CategoryInvestment process

I have been asked via emails and comments on the process I follow in analysing stocks. I have written about my approach earlier, but may have never put it formally in a single post.

My approach essentially consists of the following steps

1. Idea generation – This is typically the first step in the process. It involves searching for undervalued ideas. I do not have a strict formula for the search process. I use icici direct website to run a few screens to generate some ideas. Some of the screens are as follows

PE less than 13
ROE greater than 13%,
debt / Equity less than 0.7

Once I get this list, I export it into excel and then add additional parameters to it such as Net profit performance for last 5 years, ROE for last 5 years etc . A few companies get eliminated at this stage if they had losses for the last few years and have only been profitable for a year or two. Once I have shorter list, I start looking at the Profit and loss statement, Balance sheet and ratios. A few companies get eliminated if I don’t like what I see at this point of time. For ex: If the free cash flow is poor for the company, I will remove the company from the list.

In some cases the elimination is not really scientific and is driven by my whims and fancy ( I am not as rational as I should be). So highly cyclical companies, which seem to have a very low PE due to sudden profit spurt are eliminated if their normalised PE is not attractive. After all this number crunching, I may be left with a 10-12 companies.

Another source of ideas are blogs of other value investors, articles or suggestions by some other investors I admire and follow. If I see them talking about a company, I add it to the list and start investigating it.

2. Annual report review – Once I have a list of interesting ideas, I start scanning the annual reports of these companies to look for any red flags or hidden value. Some companies get eliminated at this stage if I find something fishy. Once I like the numbers I see, I start reading the Annual report from the beginning, starting with the Director’s report, Management discussion etc.

3. Valuation template – Once I have a rough idea of the company and if the company still looks good, I start updating my valuation template. I start with the Quantitative numbers, follow it up with an industry analysis, competitive analysis etc. I keep referring back to the annual report to update the worksheets and answer some of the questions in the template. I also use this stage to generate more questions on the company.

4. Broad research – After updating the basic numbers and the qualitative worksheet, I may end up with some open questions. For ex: How is the industry expected to do over the next few years? . How will competition impact the company etc ?. At this point, I start doing some research on the net to find answers to these questions though I may or may not be successful at this stage in finding answers . I may even download the AR of the main competitors and review it to get a feel of the industry. This stage is fairly unstructured and I just trying to gather as much information about the company and industry as possible

5. Valuation – If I am still comfortable with the company, I start the DCF calculation and other valuation exercises. Over time I have realised the valuation exercise is fairly redundant. If the undervaluation is not perfectly obvious by now, then plugging some numbers and making a bunch of assumptions is not going to make the company an attractive buy. The numbers being plugged into the model are dependent on the qualitative analysis done during previous stages.

During this stage I go through a DCF valuation, comparative valuation and a probability based valuation exercise. If the numbers match with each other in all the approaches, then I am more confident of the Intrinsic value estimates

6. Portfolio inclusion – I typically try to keep 12-15 companies in my portfolio. So if a company has to get added, another has to go out. This prevents my portfolio from becoming a zoo of mediocre ideas. I compare the discount at which the new company is selling to my estimate of the intrinsic value. I then compare this discount with that of the other companies in my portfolio. If the new idea is better than an existing one, then it replaces it. Else I may make just a very small token investment to track the company and wait till it become more attractive or some other company goes out of the portfolio.

Although I have listed the steps in a very linear and logical fashion, in reality it is not so neat. Multiple steps are going on at the same time and I may sometimes skip a step too.

As you can see, the process is a bit elaborate and time consuming. I however do not find it cumbersome as I enjoy doing it.

Come to think of it, why should it be easy? is there any competitive profession in the world where you can make good money without any effort ? why should investing be any different ? Have you ever heard that someone has become a heart surgeon in a day?

Was reading this article – mutual fund NAVs take the plunge. The following caught my eye

“The high erosion in the NAVs is the outcome of heavy concentration by mutual fund industry in sectors like banking, real estate, capital goods, engineering, cement and construction which were going great guns in 2007, but have eroded sharply this year. Most schemes had comfortably ignored sectors like pharma, FMCG and IT, which have started to perform now. So, the funds that failed to tap in these opportunities then are paying a heavy price today.”

The above statement gives me such a feeling of deja-vu. History repeats itself in the stock market, again and again. I saw the same thing happen in 2000 with IT. Most of the mutual funds piled into the IT sector, right before the crash. The same seems to have happened now.

Ofcourse it takes courage of conviction to go against the crowd. It is not rocket science to figure out that a company selling at 70 times earnings could be overvalued. But then most of the fund managers, wanting to keep their jobs are more worried about their quarterly performance than doing well in the long run.

For those who say that the small investor is at a disadvantage v/s the pros, I would say it is complete hogwash. All other factors aside, as a small investor I am personally not forced to invest in the current hot stocks. At the cost of looking like a moron in the short run, I can afford to pickup undervalued scrips which will give me good long term returns. That advantage alone is more than all other advantages the big boys have such as more research, access to management etc.

This rear view approach is however not limited to the big boys alone. Unfortunately a lot of small investors do the same. However if they lose money, they end up blaming everyone except themselves.

I am guilty of doing the same thing in the past. However the sensible thing I did was to blame myself completely for the losses. It is not that I mindlessly go against the crowd ( I wont cross the road with a red signal when everyone else is standing on the sidewalk for the sake of going against the crowd 🙂 ).

If am looking at a company, I need to convince myself why the market is undervaluing the company and what is my variant perception. For stocks which favored by everyone else, I have generally found that the market is either too optimistic or is valuing them fairly and hence it is unlikely that I will make good returns.

In all my posts on investment ideas, I typically refer to the instrinsic value of the company. Although the definition and the concept is deceptively simple, application takes a lifetime.

What is intrinsic value – It is the total free cash flow the company will produce from now to closure of the firm. Discounting these cash flows gives the intrinsic value.

I will not be able to give a complete rundown on the DCF (discounted cash flow) computation. That could be another post, when I am really in mood to bore everyone to tears :). However the formuale for the computations is present in my valuation template – see the tab ‘DCF’

You can find the formulae here. The key parameters are free cash flow, discount rate, terminal values and growth rate. There are volumes written on each parameter and I will not get into the pros and cons of it. Let me give you how I calculate each. You can find the mechanics for each in my worksheets for companies.

Free cash flow = Net profit (after adjusting for all one time gains / losses) + depreciation – maintenance capex

Discount rate = around 12-13 %. That’s the hurdle rate for me. I don’t use any risk premium above that. Discount rate is a research topic in itself. I prefer to use a rough approach though and not tie myself up in academic acrobatics.

Growth – self-explainatory

Terminal value – It is the value of the company from the nth year ( n-1 year are the no. of CAP years) onwards. I would suggest looking at some textbook for more details as it is difficult to explain it in a short post.

I take it as 12 times Free cash flow of the previous year. Simple formulae for terminal value is NOPAT (net operating profit after tax)/ WACC (weighted average cost of capital). However let me warn you that the DCF calculations are very sensitive to the terminal value and it is important to be conservative on this parameter.

Once you have worked these numbers, you can plug them into a spreadsheet and get the intrinsic value. As you can see all these numbers are estimate and hence intrinsic value is an estimate too. The trick is in the assumptions you make. You have to be careful in making conservative assumptions, otherwise the DCF calculation could give you inflated numbers. That’s why a good valuation requires an indepth understanding of the company and its economics.

Discounted cash flow (DCF) analysis is the most fundamental way of calculating the instrinsic value. The other approaches such as PE, relative valuation which depends on comparing the valuation with other companies in the same industry etc are indirect valuation approaches. They can be used an input into the valuation process, but should not be the sole approach

A lot of energy is wasted around discussing the market levels. Short of buying an index, I think if you are focussing on a company, the market levels do not matter. If the company is overvalued in your opinion, the market level will not matter and vice versa. So all the decision is around the stock price and its relationship with the intrinsic value.

That said, it is not easy to ignore the noise. In order to so do, I have modified the way I manage my portfolio and track individual stocks. I have done this also to avoid anchoring to the price at which I buy the stock. To read on anchoring see here

The normal tendency is to look at how the stock has done v/s the price at which it was bought. So I used to get pained if it went below the buy price and happy when it went above. That can mislead us – this is how

Suppose the company you bought came out with results which are poorer than expected. You analyse the results and realize your estimate of the intrinsic value is off by 30%. What should you do ? If you are anchored to the purchase price and if the current price is higher, you tend to discount this information and may continue to hold on to the stock, when a good decision could be to sell.

This is how I currently try to avoid the problem –

I maintain a spreadsheet of all my holding with the following columns

Name
No. of stocks
Intrinsic value estimate
Buy price
Current price
Discount to intrinsic value (intrinsic value- current price / current price)
% gain/ loss

I am constantly looking at the discount to intrinsic value number. If the price drops and the discount is more than 50%, I start buying. If the discount is less than 50%, I sit pat.

After every quarterly/ annual results, I review the instrinic value estimates again and update this number. Check the discount again and buy if below 50%. In addition if I come across some information which I had not considered, I review the instrinsic value again.So the comparison is always to the intrinsic value (which is changing based on new information) and buy/hold or sell decisions are based on the discount to the intrinsic value.

The above ensures that I am not fixated to the current price or market level or what the analysts are saying – Ok I am joking about analysts, I never bother about their opinions (prefer to make my own blunders).

Next post : Adding, selling stocks and adjusting wieghtages