Why did Reliance announce a share buyback?

Regular readers of this blog know that I am biased against any company that has ‘Reliance’ in its name. So it should not come as a surprise that all actions by the Ambani brothers are viewed through a lens of strong suspicion by me.

If you are a dyed-in-the-wool Reliance investor, please don’t take umbrage at my tirade. Just ignore it. If you are considering an entry into this erstwhile darling of the Indian stock market, please read through and then decide.

The performance of Reliance companies have been less than stellar during the past couple of years. The stock market has punished all the group company stocks, including those of the big daddy of them all, RIL. The Ambani brothers have become wealthy beyond belief and have acquired notoriety by using various dubious means to circumvent the rules and accumulate the shares of their own companies. The hammering of Reliance group stock prices has dented their considerable personal wealth.

What better way to make a little extra cash than to announce a buyback before announcing Q3 results? RIL’s Q3 results – to be announced on Jan 20 ‘12 – is not expected to be great. That may lead to further selling of a stock that has already lost more than a third from its 2009 peak. The buyback announcement caused a price spurt – providing a nice opportunity to make a few extra bucks.

What will happen to small investors holding the stock? Not much – unless they use the current price spurt to book profits. Buybacks are a method used by companies ostensibly to ‘reward’ shareholders. How? Usually, the bought back shares are extinguished – which means they cease to exist. So, the equity capital of the company gets reduced and correspondingly, the EPS increases. The P/E ratio becomes lower, making the stock look more attractive valuation-wise.

But it all depends on how much of the equity capital gets bought back and extinguished. A similar buyback was announced six years back, but only a small percentage of the total equity capital was bought back. If it is a tiny percentage this time as well, it will have little or no effect on the EPS or P/E. RIL is likely to buy the shares from the open market – which means small investors will get no particular benefit.

A share buyback can be an indication that the management thinks that the shares are undervalued. It can also mean that the company is bereft of ideas about what to do with their money to enhance growth. More likely the latter, based on the totally unrelated ‘di’worse’ifications that the elder Ambani has undertaken of late – into sectors like retail, telecom, media.

Make no mistakes. The refinery business has been – and continues to be - a cash cow. But refinery margins are coming down and the gas business has been mired in controversies. None of the unrelated businesses have performed well so far. Technically, the chart looks weak and the stock price can fall to its 2009 low.

Related Posts

Why rely on Reliance?

1:1 Bonus announcement by Reliance Industries - is it good news for investors?

Use a Stock Screener to make a ‘buy’ list

The down trends in the Sensex and Nifty index charts have completed nine months, and are showing no signs of reversals. In fact, relentless selling by the FIIs in August ‘11 has turned a bad situation (from the bullish point of view) even worse.

Any sensible investor would stay far away from buying in a stock market that is showing all the signs of a full-fledged bear market. So, why a post about making a ‘buy’ list? If you have participated in the Boy Scout movement, then you wouldn’t need an explanation. The motto of the Boy Scouts is: ‘Be Prepared’.

Just as all good things must come to an end – like the heady bull run from the Mar ‘09 low did when it peaked out in Nov ‘10, bad times don’t last forever. In the not too distant future, inflation rates will start to moderate and interest rates will be lowered. The stock market will ‘discount’ the good news in advance and start to rise much earlier. That would be a good time to buy – provided you are ready with a ‘buy’ list.

Small investors face a big problem. With thousands of company stocks traded in the stock market, how does one begin to make a short-list of stocks for more detailed research? This is where a Stock Screener can come in handy. What is a Stock Screener? It is a software that allows you to use certain fundamental criteria to make a short-list of stocks that meet those criteria.

Which Stock Screener should you use? Every financial site probably has one, so there is a lot of choice. You have to do a bit of trial and error to find out one that works well for your style of investing. You can start with the Stock Scanner available at the BSE web site:

http://www.bseindia.com/stockscanner/stockscanner.aspx

It is quite rudimentary, and has only four fundamental criteria that you can use: Last traded price (LTP), Market Capitalisation, EPS and P/E. Each of the four criteria has a range of values to further fine tune your search. Try out with different permutations and combinations to arrive at a short-list from all the stocks traded on the BSE.

Edelweiss has a Stock Screener (as do many other such sites):

http://www.edelweiss.in/Tools/screener.aspx#

This also has four fundamental criteria, with Dividend Yield in place of LTP. An additional feature is you can short-list by specific sectors. If you don’t mind registering at the site (it is free, but you will get periodic mailers), then you can add more criteria for your short-listing.

Let me add here that I’m not a great fan of Stock Screeners – mainly because the criteria I use for short-listing are not available in most of the free software. In any case, you have to do a detailed study of each short-listed stock to find out if it merits a place on your ‘buy’ list.

A Stock Screener can be a good first step for short-listing stocks for making a ‘buy’ list. Be sceptical of unknown stocks that get short-listed. Don’t think that you have ‘discovered’ a hidden gem that the whole world has missed. If you keep trying different combinations, you may get lucky and stumble upon an undervalued stock.

Happy hunting!

The curious case of Crompton Greaves

This is not a post about a court-room thriller, even though the title may sound like one of Erle Stanley Gardner’s page turners. That doesn’t mean that the process of discovery of the real cause behind the serious hammering of the stock price of Crompton Greaves may not be an exciting one.

First, the facts. A less than stellar Q1 result due to significant reduction in the consumer business (mainly electrical appliances) was a shock. That was followed by the revelation that the erstwhile CEO had dumped his entire stock holdings of 180000 shares earlier in the month.

The former CEO took pains to explain that:

(a) he doesn’t like to invest in the stock market but had received the shares as part of his compensation some 11 years back; at that time he had resolved to sell the shares immediately after retirement

(b) he retired on June 1, 2011 and sold the shares within a month of retirement after following due process of informing SEBI and the stock exchanges.

Doubts remained in the minds of investors because of three reasons:

1. Insider selling of large quantity of shares is considered a warning sign

2. Though he retired on June 1, 2011 Mr Trehan is still associated with the company though he doesn’t draw a salary. That means, he had insider’s knowledge about the poor Q1 performance of the company

3. The timing of the sale seemed a bit fortuitous. What if the stock market was in a deeper correction? Would he have sold his shares at lower prices? Alternatively, if the market was in the midst of a strong bull run, would he have waited a little longer to sell at a higher price?

Only Mr Trehan can answer those questions. Bottom line is that a lot of small investors were shaken by the severity of the stock price crash. Since such a crash didn’t occur when the ex-CEO actually sold his shares three weeks back, fingers are being pointed towards a bear cartel that used the fact of the insider sale as an excuse to hammer down the stock price. A fit case for SEBI to look into.

The Joint Managing Director of Havell’s – a competitor of Crompton in the consumer appliances space – does not believe that there is any cause of worry. Retail prices were hiked some time back due to increase in input costs. That may have led to consumers delaying their buying decisions. Another explanation is that distributors picked up more inventory in Q4 to avail of the then lower prices. That is why they lifted less inventory in Q1.

What should small investors do? On a TTM EPS of 10.61, the P/E at today’s closing price of 182.55 is 17.2. Not mouth-watering valuation by any means, but not hugely expensive either. If you are planning to enter, you may want to wait for Q2 results and then decide.

If you are holding the stock and are in profits, use the short-covering bounce up to book a part of it, and hold on to the rest. Remember the old stock market adage: When in doubt, stay out.

How to read an Annual Report

It is that time of the year when Annual Reports start hitting the mailboxes of investors. There are three things you can do with the Annual Reports you receive:

1. Toss it into the recycling pile with the old newspapers and beer bottles without even opening the envelope

2. Check the Profit & Loss statement and the dividend amount before tossing it into the recycling pile

3. Actually take the trouble of going through the Annual Report in detail to find out whether the company whose stocks you are holding is growing, stagnating or flying kites.

In the wild west days in the USA, there used to be a saying: The only good Indian is a dead Indian. Of course they didn’t mean people from India (though Columbus thought he had reached the East Indies – the islands of South East Asia - when he landed up on the shores of the Bahamas).

If you believe that the only good Annual Report is the one lying ‘dead’ in the recycling pile, then this post isn’t for you. If you think otherwise, please read on.

First, go to the Cash Flow Statement to find out if the company is generating enough cash from its business to finance part or most of its expenditure for growth. If you don’t know how to read a Cash Flow Statement, please read my posts of  Mar 22 2011, Mar 24 2011, Mar 29 2011 and Apr 5 2011.

Next, check out the Profit & Loss statement and the Balance Sheet. Of particular interest should be inventory and accounts receivable (if percentage increases are more than the sales percentage increase, they are warning signs); increase in equity capital and loans (not a good sign if these increase frequently); cash in hand/banks should tally with the figure in the Cash Flow Statement (so that a Satyam-like situation doesn’t recur).

Next comes the Directors’ Report and Management Discussion and Analysis. Read through these even though there will be hardly any negative feedback in them. They will give an idea about the industry and the company’s growth plans and (rosy) prospects.

Last, but not the least, are the Notes on Accounts. However boring these notes may seem – particularly to non-accountants like me – they contain a wealth of information that usually have adverse implications on profits. If a company suddenly announces a surprising turnaround or spectacular recovery in results, chance are that they have ‘cooked their books’ (a Punj Lloyd speciality). Look for changes in depreciation calculation and inventory valuation, which can significantly alter profits without an actual improvement in performance.

Also look at the court cases – usually with various tax authorities regarding disputed demands. Prudent managements will make at least part provisions against likely future liabilities. For companies that provide stock options to their employees, use the diluted EPS to calculate P/E ratios. For companies that have several subsidiaries – listed or otherwise – use the consolidated results for analysis.

There are many other things to look for in an Annual Report – but these are the broad areas for a first-cut analysis to ensure that business and growth are on track.

(Note: Thanks to reader Jalal for suggesting this topic.)

Some strategies about buying stocks

In a post last week, I had discussed strategies for selling stocks. Most small investors know how to buy stocks, but they rarely have proper strategies for selling. So why am I writing about buying strategies?

From the spate of questions I have recently received about when and how much to buy, it seems that discussing some buying strategies may be useful after all. I had mentioned about using the ‘Margin of Safety’ concept and P/E bands to decide entry points in last week’s post.

The importance of those two concepts can’t be over-emphasised. Too many young investors follow the wild west policy of ‘Shoot first, and ask questions later’. Just switch on any business TV channel (just for entertainment) during the day when they take reader queries. 99% of the questions are: ‘I have bought thus and such stock at this price; should I hold or sell.’

It is apparent from the questions that the stock was bought near a top, and the investor is already sitting on a loss. The question – or rather, a plea – is to find out if the TV expert knows some magical formula by which the loss can be quickly turned into a profit, or, at worst, break-even with no loss.

All one has to do before placing a buy order, is to first check whether the current E/P (i.e. inverse of the P/E ratio) is higher than the long-term bank fixed deposit rate, leaving a ‘Margin of Safety’ . Also check that the debt/equity ratio is less than 1, and that the cash flow from operating activities is positive for 4 of the last 5 years.

If E/P is lower than the bank FD rate, then check the P/E band within which the stock normally trades, and buy only if it is available near the middle of the P/E band or lower. These are basic precautions, and will help prevent losses – even if you don’t have the time or inclination to do a detailed fundamental analysis.

If you are like most small investors, the stock price will fall just after you’ve bought it (and, it rises soon after you sell)!! What should you do? Do not, repeat, do not average down. That is the single cause for turning a small loss into a much bigger one. Instead, keep a stop-loss – and sell if the stop-loss is hit on a closing basis (i.e. take intra-day movements out of the equation).

You will make much more money by averaging up. When should you do that? Buy 20-25% of your intended quantity at the beginning. Add more every time the stock dips or corrects on the way up. Follow a ‘pyramid’ strategy – i.e. buy less and less quantity on the dips as a stock keeps moving up in price – till you acquire your intended quantity.

Such a strategy will prevent impulsive buying of 2000 or 5000 shares in one go, in the hope of becoming a Warren Buffett within a month. Talking of Buffett, I love his quote: ‘You can’t make a baby in one month by getting nine women pregnant!’

Wealth-building takes time. If you hone your buying and selling strategies, you have a chance of becoming wealthy in 15-20 years – but not in 15-20 months.

Some strategies about selling stocks

Why discuss stock selling strategies just when the Sensex is showing some signs of life after an 8 months long corrective move? Isn’t this a good time to buy and make some money?

The answer depends on what type of investor you are. If you want to play the momentum in the short-term, by all means buy and book profits after a gain of 3 or 5 points. May be even 8 or 10 points. Which isn’t bad at all – if you are trading thousands of shares. Such a strategy can be followed at any time.

But many small investors don’t have big money at their disposal. They can buy 200 or 500 shares at a time (I’m not talking about penny stocks here). A 5 or 10 point gain is neither here nor there – compared to the risks involved. May be this isn’t such a great time to buy after all – since the index is just about 10% below its all-time high.

Instead of having an ad-hoc hit-and-miss strategy, have a plan. For buying, holding and selling. The ‘Margin of Safety’ concept works well for buying. P/E bands work well too – for buying, holding and selling. I prefer to use an asset allocation plan for timing buy-sell-hold decisions.

Today, I want to discuss a few selling strategies. Before you buy any stock, decide on a selling plan – based on your risk tolerance, time horizon and individual preference. As a long-term investor, I prefer to have a three years time horizon for any stock to perform. You can just as well choose a one year or two years time frame. Anything less than a year, and you will be treading the fine line between an investor and a speculator.

Once you decide on a time frame, pick a realistic price point. 100% gain in 1 year may happen once or twice, but is not a realistic goal. But a 50% gain in two years, or a 100% gain in three years may be more achievable. When the price target is reached, it is best to sell out entirely. But if you feel that more upside is left, book partial profits, and hold on to the rest with a trailing stop-loss. If the price target is not reached, don’t hold on with the hope that it will be reached ‘some day’. Just sell.

If by partial profit booking you have withdrawn your original investment, don’t ever think that the balance holding is ‘free’. It isn’t. It has an opportunity cost. If the market dives and your balance holdings drop by 50%, you have lost real money. A trailing stop-loss will save you from such a calamity.

Supposing you have a two years time frame with a 50% appreciation target. After six months, the stock suddenly starts to flare up and gains 50%. What should you do? Wait for your two years time frame, or sell now? Sudden flare-ups in stock prices occur for different reasons - insider buying, some company-specific news that you may not have heard yet, a fundamental change in the sector, a merger or acquisition.

Why bother with reasons? If your target is reached, sell – even if it means paying short-term capital gains tax. After all, tax is paid from profits – so you are still ahead.

So far, I have discussed selling strategies when your stock is in profit. What if you buy a stock and it keeps falling down? Have a strict selling strategy – a 3% or a 8% or a 15% stop-loss, depending on the type of stock and the planned period of holding. Have the discipline to sell as soon as the stop-loss is hit on a closing basis.

Learn to be unemotional and unexcited about your buy-sell-hold decisions. Treat them like any monetary transaction – like buying a cup of coffee or getting a hair-cut.

Related Posts

What exactly is the Margin of Safety?

How to reallocate your assets

Why small investors should avoid ‘cheap’ stocks

There are several reasons why small investors should avoid ‘cheap’ stocks, and I will take them up one by one. Before that, one must understand what is meant by ‘cheap’ stock.

Investopedia.com has the following definition:

“The illegal practice of issuing stock options at artificially low prices shortly before an initial public offering. Often underwriters will require a company to have more qualified management before they can go public. They attract these qualified individuals by giving options with a low exercise price.”

This was a practice which was prevalent prior to and during the dot.com boom in the USA, and is not unheard of in India. While it can lead to significant profits, the average small investor won’t be able to participate - unless his uncle or friend’s father was the promoter of the company. If a company is trying to sell its stock through bulk SMS and email messages at a lower price than its forthcoming IPO price, chances are that it is a ‘dud’ company and best avoided.

Then there are those companies that were the apple of investor’s eyes during the previous bull market, and reached stratospheric levels just before the crash in Jan 2008. Real estate stocks were at the forefront, followed by the stocks with the word ‘infrastructure’ in their name. Most of these apples had rotten cores. They have not only become cheap stocks, but continue to get cheaper by the day. Don’t go anywhere near them.

There are cheap stocks which are also called ‘penny stocks’ because they trade below Rs 10. Most of them are unknown, fraud companies who have no business and no intention of doing any business. Occasionally they boost up their share price from Rs 3 to Rs 8 by planting fake stories in the media about the great opportunity for investors once they dismantle the fourth rate defunct plant that they have bought in Uzbekistan or Burkina Faso and reinstall the plant in Jhumri Tilaiya. Avoid such stocks like the plague.

Some cheap stocks may appear cheap, but are not. A Re 1 face-value stock trading at Rs 15 is equivalent to a Rs 10 stock trading at Rs 150. A Rs 10 face-value stock trading at Rs 15 may not be cheap either, if it belongs to a loss-making company, or one that is trading at a P/E of 80 or 100. Stay away from such stocks.

What about stocks that appear relatively cheap with P/E ratios below 15 that generate strong cash flows from operations, have low debt/equity ratio and double-digit profit margins? Ah-ha, now we are talking. I just love to dig and find such stocks. They are the ones that will give a nice boost to your stock portfolio’s performance.

BSE Sensex and NSE Nifty 50 Index Chart Patterns – Jun 03, ‘11

The bears continue to dominate the chart patterns of the BSE Sensex and NSE Nifty 50 indices. In last week’s analysis, I had pointed out positive divergences and bullish rounding-bottom formations in the technical indicators. Net FII buying helped the cause of the bulls in the earlier part of the week.

By the end of the week, the bullish fervour got exhausted as both Sensex and Nifty found strong resistances form their 200 day EMAs. Friday’s trading turned out to be a ‘reversal day’ (higher high, lower close) - a signal that the mini-rally from the support levels of 17780 for the Sensex and 5345 for the Nifty has probably ended.

BSE Sensex Index Chart

The Sensex will remain in a down trend as long as it trades below the blue down trend line. It is technically in a bear market, since the 50 day EMA is below the 200 day EMA and the index is trading below both EMAs. That is bad news, as far as the bulls are concerned.

The good news is that in spite of the scams, raging inflation, rising interest rates, slowing GDP growth, the Feb ‘11 low has held so far. The periodic rallies have also ensured that the 200 day EMA has remained sideways for the past 5 months, and hasn’t yet decisively turned downwards. The Sensex closed 110 points higher on a weekly basis.

The technical indicators are showing signs of weakness, but the rounding-bottoms and positive divergences are still visible. The MACD has crossed above the signal line, but both are in negative territory. The ROC is above its rising 10 day MA, but has turned down sharply to the ‘0’ line. The RSI is at its 50% level after a brief foray above it. The slow stochastic is at the edge of its overbought zone, but turning down.

Nifty 50 Index Chart

The volume bars present an interesting picture. Tuesday’s (May 31 ‘11) up day volume was the highest during the previous month, as the Nifty jumped above the 20 day EMA. Volumes are only a secondary (or supporting) indicator, but do show buying interest (or lack of it) – particularly from the FIIs. By the way, FIIs were net buyers on Friday’s ‘reversal day’. A contrarian sign?

Looks like the bull rallies in the US and European markets are stalling. On a forward P/E basis, the Sensex and Nifty are not looking that expensive. Some outflows from the developed markets may re-enter emerging markets. A number of mid-cap and small-cap stocks with strong fundamentals are trading at attractive valuations.

GDP growth has been gradually coming down over the past few quarters, though it is at a still-respectable 7.8%. India Inc. seems to have put capital expenditures on hold on growth worries and high-interest rates. In a recent interview on a TV channel, Morgan Stanley’s Ridham Desai mentioned that the top 100 Indian companies are sitting on more than Rs 30000 Crores of cash! That should set the stage for some judicious mergers and acquisitions.

Bottomline? The BSE Sensex and NSE Nifty 50 index chart patterns are mired in down trends for almost seven months. Several revival efforts have been thwarted by the bears. Despite all the negative sentiments, apathy among retail investors rules out a crash. Good time to concentrate on picking good stocks for your ‘buy list’.

What to do when stock prices fall?

Most small investors – particularly the recent entrants to the stock market – are ‘bulls’. That means, they buy a stock at a certain price and expect the price to quickly move higher so that they can sell and make a tidy profit without going through Step 1 (see below).

The idea is not entirely wrong. Being a bull is usually more ‘fun’. When you buy a stock and it starts to rise rapidly, you tend to feel elated and proud that you have made a smart choice. But it is no fun at all when the stock you have bought recently suddenly turns around for no rhyme or reason, and starts falling like a stone.

Your elation vanishes into thin air. Your pride takes a beating. You can’t confide to friends or family because they will either laugh at you or scold you for being a greedy gambler. You start losing sleep and look for ways to recover from the situation.

One of the worst things to do is to buy more as the stock price keeps falling. Your ‘average’ price goes down, but your losses keep on increasing. You eventually lose hope, and either sell when the stock price is near its bottom, or become a reluctant long-term investor.

So, what was wrong in being a bull? Forgetting that there is always another animal called a ‘bear’ in the stock market. While bulls are strong and can sweep aside all resistances when they are excited and charging, they are basically peaceful vegetarians.

Bears, on the other hand, are vicious and cunning meat-eating predators. In the stock market, a handful of professional bears make mincemeat out of the hordes of peaceful small investor bulls. What helps the bears is that they only need to pay a margin amount for shorting a stock which they may not even own. Then they square off the deal at a lower price and pocket the profit.

How do you avoid being decimated by bears? Follow three simple steps:

1. Do your homework before buying a stock. Is it fundamentally strong? Does the company have growth opportunities? Does the business model generate adequate cash from operations? What is the reputation and track record of the promoters?

Learn about some basic ratios like P/E, P/BV, Debt/Equity, Market Cap/Sales, Return on Assets. (Most of these concepts have been covered in different blog posts.)

2. Buy any stock with an adequate Margin of Safety

3. In spite of doing your home work and buying with a Margin of Safety, a stock’s price may start to fall after you buy it. Avoid a big loss by taking a small one. Learn how to set a stop-loss.

That was the long answer. The short answer is: Sell, and sit on the cash. Go to Step 1 above. Don’t go to Step 2 before becoming thoroughly conversant with Step 1.

Related Posts

How to lose more money and become a better investor

What exactly is the Margin of Safety?

What is the Return on Assets (RoA) ratio?

How to identify winning stocks – a guest post

The Sensex and Nifty have been quite volatile lately, jumping up and down like a kid on a trampoline. Small investors are not sure whether to buy or sell. At times like these, it may be better to sit back and do nothing.

Niteen has a better idea. Learn how to identify winning stocks using his 12 parameters. If you like his post, please write a comment or query. Your feedback may motivate him to contribute regularly.

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After 18 years in the stock market, I have observed that most small investors are only interested in tips for making quick money. But without exception, they end up losing money. Remember that the reverse of ‘TIP’ is ‘PIT’. ‘TIP’s can take you to the ‘PIT’s. There are no short cuts to making money. The stock market is a place that requires a highly disciplined approach. To make money, investing should be viewed as a long term process.

How to identify a winning stock without depending on tips? What are the parameters that help in choosing a winner?

The most important parameter is the ‘Margin of Safety’. The concept of margin of safety was first introduced by Benjamin Graham, author of investment classics like ‘The Intelligent Investor’ and ‘Security Analysis’.

Graham said: "Margin of Safety is always dependent on the price paid". One should buy a stock when it is worth more than its market price. This is the central thesis of the value investing philosophy, which emphasises preservation of capital. Graham looked at unpopular or neglected companies with low P/E and P/BV ratios.

If you feel that a stock is worth Rs 100, buying it at Rs 75 will give you a margin of safety. In case your analysis is incorrect and the stock is worth only Rs 90, the Margin of Safety provides a cushion against a possible loss. In India, markets tend to be volatile, so it becomes more important to look at each stock through the magnifying glass of Margin of Safety.

Very few stocks make it through the stringent screening process given below, and many potentially investment-worthy stocks can get excluded. If you come across any tips and get tempted to invest, at least you should screen those stocks through these parameters to ensure that you are not overpaying.

There are 12 parameters grouped under four heads.

(I)  Valuation & returns

• P/E ratio < 40% of highest average P/E ratio over previous 5 years: take the highest P/E ratio of each year for last 5 years and then take an average
• Earnings yield (E/P) > 2 x (RBI bond yield): RBI Bonds give a return of around 8%
• Dividend yield > 2/3 x (RBI bond yield): Dividend yield is calculated by dividing the last dividend paid by a company, by the current stock price. Some companies retain earnings and do not pay dividends to maintain growth. But most blue-chip companies that have grown from the time they were not blue-chip, have consistently paid dividends for many years

(II)  Balance Sheet related

• Current ratio > 2.0. This will give you a positive Net Current Asset Value (NCAV) number per share
• Stock price < 1.2 x (Book Value)
• Inventory trend: Inventory trend should reflect revenue numbers. Goods are produced to be sold, and not stored in a warehouse. If inventories increase faster than sales, a problem is brewing
• Minimum 12% Return on Invested Capital (ROIC)
• Debt/Profit =<5 and Debt/Equity ratio =<1.5: A company should pay its debt out of its profits, and not out of the equity base of the company. A ratio of 5 means that the debt can be paid out of 5 years profits

(III) Profit & Loss related

• Revenue and profit should preferably increase consistently during last 5 years. A drop in any one of the 5 years can be considered also
• Consistently paying dividends, bonuses: This is in line with (I) above

(IV) Governance

• Published Statements of previous 6 months/Management Discussion and Analysis (from Annual Report): If the management is over optimistic about future earnings, an investor should stay away. Infosys, which is well-known for its transparency, has always been cautious in projecting future earnings
• Shareholding pattern – Buying, selling or pledging: If management is selling/pledging their holdings, the stock should be avoided

The above parameters are available (or, can be calculated) free of cost from sites like: www.icicidirect.com, www.anagram.co.in or from economictimes.indiatimes.com.

There can be cases where you need to consider some additional parameters. The measurement of one parameter can be relaxed due to the strength of another parameter. This comes through experience and a new investor/analyst should avoid relaxing the parameters.

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(Niteen S Dharmawat is an MBA who has been working with Indian IT companies. A firm believer in long-term financial planning, and an 18 years veteran of the stock market, he likes to analyse the economy, and individual stocks. He also conducts investor education sessions.

Niteen blogs at http://dharmawat.blogspot.com.)

Related Post

What exactly is the Margin of Safety?

Using Earnings Yield (E/P) to time your investments – a guest post

In last Thursday’s post, I had taken a look at the historical P/E ratios of the Nifty 50 index and suggested an investment strategy. In this month’s guest post, Nishit takes a slightly different view. He compares Nifty’s earnings yield with the 10 years G-Sec yield to time stock market investments.

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Subhankar had written about Nifty’s P/E multiple or Price to Earnings Multiple last week. Let us delve deeper into it. He had written “Nifty’s P/E ratio has varied between 11 and 27 during the past 12 years - with peaks of 27.35 on Mar 1, 2000 and 27.64 on Jan 1 2008, and troughs of 11.62 on Jan 1, 1999; 10.86 on May 2, 2003 and 11.76 on Dec 1, 2008. The average P/E ratio over the past 12 years is 18.24.”

Price/Earnings ratio is nothing but the Market Price divided by the Profits per share of a company in rupee terms. Assume the share price of a company is Rs 100 and it makes a profit of Rs 10. So its P/E ratio is 100/10 = 10. It is a very fundamental ratio of finding out the valuation of a stock (or index). Now, P/E by itself has no significance. How do we know if P/E of 10 is stretched or P/E of 50 is stretched?

We look at the growth prospects of a company and sector. The derived ratio is PEG Ratio (Price to Earnings Growth ratio). Now if the company is going to grow at an annualized growth rate of 100% for the next 3 years, a P/E of 100 may be acceptable. This is especially true of the IT companies in the glory days of 1998-2001 when Infosys used to come out with 100% growth figures every quarter.

The inverse of P/E (i.e. E/P) is the earnings yield. It is the amount per annum you are going to earn by investing in a company. This ratio is very important in the sense that you can use it to find if a stock (or the Nifty) is over-valued or not. What will we compare against? Let us take the 10 years Government Treasury Bill return. This is the safest investment in the country. Whenever 10 years G-Sec yield is more than equity earnings yield that is the time to go long big time.

Let us take an example. During Oct ’08 – Mar ’09, the Nifty P/E ratio dropped below 15; the earnings yield was 6.66% and below. The G-Sec Yield was 7.83% in Nov ’08.That was the time when the long term portfolio of stocks should have been built up.

For the past 1 year, the Earnings Yield of the Nifty has been around 5%. The G-Sec yield is around 8%. At such times, exposure to equity has to be limited. That is, keep trailing stop losses and don’t add fresh equities.

The Earnings Yield is a simple extension of the P/E concept and comparing it to the Bond Yield gives us a perspective on finding whether the equity markets are overvalued as compared to the Bonds Market or not.

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(Nishit Vadhavkar is a Quality Manager working at an IT MNC. Deciphering economics, equity markets and piercing the jargon to make it understandable to all is his passion. "We work hard for our money, our money should work even harder for us" is his motto.

Nishit blogs at Money Manthan.)

Is the Nifty overvalued or undervalued?

Since hitting a peak in Nov ‘10, the Nifty has been in a corrective mode for 4 months. The correction began when the Nifty came near its earlier all-time high touched in Jan ‘08. What initially seemed like a routine bull market correction, turned into a more serious correction due to the unrest in North Africa and the Middle East that sent oil prices above the three figure mark.

The index dropped 18% from its peak before recovering somewhat, and has been trading within a range of 5200 - 5600 for the past 5 weeks. The FIIs have been net sellers during 2011, pulling out $2 Billion to redeploy in their home markets. Relative valuations of developed market indices like the S&P 500 and the FTSE 100 were more attractive. Of late, they seem to be buying again, as the overseas markets are correcting.

What should investors do? Is the Nifty undervalued after the correction, making it a good opportunity to buy? Or is it still overvalued despite the correction? The best way to find out is to look at Nifty’s monthly P/E ratio chart, drawn for the period Jan ‘99 to Mar ‘11:

Nifty’s P/E ratio has varied between 11 and 27 during the past 12 years - with peaks of 27.35 on Mar 1, 2000 and 27.64 on Jan 1 2008, and troughs of 11.62 on Jan 1, 1999; 10.86 on May 2, 2003 and 11.76 on Dec 1, 2008. The average P/E ratio over the past 12 years is 18.24.

Leaving the peaks and troughs aside, as it is next to impossible to catch the exact tops and bottoms, we can reasonably assume that P/E ratios between 15 and 21 is the ‘hold’ range. In other words, only stock specific buying should be done when the Nifty P/E ratio is between 15 and 21. Any drop below 15 is the across-the-board ‘buy’ zone and any move above 21 is a ‘sell’ signal. Patient, long-term investors can use these levels to decide entry and exit points for almost assured returns.

The Nifty traded at or below 15 P/E continuously between Aug ‘02 – Aug ‘03, providing the ‘mother of all buying opportunities’  in the past 12 years. It also traded continuously below 15 P/E between Jun ‘04 – Nov ‘04, Feb ‘05 – Sep ‘05, and Nov ‘08 – Apr ‘09. The market does provide great buying opportunities, if only investors would learn to wait for them.

On the other hand, between Dec 1 ‘09 – Jan 3 ‘11, the Nifty continuously traded at or above 21 P/E – giving excellent selling opportunities to those who may have bought earlier. Nifty’s P/E ratio on Mar 1 ‘11 was 21.04. So, it has only dropped to the outer edge of the ‘hold’ range – in spite of the four months long correction.

Since the Nifty is trading above its average P/E ratio of 18, it is still ‘overvalued’. That is one of the reasons why FII money is flowing out.