I got a comment rather a query from a reader asking me how do I select companies to analyse and invest in? It’s a million dollar question. And the key to becoming rich. I learnt it after a lot of hits and trials after 20 years of my investing career. And that was a Eureka moment for me.While I was planning to write about the Greek Crisis and Grexit since I just came back from Greece, this query caught my attention and I thought of attacking the important first.
The key to wealth creation through ownership of businesses (that is what Big B, oh that’s Big Buffet NOT Bachchan, calls investing in stocks) lies in not when, not how but in WHICH. Yes, which business to buy?
And the simple answer to it is businesses with moats. My checklist to evaluate a business or company are:-
1. It should have been in business for at least ten years?
2. It should have zero debt or sharply reducing debt, ie it may become debt free in 2 or 3 years.
3. It should have a Gross Profit Margin above 30%
4. It should have a barrier to entry around it of some kind. A few examples — a brand(Thomas Cook), a unique product (MS WIndows), a switching cost for a customer(Tata Sky), lowest cost producer of that item (Relaxo), a toll bridge where you pay everytime you use it (DND Flyway), a patent(Piramal Health), a state monopoly (BEL).
5. It should have increased dividends in last 5 years or paid continuous dividends for last 10 years.
6. The management and owners should be honest and share holder friendly. Thus, Noooo to Ambanis but Yesssss to Premji and Narayan Murthy.
If a business passes this simple six point criteria, then I look further.
The first thing I look at after this is ROE or return on equity. Then is ROCE or return on capital employed (which includes debt). If this is upwards of 24% for the last 6 years, then I further analyse the financials. Otherwise, I pass.
Out of 6000 businesses, you need one or two to create WEALTH.
Dear Sir,
Thank you for an eloquent and simple yet powerful explanation.I do understand only maj pts have been covered due to sake of brevity. Hence, will give my 2 cents. Here goes
1. Only buying a business which you understand. Now, for a fauji like me, i think i dont understand ANY business. But one does. The key is to read, read& read. Also, sppeak to enlightened people, People working in the industry, consumers, the like. Slowly, one gets the hang of it. Yes, its slow & tedious & many times you wont get anywhere. But then, INVESTING IS SIMPLE BUT NOT EASY, RIGHT??
2. Evaluate your own risk apetite & then only look at a business. If the volatality of YES BANK gives you acidity, pl invest in HDFC, SBI. SLeep well.
3. ALso, valuations are important after all other boxes in the checklist are ticked. I have been tracking CRISIL for about 3 yrs now, it seems to tick all boxes. However, at absurdly high valuations of 67.96 as on date, it is a big NO NO. Imagine, earnings have to rise 68 times just to justify your buy price… imagine theNo of years that isgoing to take.
(PS : I hope sir,I am on right lines…)
(PPS: I may be all preachy here, but honestly,i understand only one business in my portfolio completely, and one majorly. And i DONT knpw how banks work 🙂 )
Anshul
You are on the right track Anshul. If price is absurd buy some other business. If you want to buy a house and it sells at an absurd price, dont you leave it and look for some other property? same applies here.