The process of Stock selection is more often called an art than science. While there is no sure method to get it right, this art is not without its element of logic. With so many listed stocks, it is a baffling task to pick up the best that promises strong performance. Stock screeners, in this case, come to rescue the common investor helping him to make a start. They let one eliminate stocks that don't qualify to be a part of one's portfolio on certain measurable factors such as margins, return ratios, gearing levels etc.
So far so good. Running a screener may at times lure an investor by popping forth some stocks that do well on almost all the criteria. However, selecting stocks this way can prove costly. Infact, it's from this point that the hard work starts. That is to do a qualitative check on the stocks. And here are some points that will help:
Regulatory scenario/Government interference: In India, where Government policies are framed keeping votes in mind than the economic well being, one should know to what extent the company's operations financials are affected by actual business operations. Are Government policies and regulatory environment conducive to the business and operations of the company? If not, one should try to avoid such stocks. To give you a fresh example, Indraprastha Gas Limited's (IGL) that has shown a good financial and business performance in the past witnessed over 30% market cap erosion in a single day on account of regulation to cut in tariffs , a decision that can have significant negative impact on company's realizations and margins going forward.
Shareholding pattern: Shareholding pattern is something that is easily available on the stock exchange websites. One must give importance to the share of promoters, FIIs and free float. A high promoter stake sends a positive signal reflecting strong faith of the promoters in the company's business. It also helps to track how the promoter's stake has been moving on an interim basis. However, an increase or decrease in the stake will not always be a positive or negative respectively. For e.g., it could be the case that the management has no option but to absorb the unsubscribed portion of a not so popular rights issue that led to an increase in stake. In the same way, a decrease could be due to ESOP (Employee Stock Optionspolicy)which should not be considered negative.
Unlike Promoter holding, the high
Foreign Institutional Investors (FII) holding is a matter of concern as this makes the stock prices vulnerable to huge volatility. To give you an example, Indiabulls Real Estate has seen a price erosion of over 70% during the period from December 2009 to April 2011 during which period the stake of FII has come down from 69% to 31%.
Promoter's share pledging: Most of the stock screeners skip these criteria. Post Satyam scandal,
share pledging is seen as a critical factor in picking up stocks. Promoters, in order to raise funds for either personal or company needs, pledge their holding shares to any financial institution. Non-banking financial institutions are more active than banks in providing such loans. A good way will be to check whether the pledging is for personal needs or for growth of the business. Again, risk could be higher if market sentiments are bearish as a fall in the stock price may trigger the margin call thus further leading to heavy selling and fall in the prices.
The devil lies in details: It always helps to read the fine print before investing. The importance of going through company's accounts and notes to accounts can't be overemphasized. While it is easy to find out what the financials cover, most people tend to ignore the foot notes and hence the crucial off balance sheet items items like contingent liabilities, debt covenants, exposure to FCCB (Foreign Currency convertible bonds) , change in accounting methods and policies etc to mention a few. The amounts mentioned can give one a hint of the worst case scenario.
One should also check if the company has a structure that is not explained by business. Having too many subsidiaries, instead of helping the business, could be a ploy to keep a lot of liabilities offbalance sheet and to facilitate siphoning off funds.
Management quality: It is said that a bad management in a good business is worse than good management in a bad business. The seemingly blue chip stocks can lose their entire value in a matter of days and hence Corporate Governance is an issue that can't be ignored. A classic example of this case is Enron. The impact is worse on small cap stocks, for e.g,in case of Austral Coke and Projects, the stock prices plunged 91.5% as Securities and exchange board of India (SEBI) found fraud transactions on company's accounts (worth over Rs 10 bn) and barred it to raise any money.
Reading between the lines: Running stock screener over last year's financials may show some really good results. However, one must check financial statements with special emphasis on Cash flow statement ( unlike Balance sheet and Profit and Loss account, it is difficult to manipulate cash flows) over the past few years to get a hang of the earnings quality. For example, if over the last few years, sales have continuously increased and operating cash flows are consistently decreasing; one must take pains to find out the reasons. If this has happened without a productive investment in business, it's a reason to raise the red flag. The sudden increase or decrease in line items should also be investigated. They will let one know if there have been any changes in the accounting policies or methods used that have simply been used to cook up the books. One must be extra cautious in cases of companies with acquisitions and joint ventures which offer huge opportunities for financial manipulations, example, moving debt off one's balance sheet to the partner or Joint ventures or bloating up the sales (Significant 'related parties Sales transactions') without getting any actual cash flows.
Conclusion: While there is no foolproof way to make a perfect portfolio, one must do these basic checks to minimize the risk. It may be a little hard but it is always better not to invest in a company if you don't understand the business of the company. Last but not the least, doing these checks is not a onetime process but must be done periodically.
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