How to Generate Stock Ideas

24 Nov 2013 08:55 pm | Vishal Khandelwal

In an interview with Warren Buffett in 1993, Adam Smith, author of Supermoney, asked how the
small investor can find good investment ideas.
Warren Buffett: Id tell him to do exactly what I did 40-odd
years ago, which is to learn about every company in the
United States that has publicly traded securities, and that bank
of knowledge will do him or her terrific good over time.
Adam Smith: But there are 27,000 public companies.
Warren Buffett: Well, start with the As.
Everybody knows that Warren Buffett gets his investment
ideas largely from annual reports.
Of course, now he has become so influential that companies
call him to share their own ideas. But, fifty years ago, Buffett was not the go-to guy if you
wanted to sell your company or raise capital for your failing bank.
He was a small investor who was clawing his way up the investing street by reading whatever
annual report came his way, and then finding his investment ideas that worked wonders in the
subsequent years.
You are probably at the same stage Buffett was fifty years ago. But theres a big advantage you
have over the early day Buffett.
That advantage is technology.
With annual reports now available at the press of a few buttons (on company websites and BSE),
you can look through hundreds of companies in lesser time than it took Buffett to access ten
companies.
You may ask, But how do I select companies whose annual reports I should read?
Well, one quick suggestion is what Buffett told Adam Smith start with the As.
I would simplify this for you
1. Take, for instance, the BSE-200 list of companies
2. Remove all companies that you know are outside your circle of competence (Dont
worry if you remove lot of companiesbecause the size of the circle is not important,
knowing its boundary is)

3. For companies that remain, start reading annual reports of companies whose names start
with A, then B, and so on.
If you find this difficult to implement (and it is), here are a few other ways you can create a list
of companies you would like to do a deeper research on to generate stock ideas
Remember, good ideas rarely come from

TV, newspaper analysis and breaking news

Brokers and research analysts

Friends, colleagues, and people you meet at social gatherings

so you may rather do your own homework than relying on free tips, however enticing they
may sound.

Screening Your Way to Stock-dom!

While I am not anymore a big fan of using readymade screeners to generate stock ideas
because you tend to substitute thinking with a lot of data simple screeners still help me in doing
the initial groundwork.
Also, while there are a few paid (and expensive) screeners available in the market like Ace
Equity, Prowess, Capital Line I find a few free screeners to be very effective when it comes to
the value I can derive from using them.
Here are three steps you can use while using three free screeners I use to do a basic analysis on
companies
Step 1: Use a Google Screener
Visit this Google Finance Stock Screener page and select India from the drop down list of
countries, and then BSE or NSE from the stock exchange list.
Remove all entries like Market Cap, P/E Ratio etc, so that you can set your own criteria for
screening. Then, screen for companies using these key numbers (you may add more screening
criteria from those available)

5-year sales growth - Between 10% to 50% Neither too low nor too high to avoid
extremes or cases with sharp rise and sharp falls that may revert to the mean

5-year EPS growth Between 10% and 50% Neither too low nor too high to avoid
extremes or cases with sharp rise and sharp falls that may revert to the mean

Latest Net Profit Margin Between 5% and 75%

5-year Avg. Return on Equity Between 15% and 100%

Latest Debt/Equity Ratio Less than 1x

Latest Market Capitalization At least Rs 2.5 billion (Rs 250 crore) to exclude
extremely small companies

Latest P/E ratio Between 5x and 25x

Volume At least 100 shares traded daily

Here is how the screening and its output look like

Note: Another good screener that a tribesmen has directed me to is from Financial Times FT
Equity Screener. It has greater number of criteria than Googles screener, but does not display
the results in INR. You must however try it out for sure.
Step 2: From the list of companies you get, exclude those outside your circle of competence
businesses you know you dont understand (like I would exclude commodity businesses like
metals and mining, or oil & gas businesses).
Step 3: Glance at the last 5/10 years financial performance on sites like Screener or
Morningstar. Look for trends in:

Sales growth Check for rising and stable growth

Net margin Stable / rising margin. Be wary of margins that are falling

Return on equity Stable or rising. Be wary of falling ROE

D/E Nil or small debt is fine. Be wary of companies where D/E > 1x

FCF change Morningstar gives the free cash flow calculation, which instantly tells you
if the company is generating cash or burning it. Look for businesses that have generated
positive FCF over the past few years

Apart from the ratios given, calculate ones like FCF yield FCF per Share divided by
Stock Price, which tells you if the stock is cheap or expensive. An FCF yield of 5% or
more is a good number to look at.

The best part about these two screeners Screener and Morningstar is that you can download
companiess financial performance in excel and then do you own analyses.

Better Alternative to Step 3

While you may use Screener or Morningstar to study the past 5/10 yearss performance of

companies that you get from Step 1 and Step 2 above, a far better way is to pick up the annual
reports of the resultant companies and then read them one by one.
After having used readymade screens for the past few years, I have realized that you should not
use numbers prepared by others, but rather generate them yourself. This way you get into the
habit of actually reading annual reports and also get to learn what numbers you need to focus on.
Here are two videos that will tell you what you must focus on in an annual report
If you cant see the videos above, see here Video 1 | Video 2
Ultimately, as you would realize, just a few numbers / facts / variables will help you understand
what drives a given business.
I have seen analysts and investors trying to get perfect in their analysis by accumulating as many
data points as possible.
But then, my experience suggests that trying to increase your confidence by gathering
information that is supposedly unknown to most others really only makes you more comfortable
with your investment decisions, not better at them, and is generally an unproductive use of your
limited time.
Thus, I would suggest that after you arrive at your list of companies using any or a combination
of methods suggested above, use a Less is More Checklist while reading the annual reports of
the companies in your list.

Use the Less is More Checklist

Rather than obsessing with the bewildering fusion of news and noise, concentrate on a few key
elements in stock selection, i.e., what are the 5-10 most important things you should know about
any business you are about to invest in?
Of course, if I knew the exact answer I would have retired long ago!
Even if I could know all the facts about an investment, I would not necessarily profit. This is not
to say that fundamental analysis is not useful. It certainly is.
But information generally follows the well-known 80/20 rule: the first 80% of the available
information is gathered in the first 20% of the time spent.
So if I were to list down eight questions that, I believe, would help me do an 80% analysis of a
business, they would be
1. Is the business simple to understand and run? (Complex businesses often face
complexities difficult for its managers to get over)

2. Has the company grown its sales and EPS consistently over the past 5-10 years?
(Consistency is more important than speed of growth)
3. Will the company be around and profitably better in 10 years? (Suggests continuity
in demand for the companys products/services)
4. How has the company performed on Buffetts earnings retention test? (Suggests how
a company has used retained earnings in the past a very important question to answer)
5. Does the company have a sustainable competitive moat? (Pricing power, gross
margins, lead over competitors, entry barriers for new players)
6. How good is the management given the hand it has been dealt? (Capital allocation,
return on equity, corporate governance, performance against competition)
7. Does the company require consistent capex and working capital expenditure to grow
its business? (Companies that have to spend continuously on such areas are like running
on treadmills, which is not a good situation to have)
8. Does the company generate more cash than it consumes? (Cash generators have a
higher probability of surviving and prospering during bad economic situations)
These questions would help you answer whether the business you are looking into is great, good
or gruesome as Warren Buffett has defined each one of them to be.
Ultimately, successful investing is all about doing your own research carefully and buying good
businesses.
If you know a company well and youve done your homework, you can take advantage of
situations when Mr. Market offers them on a platter, which he occasionally does.