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Investment Due Diligence

Fundamental Analysis

• Introduction
• Investor’s mindset
• Annual report reading
• P&L statement
• Balance sheet
• The cash flow

• The financial ratio
• Investment due diligence
• Equity research
• DCF primer
• Notes

learning sharks stock market institute

12.1 – Taking stock

Firstly, We learned how to interpret financial accounts and compute a few crucial financial ratios during the course of the previous chapters. The eventual goal of this module has its roots in these chapters: – to choose the equities to invest in using fundamental analysis. If you recall, we talked about the characteristics of investable grades in the prior chapters. The conditions for a company that must be verified before making an investment choice are defined by its investable grade features. Consider the investable grade characteristics as a checklist based on the company’s fundamentals. A business is deemed investment-worthy if it checks off the majority of the checklist’s requirements.

Here are a few areas where there are variations. For instance, you might not place as much importance on an attribute that I would consider an investable grade. For instance, although I may choose to pay close attention to corporate governance, another investor may choose to pay less attention. He might dismiss it by saying, “All businesses have some murky areas, but as long as the statistics add up, I’m okay with investing in the business.”

The key idea is that there is no set checklist. Based on his prior financial expertise, each investor must create his or her own checklist. But one must make sure that each item on the checklist is justified by reason. I’ll give a checklist that I believe is relatively well-curated later in this chapter. If you are starting from scratch, you could get some advice from this list. As we continue with this subject, we will use this checklist as a guide.

12.2-Generating a stock idea

Now, before we continue and create a checklist, we need to deal with a more fundamental problem. Choosing an intriguing stock is the first step in the investment process. After choosing the stock, we must check it against the checklist to see if it satisfies all the requirements. If so, we must invest, and if not, we must explore alternative alternatives.

So how do we choose a stock that appears appealing in the first place? How can we create a list of stocks that look worthwhile enough to research further, in other words? There are a number of ways to accomplish this, including:

General Observation: Although it may seem elementary, this is one of the best methods for creating a stock idea. All you have to do is pay attention to the economic activities around you by keeping your eyes and ears open. Keep an eye out for what individuals are purchasing and selling, what things are being consumed, and what topics are being discussed in the area. In his book “One up on Wall Street,” one of the most renowned Wall Street investors, Peter Lynch, actually recommends this strategy. Personally, I have applied this strategy to some of my investments, including PVR Cinemas Ltd., Cummins India Limited, and Info Edge Limited. I chose these companies because I noticed the proliferation of PVR multiplexes in the City, Cummins diesel generators in most of the buildings, and PVR Cinemas Ltd. (Info Edge owns naukri.com, which is probably the most preferred job portal).

Stock screener – A stock screener assists in finding stocks based on the criteria you provide and enables investors to do a thorough stock analysis. For instance, you can use a stock screener to find stocks with a 25 percent ROE and a 20 percent PAT margin. When you wish to select a small number of investment ideas from a large pool of potential investments, a stock screener is a useful tool. There are other stock screeners accessible; however, my personal favorite is the stock screener and screener on Google Finance. In.

Macro Trends – Keeping an eye on the macroeconomic trend, in general, is a terrific approach to spot high-quality stocks. Here is an example of the same: At the moment, India is pushing hard for infrastructural projects. Cement businesses operating in India would clearly benefit from this effort. So, in order to determine which cement companies are best positioned to take advantage of this macro trend, I would search through all of the cement companies and use the checklist.

Sector-specific trends are covered by this. To find developing trends and businesses inside the sector that can profit from them, one needs to monitor sectors. For instance, the market for non-alcoholic beverages is a fairly established industry. Coffee, tea, and bottled water are the three main product categories. As a result, the majority of businesses only produce and market these three items. However, there has recently been a small change in consumer preferences; a promising new market for energy drinks is emerging. As a result, the investor can look for businesses in the industry that is best positioned to benefit from and adjust to this transition.

Special Situation: This method of coming up with a stock concept is a little more difficult. For the purpose of coming up with an idea based on a unique circumstance, one must watch businesses, company-related news, corporate events, etc. One instance that comes to mind immediately is Cox & Kings. You may be aware that Cox & Kings is one of the oldest and largest travel operators in India. Mr. Keki Mistry (from HDFC Bank) joined the company’s advisory board in late 2013. Corporate India has a great deal of respect for him because he is regarded as a very ethical and effective businessperson. A coworker of mine was certain that having Mr. Keki Mistry on the board of Cox & Kings would be beneficial. This alone served as the main impetus for my colleague to look into the stock more. After more investigation, my colleague made a happy investment in Cox & Kings Limited. Good for him, I know he is sitting on a 200 percent gain as I type this.

Circle of Competence: Use this to uncover potential stock ideas by utilizing your professional expertise. For a beginner investor, this strategy comes highly recommended. You must identify stocks using this strategy within the context of your line of work. If you work in medicine, for instance, your competence circle would include the healthcare sector. You are more likely to be knowledgeable about that sector than a stockbroker or an equities research analyst.

All you have to do is locate the listed businesses in this industry and select the top ones based on your evaluation. Similar to this, if you work in banking, you probably know more about banks than anyone else. Utilize your network of expertise to choose your investments.

The key idea is that any source could serve as the impetus for researching stocks. In fact, add stocks to your list as and when you think they appear interesting. Your “watch list” will eventually be this list. It’s important to note that while a stock may not meet the checklist items right now, as time goes on and company conditions evolve, it may eventually line up with the criteria. As a result, it’s crucial to periodically assess the stocks on your watch list.

12.3 – The Moat

One must use the checklist after choosing a stock to further research it. “Investment due diligence” refers to this. One must give every part of the due diligence procedure the utmost attention because it is so important. I’ll soon give a checklist that I believe is fair. However, we must first discuss “The Moat”.

The word “moat” (sometimes known as an “economic moat”) was made popular by Warren Buffet. The phrase describes the firm’s competitive advantage (over its competitors). Strong moats ensure that a company’s long-term profits are protected. Of course, the business should be able to survive for a very long time in addition to having a moat. A business would be more sustainable if it possessed a larger range of moat qualities, such as a stronger brand identity, greater pricing power, and greater market share. It would be challenging for the business’ competitors to reduce its market share.

Consider “Eicher Motors Limited” in order to comprehend moats. A significant Indian automaker is Eicher Motors. Along with the recognizable Royal Enfield bikes, it also produces commercial vehicles. There is a sizable fan base for Royal Enfield motorcycles both inside and outside of India. Its brand memory is extremely strong. Royal Enfield serves a rapidly expanding niche market. Their motorcycles are neither as cheap as TVS motorcycles nor as pricey as Harley Davidson motorcycles.

It would be difficult for any competitor to enter this market and undermine the support that consumers have for Royal Enfield. In other words, it will take a lot of work from its rivals to push Eicher Motors out of this sweet place. One of Eicher Motors’ moats is this.

Many businesses display these fascinating moats. In actuality, a sustained moat is one of the fundamental components of great wealth-creating businesses. Consider Infosys, whose competitive advantage was labor arbitrage between the US and India, Page Industries, which had the manufacturing and distribution rights to Jockey undergarments, Prestige Industries, which produced and sold pressure cookers, Gruh Finance Limited, which had small ticket size credits distributed to a particular market segment, and so on. Decide to always invest in businesses that have wider economic moats.

12.4 – Due Diligence

The following steps are included in the equity research due diligence process:

  1. Reading the yearly reports is necessary for understanding the business.

  2. utilize the checklist, and

  3. Estimating the business’s intrinsic value is known as valuation.

In step 1, “understanding the business,” we go deeply into the industry to get to know the business from top to bottom. The questions that need responses must be compiled into a list. Posting a basic inquiry about the company, such as “What business is the company involved in,” might be a nice place to start.

Instead of using Google to seek for the solution, we look for it on the company’s website or in the most recent Annual Report. This clarifies what the business has to say about itself.

When it comes to my own investing strategy, I often prefer to invest in businesses where there is little to no government interference and little to no competition. For instance, there were only 3 listed competitors in that market when I made the decision to invest in PVR Cinemas. INOX, Cinemax, and PVR. Two publicly traded companies remain in that industry following the merger of PVR and Cinemax. However, a few new firms have recently entered this market. So it’s time for me to reconsider my PVR investment idea.

When we feel confident about our knowledge of the industry, we go to stage 2 or use the checklist. We now receive some performance-related responses.

Finally, even if a business checks every item on the checklist above, buying its stock makes little sense if it is not trading at a fair price. How can we determine whether the stock is trading at the appropriate price or not? Well, this is what stage 3 entails. We must perform a stock valuation exercise. The “Discounted Cash Flow (DCF) Analysis” is the most used method of valuation.

We will go over the foundation for conducting formal research on the company in the next chapters. It is known as “Equity Research.” Our discussion of equity research will be mostly centered on Stages 2 and 3, as I believe Stage 1 entails reading the annual report quite thoroughly.

CONCLUSION

  1. Any source can provide a stock concept.
  2. It is a good idea to keep a watch list of stocks that you find intriguing.
  3. After a stock has been located, we ought to search for sustainable moats.
  4. Understanding the business, going through the checklist to understand its financial performance, and performing the valuation exercise is all part of the due diligence process.
  5. One should be entirely comprehensive with the business operation of the organization when it comes to knowing the business.
  6. As the investor gets to experience it, the checklist should be adjusted accordingly.
  7. One of the greatest methods for determining the business’s intrinsic worth is the DCF approach.