How To Pick The Best Stocks for Investing

When we take up a company for research, the first step is understanding the business as much as possible. People often miss this crucial step and go directly into the stock price analysis. Well, just analysing the stock price would be great if we had a short-term perspective. However, for long-term investments, understanding the business is essential.

Why is it important to pick the best stock for investing?

The reason is simple: the more we know the company, the higher our conviction is to stay invested, especially during bad times (aka bear markets). Remember, during bear markets, the prices react and not the business fundamentals. Understanding the company and its business well gives us the conviction to reason why staying invested in the stock makes sense even though the market may think otherwise. They say bear markets create value, so if we have a high conviction in the company, we should consider buying into the stock during bear markets and not selling it. Needless to say, this is highly counter-intuitive, and it takes years of investment practice to internalise this fact.

Anyway, moving ahead, the best source to get information related to the business is the company’s website and its annual report, press releases, presentations, earnings calls, etc. We need to study at least the last 5-year annual report to understand how it evolves across business cycles.

Understanding the Business

As a first step towards understanding the business, we need to make a list of questions we need to find answers to. Do note that the answers to all these questions can be found by reading through the company’s annual report and website.

Here are a bunch of questions that we think help us in our quest to understand the business. We have discussed the rationale behind each question.

Sl No	Question	The rationale behind the question
1	What does the company do?	To get a basic understanding of the business
2	Who are its promoters and their backgrounds?	To know the people behind the business. Sanity checks to eliminate criminal background, intense political affiliation, etc
3	What do they manufacture (in case it is a manufacturing company)?	To know their products better helps us get a sense of the product’s demand-supply dynamics
4	What kind of raw material does the company require?	Helps us understand the dependency of the company. For example, the raw material could be regulated by Govt (like Coal), or the raw material needs to be imported, either of which needs further investigation
5	Who are the company’s clients or end-users?	By knowing the client base, we can get a sense of the sales cycle and efforts required to sell the company’s products
6	Who are their competitors?	Helps in knowing the competitors. Too many competing companies mean margin pressure. In such a case, the company has to do something innovative. Margins are higher if the company operates in – a monopoly, duopoly, or oligopoly market structure
7	Who are the major shareholders of the company?	Besides the promoter and promoter group, it helps to know who else owns the company’s shares. If a highly successful investor holds shares in the company, then it could be a good sign
8	Do they plan to launch any new products?	Gives a sense of how ambitious and innovative the company is. At the same time, a company launching products outside their domain raises some red flags – is the company losing focus?
9	Do they plan to expand to different countries?	Same rationale as above
10	What is the revenue mix? Which product sells the most?	Helps us understand which segment (and, therefore, the product) is contributing the most to revenue. This, in turn, helps us understand the drivers for future revenue growth

These questions are thought starters for understanding any company. In finding answers, we will automatically start posting new questions for which we will have to find answers. It does not matter which company we are looking at if we follow this Q&A framework.

Remember, this is the first step in the equity research process. If we find red flags (or something not right about the company) while discovering the answers, we would advise dropping researching the company further, irrespective of how attractive the business looks. In case of a red flag, there is no point in proceeding to stage 2 of equity research.

From our experience, we can tell you that stage 1 of equity research, i.e. ‘Understanding the Company’, takes about 15 hours. After going through this process, we usually try to summarise our thoughts on a single sheet of paper, which encapsulates all the important things we have discovered about the company. This information sheet has to be crisp and to the point. If we cannot achieve this, then it is clear that we do not know enough about the company. After going through stage 1, we proceed to stage 2 of equity research, “Application of Checklist”.

We will now proceed to stage 2 of equity research. The best way to understand stage 2 is by actually implementing the checklist in a company.

Let us consider ABC Ltd and evaluate the checklist for the same company. The company may differ, but the equity research framework remains the same.

Application of Checklist

Stage 1 of the equity research process helps us understand how, what, who, and why. It helps us develop a holistic view of the company. However, as they say – the proof of the pudding is in the eating, so no matter how attractive the business looks, the company's numbers should also look attractive.

The objective of the 2nd stage of equity research is to help us comprehend the numbers and evaluate if the business’s nature and financial performance complement each other. The company will not qualify as an investible grade if they do not complement each other.

Here is a quick checklist for a brief understanding. Below the checklist is a more detailed understanding of how to apply the checklist: 

Sl No	Variable	Comment	What does it signify?
1	Net Profit Growth	In line with the gross profit growth	Revenue growth should be in line with the profit growth
2	EPS	EPS should be consistent with the Net Profits	If a company is diluting its equity, then it is not good for its shareholders
3	Gross Profit Margin (GPM)	Generally > 20% as it indicates pricing power	Higher the margin, higher is the evidence of a sustainable moat
4	Debt Level	The company should not be highly leveraged	High debt means the company is operating on high leverage. Plus, the finance cost eats away the earnings
5	Inventory	Applicable for manufacturing companies	A growing inventory, along with a growing Profit After Tax (PAT) margin, is a good sign. Always check the inventory number of days
6	Sales vs Receivables	Sales backed by receivables is not a great sign	This signifies that the company is just pushing its products to show revenue growth
7	Cash flow from operations	Has to be positive	If the company is not generating cash from operations, then it indicates operating stress
8	Return on Equity	Has to be positive	Higher the ROE, better it is for the investor, however, make sure you check the debt levels along with this

Let us go ahead and evaluate each of the checklist items on ABC company and see what the numbers are suggesting. First, we will look into the company's P&L items – Gross Profit, Net Profit, and EPS.

Revenue and PAT Growth

The first sign that a company may qualify as an investable grade is its growth rate. We need to check the revenue and PAT growth to evaluate the company's growth. We will evaluate growth from two perspectives:

Year-on-year growth: This will give us a sense of the company's progress every year. Note that industries go through cyclical shifts. From that perspective, if a company has a flat growth rate, it is okay. However, just check the competition and ensure the growth is flat industry-wide.

Compounded Annual Growth Rate (CAGR): This gives us a sense of how the company evolves and grows across business cycles. A good, investable-grade company is usually the first to overcome the shifts in business cycles. This will eventually reflect in a healthy CAGR.

We prefer to invest in growing (Revenue and PAT) companies over and above 15% on a CAGR basis.

Let us see how ABC company fares here:

FY	Revenue (₹ crore)	Revenue Growth	PAT (₹ crore)	PAT Growth
FY 09 -10	1,481	19.40%	167	-11.30%
FY 10-11	1,769	35.30%	148	45.20%
FY 11-12	2,392	25.60%	215	33.30%
FY 12 -13	3,005	15.90%	287	27.80%
FY 13 – 14	3,482	16.20%	367	27.80%

The 5-year CAGR revenue growth is 18.6%, and the 5-year CAGR PAT growth is 17.01%. These are interesting numbers; they qualify as a healthy set of numbers. However, we still need to evaluate the other numbers on the checklist.

Earnings per Share (EPS)

The earnings per share represent the profitability on a per-share basis. The EPS and PAT growth at a similar rate indicates that the company does not dilute the earnings by issuing new shares, which is good for the existing shareholders. One can think of this as a reflection of the company’s management’s capabilities.

Face Value	FY	EPS (In ₹)	Share Cap(₹ Cr)	EPS Growth
₹1	FY 09 -10	19.56	17.08	-
₹1	FY 10-11	17.34	17.08	-11.35%
₹1	FY 11-12	12.59	17.08	-27.39%
₹1	FY 12 -13	16.78	17.08	33.28%
₹1	FY 13 – 14	21.51	17.08	28.18%

Now, if we calculate the compounded annual growth rate of EPS using the data above, then the 5-year EPS CAGR stands at 1.90% for the period FY 09 - FY 14. 

Gross Profit Margins

Gross Profit margins are expressed as a percentage calculated as a –

Gross Profit margins = Gross Profits / Net Sales

where

Gross Profits = [Net Sales – Cost of Goods Sold]

Cost of goods sold is the cost involved in making the finished goods; we had discussed this calculation while understanding the inventory turnover ratio. Let us proceed to check how ABC company’s Gross Profit margins have evolved over the years.

FY	Net Sales	COGS	Gross Profits	Gross Profit Margins
FY 09-10	1464	1014	450	30.70%
FY 10-11	1757	1266	491	27.90%
FY 11-12	2359	1682	677	28.70%
FY 12-13	2944	2159	785	26.70%
FY 13-14	3404	2450	954	28.00%

Clearly, the Gross Profit Margins (GPM) looks very impressive. The checklist mandates a minimum GPM of 20%. ABC company has much more than the minimum GPM requirement. This implies a couple of things –

ABC company enjoys a premium spot in the market structure. This may be because of the absence of competition in the sector, which enables a few companies to enjoy higher margins.

Good operational efficiency, which in turn is a reflection of management’s capabilities

Debt Level – Balance Sheet check

The first three points in the checklist were mainly related to the company’s Profit & Loss statement. We will now look through a few Balance sheet items. One of the most important line items that we need to look at on the Balance Sheet is the Debt. An increasingly high level of debt indicates a high degree of financial leverage. Growth at the cost of financial leverage is quite dangerous. Also, do remember, that a large debt on balance sheets means a large financial cost charge. This eats into the retained earnings of the firm.

Here is how the debt stands for ABC Company –

FY	Debt (₹ Cr)	EBIT (₹ Cr)	Debt/EBIT (%)
FY 09-10	91.19	261	35.00%
FY 10-11	95.04	223	42.61%
FY 11-12	84.07	321	26.19%
FY 12-13	87.17	431	20.22%
FY 13-14	84.28	541	15.57%

The debt seems to have stabilised around ₹85 crore. In fact, it is encouraging to see that the debt has come down in comparison to FY 09-10. Besides checking for the interest coverage ratio (which we have discussed previously), we would also like to check the debt as a percentage of ‘Earnings before interest and taxes’ (EBIT). This just gives a quick perspective on how the company is managing its finances. We can see that the Debt/EBIT ratio has consistently reduced.

We personally think ABC company has done a good job here by managing its debt level efficiently.

Inventory Check

Checking for the inventory data makes sense only if the company under consideration is a manufacturing company. Scrutinising the inventory data helps us in multiple ways –

Raising inventory with raising PAT indicates signs of a growing company

A stable inventory number of days indicates management’s operational efficiency to some extent

Let us see how ABC company fares on the inventory data –

FY	Inventory (₹ Cr)	Inventory Days	PAT (₹ Cr)
FY 09-10	217.6	68	167
FY 10-11	284.7	72	148
FY 11-12	266.6	60	215
FY 12-13	292.9	47	287
FY 13-14	335	47	367

The inventory number of days is more or less stable. In fact, it does show some signs of a slight decline. Do note that we have discussed the calculation of the inventory number of days in the previous chapter. The inventory and PAT are showing a similar growth sign, which is again a good sign.

Sales vs Receivables

We now look at the sales number in conjunction with the receivables of the company. A sale backed by receivables is not an encouraging sign. It signifies credit sales, and therefore many questions arise out of it. For instance – are the company sales personnel forced to sell products on credit? Is the company offering attractive (but not sustainable) credit to suppliers to push sales?

FY	Net Sales (₹ Cr)	Receivables (₹ Cr)	Receivables as a% of Net Sales
FY 09-10	1464	242.3	16.50%
FY 10-11	1758	305.7	17.40%
FY 11-12	2360	319.7	13.50%
FY 12-13	2944	380.7	12.90%
FY 13-14	3403	452.6	13.30%

The company has shown stability here. From the table above, we can conclude a large part of their sales is not backed by receivables, which is quite encouraging. In fact, just like the inventory number of days, the receivables as % of net sales have also shown signs of a decline, which is quite impressive.

Cash Flow from Operations

In fact, this is one of the most important checks one needs to run before deciding to invest in a company. The company should generate cash flows from operations; this is, in fact, where the proof of the pudding lies. A company that is draining cash from operations raises some sort of red flag.

FY	Cash Flow from Operations (₹ Cr)
FY 09-10	214.2
FY 10-11	86.1
FY 11-12	298.4
FY 12-13	335.4
FY 13-14	278.7

The cash flow from operations, although a bit volatile, has remained positive throughout the last 5 years. This only means ABC company’s core business operations are generating cash and, therefore, can be considered successful.

Return on Equity

Return on Equity (ROE) measures in percentage the return generated by the company keeping the shareholder’s equity in perspective. In a sense, ROE measures how successful the company’s promoters are for having invested their own funds in the company.

Here is how ABC company’s ROE has fared for the last 5 years –

FY	PAT (₹ Cr)	Shareholders' Equity (₹ Cars)	ROE (%)
FY 09-10	167	543.6	30.70%
FY 10-11	148	645.7	22.90%
FY 11-12	215	823.5	26.10%
FY 12-13	287	1059.8	27.10%
FY 13-14	367	1362.7	27.00%

These numbers are awe-inspiring. We like to invest in companies that have an ROE of over 20%. Do remember, in the case of ABC company, the debt is quite low. Hence the good set of return on equity numbers are not backed by excessive financial leverage, which is again highly desirable.

How To Do Fundamental Analysis on Angel One?

1. Open the Angel One App and find the stock you want to analyse from the Search bar.
2. Click on ‘ ‘Stock Details’ and then on ‘Fundamental’. 
3. Here, you can scroll down and check the fundamental analysis of the stock you are viewing.

Conclusion

Remember, we are in stage 2 of equity research. We see ABC company qualifying quite well on almost all the required parameters in stage 2. As equity research analysts, we have to view the output of stage 2 in conjunction with our findings from stage 1 (which deals with understanding the business). If we can develop a comfortable opinion (based on facts) after these 2 stages, the business surely appears to have investable grade attributes and therefore worth investing in.

However, before we buy the stock, we need to ensure the price is right. This can be done using different valuation techniques. However, this step requires fundamental assumptions about the company and it would not be fair to value a company laced with our biases. Therefore, the valuation must be undertaken on a personal basis and keep improving through feedback and nuanced information.

Finally, remember that selecting stocks does not make one a good investor. There are other aspects and measures that one must follow, so in the upcoming chapters, we’ll learn about other aspects of investing.