January 7, 2015

Final Checklist for Buying Stocks



“SelectingTop Stocks to Buy” is a series of articles that focuses on the process of selection of stocks for investment. In this series, we have learned about:


In previous articles, I have provided readers with key takeaways in form of crucial parameters that an investor should use while analyzing stocks. Articles on financial analysis, valuation analysis, business & industry analysis and management analysis contained summary checklists that can be very handy for any investor. 

In the current article, I have compiled at one place the parameters that an investor should check each stock, before investing her hard-earned savings. This article can serve as a final checklist for any stock market investor, which will become very useful while doing detailed analysis of stocks.

Criteria
Value
Remarks

FINANCIAL ANALYSIS

1
Sales growth
CAGR >15% for last 7-10 years
Growth should be consistent year on year. Ignore companies where sudden spurt of sales in one year is confounding the 10 years performance.

Very high growth rates of >50% are unsustainable.
2
Profitability
NPM >8%
Look for companies with sustained operating & net profit margins over the years
3
Tax payout
>30%
Tax rate should be near general corporate tax rate unless some specific tax incentives are applicable to the company.
4
Interest coverage
>3

5
Debt to Equity ratio
< 0.5
Look for companies with D/E ratio of as low as possible. Preferably zero debt
6
Current ratio
>1.25

7
Cash flow
CFO > 0
Positive CFO is necessary.

It’s great if CFO meets the outflow for CFI and CFF
8
Cumulative PAT vs. CFO
cPAT ~ cCFO
Cumulative PAT and CFO are similar for last 10 years

VALUATION ANALYSIS

1
P/E ratio
< 10
Such companies provide good margin of safety
2
P/E to Growth ratio (PEG ratio)
< 1

3
Earnings Yield (EY)
> 10 year G-Sec yield
EY should be greater than long term government bond yields or bank fixed deposit interest rates
4
P/B ratio
< 1
However, I find P/B ratio irrelevant for sectors other than financial services
5
Price to Sales ratio (P/S ratio)
< 1.5
James O’Shaughnessy: Buy if P/S ratio is < 1.5 and sell if >3
6
Dividend Yield (DY)
> 0%
Higher the better.

DY of >5% is very attractive. However, do not focus a lot on DY for companies in fast growth phase

BUSINESS & INDUSTRY ANALYSIS

1
Comparison with industry peers
Sales growth > peers
The Company must show sales growth higher than peers. If its sales growth is similar to peers, then there is no Moat
2
Increase in production capacity and sales volume
Production capacity & sales volume CAGR ~ Sales CAGR
Company must have shown increased market penetration by selling higher volumes of its product/service
3
Conversion of sales growth into profits
Profit CAGR ~ Sales CAGR
A Moat would result in increasing profits with increasing sales. Otherwise, sales growth is only a result of unnecessary expansion or aggressive marketing push, which would erode value in long term
4
Conversion of profits into cash
cPAT ~ cCFO
If cPAT >> cCFO, then either the profits are fictitious or the company is selling to any John Doe for higher sales without having the ability to collect money from them
5
Creation of value for shareholders from the profits retained
Increase in Mcap in last 10 yrs. > Retained profits in last 10 yrs.
Otherwise company is destroying wealth of shareholders
  

MANAGEMENT ANALYSIS

A) Subjective parameters
1
Background check of promoters & directors
Web search
There should not be any information questioning the integrity of promoters & directors
2
Management succession plans
Good succession plan should be in place
Salary being paid to potential successors should be in line with their experience
B) Objective Parameters
3
Salary of promoters vs. net profits
No salary increase with declining profits/losses
promoter should not have a history of seeking increase in remuneration when the profits of the company declined in past
4
Project execution skills
Green/brownfield project execution
Company should have shown good project execution skills with cost and time overruns.

Exclude capacity increase by mergers & acquisitions.
5
Consistent increase in dividend payments
Dividend CAGR > 0
Dividends should be increasing with increase in profits of the company
6
Promoter shareholding
> 51%
Higher the better
7
Promoter buying the shares
Insider buying ++
If promoter of a company buys its shares, investors should buy too
8
FII shareholding
~ 0%
the lower the better

OTHER BUSINESS PARAMETERS
1
Product diversification
Pure play
Company should be either a pure play (only one business segment) or related products. Pure play model ensures that the management is specialized in what they are doing. 

Entirely different unrelated products/services are a strict NO. An investor should rather buy stocks of different companies, if she wants such diversification.
2
Govt. influence
No govt. interference in profit making
No cap on profit returns or pricing of product.

No compulsion to supply to certain clients.

Margin of Safety

MoS in Purchase Price
Earnings Yield (EY)
EY > 10 Yr G-Sec Yield
Higher the EY than 10 Yr G-Sec Yield, the better
MoS in Business Model
Self Sustainable Growth Rate (SSGR)
SSGR > Achieved Sales Growth Rate
Higher the SSGR than achieved Sales Growth, the better
Free Cash Flow (FCF)
FCF/CFO >> 0
Higher the FCF as proportion of CFO, the better

Credit Rating

1
Credit Rating History
BBB- & above
Current credit rating should be minimum BBB-

Credit rating should have been improving over the years

To see a live example of analyzing a stock on these parameters to determine whether it has the qualities of an investment-worthy stock, you should read: Equity Research - Ambika Cotton Mills Limited. In this article I have analyzed Ambika Cottom using the parameters listed above.

Investors should always keep in mind that, no checklist could ever be complete for doing stocks analysis. However, the parameters in the above test any company and its stock on some of the tough performance parameters. Hence, an investor can be reasonably certain that the stocks, which pass the above checklist, have sound fundamentals and are available at reasonable valuations. If she diligently follows these parameters, invests only in stocks that promise good fundamentals and never overpays for them, then she can be assured of good returns from her portfolio over long term. 

Temporary periods of stock price fluctuations, business cycles where even good companies would not be able to maintain sales growth & profitability, would definitely come in between. However, the investor should keep her patience and not act on impulse and stay invested in a company until the time inherent business strength of the company is intact. She would reap great benefits of such investing behavior.

No checklist is paramount. Hence, an investor should not restrict themselves to the parameters mentioned above. She should read further about investment analysis and add/remove parameters from the above list as per her understanding.

Monitoring stocks in an investor's portfolio is also equally important. An investor should delineate her monitoring activities into ongoing activities, quarterly activities and annual activities. (Read: How to Monitor Stocks in Your Portfolio)

With this, I have come to the end of this series of articles “Selecting Top Stocks to Buy”. In future articles on my blog I would write about related topics like: 

  • deciding about portfolio weight of any particular scrip 
  • decision about adding up on existing positions 
  • when to exit a stock etc.


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I would like to know how you felt while reading this series “Selecting Top Stock to Buy”, your experiences of stock markets, the checklists you follow, parameters you find paramount for analysis and any other inputs that you believe would improve the blog & its articles. You may write your inputs in the comments below or contact me here.