SIP in Mutual Funds vs SIP in stocks:

 

How To Pick Stocks Like a Pro in 10 Minutes

Last Updated on Sep 1, 2022, by Manish Thole

The right way to invest in a stock is to analyze it thoroughly. It requires effort, time, and resources, making it a lengthy process. But what if we tell you that you can pick stocks in 10 minutes, that too like a pro? Yes, it is possible with the three strategies mentioned in this article. So, let’s see ‘how to pick stocks like a pro in 10 minutes

Factors to consider before investing in stocks

Before diving into strategies to build your portfolio in 10 minutes, let’s look at some important fundamental factors that you must consider. Here are the seven most essential factors you must consider before buying a stock for the long term...

The company’s historical data

It is an essential fundamental criterion for understanding a company. Looking at a company’s historical performance helps you identify red flags if any. To check the historical performance of any company, you can analyze its financial statements, mainly profit and loss statements, balance sheets, and cash flow statements. 

Profit and loss statement: This statement is commonly referred to as the income statement, P&L statement, operation statement, and earnings statement. It usually consists of-

• The revenue of the company for a certain time period (quarterly or yearly)
• Tax and depreciation
• The Earnings Per Share (EPS) number
• The expenses incurred to generate the revenues

It gives you an insight into a company’s profitability and articulates the company’s bottom line. 

Balance sheet: This statement displays a company’s assets, liabilities, and shareholder's equity at a specific point in time. It tells what an entity owns, what it owes, and what it is worth as a company. If a company’s assets are higher than the liabilities, you can mark the company as ‘good for further assessment’.

Cash flow statement: This statement shows the movement of money in and out of a business. It determines a company’s financial health and liquidity and shows the net change in cash, which is usually divided into cash from operating activities, investing activities, and financing activities. 

An annual report includes all these statements. When you analyze the historical performance of a company, it gives you insights into how the management is and how has the impact of their decisions been on the company. It also depicts the company’s socio-economic position.

Industry growth prospects

Growth prospects of a company help in determining if it can last long. If the company is involved in the technology sector and heavily invests in new-age technologies as compared to the industry, it is considered to have growth potential. Contrary to this, if the company is not working towards the future and is simply building products that will run out of demand in the future because of the old technology, then investing in it might not be a wise decision.

Growth in sales and profits

The two factors, sales, and profit growth are most important when choosing a stock. They tell us if the company is growth-oriented or not. The year-on-year growth of a good company is usually consistently moving upward.

An uptrend in revenue signifies that the company has the potential to sell products while expanding its customer base. On the other hand, a growth in profit indicates that the company is efficiently utilizing its resources while maintaining healthy margins.

Debt 

In addition to growth prospects, revenue, and profits, looking at the debt of a company is crucial. Debt is the sum of loans taken by a company, i.e. the amount they owe. Look for companies with zero or very low debt. Because the lower the debt, the lesser the chances of a company facing cash flow problems or becoming insolvent. 

However, suppose a company is effectively using its debt to increase revenue and profitability at a rate higher than the debt’s interest rate. In that case, it is possible that a company is maintaining a healthy financial condition.

Return on Capital Employed (ROCE)

ROCE helps in understanding how well a company utilizes its capital to generate profits. Debt with all kinds of capital is also taken into consideration. 

ROCE = PBIT / Total capital employed

Where,

• The total capital employed = Equity + short-term debt + long-term debt
• PBIT = Profits Before Interest and Tax.

A higher ROCE suggests efficient management in terms of capital employed. However, a lower ROCE may indicate a lot of cash on hand as cash is included in total assets. As a result, high levels of cash can sometimes distort this metric. For higher returns, companies with ROCE higher than 15-20% must be chosen.

Return on Equity (ROE)

ROE is a critical ratio that is useful in measuring the company’s ability to generate profits from the shareholders’ investments. It assesses the return earned by the shareholders on every unit of capital invested. It is calculated as,

ROE = [Net income / Shareholders’ equity] * 100

To calculate the shareholders’ equity, subtract a company’s total liabilities from its total assets. You can get this information from the balance sheet. High ROE indicates good cash generation by the company, reflecting a good performance by the management. A low ROE signifies otherwise. An ROE equal to or above 20% is considered good.

Competitive advantage

Also called a business moat, competitive advantage means that the company has an edge over its competitors. Competitive advantage is an essential factor to consider while selecting stocks as it suggests that a company has value and is worth investing in. If a business has a competitive advantage, its success is highly likely. Hence, always keep a competitive advantage in your list to select the best stocks for your portfolio.

How to pick stocks like a pro – three strategies

The Coffee Can strategy

The term Coffee Can was first coined by a financial advisor, Robert Kirby, in 1984. It was later popularised in India by Mr. Saurabh Mukherjee, who wrote a book on the same concept. The old West Americans used to save their valuables like money and gold in Coffee Cans. They had the habit of storing it for years. The same approach applies to the Coffee Can portfolio, hence, the name. 

Coffee Can strategy uses the “buy and forget” approach to investing in the stock market. It involves investing your money in fundamentally strong companies and holding them for several years. This strategy is considered a low-risk method because,

• As you are invested for the long-term, short-term market fluctuations and volatility doesn’t affect your investor sentiment. 
• Your investments get multiplied over the years due to the power of compounding.

It is a long-term investment strategy for passive investors with an investment horizon of more than a decade. The Coffee Can strategy allows you to create sustainable wealth with a holistic approach. It also saves you time and effort as you don’t monitor your investment portfolio continuously.

How to build a Coffee Can portfolio?

Coffee Can's investment strategy primarily focuses on stock quality, i.e. fundamentally strong companies. Here are some points to keep in mind while building your Coffee Can portfolio.

• The essential part of Coffee Can investing is deciding on stocks to invest in for healthy returns. For this purpose, you can use all the factors mentioned above. You can also look at the performance of companies with a history of outstanding performance and market dominance of at least 10 yrs.
• You can diversify the investment in multiple stocks rather than concentrating on one. Portfolio diversification can help you reduce risks.
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• Revenue Growth: Filter companies that have grown at an average of at least 10% per year in the last 5 yrs.
• ROE: ROE of 15% or more is considered a good option for 10 yrs. 
• ROCE: In the past 10 yrs, the company’s ROCE should be more than 15%. It clearly indicates the company is able to consistently grow the capital used in the business.
• Cash flow: If the company has a negative cash flow, it is not wise to consider investing.
• Market capitalization: Companies with a market cap of Rs. 5,000 cr. or more are ideal for creating a Coffee Can portfolio.
• Debt to equity ratio: It should be less than 1% as it implies that the company primarily relies on wholly-owned funds to leverage its finances. A ratio higher than this indicates higher risk.

There are three ways you can invest in your Coffee Can portfolio: lump sum investment, Systematic Investment Plan (SIP), and buying in the dip. If you have a large sum of money in hand, then a lump sum investment can be the best choice. For beginners, SIP is considered the safest mode of investment.

Benefits of Coffee Can portfolio

• It is a passive investment strategy best suited for people who lack time to monitor their investments regularly. 
• The strategy multiplies your gains with the power of compounding. Hence, it is a profitable approach for long-term investments.
• You don’t incur any recurring charges, such as brokerage fees, transaction fees, and taxes, because your portfolio churn rate is almost zero.

Downsides of Coffee Can portfolio

• The investment horizon to gain benefits from this strategy is too long, and the process of selecting fundamentally strong stocks is time-consuming.
• There is always a risk to investing in low-quality stocks and then waiting for them to get good returns. Hence, always research thoroughly, as you might go on the wrong path without it.
• In the long term, the industries you have invested in carrying the risk of being replaced with new ones. Hence, there is an increased risk of stock performance getting lower.

The Coffee Can portfolio can yield manifold returns and assist you in accumulating wealth. It is a good choice if your financial strategy involves investments for more than 10 years and if you are willing to wait patiently for it. 

Warren Buffet Investing style

Popularly known as the “Oracle of Omaha”, Warren Buffet is the best investor of our time. He is seen as one of the most successful investors of all time. He has built his fortune using a simple yet powerful investment strategy. He has a very simple and unique way of analyzing businesses.

Buffet’s principles

Warren Buffet believes that reading through a company’s financials adds immense value to the investment decision. He looks deeply into how the company has performed. Investors like Warren Buffet believe in analyzing the company holistically. They believe in the long run and look for stocks priced lower compared to their intrinsic value.

Another important factor he considers is ‘Economic Moat’, which a company can use to its advantage to safeguard the business from being taken over by other businesses. He also analyses the long-term economics of the sector in which the company operates. No matter how good the company’s products or services are, it cannot survive for long if the sector’s economy does not support it.

Like in the Coffee Can investment strategy, Warren Buffet is known for his passion for the ‘buy and hold approach. He believes that it is easier to predict what will happen in 10 or 20 yrs in the future rather than tomorrow or even next week. In the words of Mr. Buffet himself, “The best holding period for an investor is forever”.

For this, he considers ‘Durable Competitive Advantage’ to be one of the most important factors as well and believes that it gives the company an edge over its competitors. As Warren Buffet puts it, “A good business is like a strong castle with a deep moat around it. I want sharks in the moat to make the business untouchable.” Remember, the durability of a competitive edge is also important.

Buffet’s tenets

In a book written by Robert Hagstrom on the core investment principles of Warren Buffet, the author presents the 12 basic Buffet principles that a company should possess to be considered for purchase. The principles cover both qualitative and quantitative business elements. Let’s explore them.

Buffet’s Business Tenets

1. Is the business simple and understandable?
2. Does the business have a consistent operating history?
3. Does the business have favorable long-term prospects?

Management Tenets

1. How is the management? Is it rational?
2. Is management candid with its shareholders?
3. Does management resist the institutional imperative?

Financial Tenets

1. Focus on ROE, not Earnings Per Share (EPS)
2. Calculate ‘owner earnings’*
3. Narrow down companies with consistent and high-profit margins
4. Look for companies that retain their earnings productively

Valuing a stock

1. What is the value of the business?
2. Buy the stock at a significant discount to its valuation, if possible.

*Owner earnings = It is similar to the calculation of free cash flow, which also subtracts dividend payments.

Owner earnings = (Net income + Non-cash charges of depreciation and amortization) – (Capital expenditures and any additional working capital)

Buffet’s strategy of using a screener

It is highly likely that Warren Buffet considers the following metrics to screen stocks:

1. Net Profit Margin (NPM): It is a key indicator to identify a business with a competitive advantage. According to Mr. Buffet, companies with an NPM of 20% or more are considered to have a durable competitive advantage. 
2. Current ratio: It tells us the companies’ abilities to pay off their obligations. He likes to sort companies based on the current ratio of more than 1.5.
3. ROE: It determines the efficiency of a company. Buffet believes that a company that gives an ROE of 15% is efficiently executing its operations.
4. Debt to equity ratio: He has mentioned that he doesn’t like a highly leveraged company. So, he looks for companies with a debt-to-equity ratio of less than 0.5.

Warren Buffet has always put the importance of keeping your emotions in check. He has suggested value investing as value investors do not get swept away by market sentiments. Further, he has always emphasized ‘not following the herd’ while buying stocks.

The Magic Formula

The Magic Formula is an investment strategy first described in the book ‘The Little Book That Beats the Market. It is authored by Joel Greenblatt, the founder, and former fund manager of Gotham Asset Management. This strategy focuses on maximising returns by finding the best price to buy stocks.

It is a relatively simple and easy-to-understand method for value investing. Mr. Greenblatt claims to have generated a return of 30% for his fund by using this method. His approach is towards buying a more diversified basket of quantitatively undervalued stocks. The magic formula is simple and diversified, providing above-average returns.

Greenblatt filters

The magic formula is a systematic way to screen stocks. It takes two factors into consideration: ROCE and Earnings Yield (EY). Greenblatt called them ‘good’ and ‘cheap’ factors. 

EY is the ratio of earnings per share to the stock price. It is the opposite of the price-to-earnings ratio. Greenblatt combines companies with high EY and ROCE to curate a list of high-quality stocks trading cheaply. The magic formula works in the following way:

• Select or screen companies with a market capitalization of a minimum of Rs. 500 cr.
• Eliminate banks, financial institutions, and utilities to try the Greenblatt filter. 
• Exclude foreign companies.
• Determine the company’s EY and ROCE.
• Based on the results you have gotten so far, rank the companies according to EY and ROCE in percentages.
• Invest in 20 to 30 highest-ranked companies after due research in each of them.
• The holding period for all these stocks should be from 1 to 5 yrs.

You can rebalance your portfolio once a year. Remember, this strategy works for long-term investment.

Advantages of the magic formula

• Simple, easy-to-understand, and follow the rules are there.
• It is suitable for all kinds of investors.
• It is based on rational, quantitative analysis.
• It has shown better-than-market returns in multiple backtests.

Disadvantages of the magic formula

• Returns do not always match the success that Greenblatt has achieved.
• The method has a scope of improvement, which can be achieved by introducing new variables or rebalancing more frequently.

To sum up

Investing in stocks or not totally depends on your financial goal, plan, and situation. Using the strategies mentioned in this article, you can build your portfolio effectively in lesser time. 

FAQs

1. How many stocks should I own?

Whilst there is no one-size-fits-all answer to this question, the average diversified portfolio contains between 20 and 30 stocks. It is usually influenced by a variety of factors, including your investment horizon, risk tolerance, and current portfolio diversification.

2. How to pick multi-bagger stock?

There are many factors to consider when picking a multi-bagger stock. Some of them are:
– Strong and capable management
– Competitive advantage and growth potential
– Strong promoter holding
– Healthy earnings growth

3. How to analyze stocks for beginners?

Below-mentioned is four steps a beginner should follow to analyze stocks:

A. Gather your stock research materials: Research a company’s financial statements and other materials you need to analyze a company.

B. Narrow down: These financial reports contain a ton of numbers. Narrow down the metrics you want to measure for the stocks such as revenue, net income, price-to-earnings ratio, return on equity, return on assets, and more. This is the quantitative analysis of a company.

C. Turn to qualitative stock research: After the quantitative analysis, turn towards qualitative analysis. It includes the answers to the questions like, ‘how does the company make money?’, ‘does the company have a competitive advantage?’, ‘how is the management of the company?’, and so on.

D. Thorough analysis: Compare the data you have gathered with its competitors. 

By Manish Thole