The market is trading above 7700 today after falling down as low to 6800 this year. On a macroeconomic level the earnings of corporate are expected to rise marginally, inflation is under control, there are many new regulations which are due to become law, banks are facing NPA issues and oil is still trading at lower price. What many investors are looking forward is to RBI cut the interest rates so that values emerge from the assets and growth engine stems up. (We did talked about interest rate rally recently on this blog. Click here to read that blog)

But none of the above macroeconomics should be relevant to investors who focus on quality businesses. Those investors would have not held no Reliance Industries, no Bharti Airtel, and no Tata Steel. The way to outperform the market this financial year is to avoid those companies conventionally referred as blue chip business and instead buy the businesses that we talk about as a quality business.

Beating the market is possible, but what is required is a portfolio that looks very different to market index.

The question you may ask now is what the characteristics are of quality business and is there any reasonable value available in the market now?

The key ingredient when determining quality is quite straightforward. You need to be invested in the businesses that can retain large amounts of their profits or large amount of capital, and they must be able to generate high returns on that capital without the help of debt. In short it is better to own a small business generating higher returns on incremental equity then having large businesses that generate low or mediocre returns on their incremental equity.

Same time it is also important that these businesses can sustain those attractive rates. And that is easier said than done. High rates of return are bound to attract competition and those competitors won’t rest in trying to take customers from the incumbent business. In order to save themselves from this competition threat, the business should have sustainable competitive edge. Usually that is something which is not replicable. It could be reputation, geographical location, popularity or historical cost advantages. The most valuable competitive edge is something that gives the business ability to charge higher price without any detrimental impact on unit sales volume.

With those elements in mind, the following companies are worth mentioning, Amar Raja, Kitex garment, Lupin, MRF, TCS and UPL. The list, of course, is not exhaustive but it is a good start for you to begin your research.

In addition to high quality as discussed above, it is also important that business possess bright prospects for its products in the future. Without bright prospects for the future, you might identify business that only looks wonderful in the rear view mirror.

Finally, it is essential that company’s shares are trading at reasonable price. We determine this by comparing the price to an estimate of what we believe the company is worth on a per share basis. So for every company we invest in, we estimate something called intrinsic value.

The question that remains is: are there currently any companies that are both good quality and cheap?

From our universe of investments, there are not many businesses that are trading below our estimate intrinsic value. It means market is expensive and at risk of weakness. Given that caveat, some of the following companies do appear to be below our estimate of their value; Alembic Pharma, Coal India, Indiabulls Housing finance, JK Bank, Kitex Garment, MRF, Power finance Corp, TCS and Zensar Technologies.

Keep in mind, estimating a company’s intrinsic value is not same as predicting its share price. Even though the share price might be below our estimate of its value, that does not mean the shares are immune from declines. We cannot predict what share price will do and that is why it’s useful to ask your adviser to buy only when the shares are at a very large discounts to its estimate value. Oh, and don’t forget valuations can change too. They change much more slowly than share prices but they do change. For the sort of business we want to invest in, intrinsic values should be rising over time.

Aziz Dodhiya is the chief investment officer for the Valueoperations funds which operates in the Indian market as an FPI (Foreign Portfolio Investor). We do not offer any personal advice to buy or sell any stocks and the views that are shared by Aziz might not incline to your personal investment strategy and this is the reason we advise you to take professional advice before going ahead with our views.