DIGGING DEEPER IN TO STOCK SELECTION

In my column titled Stock Selection- The most Important Number (Moneylife Issue dated http://www.moneylife.in/article/stock-selection-the-most-important-number/31230.html) I had talked about the importance I hold for ROE and the fact that most MNCs have delivered on this front. One of our readers wrote in about: i) ii) iii) How much returns were delivered by HUL in the last five years; How to detect accounting shenanigans with respect to ROE; and Which cash flow measures can an investor use, from the data available in the BSE website?

The ROE approach will help us to make a short list of high quality stocks. It does not mean that we should rush to buy it without looking at the price. All that the ROE criterion will help is to identify high quality stocks. The price at which one buys is critical. So I cannot comment on what returns a stock gave from one point to another. If I make a list and buy it at any price, it is senseless. The time to buy is a difficult call to take, when it comes to high quality stocks. In a falling market, they seem to hold their own, in a bearish market there is a flight to quality which pushes the prices higher and in a bull market, they can get neglected. I have seen that when people believe that the tree will rise in to the sky, the money usually chases momentum stocks, like it happened in 2007-08. At that time, there is generally neglect of the high quality stocks and could present buying opportunities. This happens when there is a disappointment about the earnings due to a slowdown or their inability to pass on cost increases. I have observed that sometimes there is an overreaction to negative surprises and there could be buying opportunities. I tend to get too conservative in my approach to buying high quality stocks. I like to look at how many times its book value (Share capital plus reserves as a total, divided by the number of shares) the share trades. I also like to believe that around seven to eight percent of ROE represents a fair price or a buying price that equals one time book value. So if a company earns 24 percent ROE, I do not mind paying three times book value. This is because I assume that the long term risk free return is eight percent per annum. If a quality stock is available at this level, it is a very juicy buy. Buying at precisely this point means that there is no premium at all for growth in earnings. Growth would have two components. One is on account of inflation and the other driven by volume. So even if a company is not growing by volumes, it can still show some growth on account of inflation. In nominal terms, the average growth in sales and profits should equal to the growth in GDP plus the inflation. If we pick up investments that beat the average, we are fortunate. An interesting analysis of last twenty years of profits showed that only 11 percent of the total listed universe delivered better returns than the index returns!! This means that almost ninety percent delivered returns equal to or poorer than the index!! Our probability of picking up winners is just ten percent!!

If a company delivers a consistent return of fifty percent on shareholder funds and pays out forty percent of the profits as dividend, each year, the shareholder funds triple in five years! At twenty five percent returns, it would become less than double. At a ten percent return, there would be only a twenty percent increase. Accounting is another area that the reader has touched upon. Whilst there is no immunity against a perfectly structured fraud, the following points should help to mitigate the risk: i) ii) iii) iv) v) vi) vii) viii) ix) x) xi) xii) A track record that is at least ten years old. I prefer fifteen; No issuance of new equity or convertibles as far as possible; Tax payout at the highest corporate rate of taxation; Consistent dividend payout; Promoter holding of at least thirty percent is good; No pledge of promoter holdings; As low debt as possible. I prefer total debt to be less than half of shareholder funds; As few subsidiaries as possible; Not more than one acquisition of another company in a ten year span. I do not mind a couple of small acquisitions, but would like to examine; No merger of wholly owned promoter companies; Increase in turnover year on year should exceed the increase in fixed assets. A stable business should not demand much capital expenditure on an ongoing basis; No change in auditors.

These are some broad checks only. There are nearly 2000 data points in analysing a balance sheet!! In addition, there is management reputation and history to be considered. All of us instinctively sort companies in to some category of trustworthiness. As regards cash flow, I am a strong believer that profits in the books should be demonstrated by the cash flow. One simple test would be to take the following numbers from the publicly available data: Profit after Taxes minus Dividend plus Changes in working capital should be a positive number in at least eight out of ten years. If not, then it calls for some detailed analyses. In short we are trying to find out how efficient the company is, in its business dealings. Working capital is the amount the company has blocked in to debtors, inventory etc and the entire number comprises of current assets plus loans and advances given out. As against this the company enjoys some credit and can get a privilege to pay some expenses with a time lag. These are displayed or reported under the head, Current Liabilities and Provisions. The difference between the Current Assets and Current Liabilities is called the net working capital. As the business grows, it is natural that both the numbers expand. However, when the expansion of this need is greater than the cash generated by the business, after paying dividends, it means that the company is going to suffer a decline in profitability. I do not deliberately consider depreciation as a cash flow for my assumptions since that cash is always needed to refurbish the assets. In addition, I like to read the auditor comments and look for any clues there, including changes in accounting policies, any differences in valuation methods or any divergences that are stated to be in

conflict with accounting standards. I do not bother to read the directors report or the other voluminous speech. It is hardly ever that a company will put in writing anything bad about itself. So why waste time on reading it? Anything that has to be said should be said by the numbers. These are some of the broad points and should not be construed to be the be all and end all for stock picking. Fundamental analysis, market technicals and patience are needed. Stocks cannot be bought simply because one has money to invest. Till you spot opportunities, keep the money in a liquid fund. If you do not have the patience and the ability, then it is better to stick to mutual funds and take the SIP route. The other caution in the above approach is that for new companies, it will not work. There one is a venture capitalist and takes a far higher risk, with the potential of higher reward. My framework will work where there is predictability about the business and the industry. So, it may work better for industries that gain from consumer spending rather than from industrial customers. Further, my framework limits my stock picking universe to a very small number. It does not mean that there is no scope outside of it. I tend to be ultra conservative and my approach to stocks may not be suitable for all persons. Money put in to stocks is money I can ignore without worrying. It is not money I put by for building a house or meeting education or marriage expenses. For that I prefer to be in to fixed income investments. Money in stocks is a wealth builder and not a savings instrument. Only after ten or twenty years will I pause and see what I have made out of my investment in stocks and maybe think about what I want to do with the money. I buy stocks with expectation of value appreciation and not to meet a specific spending goal. R. Balakrishnan (balakrishnanr@gmail.com) February 15, 2013