Investment checklist before picking a stock
Do you struggle to make money from stock market? Do you feel that picking stocks is really a difficult task and is not your cup of tea? Well, you are not alone. Most investors struggle to find great stocks to invest that can compound their wealth.
In this post, I am going to share a simple 10 point checklist that you should follow to pick great stocks for your long term portfolio.
Do you understand the business?
There are more than 5,000 companies listed in the stock exchange, picking the one that can make you rich is like finding a needle in a haystack. In order to make things easier, you must start by preparing a list of businesses that you really understand. Warren Buffett calls it circle of competence.
By understanding the business you will be able to make better projections about the businesses future growth potential and how its earnings are going to look like in the coming years. This will help you in understanding if the business in question is worth investing or not.
Do not confuse being familiar to a business with understanding of a business. For example, just because you are a frequent flyer does not mean that you understand the aviation business.
To understand the aviation business, you need to understand their revenue streams and their cost, and how different airlines are trying to maximize the shareholder value by either expanding market share (which happens in economic airlines) or by improving their profit margins (as It happens in business class airlines).
The ability to sense the changing dynamics of a business is the primary metric of a successful investor. While understanding the business is an important part of investment checklist, it makes no sense to invest in a business whose longevity and sustainability is doubtful.
There are many examples of businesses that were once very successful but were completely destroyed by change in technology or by disruptive innovation.
For example, Kodak Films, which was once a pioneer of photography films was crushed by the arrival of digital cameras as films were no longer needed.
However, there are many other businesses that have survived for more than 100 years and have been doing consistently better despite change in technology.
For example, Coca-Cola has been doing well for the past 100 year, technology had little to no impact on how people chose a beverage or which beverage they like. Businesses that are least affected by the change in technology are the ones that have better chance of doing well for a long period of time.
While picking the stock ask these questions, is the business going to be affected by the change in technology? How will the business be able to survive if there is a new competitor in the market?
Is the company working towards strategies to keep its customers loyal to its products and services?
To find the answer to these questions, you need to read the annual report of the company where the management gives you the details what actions they are taking to sustain and expand their business.
Suggested Read: 5 Signs that show a company is declining
If the management is unable to present a clear plan about company’s future growth trajectory, and keeps using complex jargon and beating around the bush instead of giving a clear explanation, it’s a clear sign that company’s management lacks clear vision for the future growth of their business.
Is the company a commodity type business or a brandable business?
Charlie Munger once said “when a company with poor economics meets a management of excellent calibre, it is the economics of the business that remains intact”
What Charlie Munger means is there are some sectors which do not have supportive economics and companies working in them often struggler to keep growing.
The best example of such business is commodity type business. What are those? These are the companies that sell similar products with no differentiation, and low switching cost.
Since these businesses do not have the luxury to differentiate their product, they survive only by providing products or services at the lowest cost compared to their peers, as a result of which there is a constant pricing war among peers and most of such companies have to work on wafer thin profit margins to keep their business afloat.
Such companies can easily slip into losses if there is a rise in operating cost or raw material prices as they do not have the cushion of high margins to protect them against such events.
Some of the examples of such businesses are power production and distribution companies, internet data providers companies and iron and steel companies. All these companies provide similar product with little to no product differentiation.
Suggested Read: Types of business you should avoid investing in
For example it does not matter if your house is powered by Tata Power or Reliance Power, if given a choice you would pick one who is able to provide power at the lowest per unit cost.
Similarly, it does not matter if you are using data services from Airtel or Reliance Jio, what matter to you is who is able to provide data at lowest cost. That is the reason Reliance Jio was able to capture huge market share in short span of time.
Commodity type business always struggle to grow as they neither have pricing power nor have high switching cost and thus are always vulnerable, as a result, these stocks do not make good investment.
Business that have a strong brand name behind them usually have a strong pricing power and low switching cost as people trust the brand for its quality For example, Nestle India has a strong brand name in the processed food segment.
Despite so many other player in the instant noodles segment, Nestle still holds position of market leader in the industry and the reason behind it is that Nestle India has created a strong brand name over past many years and people trust the company for its quality products.
This also provides huge pricing power to the company, that is, if the company decides to raise the price of its products, people would still continue to buy its products, even at higher price. Pricing power allows companies to command higher profit margins and create higher profits for each sale.
The fourth point in our investment checklist is to find if company is able to grow its sales better than its peers? Companies that show better sales growth compared to its peers expands their market share rapidly and provide higher returns to shareholders. Let me prove my point by giving you an example.
Nestle India and Britannia Industries are two companies engaged in food business. If you compare past 10 years of sales growth of Nestle to Britannia you will find that Nestle has seen a sales growth of 10.25% CAGR in the past 10 years while Britannia has seen sales growth of 11.18% CAGR, which is higher than Nestle.
Not just that even in terms for Net Profit, Britannia has done better than Nestle. In the past 10 years, Nestle India has seen a profit growth of 11.97% CAGR, while Britannia has seen a Net Profit growth of 15% CAGR, much higher than Nestle India.
As a result, stocks of Britannia Industries have given a return of 1,400% in the past 10 years while Nestle has given a return of 471% during the same period.
The example above proves the point that companies that are able to grow their sales faster than their peers reward their investors with higher returns, as it happened in the case of Britannia Industries.
Investors should always look for companies that are growing their sales faster than peers, however it should also be kept in mind that the growth of sales is also reflected by similar growth in Net Profit. If the sales are growing much faster than the Net Profit, it’s a sign that company is generating fake profits.
Does company enjoy higher profit margins?
The next factor you should consider in your investment checklist is if the company is enjoying higher profit margins. Why is that important? Higher profit margin shows that company has pricing power over its products or services.
Higher profit margins also acts as a cushion against adverse business conditions, if a company is working on thin profit margins, any rise in operating costs will push the company into losses.
On the other hand, if a company has strong profit margins, rise in operating expenses will have less of an impact on the profitability of the company. Also since companies with higher profit margins also have a strong pricing power, any rise in operating costs can be passed on to the customer without hurting the sales, but if the company is working on very thin profit margins, passing the rise in operating costs will force customers to switch to competitor.
How is the company going to defend its profit margins?
While high profit margins are always positive, it can be a real challenge to maintain those margins. Reason?
Whenever a sector or a company does well, it attracts more players, trying to take a piece of the growth offered by the sector, as new players keep coming in, companies have to try harder to keep competitors from taking away their market share for which they have to spend more on brand building, advertising, marketing, this adds a to the operating costs of the company, thereby shrinking the margins.
Companies that successfully defend their profit margins are the best investments as they have strong brand name and are largely unaffected by arrival of new players.
An example of one such company is Asian Paints. In the past decade Asian Paints has maintained its profit margins despite arrival of many new players such as Kansai Nerolac, Berger Paints.
What is also interesting is that Asian Paints is still the market leader in this segment with more than 50% market share.
Further, a large part of company’s revenue comes from repaint jobs, which means that company has strong brand loyalty.
Because of strong brand loyalty, wide distribution network, company has higher pricing power on its products compared to peers, which is helping Asian Paints maintain its profit margins.
How the company is funded (equity or debt)?
Probably the most important factor among all the factors that you should consider in your investment checklist is if the company is funded largely by debt or equity? The reason why its important is that when a company has a lot of debt, it has to keep paying interest on that debt. Think of it as an EMI you have to pay on your loans.
If a company has too much debt, a large part of its profits goes into servicing those debt, leaving very little to no profits in the hands of the company. Also, if a company suffers losses due to poor business, it still has to keep paying interest, which means that the company either has to sell its assets or file for bankruptcy.
There are many examples where too much debt and poor earnings lead to the death of a business completely. One such example I can remember is Suzlon energy.
Suzlon energy is engaged in manufacturing of manufacturing of wind turbine generators.
The company raised a lot of capital by borrowing for various sources, as a result the total borrowings increased from ₹ 5,162 crores in 2007 to ₹17,053 crores in 2014. A growth of 18.62% CAGR. As a result of this the interest cost went up from ₹276 crores in 2007 to ₹2,070 crores in 2014.
All these interest expenses started eroding company’s profits which declined from ₹864 crores in 2007 to a loss of ₹3,520 crores in 2014.
Always make sure that a company does not have too much debt on its books, if you are not sure how much debt is too much, follow a simple thumb rule that the debt of a company should not exceed current years’ net profit.
Is the company allocating its capital efficiently?
A company may have great sales and profits growth wide profit margins and may also be conservatively financed, but all of that is of little use if the company is unable to use its capital efficiently to expand its business.
Companies that utilize their capital efficiently show higher and more consistent growth in the future. There are many financial ratios that indicate how efficiently a company is using its capital, such as Return on Equity (ROE), Return on Capital Employed (ROCE), and the most conservative and reliable Return on Invested Capital (ROIC).
ROIC measures the capital efficiency of a business by looking how much profit a company has generated against the total capital employed. Higher the ROIC better it is for the company.
Is the management of the company honest and transparent?
So far we have looked at the quantitative aspects of investing in a business, which mainly deals with numbers, but we need to understand that numbers are just reflection of what the management does with the business on a daily basis.
That is why it is important to understand not just the quantitative aspect of the business but also the qualitative aspect as well.
One of the most important qualitative factor that companies must have is the transparency of the management. Good companies often share their growth and future plans with their shareholders and investors.
They also address their shortcomings and failures and what may affect their business in the foreseeable future.
Read the annual report, especially the management discussion and analysis section where company discusses the broader aspects of the sector it is working in and how the company is planning to take its business forward in that environment.
If a company is unable to chalk out a plan about its future course of actions, chances are there is no plan in the first place, which means that there is no concrete plan in the first place. Such companies lack vision and thus must be avoided.
Is the business trading below its intrinsic value?
There is a very famous quote by Warren Buffett “Price is what you pay, value is what you get”, what it means is that everything in this world that has price, also has a value attached to it.
Warren Buffett explains it beautifully in one of his speeches.
“The only reason for an investment in any asset today is to get more money later on. That is what investing is all about.
When you buy a business, and whether you are buying all of a business, or a little piece of it, always think as if you are buying the whole business, that is the approach to it, look at it and ask, what will come out of it and when?
The question here is, how do you find what the business is worth today and how much will it be worth in the future?
When you invest in bonds, it comes with interest rates( that is the future cash flows) printed on it, including the principal, which means that the future cash flow from a bond are certain and predictable, making it easy to calculate if the bond is worth investing today or not.
Unfortunately, a stock certificate does not come with interest rates printed on it, and it’s the job of an investor to ascertain, at least with some degree of certainty, how much the business is worth today, and how much is it going to be worth in the future (that is 10-20 years from now) and on the basis of these estimates, make a decision if the stock is worth investing or not.”
What Warren Buffett means is that all your investment decisions should be based on asking three basic questions:
- What are you paying today for the business?
- What is your expected future value of the business as per your analysis?
- Is the price you are paying far less than the future value of the business?
For example, let’s say you want to buy a house, the price of the house is ₹1,00,000, you want to stay invested in the house for the next 5 years and expect the price of the house to appreciate by 10% each year.
Based on the above assumptions, the future price of the house would be ₹1,61,000, that is, 60% return over the period of 5 years.
The question now is, how sure are you about the 10% growth, what is it grows at 8% instead of expected 10%? In that case, you should try to pay less than quoted price by bargaining or waiting for a fall in housing prices, this is called margin of safety, a way to safeguard yourself from the error in judgement of growth estimates.
Suggested Read: How to Value a Business?
When you pay a lot less for an investment than what you expect to get out of it, it becomes a great investment, the only tricky part in the entire process is figuring out the right growth rate of an investment.
By following these 10 points in your investment checklist, you can make the best investment decisions of your life, you don’t need to go through a hundred stocks or hold a highly diversified portfolio to become rich, all you need is a handful of carefully picked, well managed stocks with strong fundamentals, good future growth prospects and attractive valuation.
I hope the investment checklist was useful to you, do let me know your investment checklist that you follow before making an investment decision.