How to pick winners by diligent stock picking ….
In this cacophonic world of breathless headlines , screaming television sound bytes, deafening stock tips and non-stop tickers , nothing could be as boring as diligent investing . Disciplined investing , though dull and boring , can be dis-proportionally rewarding . Returns and excitement hardly go hand-in-hand . Investment ideas greeted by applause seldom makes money . On the other hand , diligent stock picking is a different breed . It is a dull and dry process , rarely evokes excitement and applause , but delivers on its promise unfailingly by measuring up on returns yardstick. Value investors rejoice stock picking for wealth creation . The edifice of stock picking stands on the fundamental principles of stock selection based on long-term value creation. Let us look at some of the essential steps that go into identifying winners that create long-term value to the portfolio.
Narrow down the narrative :
Indian stock market is a colorful universe comprising several sub-segments . They are broadly categorized as large caps , mid , small and micro caps . Large caps belong to over-researched and over-discovered space while the mid and small caps belongs to the under-researched and under-discovered space . For large wealth creating opportunities, one has to dive deep into the under-researched space ( mid and small caps) as the top-end rarely offers under-valued opportunities given the large institutional presence ( FIIs and domestic funds) in that space. In the total listed space of about 4000+ stocks , leaving the top 100 where the institutional interest is the highest , the narrative is more potent and promising in the sub-1000 space immediately following the top 100 given the liquidity related risks in the rest of the space .
Separate the wheat from the chaff :
Having narrowed down the universe , the next step is to arrive at the stock-set that holds the promise . Simple screener would do the job here . The objective here is to filter the high quality companies as a stock-set for further research and tracking. Companies with high return ratios measured by ROCE / ROE , wide operating margin , cleaner balance sheet ( with Nil or low debt /leverage) , above average historic growth rates with long operating history etc will qualify for this list . This list is much more focused and is unlikely to be more than couple of hundreds .
Magic of Margin of Safety :
“Margin of Safety”(MOS) has been called the three most important words in investing by Benjamin Graham and Warren Buffett . It represents buying a stock at a bargain price at much below its intrinsic worth. Great investment opportunities come around when excellent companies are surrounded by unusual circumstances that cause the stock to be mispriced to give significant margin-of-safety . Objective here is to look for companies from the shortlisted stock-set that are surrounded by unfavourable circumstances and going thro’ short-term troubles . Markets in its short-sighted wisdom do not look beyond few quarters and hence penalize such companies facing short-term headwinds , resulting in a great investment opportunities for long-sighted value investors . Work of MOS is most magical as it provides safety cushion from downside during the downturn while providing much needed upward thrust during recovery (rerating ) time i.e. market catches up with the MOS first and then rerates , thus giving a double kicker .
Digging deeper by due-diligence :
Once companies going thro’ unfavorable circumstances are identified , the next step is to run them thro’ a due-diligence model to qualify them for investment . This model in general revolves around four dimensions of evaluation . The first and most crucial is the Business evaluation , followed by financial , management and then finally by market evaluation. Assessing the health and quality of the business is the critical task of this due diligence . The objective is to check whether the underlying business possesses superior economics of business with high pricing power , robust return ratios and wide operating margin supported by growing free cash flows . If the answer to this yes and if it ticks the other dimensions as well with high score , then we have bumped on to a hidden gem .
Scuttlebutt research :
This final step refers to some informal checks on the company’s management and its business thro’ the company’s eco-system of employees , ex-employees , partners , distributors etc . The objective here is to identify glaring gaps if any that can’t be found from published reports . This is again a very critical part of research to validate and ratify the observations and findings from the due-diligence.
It is the not that the process outlined above is fool-proof . But , if practiced religiously and rigorously for stock picking , it can create long-term wealth by identifying many hidden gems.
Happy Value Investing !!
ArunaGiri . N