#Stock selection criteria for investing during current market crash
Coronavirus has led to investors running for cover. It has taken massive wave of liquidity injections by the US FED to stabilize the market to some extent.
Well the stock market was overheated for a long time and the bubble was waiting to burst.
Now that we have a crisis it also presents us with the opportunity of a lifetime to buy great businesses as their stock prices keep declining.
In fact I have been busy making a shopping list of stocks to buy and now I am just waiting patiently on the sidelines watching if the promoters of the companies are buying their own stocks or not.
A very important question that needs to be answered here is that how do we decide as an investor what kind of business should we bet our money on.
Folks. Today I am going to share the stock selection criteria for investing during this market crash.
In order to connect the stock selection criteria for investing with a real life example, we will consider the financial ratios of Dr. Lal Pathlabs for our reference.
So stay tuned and read until the end.
1. Return On Capital Employed (ROCE >=20%)
ROCE measures how efficient a business is in generating profit using total capital available to it (debt + shareholder’s equity).
As an investor we should look for companies with an increasing or stable ROCE over a period of 5 years or more.
I usually prefer companies with ROCE >= 20% and this level of ROCE should be maintained for a period of 5 years or more. It is even better if the ROCE for a firm is increasing over a period of time.
Let us now look at the ROCE of Dr. Lal Pathlabs.
From the table below (src: moneycontrol.com) we can clearly see the Dr. Lal Pathlabs has a ROCE > 20%. In fact the ROCE for Mar 19 is 31.65.
By any means ROCE above 25 is indicative of highly efficient use of capital.
2. Stable Or Increasing Net Profit Margin (NPM)
Companies sell products/services to generate sales/ revenue. Once the sale is made there are various expenses like raw material purchase, salaries, utility bills to pay.
Then there is depreciation, interest payments on debt borrowed, and taxes to the government to be paid. After deducting all these outflows what remains behind is the net profit.
Profit after tax expressed as a percentage of total revenue is called Net Profit Margin.
Always look for companies with a stable NPM or rising NPM over a period of 5 years or more.
Companies with stable or increasing NPM over a period of time is an indication of a sound financial company that has been through the ups and downs of the economic cycle.
Companies which have widely fluctuating NPM is an indicator of a commodity business or a cyclical business. Some examples that come to my mind are sugar, steel etc.
Investors should be very careful while investing in such cyclical companies as there margins can decline suddenly which can lead to a sharp correction in stock prices.
The table below (src: moneycontrol.com) provides us the net profit margin of Dr. Lal Pathlabs. We can clearly see that NPM of Dr. Lal is not only stable but has also increased as compared to Mar 15.
3. Stable Or Increasing Operating Profit Margin
Just as the Net Profit measures the portion of revenue a company retains after paying all its expenses, accounting for depreciation on assets, interest payments and taxes paid.
Similarly the portion of profit, a company retains after subtracting the operational expenses but before paying interest and taxes is called Operating Profit.
This operating profit expressed as a percentage of revenue is called operating profit margin.
An investor should look for companies with a stable or rising OPM over a period of time as this is an indication of a sound financial company that has been through the ups and downs of the economic cycle.
On the other hand a fluctuating operating profit margin is an indicator of a cyclical business or a commodity business like sugar, steel or metals.
Cominfg back to our example now. The operating profit margin of Dr. Lal Pathlabs has been on an increasing trend since Mar 15 which is a very positive sign (src: moneycontrol.com).
4. Debt To Equity Ratio < .5
Debt and equity are two ways a business can raise capital for conducting business.
Debt represents borrowing money which needs to be repaid after a certain time along with interest payments from a lender like a bank.
Whereas, equity means that you raise capital by parting with a portion of ownership in your firm.
The debt to equity ratio does a simple comparison of the total capital borrowed from lenders versus the total capital contributed by shareholders.
Considering the impact of Coronavirus on businesses, I am now considering investing in business with a debt to equity ratio < .5.
Highly leveraged companies may find it extremely difficult to survive in such financial conditions of tight liquidity.
Now coming back to our example. Dr. Lal Pathlabs is debt free and so its debt to equity ratio is zero.
5. Interest Coverage Ratio > 8
Essentially, interest coverage ratio helps us understand how much the company earns with respect to its interest payments.
Can you cover your interest payments? That’s the question this ratio addresses.
Considering the impact of Coronavirus on various businesses, it is better we look for companies with an interest coverage ratio > 8 to be on the safer side.
The higher this ratio the better it is for a company in such unprecedented times of tight liquidity.
Please note that debt to equity ratio and interest coverage ratio are of great importance in times like these where businesses are forced to shutdown.
Any company carrying a large debt on its balance sheet will find it extremely difficult to come out unscathed through this economic storm.
Since Dr. Lal Pathlabs does not carry any debt on its balance sheet therefore interest coverage ratio becomes irrelevant as it does not have to make any interest payment.
6. Promoter Holding In The Company >= 50%
As an investor we should look for companies where the people running the show should have significant skin in the game.
A high promoter holding ensures to a great extent that the promoter of the company will act in the best interest of the firm.
Therefore I usually look to invest in companies where promoter holds a significant stake in the company > 50%.
In fact in some stocks where I invested earlier, promoter holding was as high as 75% (the maximum permissible limit for Indian public listed companies)
As an investor it is advisable to keep an eye on the promoter shareholding at all times. If you see the promoter offloading significant stake in the market it may be time to be cautious.
On the other hand I am really interested in companies where the promoter is acquiring shares from the market especially as the stock market has been falling recently.
This gives me the confidence that promoter finds value in the stock of his company.
Dr. Lal Pathalbs has a promoter shareholding of 56.81%. Therefore it passes our count of 50%.
7. Pledged Shares By Promoter < 5%
Sometimes the promoters of a company may be in need of money and may want to raise capital for personal reasons or for funding related to the company.
So they approach a lender like a bank. The lender will keep the shares belonging to the promoter as a collateral and provide him/her with a certain agreed amount as a loan.
Just like banks may keep your property or jewellery as a collateral against the loan, the shares are a collateral for the bank against the loan given to promoters.
In unprecedented times like these where the economic impact of coronavirus is difficult to ascertain, stay away from companies where promoters have pledged > 5% of their shareholding to banks or other financial institutions.
In a falling market, pledging of shares becomes even more dangerous and may lead to forced selling of pledged shares by lender in the market.
Dr. Lal Pathlabs does not have any pledged shares by promoter.
8. Positive Cash Flow From Operations & Cumulative CFO > Cumulative Profit After Tax
As an investor we should avoid investing in companies with negative cash flow from operations. Rather cash flow from operations should be positive.
Ideally, we should look for companies whose cumulative cash flow from operations is more or equal to cumulative profit after tax over a period of time.
As this would mean that the company is able to collect its payments in cash and its cash is not stuck in inventory or receivables.
As I have already discussed in my post on PC Jeweller, while looking at the data from Mar 12 to Mar 17, we can see that while PC Jeweller reported a profit of 2075 crore (during Mar 12 to Mar 17), its cumulative cash flow from operations was only 540 crore leading to a deficit of 1535 crore.
The main reason for this difference in cash flow from operations and cumulative profit was due to cash being stuck in inventory and receivables.
Therefore we should invest in companies where cash flow from operations is positive and cumulative cash flow from operations should be >= cumulative profit after tax.
Another example which may be relevant to showcase the importance of positive cash flow is that of Jiya Eco Products.
Jiya Eco had negative cash flow from operations but was showing good profit. Eventually it’s share price crashed from 80 Rs to 7.1 Rs a share as of 31st Mar, 2020.
Dr. Lal Pathlabs Cash Flow From Operations and Profit After Tax
From the table below (src: screener.in) we can see that Dr. Lal has a positive cash flow from operations. Also the cumulative CFO from Mar 15 to Mar 19 is 868 crores while cumulative profit over the same period is 753 crores.
Therefore it passes our criteria of cumulative CFO >= cumulative Profit. This means that Dr. Lal has been able to convert its profit into cash which is a very healthy sign.
9. Sales & Profit Growth > 15%
Despite strong return ratios like ROCE or debt to equity ratio if the company is unable to grow its sales and profits year after year, the stock will not generate good returns for its shareholders.
Therefore as an investor we want to be invested in companies which are able to show strong growth. So I usually look for companies with strong fundamentals and also reporting sales and profit growth of 15% year over year.
Many investors prefer to look at the compounded annual growth rate over 3 years or 5 years but in addition to this I also pay attention to quarterly results reported by companies.
If a company shows an increase in sales and profit in a quarter of 15% or more, I make a note of it and read about it.
If the company passes financial criteria laid out earlier, and the growth in sales or profit does not seem to be a one off event, I keep it in my watchlist.
The main reason for focussing on quarterly results is that sometimes companies which were not performing well earlier begin to show growth in sales and profit.
As an investor it is advisable to find out the reason for a sudden increase in financial numbers.
Sometimes the growth may be due to new management taking over a company or some fundamental change in business environment like China shutting down its chemical factories due to pollution.
By tracking quarterly numbers an investor can catch these changes and has a high chance of not missing out on great investment opportunities.
An investor can also use the following filter on The Bull Cartel on screener.in to keep track of companies with good quarterly results listed on Indian stock exchanges.
Dr. Lal Pathlabs has show a compounded sales growth of 15% over last 3 years and compunded profit growth of 14.19% over 3 years.
While it has shown a sales growth of 12.33% in Q3FY20 vs Q3FY19 and profit growth of 17.39% in Q3FY20 vs Q3FY19.
10. Check For Instances Of Fraud Through Google Search
A simple way that can help an investor discover earlier instances of fraud in a company is to search the company name for fraud on google search.
For example, if I am searching for a company say XYZ, then a simple google search like “XYZ fraud” can sometimes provide an insight in to earlier instances of fraud if any.
May be its a case of stock manipulation, or some other shady deal that the management may have tried to pull earlier and we should know about it.
I want the promoter of the company in which I am about to invest to be absolutely clean, dedicated and passionate about his/her business.
You can also check out other ways a company may indulge in fraud in the following posts I had published earlier:
11. PE Ratio < 25
PE ratio is most widely used valuation ratio used to gauge the how attractive is a companies stock price with respect to its earnings.
The formula for PE ratio is:
PE = Stock price per share / Earnings per share
Earnings per share is the net profit / the number of shares outstanding
As an investor over last 2 years many small cap stocks of good companies were trading at expensive PE ratios > 30 or 40. This meant that investors were ready to pay 30 Rs per share for 1 Re of profit per share of the company.
Now that the market has crashed 30% some of the good companies have started to trade at lower PE ratios of less than 25 or some in single digits.
Although there is a catch. Companies like Dmart ot IRCTC are still quoting at expensive valuations > 50 or so.
May be if the markets were to correct another 20% from here, the stocks may be available still cheaper.
As you spend time in the market, an investor gradually comes to know how much PE ratio markets may assign to a chemical company, a pharmaceutical company, a consumer durable company or branded companies like Britannia.
So is Avenue supermart (Dmart) at a PE of 110 cheap. Definitely not. Will it become cheaper. Well I do not know. Valuing a company is an art but at a PE of 110 for Avenue Supermart is definitely expensive.
From my personal experience stocks that become multibaggers are usually hidden from the big institutions and are available at dirt cheap valuations after a crash.
Like in 2013, many smallcap stocks of good companies were available in single digit PE ratios (PE < 10) and once they got discovered due to their strong growth their share price went up like a rocket.
One such example is La opala RG. Great investors are always looking for such diamonds to be unearthed.
Coming back to our example. The PE ratio of Dr. Lal Pathlabs is around 46 as of 3rd April 2020.
12. Effective Tax Rate
It is extremely important that business pay proper taxes on the profits made. If for some reason a company has a very low tax payout percentage then it becomes important to understand the reason for this.
You can read how Gitanjali Gems which crashed post allegations of fraud was paying extremely low taxes. (Refer point number 6 in the given link).
From the table below (source: screener.in) we can see that Dr. Lal Pathalbs has been paying taxes at a rate of around 34% which is ideal. Post the changes in tax rates in 2019 the new ideal tax rate should be around 25%.
This brings me to the end of stock selection criteria for investing during this market crash. A quick summary of what we discussed in this post is as follows:
1. ROCE > 20
2. Stable or increasing operating profit margin and net profit margin
3. Considering the severe liquidity crunch due to the impact of lockdown as a result of coronavirus, look for companies with debt to equity ratio < .5 and interest coverage ratio > 8
4. Promoter holding > 50% and pledged promoter holding if any should be less than 5%
5. Cash flow from operations should be positive and cumulative cash flow from operations should be greater than or equal to cumulative net profit
6. Sales and profit growth of 15% or more
7. PE ratio < 25 but don’t be too rigid about the PE ratio. If the market crashes 50% from the top and stock of good company is hovering higher than PE of 25 then it doesn’t mean one should not buy it.
As I said valuations is an art. No one can get it right to the point of decimals. So don’t break your head over it.
8. Check for instances of fraud by doing a simple google search related to company or management
9. Effective tax rate should be close to the benchmark of 30-32% and now after recent corporate tax changes the tax rate should be around 25%. If for some reason a form is paying low taxes then it is better to find out the reason for it.
I hope you find the article useful and it helps you in finding the right set of stocks for your investment. Please share the articles with your family and friends and don’t forget to subscribe.
Happy Investing Folks.
Disclaimer: Stocks mentioned in the post are only for tutorial purpose. Author does not recommend any stock. Please do your due diligence before investing.
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