If you’ve landed on this page, it means you’ve searched for quality companies to invest in for the long term. In this article, we learn how to shortlist such companies.
We’ll know the process of finding such stocks on our own. There are seven golden steps that will help us find shares of quality companies available for investing.
Such companies are always hidden like needles in a haystack. Why?
Because most of the businesses around us are either plagued by weak business models or are poorly managed. This is the reason why, in the world of the stock market, avoiding is more important than investing.
This forms the basis of stock investing. First, learn to avoid bad stocks, and then from what is remaining, select the best one. Here are the seven parameters based on which we can find quality stocks that can be held (like) forever.
- Profit Making Company.
- Profitable Business.
- A Growing Company.
- Quality Management.
- Wide Moat Company.
- Net Cash Flow Positive.
#1. A Consistent-Profit Making Company
The roots of the QUALITY of a company must be soaked in profits.
What number should we look at? At this stage, net profit (PAT) numbers will suffice. But looking only at the last twelve months’ data is not enough. Because only one year’s data is not reliable, it might change.
Our goal is to find a profitable company that will remain like this for times to come. To establish such a sense of surety, we must look at the historical PAT (Profit After Tax) numbers.
I’ve plotted the PAT numbers for the last 10-Years of Hindustan Copper. The company has reported positive PAT, except for Mar’20 due to corona. So, in terms of positive net profit, it suffices our requirement.
But its trends are not what investors would like to see. Check the below chart.
In Mar ’13 the company’s PAT was Rs.355 crores. In Mar’19 it reported a PAT number of Rs.145 crores. The PAT is showing a falling trend. Personally, I would avoid investing in such a company. It is true that the trend has been increasing between the Yr-2020 and Yr-2022. But seeing the past, it may be a temporary trend. Hence, I’ll avoid it.
So, a profitable company whose PAT is showing an upward trend will qualify to be a quality company.
But there are other factors that must also be considered for investing. Let’s talk about other parameters as well.
#2. Profitable Business
A company may report positive net profits, but it may not be sufficiently profitable.
Suppose you’ve some spare cash available for investing. If the money is invested in a Bank’s fixed deposit, it will yield about 6.5% p.a returns. The significance of a Bank FD is that it is risk-free. One is almost sure of the safety of the principal and the promised interest rate.
Even after knowing that FDs are risk-free, you’ve decided to invest in the stock market. Why an investor would do that? Because shares promise much higher returns.
But not all shares yield high returns. There are several factors that together contribute to a stock yielding higher returns (more than a bank FD). One of the most essential factors is the profitability of the business. I use two particular return ratios to unearth quality companies ROE and ROCE.
- ROE: highlights the ability of the company to yield net profits for every Rupee invested by the shareholder.
- ROCE: highlights the company’s capability to pay back to the creditors, shareholders, and the government (taxes).
If ROE and ROCE are higher than the bank’s FD rates, by two times, it is a good indicator of profitability. To make the use of ROE and ROCE more effective, the use of a 5-Year average is better. Furthermore, establishing a historic ROE and ROCE trend gives further insights.
Our example company has shown a nonconsistent ROE and ROCE between the years Mar’14 and Mar’21. As an investor, we would not like to see a confusing chart as shown above. The trend should be upright and more certain.
Another example of a stock showing positive ROE and ROCE 10-Year trend is shown below. Though the numbers are not so consistent, the long-term trajectory is upwards. The trend is more clear than in our last example. Such companies give more confidence to the investors in terms of their quality of business.
#3. A Growing Company
Quality companies have the potential to grow faster than other average companies. Future growth is the key.
We’ve heard the idea of growth stocks. Investors like Peter Lynch have become legends by practicing and promoting growth investing. Why is growth so important in stock investing? Because among other factors, growth has a dominating influence on the company’s intrinsic value.
There is an article on this concept of growth driving intrinsic value. If you are interested, I’ll suggest you spend a few minutes on it. Anyways, I’ll explain it briefly in this section.
What you see above is an intrinsic value formula. Though experts will not use it as a mathematical model to express intrinsic value, it works. How? Beginners can use it to understand the influence of profit and its growth rate on a company’s intrinsic value, and hence its stock price. The price of a share will grow sustainably if its intrinsic value is also growing.
As you can see in the formula, the future intrinsic value of the stock depends on the EPS growth rate. The faster will be the EPS growth, the higher will be the future intrinsic value.
Two metrics that are most relevant to the growth of a company are revenue and EPS. In our search for quality companies, looking at these two metrics will do. Data on both of these metrics are easily available on any financial portal.
Why is revenue consideration essential? Because for sustainable EPS growth, revenue must also grow at the required rate.
Let’s see how an example company displays revenue and EPS growth over time:
Revenue and EPS growth is evident between the year Mar’13 and Mar’18. But from Mar’19 onwards, though the Revenue continues to grow, the EPS trend is not as consistent. It can happen in two cases, either the profit margins are falling, or the company has issued more shares to the public. When the share’s outstanding number increase, it dilutes the EPS.
Revenue and EPS numbers can fall, but quality companies tend to display steady recovery in the following years.
#4. Quality Management
Quality companies are run by a quality management team.
Judging the quality of management of a company using ratios is not so straightforward. Hence it is essential to select suitable ratios that are closely related to the actions of the top management.
Revenue growth and profitability enhancement are two factors that rely on management’s actions to see improvement. Out of the two, I find profitability enhancement represents management’s quality more deeply.
To judge a company’s top management, establishing the ROIC trend will prove helpful. ROIC is a ratio that highlights how much profit (NOPAT) the company is generated for every Rupee of invested capital. This is the ROIC formula:
ROIC is a unique return ratio for two reasons. In the numerator, it uses NOPAT instead of net profit. NOPAT is unique because it is a tax-adjusted operating profit. It is a good representation of cash available in the hands of the company for the creditors and the owners (shareholders).
The denominator uses invested capital instead of total capital (total assets). Invested capital is the net of cash available in the bank and the account payables. The cash parked in the bank account is doing no work, hence it cannot be treated as invested capital. Good companies make provisions for the upcoming account payable obligations. Even if there are no provisions, this quantum money needs to be paid within the next 12 months. Hence it cannot be counted as invested capital.
Here is the trend of ROIC of an example company.
What is shown above is the ROIC trend of an example company. Though ROIC did not grow on a year-on-year basis, the growth trajectory is evident. It is not practical to assume ROIC improvement every year. But ROIC enhancement on a 5-Year or 10-Year scale will suffice.
#5. Wide Moat Company – Competitive Advantage
We know the term monopoly. There are companies that have a monopoly in their industry. One such company is Google. Its monopoly over internet search is known. Such a company is said to enjoy a competitive advantage. Warren Buffett refers to such a company as one having a wide moat.
There is a detailed article on Economic Moat. I’ll suggest that you kindly read that piece. It details how monopoly benefits a company and hence its stock price.
A company that has a wide moat enjoys pricing power. They can more freely increase the prices of their products & services as desired.
As an investor, we must keep our radars sensitive towards such companies. Why? Because when held for a long term, moat stocks can give stellar returns.
Talking about Moat Stocks is easy, but identifying them is another thing. If a moat company is as visible as Google, it helps. But not all companies are so evident. What is the way to identify quality companies with a wide moat?
Out of all financial ratios, ROA and Free Cash Flow Yield highlights a moat company more clearly. Why?
Before we can answer that, it is essential to understand that high ROA or high FCF Yield (FCFY) companies need not necessarily have a wide moat. Maybe the absolute ROA and FCFY numbers are low, but if it is high in comparison to their peers, it will work.
What does it mean? Suppose there is a company in the steel sector. It is a very capital-intensive sector. Moreover, their CAPEX cycle is longer and more frequent. Due to these reasons, the ROA and FCFY of these companies are low.
It will be unfair to compare the ROA and FCFY of a steel company with that of an IT sector companies. They are incomparable. Hence, to find moat stock, we must look within a sector or industry.
Allow me to show you a comparison of the ROA of a few companies operating in the same sector/Industry (FMCG – Personal Care)
Between the FY’s Mar’13 and Mar’19, in terms of ROA, HUL clearly stands out from its nearest competitors (Dabur and Godrej Consumers). The ROA of HUL was around 30%+ when its competitors were posting below 15%-25% ROA numbers. So in this phase, HUL will qualify as one having a wide moat. Hence, during this phase, it was one of the best quality companies in the Indian stock market.
But see the ROA numbers during Mar’21 and Mar’22 FYs. It looks like the competitive moat of HUL is gone. But judging the company only from the two years’ numbers will not be right. Hence, we must wait for at least a couple more years.
The concept of valuation says that one must buy shares of even the best quality companies at the right price (below the intrinsic value). Paying a higher price will either result in a loss or subdued capital gains. How to know the right price?
There are two ways of doing it. First, we can calculate the intrinsic value using the mathematical models proposed by experts. Second, we can calculate the financial ratios and compare them to judge the valuation of a company’s stock price.
- The first method of price valuation through intrinsic value calculation is not easy. One must practice it before accurate numbers start to prop up. If you want to know more about intrinsic value calculation, I’ll suggest you start with these two lessons: Stock Basics and Fundamental Analysis.
- The second method of price valuation by ratios is what we will see in this section. We all know about a ratio called Price to Earning (P/E). In my earlier days when the concept of intrinsic value was unknown to me, I also used a combination of ratios like PE, PB, Dividend Yield, and PEG to value stocks.
Here we will talk about the PEG ratio. There is a separate article on the concept of the PEG ratio. If you like to get a feel of how this ratio works, please read the piece. It will surely lead you to new insights about stock valuation.
In our endeavor to find quality companies, price analysis is an unavoidable step. An investor cannot make money even from stocks like Google, Amazon, or Netflix if it is not bought at the right price. PEG ratio plays a decent role in unearthing the true value of a stock.
What makes PEG ratio unique for valuation purposes is its ability to factor in the company’s future growth. The concept of PEG says that for a fast-growing company even a higher PE ratio is acceptable. Conversely, for a slow-growing company, even a low PE may not be suitable.
We will see an example of a fast-growing and a slow-growing company for a better understanding of the use of PEG.
For sure PEG ratio is more effective than the PE ratio. Why? Because of its two-layered valuation parameters. Hence, the conclusion derived from the PEG ratio is more reliable than a standalone ratio like PE, PB, Dividend Yield, etc.
As shown in the above infographics, two layers of filter will give us a group of stocks with a PEG ratio of one or less. These are undervalued stocks.
In terms of formula, the PEG ratio looks simple. But we must not forget that the EPS CAGR we are talking about is of the future. How one can predict future EPS growth rates? Frankly speaking, it is not easy. But looking at the past EPS number will establish a trend. It helps in guessing how the EPS might behave in times to come (1-Yr, 3-Yr, 5-Yr, etc).
The below infographics shows an example of a fast-growing company (high EPS CAGR) but its valuation is coming out as overvalued.
This is another example of a low PE, slow-growing company. From Yr-2013 to 2019, its EPS was only falling. Hence it was showing a negative PEG. But in the last 3 years, the EPS trend is reversing. Considering that it was a low PE stock, its PEG is now below one. It is a case of an undervalued stock.
#7. Positive Net Cash From Operations (CFO)
Profitability, growth, valuations, moat everything will prove meaningless till they are converted into cash for the company. Cash flow is like blood for an organization. It must continue to flow to keep it alive.
Net Cash from operations (CFO) is the number I’m talking about. This metric is easily available in the cash flow report of any company. Before one can go ahead and tag a company as of quality, analysis of cash flow is a must.
No matter how much revenue & PAT the company is reporting in its P&L account, it is not enough. All those reported profits must flow in as cash into the company’s bank account. In short, the customers must pay, and suppliers must get paid. The net of payments received and payments made must stand out as a positive number, year after year.
Good management will do its best to convert all net profits into net cash flows. How to know about this fact? A comparison between the company’s revenue, PAT, and CFO will give a clear picture. Here is an example of a fundamentally strong company displaying a falling CFO trend.
A good company must increase its net cash flow at the rate of revenue and PAT growth.
In the above example, the cash flow from operations sees two dips, as compared to a revenue and PAT numbers, in the year Mar’16 and Mar’20. Though such things can happen a 10-Year time horizon of a company, but we as an investor can aim for a consistently growing CFO chart (no major dips).
Here are the seven parameters based on which a layman can shortlist quality companies. Pick your favorite stock and scrutinize them based on these seven parameters. See how they fair each step.
Give one point for each step. A stock that earns all the seven points will be one of high quality.
I keep at least 10 such shares on my watch list.
Most of the time, they do not qualify on the price valuation front. So I keep watching them regularly.
My Stock Screener makes my job of shortlisting quality companies easier as it displays their intrinsic value and overall score.
I hope you liked the article.
Enjoy your investments.