An equity analyst reveals what matters and what doesn't in equity research
05-Oct-2018 •Vikas Vardhan
How difficult is it to pick winning stocks from a universe of 4,000 odd listed companies? Most investors believe that analysts and experts tracking stocks spend copious hours analysing data, on the basis of which they arrive at financial models to determine the rate at which companies should grow. It all sounds too complex for ordinary people to understand. Assumptions such as these are further perpetuated by numerous business channels, which give inordinate amounts of air time to these experts, particularly during the earnings season. And when companies fail to meet the market's estimates, the management has to spend time and energy explaining its strategy and even business.
Is stock picking as complex as it is made out to be? At Value Research Stock Advisor, we believe that stock picking is way simpler. As analysts, we work on simple ideas. We work with simple assumptions. Sometimes we even walk around the office and nibble on snacks while analysing stocks! And we don't have a television screen in our research section at all.
Investors have many misconceptions about equity research. It was because of them that we decided to put out our principles of stock picking for average investors and readers. And in the process we will be busting a few myths around 'research'.
Confession: The investible universe is very small as compared to the total listed stocks
At present, there are more than 4,000 stocks listed on the Bombay Stock Exchange. So picking a few winners may appear to be a Herculean task, but it needn't be. The actual investible universe is quite small and it is easy to cut it down to just a few hundred companies. If you devise a simple approach to investment, then you can further narrow it down to a handful of stocks. For example, out of over 4,000 stocks listed on the stock exchange, only 2,500 stocks are traded on any given day. Less than 1,500 companies have been traded daily in the past six months. Thus, actively traded scrips are down to half simply because of liquidity.
The second most important filter is profitability. The best way to gauge a company's profitability is return on equity (RoE). There are only 450 companies that have generated RoEs of more than 12 per cent in the last three years. If we look at scale, then there are just 350 companies that have a market cap of more than Rs500 crore. By applying these simple filters, you can cut the investible pool to 350 companies, which is less than 10 per cent of the listed universe in India.
Confession: There are dozens of investment rationales but the most compelling ideas are built on just a few
Having done the initial sifting, we get down to applying investment rationale to the few companies that are left to select the better ones. Pick any research report from sell-side (brokerage) firms and you will find that the investment rationale given is difficult to understand.
Investment rationale can be based on variables ranging from macro situation to favourable government policies to reversal of a cycle to debt restructuring, among many others. Taking an investment call based on so many variables is like betting on several horses at the same time. However, compelling ideas are built on solid financials. The fewer the variables, the higher the conviction. For example, a company can be recommended because it is great at doing something which nobody else can do. The case is stronger if valuations are right. It can be as simple as that.
Confession: We are no expert at running businesses
Analysts are often given the status of 'demigods'. In reality, they are simply numbers experts. Managements, on the other hand, take years to master their businesses. An analyst covering multiple sectors and companies can never know the business the way an entrepreneur does.
In reality, as analysts, we do not know how to efficiently manufacture a product at the lowest cost. Nor do we know the market dynamics fully. Similarly, estimating the future earnings of a company right to two decimal points is more like crystal-ball gazing, which is seemingly made easy through spreadsheets.
We, at Value Research Stock Advisor, have an understanding of the business model and we take effort to understand how the business makes money and how it spends it. We develop the skill to identify which management or business has been doing this smartly and will continue to do so in future. As analysts, our job is to be good stock pickers but we don't claim to be masters of running businesses.
Confession: We like it when markets behave irrationally as that creates opportunities
We all know that markets are not perfect. And it is this anomaly that creates opportunities for smart investors. If everyone is investing in fundamentally good companies and at reasonable prices at all times, there will be no opportunities! Good investment opportunities come from others' ignorance. Good investment prospects are not created overnight. They are in the making for a long time and are available in the market, provided you know what you are looking for and identify them in time.
Let me take a real life example. While working on PSU companies in 2013, I came across NBCC (National Building Construction Company). It was a debt-free company with a sound business model. It had cash in hand and advances from customers of Rs1,650 crore. Its order book was more than Rs12,000 crore. All this was available at a market cap of just Rs1,700 crore. It was a case of an irrational pricing. Since then, the stock has proved to be a 10-bagger.
If all the investors would have acted rationally, then we would have never spotted such a multi-bagger.
Confession: We do not know where the market is headed in the short term
One of the biggest expectations from analysts is that they know where the market or stocks prices will go in the short term. The most frequently asked question is "Kya lagta hai? Nifty kitna jayega?" As you may have observed, many stock research reports come with 12-month price targets. But the fact is that analysts do not know where the market is headed in the short term. The shorter the time, the higher the uncertainty.
In the short term, a stock's movement is pegged to dozens of factors like general market sentiment, interest rates, economic scenario, government policies, inflation and liquidity, among others. All these are difficult to predict. In the long term, a stock's movement is pegged to just one thing - profitability. Thus, comprehending results to get a better understanding is relatively easier. What really matters is how much conviction the analyst has in the long-term potential of the company.