Important Things Before Investing -The Investment Due Diligence

Stock Selection Basis

In the last few chapters, we have understood how to read the financial statement and how to work out some important financial ratios. Using all this, we can start creating our own stock selection criteria based on fundamental analysis. We have talked earlier that before investing in every company, one has to see whether it is a company worth investing in or not. Any company that meets the criteria of an investible company can be invested in.

Most importantly, which is the company worthy of investment? The company which is investible to me may not be investable to you and the company which is investable to you may not be investable to me. For example, I may prefer to choose companies that focus more on corporate governance. But there may be another investor who doesn’t care about corporate governance and can say that there is always something wrong with every company, as long as the company’s results and other numbers are looking good, I am ready to invest in them.

This means that there is no fixed check list for selecting stocks. Every investor has to make his own preferred terms on the basis of which he will invest. Each investor decides these terms on the basis of his experience. But it should be noted that these conditions are based on some logic. Well, at the end of this chapter, I will show you my checklist. If you are just starting out with investing, you can use this checklist of mine and choose the terms of your choice.

How to start picking stocks

Before we make a check list for investing in stocks, before that some important things should be taken care of. As the beginning of the stock selection process, we should first find some stocks that we like. After liking certain stocks, we should check whether they meet the conditions of our check list or not. If they fulfill the conditions then we should invest in them and if not then we should look at other stocks.

So the first question is that how do we choose the stocks which we can say that we like them and which we want to check on the terms of our check list. There are a few ways to do this:

General Observation i.e. an eye on economic activities – It may sound like a simple thing to hear, but it is a very important method for selecting stocks. All you have to do is keep an eye on the economic activities happening around you and keep your eyes and ears open. See what people are buying, what are they selling? Which type of product is in high demand? What products are people in your neighborhood talking about? Peter Lynch, a very well-known investor in the American stock market, has discussed this method in his book “One up on Wall Street”. Personally, I have also used this method. I chose PVR Cinemas stock for investment (because I saw PVR multiplexes opening up very fast near me) Cummins India stock (I found Cummins diesel in every company building near me generator is installed), stock of infoage ltd (as i can see it is run by the most popular job website in india naukri.com)

Stock Screener – You can consider it as a filter by which you can remove good stocks from many stocks. This means creating a stock-picking process that you decide on your own. Through this you can choose good quality stocks. For example, you can create a screener in which you have placed a condition that the ROE of the stock should not be less than 25% and the PAT margin should not be less than 20%. In this way, you can choose some useful stocks from many stocks. Although there are many stock screeners online but personally I prefer stock screener from Google Finance and screener.in.

Signs of the Economy– One of the best ways to choose good stocks is to keep an eye on the state of the economy. Let us understand this with an example- you will see that these days a lot of emphasis is being laid on creating infrastructure in India. New bridges, roads and all such things are being built. Cement companies working in the country will get direct benefit from this. So, I will be looking for more cement companies that meet the criteria of my checklist and can take advantage of this new trend.

Sector Trends – In this, you try to identify those sectors where new trends are visible. Then we try to identify the companies operating in those sectors which can benefit from this trend. For example, we know that 3 types of beverages sold a lot in India are coffee, tea and bottled water. But if you look carefully, a new trend has started in the past, that of energy drinks. This market has grown very fast and there is a lot of potential in it. Now you can try to find companies in this sector that are involved in the business of energy drinks or are preparing to enter into it.

Special Events or Special Situations – This is a somewhat tricky way of working out a share idea. For this, you have to keep an eye on companies, news related to companies and such events of the company, which can benefit the company in the future. I remember one example. In 2013, Cox & Kings, one of the country’s largest tour operators, included Keki Mistry of HDFC on its advisory board. Keki Mistry has a lot of respect in business and industry, it is believed that he has a good understanding of business. A friend of mine said that Cox & Kings would benefit from Keki Mistry’s arrival. So he started researching the company further to see if the other investment conditions were met. Then he invested in that stock and today he is sitting on 200% profit.

Circle of Competence/Use of Your Ability– This is a way to generate stock ideas where you automatically take advantage of your knowledge or your ability. This is the easiest and most reliable method for a new investor. For example, if you work in a bank, then you will have a good understanding of the banking industry, if you look around you or talk to your colleagues, then you will know which bank is in a better position and can earn big profits in the future. . Similarly, people working in the medical industry have better information about health care companies than others. All they have to do is to see which are the listed companies in their industry and which of them have the potential to make a profit going forward. In this way you can use your ability to come out with stock ideas.

That is to say, stock ideas can be found from anywhere. Whenever you like a stock, add it to your list and keep an eye on it because that stock may not be fulfilling your investment conditions at that time. But if you keep an eye on it, it may be that in the coming time, it will fulfill the conditions of investment and can become a good investment idea for you. You should always keep a list of the stocks you are keeping an eye on.

The Moat

After identifying the shares, the next task is to see whether the shares are meeting the check list conditions or not. This important pre-investment work is very important and you should be very careful on every part of it.

Before revisiting the checklist, one more principle should be understood which is called The Moat. It is popularized by Warren Buffett. It tells how far the company is in comparison to its competitors and how long the company can maintain this position. You must be aware that the meaning of Moat is that ditch which was built around the fort in the olden days so that the enemy could not cross it and reach the fort. Warren Buffett has said on the basis of this that companies should create such a moat so that there is a gap between them and their competitors and their profits are not affected. The wider the gap, the better for the company.

Let us take an example to understand MOT. Eicher Motors Limited Company manufactures commercial vehicles as well as Royal Enfield bikes. Royal Enfield bikes are very popular both in the country and abroad. A particular type of customers like this bike very much. This bike is neither very expensive like Harley Davidson nor very cheap like TVS bike. It will not be easy for any other company to bring a new bike and compete with Royal Enfield. This means that Eicher Motors has a very wide thickness, it will not be easy for its rivals to give it a fight.

There are a lot of companies today that have such motes. Every company that makes money in the stock market must have such a fat somewhere. For example, look at Infosys, which had this opportunity to provide the same service from India which was being available in America at a very high price. This moat was made by Page Industry when it got the license of India for jockey innerwear. Prestige, a company that sells pressure cookers in India, also has a similar Mot. You will find many such examples.

Important tasks and precautions

The most important thing to do before doing research and investing in the stock market is

Understanding the business including reading the annual report.
Look at the terms of your checklist and test each company worth investing in.
Valuation of the company so that it can fully explain that business.

To know about a company, we have to know and identify every aspect of it properly. We have to make a list of our questions to which we have to find answers. Like the first question would be, what does the company do? We do not have to find answers to these questions on Google, the answers will be found in the company’s annual report or on the company’s website. This will also give us an idea of ​​what the company has to say about itself and its business. Personally, I prefer investing in companies that have less competition and less chance of government interference.

For example, when I invested in PVR cinema, at that time there were only three companies working in this area PVR, INOX and Cinemax. Later, Cinemax merged with PVR, leaving only two companies in the market. Now many more new players have come in this market. So now is the time to take a second look at my investment in PVR and decide what to do next. After knowing the business of the company, the next step is to see how many of the conditions in our check list are being met by the company. Take a look at my checklist which has 10 conditions.

No.	Condition of work	Comment	Meaning
1	Gross Profit Margin (GPM)	> 20%	The higher the GPM, the better is the company’s moat or gap
2	Increase in income	should be in the direction of profits	should grow at a rate equal to that of profits
3	EPS	EPS should grow at the rate of net profit	If a company is issuing fresh equity then it is not a good thing. The share of existing shareholders will be reduced
4	Level of Debt	The company should not be deeply in debt.	High debt means that the company is dependent on debt for the business. This increases the finance cost and profits go into it.
5	Inventory	applicable for companies engaged in manufacturing	Inventory and PAT margins applicable to companies engaged in manufacturing or production together is a good sign. Must Check Inventory Number of Days
6	Sales vs Receivables	Relying on receivables to increase sales is not a good sign	It means that the company is only trying to show more sales figures
7	Cash flow of operation	Cash flow must be positive	If the company is not getting cash from its business then it is clear that the company is under pressure.
8	Return on equity	>25%	the better for the investor, but also check the debt level.
9	Diversification in business	The company should be in only 1 or 2 types of business	Avoid companies that have multiple types of businesses. A company that does only one or two types of business is better
10	Subsidiaries	should be reduced	If the company has many subsidiary companies then it can be a sign that the company is withdrawing money on their pretext. Avoid investing in such a company.

If a stock meets these conditions then you should look at its price. If it is not getting at the right price then there is no point in buying the stock. How do you know what the true value means? That will be Stage 3 or Stage 3 for us. We have to do some valuation experiments. The most well-known method for valuation is Discounted Cash Flow Analysis (DCF).

In the next few chapters, we will look at what one needs to do to do equity research about a company. What we will discuss on equity research will be part of Stages 2 and 3. I think in Stage 1 we should read the Annual Report properly and in detail.

Highlights of this chapter

• A Stock Idea Can Come From Anywhere
• You can also come up with an idea by keeping your eyes and ears open or by using your ability
• Keep a watch list i.e. such a list in which you keep those stocks on which you have an eye.
• Once you have selected the stocks that you are eyeing, then see who has the Moat in them.
• After this comes the process of investigation i.e. the process of necessary work in which we see about the business of the company and about fulfilling the conditions of its check list and also we get to know how the performance of the company so far. and what is its valuation.
• When we are trying to understand the business we must examine every aspect of the business of the company.
• Keep modifying and improving your check list as you gain experience in the market.
• DCF means Discounted Cash Flow method is considered to be the best way to find out the valuation of a company.