Finance Infopedia Logo
Menu
  • Start Here
  • Personal Finance
  • Equity
  • Invest in USA
  • Fundamental Analysis
  • Mutual Fund
    • Debt Fund
  • Macro Economics
  • Products
    • Equity Investment Library
    • My portfolio
    • How to do a “Quick Test” to study business performance
    • Financial Ratios Analysis Tutorial with DCF method of Valuation
  • Passive Income
    • Blogging
  • Cryptocurrency
  • Quotes
  • Aggregated Content
  • About
    • Contact Us
    • Do Business Together
    • Vision and Mission
    • Jobs
    • Privacy Policy
    • Terms Of Use
  • Forum
  • My Portfolio
Menu

Simple Strategy On How To Identify Good Stocks

Posted on May 8, 2021May 26, 2021 by Finance Infopedia

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.

  1. ROCE
  2. ROIIC
  3. ROE
  4. ROA
  5. PE Ratio
  6. PEG
  7. Dividend Yield
  8. Debt/Equity Ratio
  9. Profit Growth
  10. Sales Growth
  11. Cash Flow Vs Net profit
  12. Free Cash Flow
  13. DCF Analysis
  14. Market Cap
  15. Operating Profit Margin
  16. Net Profit Margin
  17. Price to Book Ratio
  18. Earning Per Share
  19. Promoter Holding
  20. Pledged Shares
  21. Interest Coverage Ratio
  22. Current Ratio
  23. Quick Ratio
  24. Industry PE
  25. Price to Sales Ratio
  26. Buffet $1 Test
  27. Intrinsic Value
  28. EBITDA
  29. Equity capital
  30. Preference capital
  31. Reserves
  32. Secured loan
  33. Unsecured loan
  34. Balance sheet total
  35. Gross block
  36. Revaluation reserve
  37. Accumulated depreciation
  38. Net block
  39. Capital work in progress
  40. Investments
  41. Current assets
  42. Current liabilities
  43. Book value of unquoted investments
  44. Market value of quoted investments
  45. Contingent liabilities
  46. Total Assets
  47. Working capital
  48. Inventory
  49. Trade receivables
  50. Face value
  51. Cash Equivalents
  52. Advance from Customers
  53. 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.

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.

Growth

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.

Moat

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

Price

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
  • FCF
  • High reinvestment rate and high ROIIC

Also read: What is cryptocurrency?

Also read: What is financial literacy?

Also read: What is the future of Indian stock market?

Also read: How to invest in US stocks from India

Also read: What is an annual report and how to read it?

Also read: What is return on capital employed or ROCE?

Share this:

  • WhatsApp
  • Facebook
  • Twitter
  • Print
  • LinkedIn
  • Reddit
  • Tumblr

Related

Our Products

Subscribe To Our Newsletter

* indicates required
Author
Finance Infopedia

Hai,

My name is Ashlin Joby Thekkan. Living in Kerala in India (also known as God’s own country). Over the last 10 years, I have read and researched a lot on topics like personal finance management, equity investing etc. Now I can proudly say that all my efforts have helped me to gain knowledge and expertise in the field of equity investment and personal finance management.

I realized that the level of financial literacy among people, even among those who are well educated is very low. The moment I realized my passion for teaching personal finance management and investing, I started looking for platforms through which I can reach out to the public and teach them on related topics. I found that blogging is the right platform for me to reach out to a large audience and that helped me to become the founder of Finance Infopedia.

Categories

Recent Posts

  • Type Of Promoters You Can Find In The Market
  • Why do I like equity investment? 17 Reasons Explained.
  • What Is Meant By Stock Market Index?
  • Protected: Quick Analysis Of A Business
  • Fundamental Analysis of Asian Paints Ltd.
©2023 Finance Infopedia | Design: Newspaperly WordPress Theme