How to identify Potential Stocks using Fundamental Analysis?

How to identify Potential Stocks using Fundamental AnalysisHow to identify Potential Stocks using Fundamental Analysis?

There are a lot of people who invest money in stock market but very few of them do an analysis before investing. Most of the people first invest in stocks by listening from someone and then conducts research after the stock corrects heavily from their entry price which we often see in business channels. Analysing a company may include 'n' number of factors but I have pointed out some of the important points which a beginner should look into, while selecting a stock to include in its portfolio.How to identify Potential Stocks using Fundamental Analysis? What are the key parameters which one would look while analysing Fundamental Anaylsis for a stock?

How to identify potential stocks using fundamental analysis?

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1) Reading an Annual Report

An Annual Report is a report card of a company's operation in the preceding year, given to shareholders and other interested parties discussing about the financial performance of a company. It is a valuable piece of information about a company where the management discusses about the future prospect of the company, its long term vision, opportunities and threats etc.

Some of the key areas to focus while reading an  annual report includes-

  • Chairman's letter
  • Director's report
  • Auditor's report
  • Financial performance
  • Salaries drawn by the key personnel etc

Reading an annual report on a standalone basis will not give a better picture about a company so it is very important to do both inter-firm and intra-firm comparison. Say if you are going through the annual report of a FMCG company, Marico India, the purpose will be solved in a more better way if we make a simultaneous comparison with its peer say Hindustan Unilever (HUL).

Warren Buffett said, "We read 500 pages like this everyday. That's how knowledge builds up like compound interest".

2) Analysing Financial Statements

This is one of the very important tasks in identifying potential stocks. It includes the analysis of financial statements like profit & loss a/c, balance sheet, cash flow statement and the most important footnotes.

It is advisable to make analysis of both year-on-year and quarterly basis. There may be a situation where the profit of a particular year or a quarter is exceptionally high so it is important to check whether any extraordinary item has contributed to it or not. Since extraordinary items like sale of investment not acquired with the intention of resale etc are non-repetitive in nature. So in order to get the real picture of a particular period, it's better to exclude those items and then arrive at final conclusion.

Moreover it's very important to make inter and intra firm comparison to see how a particular company is performing with respect to its peer companies or with its historical performance, which would make the comparison more concrete and full proof.

3) Analysing Debt structure

Debt structure plays an important role in stock selection. It has been historically seen that few companies which are highly leveraged and that too under poor management had resulted in disaster, eating up investor's hard earned money. Suzlon energy is a perfect example in this situation.

It is advisable to look for those companies which are debt-free or having negligible debt as a stock selection criteria. But say if someone come across a very good company having  growth potential with some amount of leverage then he should definitely look for sound management quality otherwise it's better to simply ignore the company irrespective of its growth potential.

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4) Management Quality

The management of a company could be compared to a jockey in a horse race. The more better is the jockey, the chances of winning the race increases, though the company i.e. horse in this case, does play an important role. The good management has the ability to make a company an outperformer in the bad times where the other companies in the sector is suffering from external problem.

Investing in India follows the same rule as elsewhere, there is one crucial difference , here the quality of management has to be considered closely. Abroad one cannot go by what is there in the books, but here you have to add an additional layer- the management" – said Nemish Shah, co-founder and director of Enam Holding.

Few examples of excellent managements which has transformed their companies to a great height.

One of the examples could be Piramal enterprise, led by Mr Ajay Piramal. The company has delivered more than 25% average annual rate in the last 25 years and has outperformed the market by a very large margin. The company over the years has generated around 5 times for every rupee retained in the business. The best thing I like about him is that he has always paid very less in terms of premium while acquiring a company i.e. he very well understands the concept of margin of safety. One metric commonly used in the pharma M&A deal is price to revenue. He, in the majority of the acquisition has paid less than 1 times revenue and the highest he ever paid was 3 times revenue for ipill which he bought from Cipla in march 2010. He is a big Buffett and Munger fan and often goes to attend Berkshire Hathaway meeting in Omaha.

Another example is Vaibhav Global Limited(VGL), where Sunil Agrawal, Chairman and MD of VGL, has done a phenomenal job for the company in the last 5 years. In the time of distress, where the company was ailing with problems, he contributed large funds so as to boost the shape of the company. Therefore it's very important to have a rich promoter-manager to provide oxygen to the company in a period of distress. The best thing I like about him is the cost effectiveness which they even follow in their personal life. The MD along with all his employees travels in an economy class for his business visits. However the best example is definately the Warren Buffett and I don't think that there's a need to talk about it.

Following is a matrix of companies with regards to business and management.

How to pick stocks using fundamental analysis-management vs business

5)  Action by Top Shareholders

This may give you a hint on what the big players are having a view about a particular company. Say in case of Exide industries, LIC (biggest domestic investor) has been a seller in the last financial year and you can see its performance in terms of returns in the last one year where even the companies without any fundamental has made serious money for it's investors. So it might give you some hint about its performance in future.

How to pick stocks using fundamental analysis-5

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6) Moat Companies

Moat is the ability of the organisation to give an edge over its competitor in order to retain the market share and long term profits. Company may have moats in the form of technological innovation, cost advantage, brand value, high switching cost, size advantage etc. If a company has moat and it is able to sustain it for a long time, then it would also be able to generate high ROE for the company going forward and the investor would be greatly rewarded.

Look for the durability of the franchise. The most important thing to me is figuring out how big  moat there is around the business. What I love is of course is a big castle and a big moat with piranhas and crocodile" – said Warren Buffett in his 1994 letters to shareholders.

Few companies with moat include Colgate, Pidilite, Page industries, Ajanta pharma, Kitex Garment etc.

Thus, investing can be made simple and successful if we remember the above points in stock selection. These are the basic points which you must look into. However everyone has his own style of stock selection, so it could be used in a way satisfying your own need.

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This is guest post from from Ankit Jaiswal, 24 year old research associate in Kredent Eduedge Pvt Ltd with a strong passion in fundamental analysis in the financial market. He believes fundamental analysis is a key to successful investing and hence, he recommends everyone to dig deeper into company's fundamentals

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