘08 low of 30. The bear phase appears to have ended finally.

The daily bar chart pattern of Balrampur Chini shows an uptrend from the Dec ‘11 low of 33 (marked by blue uptrend line) that has already provided more than 100% gains in 8 months, but is facing strong resistance from the support/resistance level of 70 (marked by blue down arrow on right of chart above). This is another example of how an earlier support level can turn into a future resistance level.

Will the stock price be able to break out above the 70 level soon? Technical indicators seem to indicate otherwise. MACD is barely positive, and is below its signal line. ROC is above its 10 day MA but has slipped back into negative territory. RSI faced resistance from its 50% level, and is moving down. Slow stochastic has moved above its 50% level. Bulls have some more work to do before the stock price can move higher.

The company hasn’t been doing well. Top line shrank by 22% in FY ‘12 while bottom line shrank by 96% and was barely positive. Debt/Equity ratio is 1.42. Interest expenses continue to affect the bottom line. Q1 results showed top line growth of 21%, but hardly any improvement in the bottom line, which remained negative.

What should small investors do? If you are holding on from higher levels in the hope of getting back your ‘buy’ price, it may be a good idea to get out now. If you are one of those lucky few who managed to get in at lower levels, book part profits and hold the balance with a trailing stop-loss at the level of the uptrend line (now at about 60). If you are thinking of making a fresh entry, don’t. Much better stocks are available in the market.

Bottomline? The stock chart pattern of Balrampur Chini seems to have shrugged off the bears and is trying to enter a new bull market. That doesn’t make it a good investment candidate. There is too much political interference in the sugar sector as a whole. Stocks from the sector are best avoided.

Some strategies about buying stocks

In a post last week, I had discussed strategies for selling stocks. Most small investors know how to buy stocks, but they rarely have proper strategies for selling. So why am I writing about buying strategies?

From the spate of questions I have recently received about when and how much to buy, it seems that discussing some buying strategies may be useful after all. I had mentioned about using the ‘Margin of Safety’ concept and P/E bands to decide entry points in last week’s post.

The importance of those two concepts can’t be over-emphasised. Too many young investors follow the wild west policy of ‘Shoot first, and ask questions later’. Just switch on any business TV channel (just for entertainment) during the day when they take reader queries. 99% of the questions are: ‘I have bought thus and such stock at this price; should I hold or sell.’

It is apparent from the questions that the stock was bought near a top, and the investor is already sitting on a loss. The question – or rather, a plea – is to find out if the TV expert knows some magical formula by which the loss can be quickly turned into a profit, or, at worst, break-even with no loss.

All one has to do before placing a buy order, is to first check whether the current E/P (i.e. inverse of the P/E ratio) is higher than the long-term bank fixed deposit rate, leaving a ‘Margin of Safety’ . Also check that the debt/equity ratio is less than 1, and that the cash flow from operating activities is positive for 4 of the last 5 years.

If E/P is lower than the bank FD rate, then check the P/E band within which the stock normally trades, and buy only if it is available near the middle of the P/E band or lower. These are basic precautions, and will help prevent losses – even if you don’t have the time or inclination to do a detailed fundamental analysis.

If you are like most small investors, the stock price will fall just after you’ve bought it (and, it rises soon after you sell)!! What should you do? Do not, repeat, do not average down. That is the single cause for turning a small loss into a much bigger one. Instead, keep a stop-loss – and sell if the stop-loss is hit on a closing basis (i.e. take intra-day movements out of the equation).

You will make much more money by averaging up. When should you do that? Buy 20-25% of your intended quantity at the beginning. Add more every time the stock dips or corrects on the way up. Follow a ‘pyramid’ strategy – i.e. buy less and less quantity on the dips as a stock keeps moving up in price – till you acquire your intended quantity.

Such a strategy will prevent impulsive buying of 2000 or 5000 shares in one go, in the hope of becoming a Warren Buffett within a month. Talking of Buffett, I love his quote: ‘You can’t make a baby in one month by getting nine women pregnant!’

Wealth-building takes time. If you hone your buying and selling strategies, you have a chance of becoming wealthy in 15-20 years – but not in 15-20 months.

Why small investors should avoid ‘cheap’ stocks

There are several reasons why small investors should avoid ‘cheap’ stocks, and I will take them up one by one. Before that, one must understand what is meant by ‘cheap’ stock.

Investopedia.com has the following definition:

“The illegal practice of issuing stock options at artificially low prices shortly before an initial public offering. Often underwriters will require a company to have more qualified management before they can go public. They attract these qualified individuals by giving options with a low exercise price.”

This was a practice which was prevalent prior to and during the dot.com boom in the USA, and is not unheard of in India. While it can lead to significant profits, the average small investor won’t be able to participate - unless his uncle or friend’s father was the promoter of the company. If a company is trying to sell its stock through bulk SMS and email messages at a lower price than its forthcoming IPO price, chances are that it is a ‘dud’ company and best avoided.

Then there are those companies that were the apple of investor’s eyes during the previous bull market, and reached stratospheric levels just before the crash in Jan 2008. Real estate stocks were at the forefront, followed by the stocks with the word ‘infrastructure’ in their name. Most of these apples had rotten cores. They have not only become cheap stocks, but continue to get cheaper by the day. Don’t go anywhere near them.

There are cheap stocks which are also called ‘penny stocks’ because they trade below Rs 10. Most of them are unknown, fraud companies who have no business and no intention of doing any business. Occasionally they boost up their share price from Rs 3 to Rs 8 by planting fake stories in the media about the great opportunity for investors once they dismantle the fourth rate defunct plant that they have bought in Uzbekistan or Burkina Faso and reinstall the plant in Jhumri Tilaiya. Avoid such stocks like the plague.

Some cheap stocks may appear cheap, but are not. A Re 1 face-value stock trading at Rs 15 is equivalent to a Rs 10 stock trading at Rs 150. A Rs 10 face-value stock trading at Rs 15 may not be cheap either, if it belongs to a loss-making company, or one that is trading at a P/E of 80 or 100. Stay away from such stocks.

What about stocks that appear relatively cheap with P/E ratios below 15 that generate strong cash flows from operations, have low debt/equity ratio and double-digit profit margins? Ah-ha, now we are talking. I just love to dig and find such stocks. They are the ones that will give a nice boost to your stock portfolio’s performance.

What to do when stock prices fall?

Most small investors – particularly the recent entrants to the stock market – are ‘bulls’. That means, they buy a stock at a certain price and expect the price to quickly move higher so that they can sell and make a tidy profit without going through Step 1 (see below).

The idea is not entirely wrong. Being a bull is usually more ‘fun’. When you buy a stock and it starts to rise rapidly, you tend to feel elated and proud that you have made a smart choice. But it is no fun at all when the stock you have bought recently suddenly turns around for no rhyme or reason, and starts falling like a stone.

Your elation vanishes into thin air. Your pride takes a beating. You can’t confide to friends or family because they will either laugh at you or scold you for being a greedy gambler. You start losing sleep and look for ways to recover from the situation.

One of the worst things to do is to buy more as the stock price keeps falling. Your ‘average’ price goes down, but your losses keep on increasing. You eventually lose hope, and either sell when the stock price is near its bottom, or become a reluctant long-term investor.

So, what was wrong in being a bull? Forgetting that there is always another animal called a ‘bear’ in the stock market. While bulls are strong and can sweep aside all resistances when they are excited and charging, they are basically peaceful vegetarians.

Bears, on the other hand, are vicious and cunning meat-eating predators. In the stock market, a handful of professional bears make mincemeat out of the hordes of peaceful small investor bulls. What helps the bears is that they only need to pay a margin amount for shorting a stock which they may not even own. Then they square off the deal at a lower price and pocket the profit.

How do you avoid being decimated by bears? Follow three simple steps:

1. Do your homework before buying a stock. Is it fundamentally strong? Does the company have growth opportunities? Does the business model generate adequate cash from operations? What is the reputation and track record of the promoters?

Learn about some basic ratios like P/E, P/BV, Debt/Equity, Market Cap/Sales, Return on Assets. (Most of these concepts have been covered in different blog posts.)

2. Buy any stock with an adequate Margin of Safety

3. In spite of doing your home work and buying with a Margin of Safety, a stock’s price may start to fall after you buy it. Avoid a big loss by taking a small one. Learn how to set a stop-loss.

That was the long answer. The short answer is: Sell, and sit on the cash. Go to Step 1 above. Don’t go to Step 2 before becoming thoroughly conversant with Step 1.

Related Posts

How to lose more money and become a better investor

What exactly is the Margin of Safety?

What is the Return on Assets (RoA) ratio?

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?

A Solution to the Exercise on Cash Flows

Last week’s exercise on Cash Flows drew a large number of readers, but, disappointingly, only 6 responses. That could be because of three reasons: (a) most readers did not understand the concept of cash flow; (b) readers felt shy about making an incorrect response in an open forum; (c) readers did not feel that cash flow is an important enough concept to break their heads over.

Now that the Sensex is on the upswing again after nearly 5 months of correction, the participation in various investment groups and chat boards have increased significantly. Many of the topics are nothing but a succession of ‘buy’ calls on stocks of various pedigree, mostly questionable, with a stop-loss 2 points below the ‘buy’ price and targets of 3 points and 5 points above the ‘buy’ price. Gleeful announcements follow that the first target has been hit and one should book 50% of profits!

If more young investors learned the basics – and let me emphasise that cash flow is one of the most important concepts any investor should learn – they would know how to make really big money, instead of being happy with a 3 point or 5 point profit in 2 days (which they don’t forget to annualise into huge percentage gains to ‘prove’ their stock-picking prowess).

Pardon the rant. Now a turn to acknowledge the 6 readers who had the interest and intelligence to read and understand the concept of cash flow, and the guts to attempt answers to the exercise. Well done. All of you are winners, because you can consider yourself a few cuts above ordinary investors, who jump into the market with no idea of what they are doing.

There were no ‘right’ or ‘wrong’ answers, because stock picking depends on individual preferences and risk tolerance levels. But a distinction needs to be made on the process one follows to take a decision about a particular stock. A special hat-tip to reader ‘TK’ for the most logical way of arriving at his decision. My anonymous subscriber’s response was the next best.

Just to recap the concept of cash flow, a positive number is an inflow and a negative number is an outflow. In cash flow from operating activities, a positive number is preferred. A business should not just generate profits, it must generate cash – not as an amount to be received at some future date (which is represented by a negative cash flow). Often, the profit figure is an accounting sleight of hand. So the negative cash flow never turns positive. On this aspect alone, Company ‘A’ beats ‘B’ and ‘C’ hands down. (Cash flow can be fudged also – but will show up in the Balance Sheet. This is what Ramalinga Raju did at Satyam, and his auditors ignored or overlooked it.)

‘A’ has also been investing regularly in expanding its activities, as can be seen from the negative cash flow from investing activities. Negative cash flow here is actually good for the business. However, if the cash generated from operating activities is insufficient – as was the case in ‘06, ‘07 and ‘09 – there is no option but to resort to borrowing. Note that the cash flow from financing activities were large positive amounts. In the two years (‘08 and ‘10) that substantial cash was generated from operations, the company paid back some of its debts – as can be seen from the negative cash flow from financing activities. A sign of financial prudence.

What can’t be made out from the abridged cash flow statements is the total debt burden and interest payments. If the debt/equity ratio (which is calculated from the Balance Sheet) is more than 1, then the company may get into a debt trap after one or two bad years. Another metric to check is whether interest payment exceeds net profit (which can be observed from the P&L statement). If it does, then the banks are benefitting more than investors.

As far as ‘B’ and ‘C’ are concerned, both fail the test because I only consider companies suitable for investment if they have positive cash flow from operating activities in at least 4 of the past 5 years. Of the two, ‘B’ is better because it has achieved higher profits on lower levels of debt (as can be seen from the cash flow from financing activities). Also, its profits are growing, whereas profits of ‘C’ are stagnating.

Please appreciate that this particular analysis is a bit simplistic because the cash flow statements are abridged. However, it provides a good overall picture for short-listing potential companies to invest in. A more detailed analysis of the Balance Sheet and P&L statement should be conducted before taking a ‘buy’ decision.

Ideally, a company should not only have positive cash flow from operating activities, but also positive free cash flow. That means, cash flow from operating activities should be more than enough to fund any capital expenditure. Such is the case with many FMCG companies. One reason why FMCG is my favourite sector.

(Note: Company ‘A’ – Aurobindo Pharma; Company ‘B’ – IVRCL Infra.; Company ‘C’ – Pantaloon Retail. No particular reason for picking these three – other than the fact that they can be ranked based on their cash flow statement.)

What is the Australian Mining tax and how is Gujarat NRE Coke affected by it?

During question hour in one of the popular business channels today, a viewer asked whether he should buy the Gujarat NRE Coke stock. One of the anchors enquired why he had chosen this particular stock. The answer was enlightening: "It is a good company".

Both the fundamental and technical analysts in the show seemed positive about the stock with a long-term view - more so because the dark cloud of the Australian Mining tax had apparently lifted. The stock had already perked-up on the news. (So did many global mining stocks today.)

Mining stocks are not within my 'Circle of Competence', and I have never invested in them. A friend had strongly recommended the Sesa Goa stock many years ago, and I would have become rich had I listened to his advice.

But I have learned from Warren Buffett - who studiously avoided tech stocks during the dot.com boom - that investors should only buy businesses that they know something about.

Anyway, I was intrigued and decided to do a little digging. This is what I discovered.

Kevin Rudd, the erstwhile Labour Party Prime Minister of Australia had announced last month that he proposed to introduce a Resource Super Profit Tax of 40% on mining companies. Why?

Thanks to the huge, unsatiated Chinese demand for commodities, top mining outfits like BHP Billiton (60% Aussie owned) and Rio Tinto (30% Aussie owned) were making bumper profits from their Australian mines. Australians were not benefitting much because these foreign-owned companies were repatriating their profits overseas.

'Super' profits meant any profits above the long-term Australian Government bond rate of 6%. So any excess profit above 6% was proposed to be taxed at the rate of 40%. Needless to say, the mining companies were up in arms and started lobbying against the tax and threatened to take their business elsewhere.

The adverse publicity and pressure forced Kevin Rudd to resign, as elections are around the corner. The new incumbent, Julia Gillard, is the first female prime Minister in Australia. She opened the door to negotiations with the mining companies without abolishing the proposed tax - which will come into effect from July 2012.

Whether the tax proposal is changed or remain unaltered, the balance sheets of mining companies will get affected only from 2013. There will be no effect for the next two years.

Does this 'positive' news for mining stocks worldwide and Gujarat NRE Coke in particular warrant today's price rise? There is no proposal to remove the tax - only an offer to negotiate, which could lead to a possible reduction in the rate.

Gujarat NRE Coke has a mining subsidiary listed in the Australian stock market. I am not sure how much profit it makes, or whether it makes any profits at all. The company itself can hardly be termed 'a good company'!

At today's closing price of Rs 65, the stock is trading at a P/E of 62.5! The company has bloated equity, debt of Rs 1328 Crores, debt/equity ratio of 1.12, negative cash flows from operations in three of the last five years, net margin and RoE in single digits.

Technically, the 50 day EMA is below the 200 day EMA and the stock is trading below both its medium-term and long-term moving averages. The stock is weak fundamentally and technically. Just the kind of stock from which small investors should stay miles away.

Related Post

What is your Circle of Competence?

How to use the Market Cap to Sales (or Price to Sales) ratio to value stocks

Before learning when and how to use the Market Cap to Sales (or Price to Sales) ratio, some definitions may be in order.

Market Capitalisation (Market Cap) = Total number of equity shares x Price per share

If the equity capital of a company is Rs 10 Crores and the face value of each share is Rs 10, then the company has issued 1 Crore shares. If the share price is Rs 50 (on a given day), the Market Cap (on that day) is Rs 50 Crores. As is evident, the Market Cap is a number that changes with the share's price.

Why should we be concerned about this number? It represents the total value of the company in the stock market. In other words, if you had a lot of money and you wanted to buy the entire company (which has to be listed in the stock exchange), then you will have to pay an amount equal to the Market Cap, i.e. Rs 50 Crores.

The Market Cap to Sales ratio, also referred as the Price to Sales ratio (P/S or PSR), is calculated by either dividing the Market Cap by the total sales of the previous 12 months, or by dividing the share price by the per-share sales of the past 12 months.

P/S or PSR = Price per share/Sales per share = Market Cap/Total Sales

If the company in our example had sales of Rs 80 Crores in the previous year, its Market Cap to Sales ratio will be 50/80 = 0.625. A ratio less than 1 is considered a sign of 'under-valuation'. Why? It means that for each Re 1 of sales you will be paying 62.5 paisa if you were buying the entire company.

If another company in the same sector has a similar equity capital, but a share price of Rs 60 and sales of Rs 100 Crores, then its Market Cap to Sales ratio will be 60/100 = 0.6. That means, the higher priced share is actually 'cheaper' valuation-wise.

This is an important point for small investors to note. Many say that they have limited capital and therefore, opt to buy shares that are cheaper in price. They end up buying a small cap or mid cap share. Valuation-wise, a higher priced large cap may be a better buy.

Please remember that different sectors have different operating criteria. Some require heavy capital expenditure, others don't. Some sectors have low sales and high profit margins. Others have large sales but low profit margins. The Market Cap to Sales ratio should be used only for comparing companies within the same sector.

Several other ratios, like Debt to Equity, Interest Coverage and Return on Assets, had been discussed earlier. Do we really need to look at another ratio? The Market Cap to Sales ratio is particularly useful in valuing companies which are incurring losses. Because they have no earnings, the more popular valuing metric P/E can not be used.

As a general thumb rule, small investors should avoid loss-making companies. What if an otherwise fundamentally strong sector or company gets into a temporary difficulty and incurs losses? It happened to Tata Motors and Hindalco. It happened to the export-oriented textile sector. The Market Cap to Sales ratio will help to separate the men from the boys.

Many analysts prefer to use the P/S ratio over the P/E ratio, because it is easier to fudge earnings, whereas sales can be more readily verified. That does not mean a 'creative' company like DLF can't fudge their sales figures!

It is best to check both the P/E and the P/S ratios when selecting a company from a particular sector. If both indicate 'under-valuation', then the stock can be included in a 'buy' list. If the indications are contrary to one another, it is an alarm signal that management is probably doing some fudging.

Debt-burdened companies often trade at low Price to Sales ratios. Their sales may not be affected and may actually be growing, but interest and capital repayments may be causing a drop in margins and cash flows. Investors should avoid such 'value traps' by checking the Debt/Equity and Interest Coverage ratios.

(A short exercise for readers: In the recent stock selection exercise, most readers chose Stock 'N' as the best of the three. However, on the basis of the Market Cap to Sales ratios, Stock 'N' is more expensive with a ratio of 0.79. Stock 'S' and Stock 'I' have ratios of 0.47 and 0.46.

Will readers still choose Stock 'N' over the other two? If yes, why? If no, why not?)

How to select a stock - an exercise for readers

From time to time, I receive requests from readers to write about how to select stocks. I wrote a post back in Feb '09 titled:

How to Select Stocks within Infrastructure Sector

In that post, I had highlighted the importance of studying the cash flows from operating activities (a statement usually well hidden in the depths of an Annual Report) which separates the champions from the pretenders.

This time around, I would like to put the onus on the readers to do the selecting. Readers need to use the 'Comments' link below the post (or, if you are feeling shy, send me an email) to briefly explain which one of the three stocks is the best choice and why.

To remove any bias, the sector name and the names of the stocks are not being revealed. All three are manufacturing companies that sell their products in India and overseas. Let us call them S, I, and N.

They are fundamentally strong small-cap companies that have been around for more many years, and outperformed the Sensex by going past their Jan '08 bull market highs during the recent rally.

Given below are the brief details of the three stocks, based on which readers would need to make a choice. Why only these criteria and not others? Because these are the ones I take a quick look at to decide whether a more detailed study is warranted.

Stock 'S' : Almost 50 years old, part of an NRI group.

• Equity: Rs 4 Cr (Promoters hold 75%); EPS: 20; P/E: 4; NPM: 8%; RoE: 14
• Sales: Rs 68 Cr; M-Cap: 32 Cr; Debt: negligible
• Dividends: steady for the past 5 years
• Technicals: fell to the level of the Jan '08 top during the recent correction; after a brief consolidation has slipped down

Stock 'I' : 35 years old, Indian company with foreign collaboration.

• Equity: Rs 9.5 Cr (Promoters hold 60%); EPS: 6.5; P/E: 6; NPM: 10%; RoE: 9
• Sales: Rs 80 Cr; M-Cap: 37 Cr; Debt: negligible
• Dividends: intermittent in 3 of the past 5 years
• Technicals: fell to the level of the Jan '08 top during the recent correction; seeking support there

Stock 'N' : 30 years old, Indian company with foreign collaboration.

• Equity: Rs 8.5 Cr (Promoters hold 80%); EPS: 30; P/E: 6; NPM: 8%; RoE: 17
• Sales: Rs 190 Cr; M-Cap: 150 Cr; Debt/Equity: less than 10%
• Dividends: rising during past 4 years
• Technicals: fell during the recent correction but remains 60%above the Jan '08 top

Note: Assume all three companies have positive cash flows from operations. NPM = Net Profit Margin; RoE = Return on Equity. The indicated figures are rounded-off.

The reader with the best logical explanation for the choice will be duly acknowledged on my blog. I may or may not agree with the choice.

So put on your thinking caps, and give it your best shot.

How to spot and avoid 'pump and dump' stock scams

Before I explain what a 'pump and dump' stock scam is and how you should avoid it, a brief digression may be in order. Such scams tend to proliferate during a particular environment and state of the stock market. And we are bang in the middle of exactly such an environment.

The Indian stock market has been on a one-way ride upwards ever since the global markets changed trend from bear to bull back in March '09. Stocks in practically all sectors have moved up by leaps and bounds.

The election results in May '09 provided a major boost to the bulls. But after gaining more than 100% from the Mar '09 low of 8000 to the Oct '09 high of 17500, the Sensex has hardly progressed much in the past 6 months. At today's close of 17822, the Sensex has gained a mere 1.8% over its Oct '09 high.

Most of the index stocks and the good non-index stocks have outperformed the index and are trading at prices that are considered 'too expensive' by small investors. Many new investors have heard stories about the phenomenal gains that can be made in stocks and are itching to jump in - or have already done so.

The stage has been set for scamsters to exhibit their bag of tricks. The first stage of the scam is well hidden from the unwary public. Promoters and associates of small, unknown companies trading at low prices join hands with a group of friendly brokers and start buying up their own shares.

Since the floating stock of such companies tend to be small, a few 'buy' orders help to 'pump up' the stock's price, which starts hitting upper circuit limits. A few judicious emails to various Internet investment groups and SMS messages to individuals reveal a huge upcoming order, or a phenomenal new technological breakthrough, or 300% growth in profits in the just-concluded quarter and a likely bonus issue.

That is enough to lure hordes of small investors to place large 'buy' orders in an effort not to miss out on a fantastic multibagger opportunity. The stock continues to hit upper circuits for a few more days. That is when the 'dumping' starts.

The promoters and their friends start unloading the stocks - in small quantities initially, which get easily absorbed in the buying frenzy. Then the big unloading happens, and suddenly the stock starts to hit lower circuits right at the beginning of the trading day. Most small investors are too inexperienced to get out, and remain stuck with large quantities of stocks that soon revert back to their earlier low-price, low-volume status.

The best way to avoid getting caught in a 'pump and dump' scam is to ignore free stock tips from unknown people. If it sounds too good to be true - it usually is. If it concerns a 'penny stock' (i.e. trading below Rs 10 for a stock with a face value of Rs 10) don't give it a second look.

Even if the stock seems interesting and is trading above its face value, don't neglect to do your due diligence. Check the debt/equity ratio and the cash flows from operations. A large debt and negative cash flows from operations are a given for these 'pump and dump' stocks.

Related Post

What does the Debt/Equity ratio indicate?

What does the Interest Coverage Ratio signify?

The Interest Coverage ratio (also called Times Interest Earned) is another measure of a company's financial health. It signifies the ability of a company to meet its debt obligation.

In earlier posts, I have covered Current Ratio, Quick Ratio and Debt/Equity ratio. These financial ratios, together with cash flows from operations give a clear view of the financial soundness of a company.

The definition of the Interest Coverage Ratio is simple enough. It is the EBIT divided by interest expense:

EBIT is the earnings (or Profits) before interest and tax payments. It is calculated by adding the interest expense to the PBT (Profits Before Tax). The PBT and interest figures can be obtained from the Profit and Loss statement in any Annual Report of a company.

Let us look at Maharashtra Seamless' Mar '09 annual figures. PBT was 385 Cr; interest expense was 11.6 Cr. That gives an EBIT of (385+11.6=) 396.6 Cr. The interest coverage ratio is 34.

What does that mean? Maharashtra Seamless can pay its debt obligation 34 times with its earnings before interest and taxes. Let us look at another company - 3i Infotech, which is quite popular with small investors.

PBT was 288.5 Cr; interest expense was 95 Cr for year-ending Mar '09. EBIT = 383.5 Cr, not much lower than that of Maharashtra Seamless. But the difference in the interest coverage ratio is startling - an adequate 4, against a very comfortable 34!

An interest coverage ratio of less than 1.5 means that the company may have trouble meeting its debt obligations and may need to borrow more to pay its previous debts. A ratio less than 2.5 should be treated as a warning sign. Avoid companies with a ratio less than 1.

It is important to check a company's financial health over the past 5 years or more. A decreasing interest coverage ratio - even if it is above the threshold values mentioned - is a red flag. Look for companies with consistency of earnings. They can afford to have a lower interest coverage ratio - though the higher the ratio, the better their financial health.

Conservative investors can use a more stringent ratio, by using only EBI on the numerator. That is, they should deduct the tax amount from EBIT before calculating the Interest Coverage Ratio.

This concludes the series of posts on how to evaluate the financial health of a company. Readers may want to go through an exercise of calculating the financial soundness of stocks in their portfolios. The time spent will be well worth it.

What does the Debt/Equity ratio indicate?

An important measurement of a company's financial health is the Debt/Equity ratio. In an earlier article, I had discussed about assessing a company's financial health by calculating the 'Current ratio' and 'Quick ratio'.

The usually applicable definition of the Debt/Equity ratio is:

Debt/Equity ratio = Total debt / Shareholder's equity

Total debt includes both short term and long term debt, such as, secured and unsecured loans, mortgage payments. Shareholder's equity includes equity shares and reserves. (Preference shares can be a part of debt or of equity, depending on the terms of issue.)

Accountants some times use 'total liabilities' instead of 'total debt' in the Debt/Equity ratio to assess a company's true financial health. There is logic behind such a definition. But we will use the commonly accepted definition mentioned.

What does the Debt/Equity ratio indicate? It measures how much money a company can borrow over the long term without running into payment problems. When a company keeps borrowing, its fixed costs keep increasing due to the interest payments.

Is that a bad thing? Not necessarily. A newly formed company and/or one that is on a high-growth path may not be able to raise much equity capital because of lack of track record or the state of the stock market (or because it has already raised a lot of equity). Recourse to debt may be the only option for growth and survival.

As long as the interest and principal repayment costs can be covered by the cash generated from operations, there should be no problems at all. A company that can earn 17% on every Rupee invested and is able to borrow at 12%, will be foolish not to borrow when business is good. Every additional Rupee earned after fixed costs are covered, goes straight to profits.

Trouble starts when a company tries to grow too fast too soon and takes on too much debt. When the going is good, it can make bumper profits. During a business downturn, the high fixed costs can reduce the earnings drastically. And if a company has a long receivables cycle, or huge inventory (like in manufacturing and retail) then it may face difficulty in making payments, and to make matters even worse, need to borrow more (a la Pantaloon).

Ideally Debt/Equity ratio should be less than 1, and the lower the better. But this is a thumb-rule. For certain industries like auto manufacturing, the ratio can be 2 or more. One needs to make peer comparison in a sector or industry to arrive at typical ratios.

Bloated equity can obviously lower the Debt/Equity ratio. Is that good or bad? Given a choice, I'd prefer a company with high equity than one with high debt. Why? There are no fixed costs involved with equity shares. If business is good, more dividend payout may be involved. If business is bad, dividend payment can be slashed. Interest payments due to high debt will need to be paid regardless.

There are downsides to bloated equity. With too many shares available in the market, stock prices tend to stay depressed. Also, each individual shareholder may end up with a smaller percentage of the company's equity if shares are issued to FIIs and private equity investors. This should not affect small investors holding a couple of hundred shares.

Too small an equity capital restricts the ability of a company to borrow large sums of money. Most loans are sanctioned as a percentage of shareholder's equity. That is why you may find a huge bonus issue (like 5:1 or 10:1) preceding a company's intention to take on a big loan - for growth or an acquisition.

What about companies with Debt/Equity ratio close to zero? These are usually stalwart businesses that have been around for years and generate a huge amount of cash flow from operations. FMCG companies are a good example. Because they are in a mature sector, growth is typically in single digits. Taking on additional debt is meaningless, because internal accruals may be sufficient for any expansion.