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How to Generate Stock Ideas

In an interview with Warren Buffett in 1993, Adam Smith, author of Supermoney, asked how the small investor can find good investment ideas.

Warren Buffett: I’d tell him to do exactly what I did 40-odd years ago, which is to learn about every company in the United States that has publicly traded securities, and that bank of knowledge will do him or her terrific good over time.

Adam Smith: But there are 27,000 public companies.

Warren Buffett: Well, start with the A’s.

Everybody knows that Warren Buffett gets his investment ideas largely from annual reports.

Of course, now he has become so influential that companies call him to share their own ideas. But, fifty years ago, Buffett was not the go-to guy if you wanted to sell your company or raise capital for your failing bank.

He was a small investor who was clawing his way up the investing street by reading whatever annual report came his way, and then finding his investment ideas that worked wonders in the subsequent years.

You are probably at the same stage Buffett was fifty years ago. But there’s a big advantage you have over the early day Buffett.

That advantage is – technology.

With annual reports now available at the press of a few buttons (on company websites and BSE), you can look through hundreds of companies in lesser time than it took Buffett to access ten companies.

You may ask, “But how do I select companies whose annual reports I should read?”

Well, one quick suggestion is what Buffett told Adam Smith – “…start with the A’s.”

I would simplify this for you…

  1. Take, for instance, the BSE-200 list of companies
  2. Remove all companies that you “know” are outside your circle of competence (Don’t worry if you remove lot of companies…because the size of the circle is not important, knowing its boundary is)
  3. For companies that remain, start reading annual reports of companies whose names start with A, then B, and so on. 🙂

If you find this difficult to implement (and it is), here are a few other ways you can create a list of companies you would like to do a deeper research on to generate stock ideas…


Remember, good ideas rarely come from…

  • TV, newspaper analysis and breaking news
  • Brokers and research analysts
  • Friends, colleagues, and people you meet at social gatherings

…so you may rather do your own homework than relying on free tips, however enticing they may sound.
Screening Your Way to Stock-dom!
While I am not anymore a big fan of using readymade screeners to generate stock ideas – because you tend to substitute thinking with a lot of data – simple screeners still help me in doing the initial groundwork.

Also, while there are a few paid (and expensive) screeners available in the market – like Ace Equity, Prowess, Capital Line – I find a few free screeners to be very effective when it comes to the value I can derive from using them.

Here are three steps you can use while using three free screeners I use to do a basic analysis on companies…

Step 1: Use a Google Screener
Visit this Google Finance Stock Screener page and select “India” from the drop down list of countries, and then BSE or NSE from the stock exchange list.

Remove all entries like “Market Cap”, “P/E Ratio” etc, so that you can set your own criteria for screening. Then, screen for companies using these key numbers (you may add more screening criteria from those available)…

  • 5-year sales growth – Between 10% to 50% – Neither too low nor too high to avoid extremes or cases with sharp rise and sharp falls that may revert to the mean
  • 5-year EPS growth – Between 10% and 50% – Neither too low nor too high to avoid extremes or cases with sharp rise and sharp falls that may revert to the mean
  • Latest Net Profit Margin – Between 5% and 75%
  • 5-year Avg. Return on Equity – Between 15% and 100%
  • Latest Debt/Equity Ratio – Less than 100%
  • Latest Market Capitalization – At least Rs 2.5 billion (Rs 250 crore) to exclude extremely small companies
  • Latest P/E ratio – Between 5x and 25x
  • Volume – At least 100 shares traded daily

Here is how the screening and its output look like…



Note: Another good screener that a tribesmen has directed me to is from Financial Times – FT Equity Screener. It has greater number of criteria than Google’s screener, but does not display the results in INR. You must however try it out for sure.

Step 2: From the list of companies you get, exclude those outside your circle of competence – businesses you “know” you don’t understand (like I would exclude commodity businesses like metals and mining, or oil & gas businesses).

Step 3: Glance at the last 5/10 years’ financial performance on sites like Screener or Morningstar. Look for trends in:

  • Sales growth – Check for rising and stable growth
  • Net margin – Stable / rising margin. Be wary of margins that are falling
  • Return on equity – Stable or rising. Be wary of falling ROE
  • D/E – Nil or small debt is fine. Be wary of companies where D/E > 1x
  • FCF change – Morningstar gives the free cash flow calculation, which instantly tells you if the company is generating cash or burning it. Look for businesses that have generated positive FCF over the past few years
  • Apart from the ratios given, calculate ones like FCF yield – FCF per Share divided by Stock Price, which tells you if the stock is cheap or expensive. An FCF yield of 5% or more is a good number to look at.

The best part about these two screeners – Screener and Morningstar – is that you can download companies’s financial performance in excel and then do you own analyses.

Better Alternative to Step 3
While you may use Screener or Morningstar to study the past 5/10 years’s performance of companies that you get from Step 1 and Step 2 above, a far better way is to pick up the annual reports of the resultant companies and then read them one by one.

After having used readymade screens for the past few years, I have realized that you should not use numbers prepared by others, but rather generate them yourself. This way you get into the habit of actually reading annual reports and also get to learn what numbers you need to focus on.

Here are two videos that will tell you what you must focus on in an annual report…

     

If you can’t see the videos above, see here – Video 1 | Video 2

Ultimately, as you would realize, just a few numbers / facts / variables will help you understand what drives a given business.

I have seen analysts and investors trying to get perfect in their analysis by accumulating as many data points as possible.

But then, my experience suggests that trying to increase your confidence by gathering information that is supposedly unknown to most others really only makes you more comfortable with your investment decisions, not better at them, and is generally an unproductive use of your limited time.

Thus, I would suggest that after you arrive at your list of companies using any or a combination of methods suggested above, use a “Less is More Checklist” while reading the annual reports of the companies in your list.

Use the “Less is More” Checklist
Rather than obsessing with the bewildering fusion of news and noise, concentrate on a few key elements in stock selection, i.e., what are the 5-10 most important things you should know about any business you are about to invest in?

Of course, if I knew the exact answer I would have retired long ago! 🙂

Even if I could know all the facts about an investment, I would not necessarily profit. This is not to say that fundamental analysis is not useful. It certainly is.

But information generally follows the well-known 80/20 rule: the first 80% of the available information is gathered in the first 20% of the time spent.

So if I were to list down eight questions that, I believe, would help me do an 80% analysis of a business, they would be…

  1. Is the business simple to understand and run? (Complex businesses often face complexities difficult for its managers to get over)
  2. Has the company grown its sales and EPS consistently over the past 5-10 years? (Consistency is more important than speed of growth)
  3. Will the company be around and profitably better in 10 years? (Suggests continuity in demand for the company’s products/services)
  4. How has the company performed on Buffett’s earnings retention test? (Suggests how a company has used retained earnings in the past – a very important question to answer)
  5. Does the company have a sustainable competitive moat? (Pricing power, gross margins, lead over competitors, entry barriers for new players)
  6. How good is the management given the hand it has been dealt? (Capital allocation, return on equity, corporate governance, performance against competition)
  7. Does the company require consistent capex and working capital expenditure to grow its business? (Companies that have to spend continuously on such areas are like running on treadmills, which is not a good situation to have)
  8. Does the company generate more cash than it consumes? (Cash generators have a higher probability of surviving and prospering during bad economic situations)

These questions would help you answer whether the business you are looking into is great, good or gruesome as Warren Buffett has defined each one of them to be.

Ultimately, successful investing is all about doing your own research carefully and buying good businesses.

If you know a company well and you’ve done your homework, you can take advantage of situations when Mr. Market offers them on a platter, which he occasionally does.

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About the Author

Vishal Khandelwal is the founder of Safal Niveshak. He works with small investors to help them become smart and independent in their stock market investing decisions. He is a SEBI registered Research Analyst. Connect with Vishal on Twitter.

Comments

  1. Hey Vishal,
    Visited ur site after a while , nice post as always and gained info on FT equity screener … ( noticed your nice pics from Kerala too ! )
    Cheers
    Austin.

  2. Sachin Thakur says:

    Wow!! This is great!!

    Thanks for sharing!!

    There are so many things to learn not sure how a person who’s on regular job can manage learning all this. Your posts are inspiring me to read more and learn more before putting my savings into something equivalent to gambling, without having knowledge about how it works, just by looking at markets going up and down…

    Your post on “Biases”, makes me realize why I was wrong when I started buying stocks like Ashok Leyland from Rs. 22 till 16 and then it went onto 13…I should have studied why its going down at the first place…

    I am trading for past 5 years…not very frequently though….recently I had doubled my money in 3 months time…and then lost the profit in 2 weeks….

    Somehow getting a feel that this whole investing business is not that easy and I should go for traditional investments like property.

    I have started this detailed value investment thing just few weeks back after I stumbled upon your blog. I am not going to give up and will invest 6 months-year to understand the basics…till that time all the money will go in FDs.

    Even after spending that time to understand how companies work then I will consider myself dumb and not suitable for this type of investments and continue with FDs.

    People like you are really helping this country.

  3. Hi Vishal,

    In step-1 using the Google screener, : I know you have provided just an example : But – if you wanted to see the stocks having the D/E ratio 1x, then the number to be given in the right side box is not 1. I think it should be 100 Google s/w. For some reson the Google s/w take input as % and not as ratio. Otherwise, the company like Cera Sanitaryware which meets your criteria does not show up inspite of giving these values. Just a check – I am sorry if I misunderstood.

    I have a question. Why do you exclude extremely small companies and choose companies with high volume? You mentioned in one of your posts earlier that “ITC” now was just “itc” earlier. I see the company “Control Print” (market cap 46 crore – small company) But has excellent business and balance sheet. Currently trading at around 62 Rs a share. I understand that in the market there are only buyers (no sellers) of this share. Can you please share your thoughts on it if you have time ?

    Regards,
    Shyam

    • Thanks for correcting Shyam! I’ve changed the range for D/E to <100% in the text above the image.

      I just showed this for explanation purpose and won't exclude small companies from my screening. Regards.

  4. 1. In stock selection one should focus on first 1) business then 2 ) management and last 3 ) valuation .

    2. While a lot has been written on data screeners , I feel they just churn out patterns from the past data but do not really help in predicting future performance . 2 examples :

    a ) Tata Power’s financials have got for a toss because of expensive imported coal for Mundra . If a data screener had given out a buy call based on the past financials it could not have anticipated Indonesian policy change for coal exports .

    b) MPS under the foreign management was going though a horrible time and the stock reached a low of around Rs. 30 – 40 last year . This was when it was taken over by a dynamic individual who in a matter of little over a year turned the stock into a multi-bagger .No data screener could have predicted this based on past financials .

    3. One should focus on companies having negative working capital as this results in free ‘ float ‘ funds which gives a big boost to ROCE and thereby valuations .FMCG companies like HUL , GCPL generally operate with negative working capital .

    4. Warren Buffett says don’t hold a stock for even 10 minutes if you are not willing to hold it for 10 years . There is a lot of wisdom in this . Underlying this is earnings visibility which comes from businesses with modest rate of change .Brokers with an aim to earn fees always come out with buy calls based on the latest flavour of the day .Analysts also have a tendency to overweigh recent performance and use that to extrapolate the future . By the way even star foreign analysts like Mary Meeker and Henry Blodget have bitten the dust with their calls .

    Stocks like Tulip Systems , SKS Microfinance , Jain Irigation , Educomp , Pentamedia , HFCL , GTL etc .all soared to obscene levels . Could one say with confidence then that 10 years down the line they would be existing ! Sure a few stocks like Google , Apple would be multi-baggers , however for every Google there are thousands that bite the dust .

    However if one looks at businesses that cater to basic human needs like shaving ( Gillette ) , housing ( HDFC ) , power ( Tata Power ) , paints ( Asian Paints ) and so one there is perpetual earnings visibility .

    5. There is a whole lot of emphasis on calculating the intrinsic value by way of DCF . Bruce Greenwald rubbishes DCF because 1 ) ignores the balance sheet 2 ) cash flows are uncertain 3 ) whole lot of assumptions , a mere tweaking of which would result in a large variation in results .

    Analysts ( like hyperactive fund managers ) in order to earn their keep spend a lot of time on elaborate financial models just to justify their predictions .While the theory behind J.B. Williams DCF proposition is sound , in actual practice it is far from so .

  5. Thanks for the google stock screener page. I was not aware of it.

  6. Hi Vishal

    Have been a silent reader for around a year but this was such an excellent post that couldn’t stop commenting on it…have used google screener but morningstar financial data will be really helpful…so far using moneycontrol data links in my excel sheet but they are just for last 5 years/quarters…thanks a lot and keep posting valuable content,,,

    JP

  7. Nice post. Thanks for all the info. Lot of useful bits for a beginner like me – especially about screeners and other blogs.

  8. Fantastic post, thank you so much!

  9. Hello Vishal, Do u have an article or recommendation on what to look for to decide if we need to sell a share in the portfolio ?

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