4 rules for successful stock picking

By Morningstar |  28-05-18 | 
 

On Dalal Street, the industries, personalities and names change. But certain basic stock picking principles are persistent through changing times.

Arun Mukherjee and Soumya Malani, creators of the ShareBazaar App, propose four basic tenets to keep in mind when navigating the manic twists of the market. 

#1. Stay bottom-up. Stay company centric.

Have you heard this quip before?

Q: How can you spot a value investor at a cocktail party? A: He is the only one talking about an actual company while others stand around discussing the stock market.

Despite us being intrinsically growth investors, we can see the immense wisdom in that. The print media, financial websites, talking heads on television, and Twitter provide sufficient fodder to fret over the machinations of the market. When investors get caught up in the news flow, they tend to make hasty decisions which does nothing in their quest for wealth creation. For that, you need to consistently focus on individual stocks and not the market.

Look at the Sensex. It hit a high of 21,000 in 2008. A decade down the road, the returns on a CAGR basis have been minuscule. But all companies have not followed the same path. Caplin Point Laboratories, Bajaj Finance, Symphony Ltd and Avanti Feeds have all been multibaggers, to cite a few examples.

Stick to rational analysis and isolate yourself from market emotions. 

#2. Be sectoral agnostic.

If the relevant industry is growing at 20-30%, then the tail wind will be phenomenal. But it is not strict criteria that we adhere to. The environment could be in an upheaval, but a company that has potential will outperform.

Take 2008 when Real Estate went bust. But companies like Ashiana Housing and Poddar Housing rewarded their investors phenomenally.

We look at high scalability, the size of opportunity, increasing margins, and the potential to cannibalize market share. Once we get those, we buy the stock and add to them when conviction increases.

Not too long ago the entire pharmaceutical industry was going through tremendous upheaval. The U.S. Food and Drug Administration (USFDA) unequivocally emphasized that pharmaceutical companies in India need to adhere to a quality culture and be diligent on matters relating to data integrity.

While the industry was facing tremendous pain, our investment in Caplin Point Labs and Medicamen Biotech turned out to be massive multi-baggers in the last few years. Bigger companies into generics ignored markets like Africa and Latin America citing low scalability of few thousand crores and security reasons. But for tiny companies like the two we mentioned, with sales of less than Rs 100 crores, it represented a lucrative business opportunity. They meticulously studied and penetrated the markets. Moreover, they are insulated from the USFDA vagaries too in such emerging yet high potential markets.

The ‘gamble’ paid off and both companies have been 50 baggers over the last few years.

#3. Even when looking at ratios have perspective.

For illustrative purposes let’s look at the ubiquitous PE ratio. The price-to-earnings ratio is invariably the first and most commonly used valuation ratio to make sense of how expensive or cheap a stock is.

The mistake new investors make is to base their entire valuation exercise on it. This is a grievous error because no metric is unrivalled in a vacuum.

Growth investors should not consider the PE ratio on its own. The growth a company can deliver also has to be taken into account. And once you do so, then buying high PE stocks on a low base with high growth isn’t that bad. Titan’s average PE multiples in 2005, 2006 and 2007 were 57, 51 and 53 times. In 2007 it traded at 80 times. Yet, a look at the returns the stock has delivered will stun most. Since 2007, the stock has returned 800% or around 25% annually.

A smarter thing to do is focus more on PEG, which is price/earnings to growth ratio.

Look at the below and you will see that the higher growth of Company A compensates for the higher valuation. The PE ratio for Company A is higher, but on a growth basis Company B is more expensive with a higher PEG ratio.

Company A

  • PE = 20
  • Growth = 15%
  • PEG = 1.33

Company B

  • PE = 15
  • Growth = 10%
  • PEG = 1.5

We are happy to pay a PE of 50 times if the growth CAGR is expected to be around 50. Discount the PE for the next 2 years and your 50PE would look much more attractive. Granted. It sounds exorbitant. But a lot of small caps would grow by such percentages for years.

#4. Have an investment strategy that guides you.  

All investors will look at PE, ROC, ROCE, ROE, dividend yields, scalability, promoter shareholding pattern, market cap/sales, and so on and so forth. Besides all these quantitative factors, there are other qualitative parameters that guide us.

For the sake of illustrative purposes we shall elaborate on one such guideline: legacy companies that have been in the business for 40-50 years. We then wait for a trigger that will propel them into a different orbit.

Take Eveready Industries. The company was grossly inefficient and run like a public sector company. A fairly sound balance sheet, a strong brand, and an amazing distribution network – 3.2 million outlets, was just not leveraged.

When Amritanshu Khaitan took over, he candidly admitted that they had not done justice to the Eveready brand and he set out to recharge it. He was handed the reins in 2012-13 when the company had sales of only Rs 1,000 odd crores and a mere PAT of Rs 5 crores. Cut back to 2017 and Eveready delivered Rs 1,355 crores in Sales with profits hitting over Rs 90 crores. The stock meanwhile jumped from Rs 17 to Rs 415. A very cool 24 bagger in just 4 years!

In conclusion, we would like to emphatically state that this is not intended as a comprehensive list but rather a starting point when attempting to scour for wealth creators in the mid- and small-cap space. You can develop your own investment philosophy and its applicable parameters as you evolve as an investor.

Happy Investing.

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