Learning Fundamentals

Yesterday I had an opportunity to interact with a fundamental investor who have picked Bharti Airtel @ Rs 20, Pantaloon Retail @ Rs 7 and loads of similar scripts and is still holding on to them or have booked profits once they have multiplied at least 15-20 times its initial price. There are many things which he told me is good to see/check before investing in any stock and I thought to share some with you people also.

The first thing which is important in this troubled environment is to go for stocks with high dividend yield and a good payout ratio. This protects the downside risk from the stock. For example if we buy Rs 200 stock with a 5% dividend yield and when the markets are tanking that same stock at Rs 100 (or around the same range) becomes a 10% yielding stock. Thus offering a return better than a FD and hence protects the further downside in the stock.

The next rule is to ignore a loss making company because in that case neither the DCF nor the PE valuation process can be used. But still if one gets tempted to buy the company because of a belief that it will turn around and generate returns then the best metric to use is its market cap. To use market cap is to check whether or not it makes sense to buy the company X at a particular market cap given its revenue, production capacity, ..., etc.

To check whether or not a company's Return on capital employed (ROCE) is high or not. By high he meant at least 30%. ROCE is the actual return a company generates with the money we invest in its stock. To also check what drives a company's ROE, whether its the high leverage or the asset turnover or the net profit margin. This is because during the last bull run most of the ROE expansion by companies was because of higher leverage and they are only the ones in big trouble presently.

He also mentioned that presently its good to invest in companies where the P/E have collapsed but earnings have remained almost stable, because these will be the companies which will perform on the bourses when the market recovers. Moreover companies which currently are not operating at 100% capacity utilization but around 60-70% will tend to benefit more when the demand recovers as they will be ready to supply more as compared to companies which are presently utilizing 100% of their capacity (because capex for new capacity will be time consuming)

He mentioned a 30-5-5 rule, which is any stock with at least 30% ROCE , 5%dividend yield and a P/E of 5 is a good investment and has a potential of becoming a multibagger.

There are many more which I would be sharing in my later posts. Till then wait and watch whether or not Nifty breaks 3500 or this euphemistic bubble bursts.