Investment in stocks is a tough and complex process. Before you go through this checklist, I must point out that no checklist can be a magic wand that transforms the process of finding valuable stocks into a quick, leisurely process. Think of it as a route map that you can use to focus your research efforts better as you go through the journey of understanding and researching a company.
My checklist is limited to three major parts:
industry attractiveness, management quality and competitive advantages.
One should keep in mind that this is a process for evaluating businesses and not stocks. We have to focus on how a handful of companies have consistently delivered good results over long period of time. In doing so, they have created astonishing amounts of wealth for their shareholders.
Each company has strong and weak points compared to other industries. We will check this out here.
1) Dependency on government regulations?
Many industries in India are heavily regulated. This regulation protects the consumer and governments interests over the companies interests and, in the process, takes away from the producer and redistributes profits in favour of the consumer or the government.
In some cases, this regulation provides a monopoly. As mining coal in India was controlled by coal India.
Similarly, the ROE for government own power companies is regulated by government. Because of this these companies can not earn any excess returns above stipulated limits.
Consumer goods, automobiles, paints and electric items can be easily produced and sold in India without any significant government regulation regarding how these goods are priced to consumers.
In contrast, companies in industries with extensive government intervention have less control both on the process of production and on the profits.
So we should focus on industries with moderate government regulations and minimal intervention.
2) Number of competitors and competitive intensity?
However, just looking at the number of players may not be the best way to measure competitive intensity. If the industry size itself has a high growth potential, a large number of players can profitably coexist. Pharma and IT are the best example for this.
On other hand , in low growth industry, even a small number of players can dent each other’s profitability. Telecom industry is a best example of that. You have seen, what had happened with so many telecom players.
Most industries in India are open to completion, with relatively low barriers to entry. Hence, it is much easier for new competitor to come in. As a result, prices drop, competition rises, leading to lower profitability for the companies in that industry.
Hence, the more preferable option is to look for those companies that rise up the ranks to become one of the top two three players in that sector.
3) Size of the industry and its grow potential
Companies in high growth industries tend to have better prospects.
For example, over 65% of Indian population is below the age of 35. This represents a large market for almost all industries. Yet, at the same time, one must consider that an industry with large opportunity is also likely to attract more competition.
Thus, identifying the growth potential within the industry is important.
4) Does the management have a track record of good governance and clean accounting?
For a listed company, there are two types of shareholders: the promotors who own control of the company and and non – promotors, which include retail and institutional investors.
The process of running a company involves balancing relationships and interests between the board, the promotors, the management, minority shareholders, auditors as well as other stakeholders. By now, I am sure you are wondering, ‘How do I know that a company is following high standards of corporate governance?’
The answer is simple: start from the annual report. It includes the director’s report, the auditor’s report, the profit and loss , balance sheet and cash flow statements, and also a section on corporate governance.
In companies where minority shareholders are being short-changed, the financial statements will be rosier than the underlying performance of the business. Therefore, taking reported financials at face value is the most common and perhaps the most damaging mistake investors make. In simple words, companies which have high quality accounts also tend to be companies which have high quality management.
5) Cash flow from operations/ EBITDA
A firm might be inclined to meets it annual targets by pushing inventory in the chennal, without the quantity actually being sold to the end costomer.
While this inventory will reflect in revenues, operating profit and net profit numbers, to the extent that the quantity has not actually been sold to the customer there will not be commensurate cash flow. Such a firm will have lower cash flow from operations EBITDA ratio compared to a firm where the sales have actually materialized to the end consumer. A lower number on this ratio therefore is a red flag and warrants deeper scrutiny.
6) Company’s investment in brands and reputation?
Stephen King, the famous American novelist, author and TV producer, once said, ” A product can be quickly outdated, but a successful brand is timeless.”
Brands and reputation are extremely expensive to built, maintain and sustain. However, once built, they are a very powerful source for competitive advantage. Brands and reputations are often built by consumers using the product over a long period.
7) Does the company have ROCEs that are higher than the industry average?
A company ROCE can be used as a broad measure of its sustainable competitive advantages. Generally speaking, a firm with ROCEs which are more than 15% and significantly better than the industry average, is likely to have sustainable competitive advantages.
Hope all these things will help you to find a gem of industry.
Disclaimer: This information is only for educational purposes. Do not make any investment decisions based on the information in this article. Do you own due diligence.