Value Investing-4

Welcome to this fourth issue on value investing.
As brought out earlier, value investing is a process of selecting good stocks (looking for inherent strength), evaluating if these are available cheap (Valuation) and then buying and holding them for a long term. Periodic monitoring, of course, is a must.
You must have frequently come across stock tips by big investors, banks, brokerage houses and friends.  Each of the tip providers has his own reasoning for his recommendations and they all follow some process. However one must evaluate such recommendations for himself before making an investment decision. The process outlined above will help you to evaluate these tips on the basis of time tested financial and other parameters to make that decision. We will now look at the process in detail.
There are numerous parameters used by financial analysts to evaluate stocks. However, a few important ones listed below can get us 80% information required to make a decision. I had listed a few “Business-related” and “Value related” indicators in the last issue. Let us try to understand the first category. 
Before we get down to understanding financial parameters, a word here about industry types and typical challenges faced by each industry will not be out of place. One must keep in mind that passing values for these parameters differ significantly with the type of industries. For example, the margins in IT & FMCG (Fast moving consumer goods – Nestle, Hindustan lever, etc.) are generally much higher compared to manufacturing. Also, IT and FMCGs are generally debt free, dividend-paying and have the best of financial parameters across industries. Top performers from the IT sector, therefore, figure in the “Blue chips” group. But, here is the catch. These are rarely, if at all, available at cheap valuations (high P/E ratio among other valuation parameters – P/E ratio is the ratio of price to earnings. Will see in detail later). In comparison, engineering, manufacturing, auto, banking & NBFCs have lower margins and have high debt levels. But these are more likely to be available cheap. For example, after the recent Il&FS fiasco a few of the banking and NBFC stocks tumbled to very low levels and were available cheap in October-January period. These have since recovered in the last one month. Some of them are listed below. (https://www.businesstoday.in/opinion/prosaic-view/infrastructure-leasing-and-finance-debt-fiasco-not-a-lehman-moment-for-india-but-a-wakeup-call-for-the-government/story/282997.html)

Company	52 week low Rs.	Current price Rs.	% rise
Yes Bank	147	277	88.4
Indostar capital	275	422	53.4
LIC housing finance	387	539	39.2
Repco home	293	464	58.4
IDFC First bank	33	56	69.7
Can fin homes	216	359	66.2
Federal Bank	67	98	46.3

Mind you, it was only the extremely negative sentiment, fear and panic which made these stocks crash to ridiculously low valuations. No change in fundamentals at all. I have only listed the stocks above that I hold in my portfolio and monitor closely. There are many others which have staged a smart recovery. The example is to show you how stocks recover remarkably once the market sentiment changes. The stocks that are fundamentally sound are the first to recover. There is still a lot of steam left in these stocks but the valuations are now not as mouthwatering as they were a little while ago and these are all fundamentally strong stocks. To caution you, I also have Il&FS in my portfolio bought ar Rs. 111 and currently quoting at Rs. 6. There will always be some such black swan cases.

Be greedy when others are fearful and be fearful when others are greedy.

Warren Buffet

This simply means that the best strategy is to identify fundamentally strong stocks and wait for the valuations to turn favourable (cheap) to buy (when markets are down and everybody is fearful and selling and none is talking about stocks) and hold till market goes up and valuation turns steep to sell (when there is a buying frenzy in the market and every tom dick and harry has a stock tip to share). There are also stocks which one can hold across market cycles which continue to report good financials year after year and which you may keep permanently in your portfolio.
We are currently some distance above the lower end of this market cycle. The next two years are likely to be exciting.  At the height of the cycle, people will be mad about stocks before the next crash happens. This happens again and again so you will get opportunities if you are ready with your ammunition (i.e. knowledge, analysis, patience & capital) when the time comes to fire.
Lets now get down to serious business of learning about these parameters.

Business-related Parameters-Easily understandable business: This is the first requirement of the Warren Buffet and Peter Lynch for stock selection. Choose a stock which has a business you can understand. For example, the requirement for cars and scooters in India will always go up with population and earning. Same will be true for housing loans, car loans, scooter loans, the same will be true for auto parts, tyres, paints etc. So it is easy to understand what is selling most in the market and look for companies providing it. Engineering, steel and cement demand will largely depend on infrastructure requirement and budgets allocated. Peter Lynch states in his book that most of the investing ideas come from keeping eyes open to what is happening around you and from common people. He got some of the best ideas from casual conversations with his wife. Of course, rigorous research has to follow to convert these leads to investment decisions. Warren Buffet, in fact, was very strict about this aspect and he did not invest in Apple or Google because he did not understand the business. He admits this as his mistake now. So, though we need to choose businesses that we know, sometimes it may not be possible to understand the intricacies of all businesses.
Management quality: This is the second most important criteria in stock selection. Bad captain of the best ship in fair weather can lose the way. This parameter by definition is qualitative and not easily quantifiable. However, there are many indicators available such as dividend payment, capital allocation, transparency, management disclosures and management salaries that tell us if the management integrity, if everything is above board and if they are investor friendly.
Equity capital & Promotor shareholding : High promoter shareholding (above 50%) in the company equity capital is always considered a positive indicator. Skin in the game – so to speak. Increasing promoter shareholding further confirms management faith in the business. Off late, many promoters of good stocks have increased their shareholding by purchasing their own shares from the market to take advantage of cheap valuations. It is also important to check that promotors have not pledged their shares.
Sales growth (Same as topline and growth) : This parameter indicates the growth history of the company. One has to still assess future growth prospects and whether it will be organic (growth through internal revenue accruals) or inorganic growth (Growth through mergers and acquisitions – M&A). Average topline growth of a minimum 10% could be a good starting point.
EBIDTA Margins : EBIDTA is earnings before interest, depreciation, tax and amortization. In other words, it is a gross profitability matrix. It can vary a lot across industries but a minimum 25% margin could be considered. This parameter must be seen in conjunction with the net profit margin. For example, a manufacturing company having a lot of debt on its books may have big contributions towards depreciation and interest on debt so the net profit margins could be lower even if EBIDTA margins are high. In such cases, one needs to look if the debt is reducing and sales are increasing yearly. Such a trend will ensure growing profit margins in the future. Moreover, since the current margins are low, valuations may be cheap. I can cite one such example – Himatsingka Seide. Evaluate for yourself.
Net profit margin and growth (same as bottom line and growth) :This is one of the most critical parameters. A minimum net profit margin of 10 %, growing yearly at 15% could be a good start. In fact, as per Peter Lynch, if a stock is available at a P/E value of 50 to 75% net profit growth number, it is prima facie a good investment. i.e. If a company has grown its profits 15% annually and is quoting at P/E of 7.5 to 11, it is a good buy. Himatsinga Seide had profit growth of around 25% during the last three years and it was quoting at a P/E of 8 just three months before making it a screaming buy. Even now it is quoting at 11 P/E.
Debt to equity :Companies frequently take debt for expansion. Some companies have short term debt to cater to working capital requirements. Debt to equity ratio of above one is always a concern. In the case of economic downturn and fall in sales and revenue, companies with high debt on their books can go down very quickly. However, at times, growth is not possible with capex and therefore debt becomes essential. One has to be assured of revenue visibility in the future years to be able to service the debt and sustain profit margins. Talking again of Himatsingka Seide, this company has high debt to equity ratio of around 1.7 so it is inherently risky. However the capex is over and the company is about to increase production through expanded capacity, boosting revenues. (This is called sweating of assets). The risk is generating and sustaining enough sales volumes to ensure capacity utilization for a few years till the debt is reduced to manageable levels. This risk an investor has to take. Assessment of management quality becomes important here.
Book Value :Book value is the value arrived at by dividing the value of company assets by the number of shares. It is the value per share the investors may get if the company is liquidated. Usually rather than absolute book value, the ratio of price to book value is seen as the reference. A price to book value ratio of 1.5 or less is ok. This parameter is important for manufacturing companies which have solid assets. Companies in sectors like IT will have high earnings but very low book values and this ratio is not relevant for them. For example, TCS has a price to book ratio of close to 9. Himatsingka Seide has a price to book ratio of 1.8 which is on the higher side.
EPS, ROE & ROCE :These are the most important profitability matrices. EPS is the net profits divided by the number of shares. It is profit per share. TCS reports a profit of Rs. 30,250 crores. It has issuedto date 382.84 crore shares. So the EPS works out to be Rs. 79 per share having a face value of Rs. 1. The EPS was Rs. 160 when the face value was Rs. 2 some time back.ROE(Return on equity) is another important ratio which determines how effectively assets are being used to get profits. It is the ratio of Company net profits to shareholders equity. Shareholder’s equity is company assets minus liabilities. So it is the original equity capital plus accumulated reserves.ROCE (Return on capital employed) is another profitability matrix obtained by dividing operating income (EBIT) by capital employed (Assets plus debt). This indicates how effectively company capital is used to generate income. ROE & ROCE values of 15 or above are good.

So this was the primary scrutiny of stocks under consideration. There is the risk analysis and valuation to be considered still that will be dealt with in the subsequent issues.
We have so far learned to identify good products from a variety of products available in the market. In subsequent issues, we will see if these are fair value for money and what are the risks.

Please revert with your comments, suggestions and queries.

Happy investing

bhushan