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5 Stock Picking Criteria for Those who don’t know much about Stock Analysis & Finance

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.

You devour Buffett’s letters to BRK’s shareholders and can recall his legendary quotes on wealth and investing verbatim.

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.

Is investing tough
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

Example
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.

Tata Motors Interest Burden
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.

Example

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

Cash Flow From Operations
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.

Example

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
Sales & Other Growth
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

Example
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
Glaxo Sales Profit Growth
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.
ITC Sales Profit Growth
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.
Example

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
Bajaj Auto dividends
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.
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Tata Motors DVR – Why is it Rising Faster than shares of Tata Motors?

Recently there has been a lot of noise about reduction in percentage difference (discount) between ordinary shares of Tata Motors and its DVRs.

For those who don’t know, Tata Motors has two kinds of shares listed on exchanges.

Ordinary shares (TTM) …and the DVR shares.

What is a DVR share?

DVRs are a completely different class of shares of a company whose ordinary shares are already listed on exchanges. DVR stands for Differential Voting Rights. It means that when compared to ordinary shares, a DVR carries different voting rights.

In India, it all started in 2008 when Tata Motors became the first Indian company to issue DVRs. The company came out with a Rights Issue where existing investors of TTM, were offered 1 DVR share for every 6 ordinary share held by them. As for the voting rights, one DVR share of Tata Motors has only 10% voting rights of an ordinary share, i.e. you get only one vote for every 10 DVR shares.

Apart from Voting Rights, is there any other difference between a DVR and an Ordinary share?

When you buy DVRs, you have lesser voting rights. And this needs to be compensated for. The shareholders of DVR are entitled to an extra 5% dividend compared to ones given to ordinary shareholders.

Tata Motors DVR Dividend
Dividend History (2010 Onwards) – Tata Motors (Ordinary & DVR shares)
Unlike India, DVRs are used extensively in other countries to prevent hostile takeovers. At times these are used to bring money into the company without significant dilution of promoter’s voting rights. On an average, DVRs trade at a 10%-15% discount to ordinary shares.

Tata Motors – DVR Discount Trend Analysis

Like global peers, TTM-DVR also trades at a discount to ordinary TTM shares. But there is something interesting about this discount. I plotted this discount and found that in past 4 years, this discount has oscillated between 30% to 50%. And this is nowhere close to global average of 10-15%.

As of now, its quite close to its 4 year lows. And this has happened because share prices of DVRs have outpaced that of ordinary shares since start of 2014.

Tata Motors DVR Discount
Discount at which DVR has traded in last 4 years

Now in 2008, when DVR was originally offered, the discount was a reasonable 10%. But over time, this discount kept widening until it reached almost 60% in mid-2013!

And this seems to be against common sense. That is because both DVRs and ordinary shares are based on the same business. Only difference is of the voting rights. And that anyways has been compensated for by a higher dividend promise to DVR holders. Ideally, discount should not be so large.

But in past few weeks, this discount has reduced to 33%. And many market participants now believe that this trend will continue and eventually, discount will settle at levels of 10%-15%. But we must remember that this is not the first time discount has come down. Few years back in 2010, discount had narrowed down to levels below 30%. Even at that time, experts felt that time had come for markets to give more respect to DVRs and that discounts will stabilize at 10-15%. But markets have this uncanny knack of surprising…And it did surprise once again by proving the experts wrong.

Price of DVRs fell and once again, it was available at huge discounts to ordinary shares. As mentioned above, discount almost touched 60%.

This time too, I am not sure if experts have any idea what they are talking about when they say that discounts would further reduce. 🙂

Beware – Controversial Idea Ahead

The last traded price for TTM was Rs 468 and that for DVR was Rs 312. Now simple calculation tells that for gaining ‘a’ vote in Tata Motors’ votings, you will have to shell out Rs 156 extra (468-312). I personally don’t think this makes sense for small investors. It might make some if you have substantial stake in Tata Motors and want to affect company’s decision making. But since you are reading this post on this small website, I assume you don’t have a very big stake in Tata Motors. 😉

I agree that its very important to exercise voting rights if the company is not being managed properly or its taking certain decisions which are not in best interest of minority shareholders. But broadly speaking, Tata Motors is managed decently if not brilliantly. And hence a small investor should not worry too much about his voting rights and consider DVRs as long term bets (if convinced about Tata Motors business).

One is getting the same business at 30% discount with assured higher dividends.

And if the DVR discount was to reduce further, a DVR investor stands to gain further as he will also be earning higher dividends in addition to capital appreciation. And if discount does eventually become insignificant, one can always sell DVRs and buy ordinary shares.

But having said that, please understand that we are not valuing DVR here. We are just discussing the discount at which DVR shares are available. It is very much possible that ordinary shares are over-valued and consequently, DVR may themselves be overvalued.

Why Did DVR Rise Much Faster Than Ordinary Shares in 2014?

The DVR shares have outperformed ordinary shares in last 6 months as evident from graph below:

Tata Motors DVR 2014
Price Appreciation in last 6 months – TTM and DVR

Now the text that follows can be speculative and you should take it with a pinch of salt.

In last week of June 2014, a UK based fund house Knight Assets came out with a recommendation for Tata Motors. It advised the company to list its (planned) new DVR shares on New York Stock Exchange. But it asked Tata Motors to add the words ‘Jaguar Land Rover’ to the name of the DVR before listing. This according to fund would help it correct the big discount which DVR trades at and bring it in line with global averages of 10-15%. And since US markets are more familiar with JLR brands and with the dual-class shares, it would help listing the DVR in US markets.

This possibility of international listing might not be the only reason, but possibly one of the main reasons why DVR prices were running way ahead of ordinary shares.

Another possible reason can be that markets and analysts in general had ignored this stock completely in past few years. And because of this absence from analyst’s radars, it kept going down without any logical reason. Another evidence that markets can be irrational at times.:-)

What do you think? What are your thoughts about DVR shares of Tata Motors?

Disclosure: No positions in both the shares discussed above.

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10 good stocks to buy if markets correct

After witnessing substantial falls in good, stable stocks like Bharti & SBI (Almost 10% in 2 days), it occurred to me that what would happen if suddenly, the markets decide to correct? My first reaction was that I would start picking up good stocks.

 

But what actually happens is that when the markets fall, a large number of stocks start appearing on the buying screen. And because one is spoilt of choices, it becomes very difficult to choose among so many good stocks available at cheap prices. I faced a similar situation in early 2008 when all indices and stocks were falling like there was no tomorrow. But I was lucky to make some money during that period.

So how to be prepared for such falls?

The answer is to have a Stock Watchlist.

It is always wise to be ready to grab an opportunity rather than allowing opportunity to take us by surprise. A watchlist helps in this case. How? Once you create a watch list of great companies, you can monitor these companies. As share prices fall, sooner or later they will become good investments too (in addition to good companies).

Though we do follow a number of stocks mentioned in our Stocks We Stalk section, below is a list of stock which we would be delighted to buy in case market corrects and these stocks are available at lower prices –


Stocks to buy during market corrections

So now we know which stocks we want to buy in case markets correct. So what should we do now? Pray for a major correction, what else? 🙂