Investment Checklist- How to better understand a business!

Investment Checklist- How to better understand a business!

November 24, 20198:10 am

With every experience in investing in the stock market, I tried to create a checklist that can help me avoid pitfall in my next decisions. It is applicable mainly to manufacturing businesses. I will share them in the blog “Investment Checklist- How to better understand a business!”. It is NOT a just Yes/No checklist and it more about understanding the business.

{B2B-> Business to Business, B2C-> Business to Consumer}

Investment Checklist- How to better understand a business!
  1. How are the company’s product prices determined? Is it determined by the prevailing market prices(commodity business)or is it decided by negotiation between the 2 parties or is it bidding based or is it decided by the company itself(B2C)? 

If the prices are decided by negotiation(Eg Fine Organics) or tender based(B2B), we can expect the margin to remain stable. 

Is the product prices determined by the company(B2C)? Eg.VIP Industries, Britannia, etc.,it would depend on the brand power. 

But with commodity business, it is derived by global factors. We need to be aware of the news around the commodity prices, better to start buying when the commodity prices have started to move upwards.

2. If its a commodity business, what is the product price now and how much has it gained in the past 1-2 years?

For a commodity business, if the prices have already moved too much, it leaves little room to go upwards. One should be cautious.

3. Is the change in company’s performance temporary or long term in nature?

Many times all of a sudden company’s performance changes. We need to find out if it is internally driven by bringing better efficiency/ product mix change/something else or externally driven. If externally driven, can we expect such a situation to continue? The former is always better to be on the safer side.

Eg: HEG Ltd saw its profitability on the back of increasing Graphite electrode prices. There was no change in the internal operations of the company. After a year and a half,  the prices started falling and so did the share prices. And to be honest for such high prices to last for 1.5 years in itself is much longer.  

All these things happen in the bull market only, we can take chance with only a small amount of capital and for a small period of time.

Britannia would be example of the changes brought about internally.

4. Is the expectation to performance very high?

This is more of a judgement based criteria. The performance of expectation can be considered to be high when everyone is talking about the company in bullish tone and expecting the company to be the next big thing.

If anything negative comes out, the prices fall dramatically the way it move upwards.

5. Does the share have enough liquidity?

While many don’t pay heed to the liquidity on the company’s share, it is very important to me

Eg: If I purchased a share and later realized that I made a mistake, then in order to sell it, I require enough number of buyers. If the share liquidity is low, it will take a good amount of time and I will have to keep selling at lower prices(Since if you are selling in a low liquidity stock, the share prices fall much more quickly). The average volume should at least be 20,000 per day as of now for me.

6. Is the market opportunity/ market size big enough?

Is the market size large enough for the company to keep growing. In case the market size is small, the growth stagnants after a while. Market sizes can be found in the annual report/ industry/ research reports. Look at the revenue of the company and the market size for the room for it to grow.

Eg: Mayur uniquoters, La opala RG

7. Is the promoter shareholding increasing and if the Shareholding pledged(% stake pledged):

It is always a good sign if the promoters are raising their stake in the business, implying their skin in the game. On the other hand, unnecessarily reducing stake would be considered to be negative. 

In India, when the company’s borrow, financial institutions want the shares of the promoters to be pledged as security. But many a time, promoters pledge their shares as collateral to borrow for a personal reason. If its the former then it’s fine, but if it’s the later then it is a negative sign. Difficult to get this information but conference calls and interviews might offer some answers.

Company buybacks are good as it increases everyone’s shareholding but if the promoters are themselves are taking part in the buyback is a negative sign(Why would they be wanting to sell their shares?).

8. Does the sector require a lot of Regulatory approval?

If there are too many regulatory approvals required to do  business and if the govt gets involved in each and every decision, the consistency and predictability of performance will depend on the govt’s sticking to its policies which seldom happens in India.

For eg: In the sugar business, each and every aspect of the business is decided by both State and Central govt and any change in their policies will create inconsistencies in the company’s performance.  

9. Client concentration or supplier concentration:

Client or supplier concentration would mean the company’s over-dependence on single or a group of clients/suppliers. In case any of them decide to end the business relationship with the company, the company goes into deep trouble.

Eg. RS Software which used to get 90% of revenue from VISA saw its revenue and profit plummet when the contract was canceled. So did the share price. Shaily engineering plastics’ 55% revenue comes from IKEA. Dixon technologies and Amber enterprises derive 60-70% of their revenue from a handful of customers.

10. Currency risk:

If the company imports raw materials or export finished product or service, the company gets exposed to currency risk. For those importing, the drop in rupee rate is bad whereas those exporting it is good. 

It is important to understand this risk and the extent of it on the company’s performance. 

Eg: Towards the end of the year 2018, the crude oil prices rose significantly as well as the rupee fell steeply. Companies importing crude oil-derived raw materials witnessed a sharp increase in cost. 

Investment Checklist- How to better understand a business!

11. Is the company’s market share increasing continuously?

Is the company taking away the market share from the leader? Usually, done by smaller ones taking the share of the larger peer.

12. Changing habits of people:

We need to have a tab on how the habits of people are changing. Many good companies went bust as they could not adapt to the new technologies or trends.  We can ask ourselves if the company’s products are going to be relevant in the future?

13. How are the end consumer performing & expected to perform: 

If the clients are not performing well, it is likely that they will reduce their orders and hence reduced revenues for these companies(B2B). In case of B2C, it would depend more on the macroeconomic situations and the prevailing trends.

For eg: Bhansali Engg Polymers Ltd(BEPL) is into the sales of Auto components. Since the time Auto companies have been facing issues, the sales of the company(BEPL) is facing a declining trend. 

14. Number of subsidiaries/joint ventures(JV)/associate companies– 

I try to avoid companies when there are a lot of subsidiaries/JV/associate companies and that too in different geographies. It becomes very difficult to understand the entire business and that too if they are into unrelated businesses. Also, in many financial shenanigans case, the routing of money was done from one subsidiary to another, the higher number of related parties, better the ability to hide.

It can be checked in the latest annual report. Just search the keyword in the annual report(subsidiary/subsidiaries/ joint ventures/ associate company).

Eg: Rain industries have more than 35+ subsidiaries which makes it very difficult to understand.

15.Entry barriers:

Does the business have some sort of competitive advantage: Network economies, Economies of scale, Brand loyalty, Patents, Regulatory licenses,  Switching cost(Microsoft), Cost advantage.

Eg: Companies such as Dixon Technologies and Amber Enterprises have very thin margins due to the nature of their business model. But even to reach such margin, one needs a very large scale to bring in economies of scale.

16. Capacity utilization:

If the company is running at full capacity, deriving additional revenue from the same capacity becomes difficult. Hence the sales become stagnant, so does the price appreciation. It can be found out from Annual report/ Concall transcripts/ TV interviews. In the Annual report/ Concall transcripts, one can just search for words like “Capacity/ Utlization/Expansion/”

Eg: Maithan Alloys Ltd has been running at full capacity in the recent past and in order to build a greenfield facility it takes 2-3 years. So they are looking at acquiring stressed assets to increase capacity immediately. We cant expect revenue growth in the near future in the company.

17. Debt reduction:

Debt to a certain level is fine but if the interest payments start eating away a large part of your profits and if accompanied by the deteriorating business environment, problems are much easier to say in theory than the practical situation failed.

Eg: Bhushan Steel and Essar steel are atypical examples of the point mentioned above.

18. Payment to auditors:

Payment to auditors depends on the size of the company and the number of subsidiaries. Usually, it varies from ₹5 lacs to ₹20-30 lacs, it can vary here and there.

Any unusually high amount of payment is a red flag.

19. Is Profitability growth> Sales growth:

Profitability growth should be greater than sales growth. The market always rewards profitability growth i.e. earnings growth. It should not be for just one quarter, at least for a few quarters(3-5).

20. Is the company lowest cost manufacturer:

Since for general manufacturing businesses, the end product selling price is more or less similar for all the companies, the differentiation comes from being a lower-cost producer.

How can a company become a lower-cost manufacturer?

1. Bringing efficiency in the manufacturing process

2. Replacing outdated machinery

3. Low to almost no debt

4. Captive power generation

5. Higher asset turnover

6. Lower logistical expenses

Investment Checklist- How to better understand a business!

21. How is the cash conversion cycle trending:

The cash conversion cycle is the time taken to convert cash used from procuring raw material to receiving cash after selling the finished products.

It varies from one industry to another. It would be appropriate to compare among the similars. THE LOWER THE BETTER. If the Cash conversion cycle is consistently going down, it would imply something going positively for the company and vice-versa.

22. Is the company able to bring down costs(Power, Employee, etc):

If any company is trying and are able to bring down the costs by increasing efficiency, using captive power, etc, is definitely a good sign. But sometimes companies recategorize certain cost items hence the percentages look much lower. Be careful here and make sure the drop in costs is reflected in the EBITDA margin as well.

23. Is there any anti-dumping duty imposed in the domestic country:

Anti-dumping duty is used to restrict cheaper imports. This enables local producers to charge higher prices and thus leads to higher margins. Indian Paper industry is having a great time due to high demand as well as Anti-dumping duty on cheaper imports.

24. Trade receivables to Sales: Many companies in order to show higher sales provides many liberal terms to its distributors/customers. In case your cash is tied there, you are dependent on external capital for running your day to day business operations. 

For eg: A listed company by the name of Jyoti Resins and Adhesives Ltd has shown a sales CAGR of 39% for the last 5 years. But when you look at their Trade receivables to Sales ratio, it is more than 80% for over these entire 6 years, implying they sell more than 80% of products on credit.

25. Net Sales to Fixed asset ratio: 

Commodity businesses usually require high assets to generate one unit of revenue. Usually, one unit of the asset would produce 2 units of output at maximum capacity.

It should be looked into. It does not mean business is bad but it should be looked along with everything else.

But with other kinds of businesses, the ratios can be much higher(including few commodity ones). That would mean to generate incremental revenue, investment would be lower.

26. Never trust whatever the promoter says about his company. Use your own due diligence.

It is almost impossible to get a perfect company, you need to weigh the positives and negatives based on your understanding.

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Shekhar Yadav

I am a full time stock market investor. The blog is an extension of my research, thoughts & opinion. Please don't consider anything on this website to be an investment advise.

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