It is a basic factor that we make investments for generating returns. However, finding the right instrument to attain your financial goals is also a critical task. As we usually say, Equity investment is a good way to achieve your long-term financial goals. However, the question arises, how to select a good stock if someone wants to take exposure to direct equity. The simple answer to the same is to go for a top-down approach or an EIC analysis. To put it in a simple way, EIC analysis means Economic, Industry and Company analysis. While there are different macro and micro parameters for Economic analysis, there are various different parameters to analyse an industry in detail. When an economy is doing well it means overall the business scenario looks good. However, not all industries are considered good at a given point in time. There is always some rotation that occurs in terms of sectors that drive the indices. Hence selection of the sector ahead of the curve is very much important.
There are many factors and parameters if looked after properly can guide us to select the right sector or industry for investment. However, more than the quantitative factors we must focus on the qualitative factors on deciding our investment strategy. Going ahead we are discussing various qualitative factors to streamline our investment strategy.
Size of the Opportunity
When we focus on investment opportunities, we must look at the size of the opportunity. However, the problem is, everyone looks at the market size or the opportunity – how it was in the past and how it stands today. In simple words investing is not about how big something was in the past or has become today. It is much more about how large it can get from where it stands today. All in all – it is less about the past but more about the future.
Growth – ‘Scalable’ But should also be ‘Sustainable’
Growth as we mentioned as the size of the opportunity in the future is the second important factor. Remember, ultimately the investments that are showing great returns are winning due to compounding factors. It is important to understand that, even if you take a reasonable rate of 12-15% growth for a very long period of time in a durable and predictable way, there is a huge power to create a compounding machine out of that business. These compounding machines enjoy fantastic valuation in the market because they acquire an aura. So consistent growth is what matters the most.
Growth – What Parameter?
While we speak about the growth, most of the readers would be thinking about either Topline (revenue) or bottom-line (Net Profit) growth. A few would be even considering the EBITDA (Earnings Before Interest, Tax, Depreciation, and Amortisation). However when we mention growth, it does not mean growth of the top line, it is not even entirely the growth of the bottom line but it really the growth of cash flow over a period of time because that is the only reality. As the saying goes – “Top-line is the Vanity; Bottom-line is the Sanity and Cash Flows are the only reality”.
Capable Management – Qualitative Aspect
The third aspect which is directly linked to the first two is another qualitative aspect – Management quality. It is true that when the opportunity is large, compounding growth is possible. But remember, it is not automatic. Such a large opportunity has to be earned by a ‘Capable Management’. This means the third factor is the quality of management in terms of integrity and fairness. It means management quality in terms of vision to see farther (having a foresight) and even more important is ability to execute that vision on a long term basis. And this leads us to the most important parameter – Capital allocation. The foresight for business growth and capital allocation are two different signs of good management. A good management has a great capability to allocate capital in a very judicious manner amongst competing opportunities and has a relentless effort of ensuring capability by distributing away unnecessary amounts of cash from the balance sheet. This clearly suggests that capital allocation and right execution are the third most factors.
Quality of the Business
The fourth aspect to analyse is – quality of the business. It is impossible for a business which is inferior to create economic value. And if a business cannot create economic value, it cannot result in price appreciation of stock as well. Despite a weak business which is unable to create economic value if it acquires a stronger stock price, it is an image which is bound to be broken one day. You can never stop price performance going for a long period of time for a weak or inferior business. Similarly, you cannot suppress the valuation for a good business for a very long period. So fundamentally a business should have the capability to create economic value for a stock price to expand. The economic value will get created when the business fundamental earns a return on the capital if it is put to work superior to the cost of capital.
Margin of Safety – Utmost Important
And finally along with these attributes the most important parameter is – margin of safety in your favour. In simple words it is nothing but the price you pay as compared to the value that you get. These over 300 years of organised investing are to our mind, are enduring ideas as about which businesses would perform.
Many times it is a myth to believe that stock prices are dissociated with what is happening to the business. This may occur temporarily, that price may not have any correlation with the real situation of the business. But it is impossible to believe that on a more enduring basis such disassociation can happen. Always remember, price can perform only if the business has basic characteristics that it deserves and if the business lacks above characteristics it is impossible for price to acquire that stature.
Consistency is that matters
In an organised investing history, the above investing style remains an enduring, predictable and successful investing approach. Many people may have temporarily achieved richness by timing the market. In many bull markets that may happen. Remember, if after obtaining such returns, if they (timing the market) stay away from making such experiments then the wealth is retained. But if they try to do that again and again, then invariably it is followed by reversal. Eventually the wealth gets eroded. So timing so far has not proven to be a very successful exercise. The bright minds in the market cannot resist the temptation of trying to judge and make an opinion about the direction of the quantum of change of the market in a given defined time frame. To my mind, it’s a futile exercise. When you may work out right by succeeding at times but when you do it enough times, there will be failures. So, the net result is not attractive.
Hence it is important that you find a good business, judge it on the criteria that we have explained above where it has a larger opportunity, there is a compounding capability, and has a quality business to buy it at a reasonable price. Don’t worry about inflation, we are not saying ignore all these factors but ultimately you are buying a stock, you are not buying some economic tricks, you are not buying the market, you are not buying the country but you are buying a stock. It is determined by the cash flows, if they are real they are going to be durable and they are going to grow and it will have a value no matter what happens. And that I am sure we can succeed in forecasting, we should be successful in a pretty decent way.