There are different methods, strategies, and techniques available for you to become a successful investor. I have been trying to become the master of many of these methods to make a good fortune in the stock market. Last 8 years I worked day in day out to achieve this dream. Even though I managed to learn most of the subjects that one should learn to become good in the stock market investment, I always felt that something is missing. I felt like something is not right. Even though I was able to identify good stocks, I was not confident enough with my stock selection. I always look back at my portfolio and wonder whether my stock selection is right. When I try to go back to re-assess my earlier “buy” decision, I found it difficult to find reasons why I bought those stocks earlier. Afte going through this trouble for a long time, I started looking at the methodology I followed for fundamental analysis and stock picking and I realized one thing.
That one thing is “CLUTTER“
Last 8 years I was busy collecting and learning all tips, methods, strategies, techniques, do’s and don’ts of investing. After a period of time, all my learnings were like “Cluttered Building Blocks” just like the images given below. I have all types of building blocks available in the market, but those blocks that I really need to make my building is kept hidden under those cluttered building blocks most of which are not required really required but creating trouble and causing indecisiveness.
I was confident that learning all ratios and using them for my fundamental analysis of a company is good and necessary for investing. But somehow it was not helping me.
Just to give some examples, if you want to do fundamental analysis, you can use different financial ratios that will give you information about the performance of the companies. Following are some of the examples.
- PE Ratio
- Dividend Yield
- Debt/Equity Ratio
- Profit Growth
- Sales Growth
- Cash Flow Vs Net profit
- Free Cash Flow
- DCF Analysis
- Market Cap
- Operating Profit Margin
- Net Profit Margin
- Price to Book Ratio
- Earning Per Share
- Promoter Holding
- Pledged Shares
- Interest Coverage Ratio
- Current Ratio
- Quick Ratio
- Industry PE
- Price to Sales Ratio
- Buffet $1 Test
- Intrinsic Value
- Equity capital
- Preference capital
- Secured loan
- Unsecured loan
- Balance sheet total
- Gross block
- Revaluation reserve
- Accumulated depreciation
- Net block
- Capital work in progress
- Current assets
- Current liabilities
- Book value of unquoted investments
- Market value of quoted investments
- Contingent liabilities
- Total Assets
- Working capital
- Trade receivables
- Face value
- Cash Equivalents
- Advance from Customers
- Trade Payables
The list goes on and on …
I can easily list down hundreds of ratios that can scare you 👹. But don’t worry, I am coming with a remedy soon in this post itself.
See, all these ratios matter. They all convey information about a company from different angles and all this information makes sense for an investor. If you take all these ratios individually it conveys some level of information about a company.
But, the point is, you really don’t need to go through each and every ratio available to make an informed decision. Too much of anything is good for nothing. When you start analyzing too much data and ratios in your brain, you will get into a stage called “ANALYSIS PARALYSIS”. You have all the information in the world about a company, but still, you are not able to make a decision as your brain is not able to process all the information you have bombarded into your head. Hence, you cannot consolidate all those information to a decision that turns into an action ie “BUY A STOCK” or “SELL A STOCK” or “HOLD A STOCK”.
The other problem with this “TOO MUCH OF INFORMATION” is, even if you buy a stock, after a period of say 1 year or so, when you review the performance of that same company, you will find it difficult to make a decision to hold those stocks because you are not sure on what thought process you have bought those stocks in the beginning. This I experienced year after year. I buy one stock and after 1 year or 2 years when I look back and try to figure out the reason why I bought those stocks, I always find it difficult to reproduce my earlier investment thesis. This stops me from buying more shares when the stock price goes down and also make me miserable when the stock crashes which most of the time makes me sell good stocks from my portfolio.
Realizing this, I decided to declutter and follow minimization as my investment strategy. Many of the ratios overlap with many other ratios in one way or the other. As I mastered many of these financial ratios, I was able to find connections between many financial ratios which in Charlie Munger’s words is called “Lattice Work of Mental Models”.
Image credit goes to link
Image credit goes to link
Image credit goes to link
Image credit goes to link
As Charlie Munger says
“What is elementary, worldly wisdom? Well, the first rule is that you can’t really know anything if you just remember isolated facts and try and bang ’em back. If the facts don’t hang together on a latticework of theory, you don’t have them in a usable form.
You’ve got to have models in your head. And you’ve got to array your experience – both vicarious and direct – on this latticework of models. You may have noticed students who just try to remember and pound back what is remembered. Well, they fail in school and fail in life. You’ve got to hang experience on a latticework of models in your head.”
I started taking out financial ratios which are not relevant and identified those ratios that matter most. I ended with the below-mentioned criterias and ratios which are good enough to make a sound investment decision.
Table of Contents
Circle of competence
Never invest in a company that you can’t understand. Invest only in those businesses where you can understand what product or service a company is produced or delivered. You should be able to understand how the company makes a product or how a service is rendered. You should be able to understand its business model. You should be able to understand their customers and what kind of customer’s problem is the company trying to address.
Quality of business – Good ROCE
Growth without quality is of no use. For the sake of growth, if you are not focusing on the quality of growth it is a kind of value destruction. You should not invest in any company that gives a return of 15% or above. For a corporate loan that you take from a bank, you are supposed to pay interest of around 11%, which means just to cover the interest rate monthly, you need to find 11% return, now to cover other expenses, you need some extra income which we can say as 4%. So as a thumb rule, you should get at least 15% ROCE on all your investment.
The company must grow at a rate of 15% or above. That shows that the market is not saturated for the product or service the company is selling. This shows that the business product/service is in demand/need for the market/community and there is still a large group of customers who are yet to use this product service in the existing population because of which company will keep growing. Along with this, you should be able to say whether more customers are going to buy this product or service in the future that will ensure its growth continuity.
Longevity of business
Once we find a company having above 15% growth potential and 15% ROCE, we invest in that company assuming that the company will grow at the same rate for a long time. But what if after 5 years of your investment the company stops growing. Your investment growth will come to a halt, right?
For all your investment, you will try to brainstorm many reasons that could potentially spoil the longevity of your business. You should not be able to visualize the business model getting obsolete in long term?
Just to give one example, look at the image given below. Can you tell me a company that sells this product? It is Cera Sanitaryware Ltd.
Try to find a reason why this business model gets obsolete. Remember, I am not talking about competition and profit margin here. I am only checking whether the product or service gets obsolete in long term or not. Products like western toilets and urinals will always be in need for the community as it is connected with human anatomy and as human anatomy is not going to change at all for millions of years, any product that is associated with it is also not going to change much. Even though the material used, size, shape, and associated technology will change, overall the need for this product will stay intact.
Protection from the competition and secured from all threats as per porter’s “Forces driving industry competition” which are
- Threat of new entrants
- Threat of substitute products or services
- Bargaining power of buyer
- Bargaining power of suppliers
Can I find a reason why I think the company is protected from each threat mentioned above. Any reason why the company can protect itself from the above threat is called a Moat. So of the list of moats identified are
- Intangible assets
- Switching costs
- Network effects
- Cost advantage
- Size advantage
Buy at a reasonably low price after considering the industry PE ratio and the company’s average PE ratio. Also, you can look at companies’ DCF analysis to find the intrinsic value of the company. Personally I don’t like to invest in companies with PE ration below 50 and PEG ratio below 1.5
Other Stock selection criteria
- Unavoidable/non delayable/BtoC product
- Market leader – First or second position
- In business for at least for last 20/25 years
- Debt to equity – Less than 1
- Promoter holdings – Above 50%
- Shares not pledged
- ROCE – Above 15% in last 3 years
- ROA above 15% – Capital light business model
- Sales growth above 15%
- Profit growth above 15%
- Profit margin increasing/better than competitors
- CFO matching with net profit
- High reinvestment rate and high ROIIC
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