August 15, 2008

How i analyse stocks

I have been asked via emails and comments on the process I follow in analysing stocks. I have written about my approach earlier, but may have never put it formally in a single post.

My approach essentially consists of the following steps

1. Idea generation – This is typically the first step in the process. It involves searching for undervalued ideas. I do not have a strict formula for the search process. I use icici direct website to run a few screens to generate some ideas. Some of the screens are as follows

PE less than 13
ROE greater than 13%,
debt / Equity less than 0.7

Once I get this list, I export it into excel and then add additional parameters to it such as Net profit performance for last 5 years, ROE for last 5 years etc . A few companies get eliminated at this stage if they had losses for the last few years and have only been profitable for a year or two. Once I have shorter list, I start looking at the Profit and loss statement, Balance sheet and ratios. A few companies get eliminated if I don’t like what I see at this point of time. For ex: If the free cash flow is poor for the company, I will remove the company from the list.

In some cases the elimination is not really scientific and is driven by my whims and fancy ( I am not as rational as I should be). So highly cyclical companies, which seem to have a very low PE due to sudden profit spurt are eliminated if their normalised PE is not attractive. After all this number crunching, I may be left with a 10-12 companies.

Another source of ideas are blogs of other value investors, articles or suggestions by some other investors I admire and follow. If I see them talking about a company, I add it to the list and start investigating it.

2. Annual report review – Once I have a list of interesting ideas, I start scanning the annual reports of these companies to look for any red flags or hidden value. Some companies get eliminated at this stage if I find something fishy. Once I like the numbers I see, I start reading the Annual report from the beginning, starting with the Director’s report, Management discussion etc.

3. Valuation template – Once I have a rough idea of the company and if the company still looks good, I start updating my valuation template. I start with the Quantitative numbers, follow it up with an industry analysis, competitive analysis etc. I keep referring back to the annual report to update the worksheets and answer some of the questions in the template. I also use this stage to generate more questions on the company.

4. Broad research – After updating the basic numbers and the qualitative worksheet, I may end up with some open questions. For ex: How is the industry expected to do over the next few years? . How will competition impact the company etc ?. At this point, I start doing some research on the net to find answers to these questions though I may or may not be successful at this stage in finding answers . I may even download the AR of the main competitors and review it to get a feel of the industry. This stage is fairly unstructured and I just trying to gather as much information about the company and industry as possible

5. Valuation – If I am still comfortable with the company, I start the DCF calculation and other valuation exercises. Over time I have realised the valuation exercise is fairly redundant. If the undervaluation is not perfectly obvious by now, then plugging some numbers and making a bunch of assumptions is not going to make the company an attractive buy. The numbers being plugged into the model are dependent on the qualitative analysis done during previous stages.

During this stage I go through a DCF valuation, comparative valuation and a probability based valuation exercise. If the numbers match with each other in all the approaches, then I am more confident of the Intrinsic value estimates

6. Portfolio inclusion – I typically try to keep 12-15 companies in my portfolio. So if a company has to get added, another has to go out. This prevents my portfolio from becoming a zoo of mediocre ideas. I compare the discount at which the new company is selling to my estimate of the intrinsic value. I then compare this discount with that of the other companies in my portfolio. If the new idea is better than an existing one, then it replaces it. Else I may make just a very small token investment to track the company and wait till it become more attractive or some other company goes out of the portfolio.

Although I have listed the steps in a very linear and logical fashion, in reality it is not so neat. Multiple steps are going on at the same time and I may sometimes skip a step too.

As you can see, the process is a bit elaborate and time consuming. I however do not find it cumbersome as I enjoy doing it.

Come to think of it, why should it be easy? is there any competitive profession in the world where you can make good money without any effort ? why should investing be any different ? Have you ever heard that someone has become a heart surgeon in a day?

20 comments:

Shiv Kumar said...

hi Rohit,

Very informative post on how you go about systematically short-listing companies.

Could you post something on how successful have your efforts been over time. I am presuming you have have been at this for a few years at least.

Rohit Chauhan said...

Hi shiv
i have been seriously investing for the last 8-9 years. I have averaged around 30-32% per annum versus an index return of 17% during the period.
ofcourse these are not audited returns and involved small sums of money.
regards
rohit

Anonymous said...

Hi Rohit,

Just for the record. Are you in a job of investments or you have a different day job and this process is only for your surplus funds. I think this is important for those who read your blog to gain a fuller perspective.

A small personal background (of course only investments-related) would help.

Thanks
Prashant

Rohit Chauhan said...

Hi prashant
no i work as a supply chain consultant. investing is a side thing ..though i spend 8-10 hrs a week or more on it.

i will post on my personal experience with investing ..

I invest for me and my family,although i have ambitions of eventually starting an investment partnership, but that is still some time away.

regards
rohit

Vishnu said...

Hi Rohit,

I know the whole India is interested in Sensex and Stocks etc..

What about your experience in the follow ?

1) Bond Investing ( Traded through NSE / BSE ? )
2) Convertible Bonds (Traded through through NSE/BSE? )
3)Closed End Mutual Fund Investing ?
4)Short Term Government Notes ?

Regards
Vishnu

Rohit Chauhan said...

Hi vishnu

i have not invested in any of these instruments.i invested in closed end mutual funds once, but found it to be cumbersome. for fixed income i have concentrated only on mutual funds. convertible bonds looks like an interesting area, but i have not looked at it

regards
rohit

xxdhoomxx said...

Rohit,

I wanted to commend you for your excellent work here. I'm an aspiring value investor and I'm currently just in the learning phase of things. My question to you is what sources and/or methods did you use to acquire knowledge on value investing, i.e. books, courses, classes etc?

Thanks
Abhijeet

Rohit Chauhan said...

Hi abhijeet
mainly books to learn about valueinvesting. i am highly influenced by warren buffett, phi fisher, benjamin graham etc. so i have read a lot on these investors in the last few years. that is how i have developed my investment approach
beyond that the learning has come via studying companies and investing in them and learning from my own mistakes and success.

investing is a cumulative process..as you learn more you better by the day

regards
rohit

Ninad Kunder said...

Hi Rohit

You mentioned about starting a investment partnership. Have you done any groundwork in Indian laws in terms of possible structuring of the patnership.

I am referring specifically to the tax laws.

Cheers

Ninad

Rohit Chauhan said...

Hi ninad

i havent done any groundwork on an investment partnership. do you have an idea on that ?

regards
rohit

Anonymous said...

which companies did u invest in? Did u put in Geodesic, ICSA, or Micro techonlogies. High growth companies?

Rohit Chauhan said...

Hi anon
no i have not invested in any of these companies

regards
rohit

Anonymous said...

If you are value investor and have not put money in companies like Micro techonologies, Vakrangee, Venus Remedies,ICSA. Then I wud like to understand the reasons as to why u dont value such companies.
It all boil downs to the result that you produce. To attain great results you have to be with consistent high growth companies with strong fundamentals. Had u invested 1 lakh in Infosys in 1994 and remained in it and slept in it till 2008, i hope u know what kind of money u wud have made.
There may be successful strategies but nothing better than the kind of return u get using this strategy.
Another case studies cud be Matrix Labs, Rajesh Exports, Educomp.
I wud be love to get myself proved wrong by you.

Rathin Shah said...

Hi Rohit,
sorry for writing after such a long time...hust wanted to ask whether owner earnings is better or is it the free cash flow to guage the cashflows of the companies. I must say that owner earnings is esaier to calculate. In ur post u said that u undertake FCF for further resaerch. So how do u calculate that quickly...

Regards
Rathin

Rohit Chauhan said...

Hi anonymous

you are looking at companies in the rear mirror view basis. looking back infosys looks great if you invested in 1993, but how many people knew that in 1993. also for every infosys there are 10 other companies which did not do well.

also you make money in companies which are doing well, but the price does not reflect the performance. if you invested in infosys in 2000 at the wrong price, you would have lost money.

what you refer to is growth investing. I am not comfortable with that kind of investing. some companies like ICSA etc i have reviewed to a certain extent and have yet to decide on them. any company which has shown growth in the recent years is not necessarily a bargain. that said, i do not know much about these companies to comment.

about the other set of companies such matrix labs etc ..i have not analysed and hence cannot comment. educomp seems to be richly valued ..the company may have a lot of promise ..but that type of investing is not my cup of tea.

I think your investing approach maybe different than mine ..so i cannot prove you right or wrong ..it is just that we operate in different areas.

regards
rohit

Rohit Chauhan said...

Hi rathin
i think buffett talks about owners earnings which as far as i know is different term for FCF ..anyway my formulae is as follows

FCF = NOPAT (net operating profit after tax)+ deprecitation - maintenence expenditure.

I have this formulae in the valuation template. you download it from the google groups

regards
rohit

Anonymous said...

Hello Rohit
I am trying to learn & understand how to calculate intrinsic value, i have downloaded all your spreadsheets. but i am facing one problem. I can't see financial figures are same across various sites. I currently refer Rediff & Moneycontrol, but they also have different figures. How do you do that? I preferred in case respective company's website for referring results.
Also please tell me only
1) PAT
2) Depreciation
3) Capex
4) Shares outstanding
and growth rates are sufficient to calculate intrinsic value? Will that be correct value or approximately.

also i referred few formulas that take only FCF to calculate Intrinsic value. are those formulas correct?

Please reply.
regards
Ani

Anonymous said...

Hi Rohit,

If I take u back to 1994, how would u have spotted Infosys. The only way one could spot it cud be through the market opportunity, gud results and good management.or u may enlighten if there was any other way. So it cud have been a kind of recurring deposit wherein one wud have seen gud results and put money in that company every quarter.
I agree there cud have been companies where the growth wud have stopped, but then its like finding out 20 horses in a race of 5000 and then slowly and steadily identifying the best horse through results only. When I say results I mean higher EPS also and not just a company like Teledata or any other which diluted its equity too.

Thats what big companies like GE, Tatas do. Hire gud people and then thru performance weed out the non performers.

Agreed that Educomp is richly valued or investing in Infosys in 2000 wud have been burning fingers. What I am saying is that implmenting the value investing approach with growth companies.
Take micro technologies for instance. It has been growing at CAGR of >50% for last 4 years. It has a book value of 206 approx. It trades at 220. EPS of around 50. Almost no debt. Mcap of <250 crore at a sales of 170 crores.
or we take a company like Geodesic. growing at >60% CAGR for last few years. These companies are not richly valued at all.

Thru Value Investing combined with Growth, I cud see huge returns. Unfortunately I did not put a lot for money. e.g Rajesh Exports in a single year increased its sales from 200 to 2200 crore somewhere around 2003. That time the stock did not appreciate and had excellent value(128 book value, eps around 40, Price around 150. It gave 25 times returns since then), That was the time to enter and make huge money. and I did but with a small amount as I was learning then.

Rohit Chauhan said...

Hi ani

use the company's annual report to get the numbers. In addition to the numbers above you need future growth and CAP (competitive advantage period) to calculate intrinsic value

i am not sure which FCF related formulae you are refferring to

regards
rohit

Anonymous said...

Hi I would like to know that from where do you short list the cos you do i mean do you use a database? secondly how do you get hold of the balance sheet???