How to identify quality stocks for your portfolio

What you need to invest in the stock market? The simple answer is money, bank account and trading account. If you have all of these three things then you are ready for investing in the stock market. You pick 10 stocks from the market with whatever your selection process is and after a year you found your portfolio had given a return of 20%.

You are excited and you think you have cracked the secret on how to invest successfully in the stock market and you repeat the same stock selection process for the second year. But this time at the end of the second year you notice that your portfolio had lost 40% of value from what you started.

You applied the same process then why did you have different result this time?

If I give one rupee coin to one crore people and ask to flip every single day. If it turns head you win and you get another chance to flip next day. But if it turns tail you lose and you have to give your coin to the winner. On 21st day of this exercise there will be one person standing with one crore rupees as a winner!

Wow!! What a feeling to be crorepati.

This winner might have some skills to flip coin and turn it into heads every time is what you might be thinking. He managed to do this continually 21 times. But can he repeat the same performance again? What are his chances to win second time?

This is how stock market works in the real world. Everyone thinks he can become crorepati in 21 days!

You can pick any random stocks from the market and outperform market returns. But chances of repeating the same results next year are still same, one in ten million (crore).

But there are very few people in the world who are still flipping the coin from the past 57 years! They must be doing something differently then what others aren’t.

If I give you Rs 100,000 to invest in the stock market. Is your process of investment is robust to stay liquid for 50 years without investing another extra rupee from your pocket? If your answer is ‘yes’ then good on you. You have done a good job.

But if your answer is ‘no’ then you need to read this post and refresh your investment process.

Let me divide this investment process into two parts.

  1. Portfolio Management
  2. Stock selection

In this post we will focus on stock selection and I will cover portfolio management in another post.

Stock selection

Stock selection plays critical role in your success in stock investing. I will give 95% weightage to it. There are thousands of stocks listed in the market. Starting from market capital of Rs 10 crore to Rs 500,000 crore. Which one should we go with?

If you’re main goal is to preserve the capital so that you can play this game for longer time then you might think it is better to stay invested with big market cap companies and if you are here to become rich quick then your interest might turn to small or mini companies who are growing their earnings at extraordinary rates.

But both of the above strategies will not keep you motivated to stay invested for 50 years. Lower returns might force you to offload the money from the table and invest somewhere else. And if you are aggressive investor then couple of wrong decisions might wipe all of your money.

There should be a process where our capital is also preserved and we make good returns to stay motivated to keep investing in the stock market.

Looking back into the history of successful investor I found that to become wealthy you do not need 100’s of multibagger. They all generated vast amount of wealth (almost 80% of their wealth) from 3 – 4 multibagger in their whole investing career. So let us focus on the characteristics of these multibagger.

Leverage

We found that multibagger have either no or very less debt. So it is always good to check their debt ratios before investing. There are some exceptions like banks and NBFC’s, the kind of business model these two sector do business there is no way they can be profitable without leveraging.

We selected ONGC and Hindustan Zinc in our 2018 portfolio. So let us check their debt ratio. In 2016 ONGC’s net debt ratio stands at 0.13 times and Hindustan Zinc does not have any debt. So they both pass this leverage test.

It is important to keep check on their debt ratio regularly every quarter and year.

Bharti Airtel use to be considered as multibagger by many investors 10 years back. But not anymore. Compare the price chart from 2017 – 2010 and 2004 – 2010. They have given far good returns from 2004 – 2010 then from 2010 – 2017.

They planned to expand their business in Africa in 2011 and took over a massive debt on their shoulders. If you ask management they will say even today that it was good for company. But if you ask investor who bought its shares in 2010 and still holding in its portfolio waiting for it to turn multibagger had fetched 6% per anum return!

There is nothing wrong or we are against expansion of business. But you should know your limits on how much debt is a good debt or a contingency plan on how they will get rid of those debt. In 2007 their net debt ratio was 0.36 and that has changed to 1.90 in 2016.

Return on Equity (ROE)

This ratio is very important for us while selecting any stock for investment. To us It is the indicator of how much stock value will rise in a year. So if a business is consistently reporting 20% return on equity, its stock value will grow by 20% year after year. And in the long run we believe that stock price follows the intrinsic value.

Hindustan Zinc and Indiabulls Housing pass this test too. But ONGC does not. ONGC is expected to report its ROE around 13% for 2017 financial year. But if oil prices climb 20% – 25% in 2018 than its ROE for 2018 will be around 16%.

So why investors select loss making and lower ROE stocks for their portfolio?

They pick those stocks in the hope that business will turn around or will make higher profits as we expect for ONGC. But there is a difference between our hope and expectations.

We do not have resources similar to brokerage houses who appoint a dedicated analyst for each company and keep track of every single business transaction of company. But we have access to those 47 different analysts’ reports who are following this company closely. All of these analysts have their own independent opinion about ONGC and their rationale behind it. Analyst who are bullish are expecting its earnings to grow by 25% and analysts who are bearish expect only 5% growth in their earnings for 2018.

As a value investor, we found opportunity of making a little value in this expensive market where all the good stocks are trading at premium prices.

Cash Flow

Cash flow statement is the real barometer to judge the performance of any business. A good quality business will generate surplus cash from its operations to pay all of its bills and fund all the expansion plan. Similar to leverage, ignore the banks and NBFC cash flow as they do not generate cash from operations. They generate cash from finance activities.

Hindustan Zinc and ONGC in the past have generated a lot of cash from their operations. The best thing is to compare their net operating cash flow with their reported profits figure. If operating cash flow is below reported profits then be careful. It means the profits have been artificially inflated with the help of accountants.

Conclusion

To keep your game of stock investing alive, fruitful and safe for the long term:

  • Filter your stock selection with the above ratios
  • Look for analysts’ reports or stick to those companies which brokerage houses are following (Build your circle of competence).
  • Buy them only when they are trading within your valuation band. This will help you to buy them at cheap price and will also guide when to sell.
  • Finally manage your portfolio (capital allocation) rationally.