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Mailbag: Why do you choose such simple criterias for shortlisting stocks?

We received a question in comment section of our last post on selecting 10 stocks to buy in next market crash. The question asked was very simple, but relevant…

 
“Why do you guys choose such simple filters for shortlisting stocks? There are more comprehensive and well proven methods of doing the same.”
We will first explain a little about these 5 filters and then answer the question –
 
Filter 1: Management (Atleast Decent)
 
The last two words of this filter, ‘atleast decent’, make this a completely subjective criteria. We believe that we are average investors. Hence, we are the last ones to receive company / promoter related news, leave alone insider information. Hence, in the event we do come to know that management is not trustworthy (read decent), then it means that there is more negative news which has not even come out in public domain. Isn’t it? Hence, we will prefer to stick with companies with ‘known decent’ promoters / management.
 
Filter 2: Not Highly Cyclical
 
Some experts say that one should buy cyclical business at high PEs. It is at these times, when things are about to turn around for better. They may be right. And sometimes, it seems logical on face value of the argument. But we are not sure. Frankly, we haven’t devoted adequate time to analyzing cyclical businesses. And hence, we don’t understand them too well. Also, highly cyclical businesses are highly uncertain. Such companies are at the mercy of the economic cycles. So it’s better that we avoid such companies.
 
Filter 3: Atleast Average Growth Potential
 
If the underlying business does not have any growth potential, then how can we expect the stock to move up? We should never forget how Kodak, a great company which did not embrace the advent of digital photography and how it paid the price with its bankruptcy.
 
Filter 4: God Dividend Record
 
We just love dividends. That is all we have to say. 🙂 But we have a reason for it. You can read it here.
 
Filter 5: Are we ready to hold the stock for 10 Years?
 
Mr Buffett once remarked, “Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.”Being self-claimed long term investors, we ourselves would like to hold stocks of great businesses. We would love to act like owners of companies. And when a great company is going through tough times, the owners don’t sell and runaway. They stick with it. They know that when times will change, the company would be back. And in a much better shape.
 
So now, we are back to our original question…
 
Why do we use such simple filters??
 
The primary reason for using such simple filters is that these have worked for us. It is easier to evaluate stocks on these filters than more complex quantitative ones. Though we do use such quantitative metrics in our case studies of individual stocks, we always prefer to keep things simple. We try to stick with proven businesses. We try to find indicators of overall pessimism in the market, so that we can be a little sure that we are being greedy when others are fearful. We know that by following these filters, we are simply eliminating the possibility of finding those 50 and 100 baggers. We are restricting ourselves to a very small universe of 40 (or max 50) stocks. But we accept this tradeoff. We don’t want to lose money in stock markets by taking very risky bets. We know what we are good at and we will prefer sticking to our strengths. Over time, we will increase our expertise in other areas and may be, would be able to find the next multibagger. As of now, we are happy to lay a strong foundation for our long term portfolio.
 
We hope this post clarifies the doubt which our reader(s) had. 🙂
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Best Nifty Stocks and 3 questions that let us shortlist them

Taking cues from Morgan Stanley’s ‘Connecting the Dots’ (June 2012), we decided to shortlist our own set of dependable stocks. For this we used following filters –


Filter 1: Is the Sales growth faster than nominal GDP growth?
This can be achieved by either being a part of a fast growing industry and/or gaining market share within the industry.

Filter 2: Is Profit growth faster than Sales growth?
This signifies a combination of several dimensions like market dominance, pricing power, better cost management, judicious investments and right mix of debt and equity.

Filter 3: Is Earnings per Share (EPS) growth broadly in line with Profit growth?
This signifies that growth and capital efficiency are linked. This also indicates whether an individual shareholder participates proportionately in company’s growth or not.

After shortlisting stocks by using the 3 filters, we added information about Return on Equity (RoE), Debt/Equity (D/E) & Dividend Yield (DY) as these are information which should be looked into before taking a final call to buy any stock.

We started with a universe of 50 safe large cap stocks which form the Nifty50. After putting Filter 1, we were left with 35 stocks. On putting Filter 2, we were left with 19 stocks. Final filter resulted in shortlisting of 13 stocks, which met all three criterias.

During last 3 years, average sales growth of these 13 stocks was 22.10%, which was much above the nominal GDP growth rate of 13 percent. Average Profit growth for these stocks was 31.40% & EPS grew at an astounding CAGR of 33.40%.

So, without much delay, we present the 13 rock solid and dependable stocks of Indian markets…
  • TCS
  • ITC
  • HDFC Bank
  • Wipro
  • BHEL
  • Power Grid
  • Bajaj Auto
  • Kotak Mahindra Bank
  • Axis Bank
  • Hero Motocorp
  • Asian Paints
  • Bank of Baroda
  • IDFC

How these 13 stocks fared on 3 criterias is detailed in table below –

During the last 3 years, an investment made in portfolio of these 13 stocks would have given a market beating return of 17.90% (CAGR)

Only one stock, BHEL, gave negative returns (-17.34%) in this period. Overall market returned a meager 3.73%. This portfolio outperformed the market by 14% + (!!).


A snapshot & analysis of all 50 stocks can be found below. Please click the image to enlarge.

Click to enlarge
Caution – This is not a recommendationto BUY any of these stocks. We have not considered valuations of these stocks in the post. So do your due diligence before buying any of these stocks. Also, past performance is no guarantee of future results.

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