Investing in Equities -part 2

I will share with 14 questions that we need to ask before we invest in any share – these questions describe the way Warren Buffet analyses companies – these questions are not mine – it is from a very popular book called Buffetology by Mary Buffet – she had access to Buffett’s thought process as she was his daughter in law for 12 years and she has described his philosophy of investing in the book - I have tried to follow it since 2003 and it has given me good results. 

I will also take the example of CRISIL to discuss the issues raised in these questions. As a starting point, I have uploaded the Balance sheet and the P&L statement of Crisil of the past 10 years along with some calulations – it is available in  http://www.slideshare.net/sgrajasekharan/crisil-data . Before you go ahead with my questions, it is suggested that you look at this data of Crisil. The presentation made in this session is also available for download in http://www.slideshare.net/sgrajasekharan/wealth-management-session-3.

So here are questions that we need to ask:

Q1 – Does the company have an identifiable durable competitive advantage?

The company must have product /service offerings that is somehow unique and difficult to reproduce – strong brands, entry barriers (like telecom licensing in India) or technology leadership (like patents in Pharma industry) are good examples of identifiable durable competitive advantage. Normally companies in this category would have strong upward trend in earnings ( Crisil’s Net profits have consistently increased over the last 10 years) – these companies normally are cash rich and do not need excessive debt ( Crisil has zero debts for the past 10 years) and a high return on shareholder’s equity (Crisil’s average ROE for the past 10 years is 23%).

The answer for CRISL is a YES – it is a well respected brand, a market leader and a pioneer in this industry in India and it’s financials also show that it has a durable competitive advantage

Q2 – Do you understand how the company’s business model works?

Before investing in even a single stock – you will need to figure out the industry dynamics – the key areas where the target company is strong vis a vis it’s competitors –and what is required for the company to survive in the next two decades.

Crisil’s business is based on it’s internal processes and templates that has been perfected over the years, on it’s ability to attract and retain talent and it’s good track record.  So the answer to this question is also YES.

Q3 -What is the chance that the product /service/business model would be obsolete in the next 20 years?

Will there be a market for this product /service 20 years from now and will the company be able to manage the changes that can happen in technology, consumer preferences etc.

Crisil’s product /service offerings will be required after 20 years as well – rating is an expert’s job and one cannot automate it fully and there will always be investment opportunities that need to be rated. So the answer to this question is also YES.

Q4 - Does the company allocate capital exclusively in the realm of expertise?

Does the company sticks to what is knows best and does not invests in completely new businesses. What has been the track record in this area in the last 10 years.

Crisil has not had any unrelated diversifications in the past 10 years and it is allocating capital to it’s realms of expertise. Here too we will give a Yes answer

Q5 - What has been the company’s EPS history and growth rate?

Earnings per share is a very good starting point to see the financial performance. The company that we will short list for investing should have a consistently good record of growth of EPS over the past 10 years – erratic EPS growths and dips will disqualify the company from our shortlist.

Crisil has had a good growth of EPS from Rs 20.83 per share in 2000 to Rs 208 per share in 2009. There has been two years where there were dips in the EPS  - one of them 2001 is not a minor dip  - but we also know that in 2001 there was a global slowdown post the Ecommerce bust in the US markets . So the answer to this question is also YES.

Q6 - Is the company consistently earning high Return on equity?

Return on Equity = Reported Net profit / Net worth

The company must show a consistently high ROE over the past ten years – In India, an average ROE above 20% would qualify as a high ROE.

Crisil’s average ROE for the past 10 years is 23% and hence the answer to this question is also YES.

Q7 - Is the company consistently earning high Return on total capital employed (ROCE) ?

Return on total capital employed = Reported Net profit / (Net worth + secured loans+ unsecured loans)

Like in the last question, the company must show a consistently high ROE over the past ten years – we need to compare the ROCE with it’s peers in the industry.

Crisil has no debts and hence it’s average ROCE for the past 10 years is a very high 23% and hence the answer to this question is also YES.

Q8 - Is the company conservatively financed?

This question again looks at the debt coverage for the company – companies that we want to shortlist and invest must have strong cash flows and hence would be cash rich and would not have requirements for large long term debts.

Crisil has no debts and hence the answer to this question is also YES.

Q9 - Has the company been buying back its shares?

Cash rich companies have the option of reinvesting their earnings within the company by buying back it’s shares – if there is a history of share buyback, then there is a good chance that the company is financially strong.

Crisil does not have a history of buyback – in fact it has increased it’s number of shares from 62 lac shares to 72.25 lac shares in the period 2000 to 2010. However, we will progress forward with our shortlisting despite a NO as an answer.

Q10 - Is the company free to adjust prices to inflation?

Companies with sustainable competitive advantage would be able to increase the prices to inflation without the risk of losing significant volume of sale –this means that the profitability of the company will not be eroded overtime by inflation.

Crisil, we believe, can increase it’s prices and hence the answer to this question is also YES.

 Q11 – The company should not need to constantly reinvest in capital?

Retained earnings must first go toward maintaining current operations at competitive levels, so the lower the amount needed to maintain current operations, the better.

Crisil does not really need too much of reinvestment to keep it’s operation running. Hence the answer is again a Yes.

Till now Crisil has passed all the filters – just take any company of your choice and try answering these questions – you will be surprised with the discovery that very well known companies would not pass these filters. Only after the company passes these 11 questions with a Yes answer, does it qualify for our investment.  Once it is qualified, then we need to look at whether the current price in the market is right to enter or not. That will be covered in the last three questions.

 I would share the last three questions in a day or two – through those questions, we will qualify the current share price as low or high and also forecast the future share price ten years from now - that will ultimately decide at what price the share is a good buy.