In the 1st part of value investing, we saw basic terms and introduced very important factor responsible for stock surge, expectations of growth, specially growth in EPS. Now we will understand how can we select stocks for investing. Please keep in mind that, we need to find stock for whom we are expecting rise in EPS by sufficient levels for us to consider investing for long term.
To understand stock selection, let's take 1 simple business model example
Mr. A started manufacturing Hair clips. He bought Machines worth 20,000 and purchased raw material worth 5000/- sold it for 7000/- after making (not going deep in costing which includes depreciation, interest etc. Just basic simple model). He is also paying the rent of 3000/- for the shop in which he is working
So total expenses is rent+machine+Raw material for the first month=18000 cash outflow and 7000 cash inflow. This is 11000 loss for the first month.
Second month
7000 raw material
9500 sales
Rent 3000
7000 raw material
9500 sales
Rent 3000
Total expense-10000
Third Month
Sales 9500
Loss-500
Fourth Month
Third Month
Sales 9500
Loss-500
Fourth Month
Mr. A hired Mr. B and started giving him salary of 3000/month.
Total expense, 18000
Sales 17000
Loss-1000
Sales 17000
Loss-1000
If anybody sees the balance sheet at this moment, one will refrain to invest in companies like this, but if a person knows how this figures came, and he is given the opportunity to invest by purchasing shares of it, he will buy the shares will full conviction and will sit tight on his investment for long term. We all have heard the wealth multiplier stories of Infosys, Wipro, Motherson sumi, etc. Imagine if 1 would have known the growth potential of the companies. Basically, its all about growth potential then actual balance sheet numbers.
In above example, Mr. A is aggressively increasing its market base which will make his venture profitable soon. By hiring a person for mfg work, we can understand that he can now focus on marketing. But balance sheet figures don't speak this stories directly. I personally focus on jotting down points for growth potential and then joining the points to paint complete picture. Let us take actual examples for implementing this knowledge base. I will cover only simple things without complicating the case study.
Mr. B invests Rs. 10,000/- and earn revenue of Rs. 12000/-, Mr. B invests Rs. 12000/- again and earn revenue of Rs. 15000/-, this way, every time Mr. B invests, he earns profit and he invests it back to the business. So if we see the financial statements, we will observe that, there is a consistent growth in earnings, but Mr. B is not using the revenue for his own purpose. He is re-investing it back to the business to earn more revenue in next quarter. So generally, if Layman takes decision of buying stocks of such companies by seeing growth, he may fall into victim of this increasing capex. For shareholders to earn money, it is important for company to increase his earnings per share without increasing his capex. Till the time, company keeps on utilizing sufficient part of money for his business, shareholders will not enjoy fruits. Like if we make Fixed deposits(FD) of some amount and keep on investing interests and principal back to FD, then how can we use that money for our own purpose??? For returns from FD to be of use to us, we should withdraw money from FD or after its maturity for us to accrue monetary benefits. Same way, business should also be able to give benefits to shareholders. Even if the company is adding shareholders by diluting equity in their every growth phase, profits gets divided in more number of shareholders. So even if the company grows in this respect without utilizing money, profits is getting shared in more number of investors now. Hence, according to this strategy, we will be targeting those companies, which are into expansion spree and shareholders will be able to reap benefits of earnings soon.
Case study 1: Meghmani Organics
Now, lets check the balance sheet as below:
Fixed assets of the company is in continuous growth. Even Borrowings and other liabilities growing. Borrowings continuously adds interest cost burden to the company and addition of fixed assets adds depecreciation cost to the company. Extent to which this cost is added depends on the quantum with respect to net profit. It is in the March 2016 that company is able to cross its net profit made in 2010. This isn’t the only reason for investors to invest in stock. If we see analyst presentation published by company on 9th February 2016, then notice following page
Company have showed its intention that no additional/major capex required for next 2 years. Means company is favourable for shareholders now. Also, deleveraging would reduce interest cost burden. This will ultimately lead to increase in ROE/ROCE. Which is nothing but return on equity and cost of equity. This is what we have discussed above. So anybody, who would have noticed this at the earliest, would have benefited a lot till now. Stock price was in the range of Rs. 21-22/-. Stock made low of around 18.25 after this presentation was out. Right now stock is trading around Rs. 48-49/- range. Stock is more than double till now. For investors, who are always confused as what to do when they hold multibaggers and stock price starts running, they should sell their 50% stake in that shares when stock price doubles from their buying price and carry forward free stocks. This will ensure they don’t panic sell such stocks and can enjoy dividend income for their lifetime and can book profits at their comort or whenever they need money. They should not worry about targets or time frame for the stock, for Meghmani, as they have showed clear intention of not increasing capex for 2 years, one can stay invested for 2-3 years with free stocks.
One can download above shown analyst presentation from the following link:
One can look at few more examples for their own practise as value unlocking exercises with above mentioned strategy
JK Paper.
Fixed assets in Mar 2013 from 771 crores to 2468 crores in Mar 2014. It was in loss till March 2015. JK Paper normally operates at 19-20% Margin. But after expansion spree, margin came down to single digit and on the track of improving margins again. Sales figure & profit margin should reflect investment made in fixed assets. Sales are yet to multiply three times from March 2013.
Tamil Nadu Newsprint & papers Ltd.
Company innaugrated 2 lakh MT capacity board manufacturing plant with the outlay of 1650 crores and cement capacity expansion from 600 to 900 tonnes per day with the outlay of 50 crores.
Kuantum Papers
Fixed assets from 264.95 crores in Mar 2014 to 673.22 crores in Mar 2015
Emami Paper
Fixed assets in 447.61 crores in Mar 2015 to 1195.36 crores in Mar 2016
Above mentioned examples are just for the reference where one can see drastic difference in fixed assets indicating company expansion plans directly. One can study and use logic explained in Meghmani case to the other stocks as mentioned. all practise examples are given from only 1 sector for the ease of understnading of value unlocking exercise.
One of the best example that we can see will be of Grasim. Continous growth in all respect. Sales, assets, net profit, etc.
Please note that there are many ways of finding stocks for investments. I found this way of finding stocks easiest for common man without getting much into detail. Also please note that this analysis can be done only on Manufacturing companies and not service industries.
Bottom line:
Observe increase in fixed assets, see how company has planned for expansion. Keep close watch on company activities as when will company start utilizing its expanded capacity. Changes in share capital and interest cost and to see if company has more plans to do any major investment.
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