Note – This is a guest post by Anoop. Anoop refers to himself as a work-in-progress investor, who combines fundamental value principles with a mildly contrarian streak. He believes a large part of investing success depends on overcoming our behavioral biases. Read more about him at The Calm Investor.
You subscribe to websites and blogs that focus on “Value Investing”.
Your twitter list is full of people who comment on capital market topics ranging from macroeconomics to investing advice.
You’ve read “The Intelligent Investor”, the timeless classic by Ben Graham from cover to cover.
Except, you’re a science / engineering / philosophy / (other non-finance) major and didn’t learn about balance sheets in college. You sometimes unsuccessfully stifle a yawn when hearing about “stock buybacks” and “convertible debentures”. Phrases like “capitalized expenses” and “adjustments for extraordinary income” make the task of identifying strong investment-worthy companies sound as difficult as trying to pilot a commercial aircraft, without the training.
Most of all, you wish there was a way to bridge the gap between the abundantly available philosophy of sound investing with more practical ways to identify your own set of stocks in the Indian market.
While each investor evolves their own investing strategy, here are five specific things an investor should consider before deciding on investing in a company:
1) Not a Serial Borrower
Growing up in India, we’re brought up to be reluctant borrowers, with good reason. A loan is a promise to pay back the borrowed money over a set time period with cost of the borrowed money in the form of interest.
Just like other expenses can’t get in the way of making an EMI payment, in a corporate setting, a debt-holder has first claim on the company’s profits. Only after the interest is paid do the equity shareholders have access to the profit pool. To make matters worse, in a “poor” year when sales and profits dip, the debt-holder can choose to sell off the company’s assets to make his money back, in the process liquidating your investment.
Since every company is almost certain to face lean times depending on economic cycles, a company that borrows consistently is a higher risk investment than one that does not.
Where to look:
On the Profit & Loss statement, look for the ‘Interest’ payment and compare it to ‘Profit before Depreciation, Interest and Tax’ (PBDIT). If the Interest payment constitutes a significant percentage of PBDIT, that’s a warning sign that the company has large borrowing and might be a risky equity investment
Tata Motors shows an increasing debt burden, interest as percentage of PBDIT increasing from 2010 to 2014. Note how the interest payments have not varied significantly year-on-year, the sharp drop in profits means added pressure on being able to make interest payments.
2) Busy Cash Registers
Next time you go to a busy Udipi restaurant at lunchtime, notice the frenetic activity in the place. Customers walk in, are quickly directed to tables, their orders taken, food served usually in under 10 mins. They are out the door soon after, their money making its way into the cash register manned by the watchful proprietor overseeing the entire operation. Pay attention and you’ll hear the slamming of the cash register quite a few times in the short space of time you wait for your meal.
Now imagine if you walked up to this gentleman and offered to bring him your lunch business every day for the next year. He’ll be pretty happy about that. But then you add that you will only pay at the end of the year, if you have the money. You don’t need to be a master investor to guess the proprietor’s reaction to such a proposal. You’ll need to find a new lunch place.
Many publicly listed businesses however routinely use such practices, albeit in more sophisticated form, in order to show sales and accounting profit growth. Simply put, they show earnings and profits that are not a reality in the present and are only a probability at some time in the future.
A company that generates cash earnings from its core business that are reasonably close to its accounting earnings is a healthier and safer investment
Where to look:
On the Cash-Flow Statement, look for ‘Cash Flow from Operations’ (CFO) over a five year period and compare against PBDIT on the P&L statement. While CFO will not likely match PBDIT, ideally, you want to see it constitute a significant part of accounting earnings.
The cement manufacturer, Grasim Industries, shows an alarming decline in cash generated from operations even as it’s PBDIT has declined at a much slower rate, raising questions about the health of its core business
3) Grows, but without Steroids
As of early March 2015, the Nifty is trading at a Price-Earnings (P/E) of 23.14. Another way to think about this is that we pay ₹23.14 for every ₹1 in earnings being delivered.
Think about that for a second. If I offered to pay you ₹1 on March 31st each year for the foreseeable future in exchange for a one-time payment today of ₹23, how would you react? Doesn’t look like a good deal. Instead, if I offered you ₹1 growing at a steady rate of 10% per year each year for the next 20 or so years, you’d be receiving ₹1.61 by year 5, ₹2.60 by year 10 thus making it a much more attractive proposition.
The prospect of future earnings growth plays a large part in determining price of a share and a company that has significant growth prospects is a far more attractive investment than one with the same current earnings but no growth prospects.
The impact of reported quarterly earnings growth on stock prices is not lost on company managements. So they often apply methods ranging from short-term focused (e.g. dropping price for volume growth, deferring essential investment) to downright unethical (e.g. accounting sleight of hand to capitalize operating expenses) to show growth. An investor should therefore look beyond just Earnings per Share (EPS) growth while assessing the growth track record of a company.
Where to look:
Since any estimate of the future is already wrong, look at growth rates over the last five years; revenue, operating profit, earnings per share and cash-flow from operations. Specifically look for deviations across these metrics, a high revenue growth rate with stagnating operating profit or declining cash-flows might signal management is facing challenges with growing profitably.
The Aditya Birla Group’s flagship company Hindalcohas shown reasonable sales growth over the last 5 years, however other metrics like PBDIT, Dividend / share and Earnings / share have dipped over the same time period indicating worsening efficiency of running the business thus putting pressure on returns to shareholders
4) Boring in its Consistency
“In fiction: we find the predictable boring. In real life: we find the unpredictable terrifying.”
― Mokokoma Mokhonoana
Replace “real life” with “investing” and the quote still holds. While it’s exciting to not know what’s coming as you turn the pages of a murder mystery or a political thriller, you can do without that kind of excitement from the companies you invest in. A company that shows 40% growth in sales and earnings one quarter and a 70% drop the next might be a good business, but the difficulty in arriving at a fair value for such a company with any kind of confidence makes it a questionable common stock investment.
Mind you, consistency in this context doesn’t mean sameness or lack of growth, but a steadily increasing graph of the key measures of revenue and earnings, accounting as well as in cash. Look carefully and there a significant number of such companies that show dependable growth, margins and earnings.
What if the sector that the company operates in has inherent unpredictability? It’s hardly the management’s fault you might say. You’re right, but as an investor, you have the luxury of letting as many potential investments go by as you please until you find the ones that check all your boxes.
While consistency on its own does not make a good investment, a company that measures up well on your other criteria while also being operationally consistent is a safer investment.
Where to look:
Instead of absolute numbers, look at the extent to which key metrics on the P&L and Cash-flow statements change one year to the next
Glaxo Smithkline shows significant variation in growth rates from one year to the next as shown by the trend lines. This volatility makes it difficult for an investor to predict what might be coming over the next few years
Compare GSK’s growth rates to ITCand you see more consistent growth one year to the next as demonstrated by the more stable trend lines.
5) Offers (some) Yield
So far, none of the points made touch upon the all-important aspect of “price” of a stock. This one does, but in an indirect manner.
Investing is all about opportunity cost: “What else could I be doing or earning with the money I choose to invest in a stock?”
Before choosing to invest ₹100 in the stock of a company, you could choose to spend it on watching a movie, put it in a Fixed Deposit to earn an annual interest rate of ~9% or leave it in your savings account giving you flexibility to choose later but also earn ~4%.
Yield refers to the annual payment that the company pays out, in the form of dividends as a percentage of the price of the stock. Given that the primary reason for buying a stock is the gradual but significant expected price appreciation over time, an investor can’t expect high annual yields. However, can a stock compensate me, at least partly, for the loss of flexibility of having access to my money?
As of 16th March 2015, the Nifty’s yield stood at 1.27. Simply put, you get ₹1.27 as annual dividend for ₹100 you invest. As you’d expect, this number varies when considered at a stock-specific level.
Since dividend policies do not change frequently, even a modest but regular yield represents a prudent management that works to ensure that there are enough “cash earnings” to pay out dividends regularly.
Think of it like the test email that you send yourself to ensure your email account and the 3G phone connection are working fine. Regular dividends serve as a reminder that the business is operating as it should. As long as the company is not borrowing to pay out dividends, a steady dividend is a healthy sign.
Where to look:
Look for total ‘Equity Dividend’ paid out as a percentage of Net profit and Cash Flow from Operations over a period of time.
Bajaj Auto is a consistent dividend payer as shown by the table below. It has maintained a steady payout as a percentage of both net profit and cash flow from operations indicating sustainability. When seen in the context of the prevailing share price, the company has managed to provide a yield of just under 3% which is close to the post-tax interest from a savings account
While identifying a great stock involves other factors, including qualitative aspects of the industry and a generous dose of luck, for the long-term investor, investing in stocks that do well on the criteria above, offers a good probability of healthy returns.