Hope you enjoyed reading the last one (Value-investing-2) and trust it helped you understand the concept. We will now start with the first step of value investing which is the stock selection. It is a process to identify stocks which qualify for minimum acceptable values for various financial parameters. To do this we first need to understand what are those critical parameters one must look at.
We are all always interested in knowing future and I will, therefore, take the liberty of digressing a bit here.
Being a student of astrology for some years now and having attained some proficiency, I find striking similarities in astrology and stock investing. I will try to bring out a few below:
| Astrology | Stock investing |
| It is more of an art than science (Basic assumptions not proven yet by modern science. So one may not agree to call it science in the first place) | It is as much art as science. |
| Too many permutation combinations of affecting factors viz. Nine planets, twelve houses, twelve rashi and 27 nakshatras | So many affecting factors viz. financial parameters, industrial sectors, economic factors, social and global factors |
| It requires a lot of experience to identify striking and controlling features of the Kundali and disregard superfluous data. To filter the noise – so to speak | Same here |
| Every Kundali is unique and so is every person | Every company is unique |
| There are ups and downs | There are ups and downs |
| Often one predominant factor has the capacity to make or break despite many other positive factors. | Same here. Recall Satyam, IL&FS, Kodak |
| No one has been able to predict with perfection. Generally 60-70% true predictions | Same here |
Interesting. Isn’t it?
For understanding different financial parameters, let us first look at the categorization of companies by size and sector. It is for the reason that the rules apply differently to a set of companies falling in a particular business sector and company size. We generally know about different industrial sectors like Banking, NBFCs (Non-banking financial companies), Pharma, Auto, Engineering, Chemicals, IT, Metals, utilities etc. Most of us also understand the small-caps, midcaps and large-caps. However, for the sake of clarity, let me explain the generally accepted criteria. In order to do that we need to understand what is market capitalization.Market capitalization is simply the product of share price and a number of shares issued by Company. For example, if a company has issued 10 crore shares and the share is quoting at Rs. 100, then the market capitalization of the company would be 10X100=1000 crores. As the share prices keep changing, the market capitalization keeps changing too.Smallcaps- Market capitalization of Rs. 4000 crores or less: These are companies in the nascent stage. The business is not established but are fast growers. Alternately, some of these operate in a very small sector and there is not much growth potential. These are riskiest of the three categories but have the potential to offer big gains. Only a few of these graduate to the next level of midcaps but those which do, grow multifold. Generally, investment advisors recommend investing in small-caps only up to 10% of the portfolio. However, it depends on individual risk appetite. I’m having 55% of smallcaps in my portfolio (Being already through with my retirement planning).Midcaps- Market capitalization above 4000 crores but less than 20,000 crores: These are fairly established businesses, mostly dividend paying and capacity to grow further depending on economy and management vision.Largecaps- Market capitalization above Rs. 20,000 crores: These are well-established businesses, are in existence for years and are market leaders. That is why are called blue chips.
Below are tabulated characteristics of the three categories for easy comparison.
| Characteristic | Largecaps | Midcaps | Smallcaps |
| Market Capitalization (Crores) | >20,000 | 4000 – 20000 | <4000 |
| Business | Well established | fairly stabilized | Under stabilization |
| Risk | Safe | Riskier than largecaps | potentially risky |
| Growth | Limited | Faster growing | Have best growth potential |
| Returns | 15% or thereof | Could be up to 25% | Can be multi-baggers |
| Recommended portfolio weight | 60% | 30% | 10% |
| Financial parameters | Generally very good | Good | Generally not very good but improving yearly |
| Dividend | Generally pay good dividends | Some companies pay dividends but less percentage | Very few pay dividends. |
Now as we have a good idea of company categorization by market capitalization and industry, let us look at how the mutual funds are categorized. Mutual funds are nothing but specialized portfolios managed by experts. Investing through mutual funds saves you the trouble of (If you consider it trouble – I derive lot of pleasure out of it) closely looking into financial parameters of each individual stock. That is done by the fund manager. Mutual funds are also categorized as large-cap, midcap and smallcap funds under equity funds. In addition, there are sectoral funds like pharma, banking, auto etc having portfolio limited to that sector. There are also the debt funds, tax-saving funds (ELSS), Hybrid funds and arbitrage funds. Each fund caters to different consumer requirements and it is wise to choose as per requirement and risk appetite.
Now to decide upon the stock, various financial parameters to be looked at for that stock are (as a minimum) as below:
Business Related
- Easily understandable business
- Management quality
- Equity capital & Promotor shareholding
- Sales and growth (Same as topline and growth)
- EBIDTA margin and growth
- Net profit margin and growth (same as bottom line and growth)
- Debt to equity
- Book Value
- EPS, ROE & ROCE
Risk Analysis
- Regulatory risks
- Cyclicality risk
- Competition risks
- Transparency Risk
- Capital allocation risk
- Debt & interest coverage risks
Valuation Related
- P/E (Current, historical and industry)
- PEG (Price to earnings growth)
- Cash flow & Intrinsic Value Calculation (by discounted cash flow, Ben Graham formula, Dhando formula)
Quite a list. But do not get overawed. It’s really very interesting and gets easier as you learn.
In the next issue, we will discuss at length and try to understand each one of these parameters and why they are important.
Please do write back with your comments and suggestions. That will be my motivation.
Happy Investing
bhushan
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