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?