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After establishing the context, we will now create a method for conducting limited resource equity research. It is called a 'limited resource' because retail investors have only limited resources for equity research. These resources include the internet, company annual reports, and MS Excel. Institutions have access to human resources (analyst), company management and financial databases (such as Bloomberg, Reuters or Factset). ), industry reports etc. My goal is to show how you can better understand a company's business using the resources available. We will keep the ultimate goal in mind, i.e. deciding whether or not to purchase a stock, as we do this exercise.
We will be dividing the equity research process into three stages, as we mentioned in the previous chapter.
Each step in the above stages has many steps. It is important to understand that there are no shortcuts and that you must not compromise any of the steps.
The first step in researching a company is to get as much information as you can about it. This crucial step is often overlooked and people rush to the stock price analysis. If you only have a short-term perspective, it is fine to analyze the stock price. Understanding the business is crucial for long-term investments.
You must be thinking why it is so important. The reason is simple. If you are more familiar with the company, the greater your confidence in staying invested, even during bear markets. Bear in mind that bear markets are when the price reacts to the fundamentals of the business. Knowing the business and company will give you the conviction necessary to justify why it is a good idea to invest in the stock, even if the market thinks otherwise. Bear markets are good for creating value. If you believe in the company, then you should consider investing in the stock during bear market conditions and not selling it. This is counterintuitive and requires years of experience in investing to fully understand.
Moving on, the best place to find information about the company is its website and annual report. To understand how the business is changing across business cycles, we need to review at least five years of its annual reports.
To begin understanding the business we must make a list. You can find the answers to these questions by looking through the annual report of the company and the website.
These are some questions I believe will help us understand the business. Each question has a rationale.
| Sl No | Question | The rationale behind the question |
| 01 | What does the company do? | To get a basic understanding of the business |
| 02 | Who are its promoters? What are their backgrounds? | To know the people behind the business. Sanity check to eliminate criminal background, intense political affiliation etc |
| 03 | What do they manufacture (in case it is a manufacturing company)? | To know their products better, helps us get a sense of the product’s demand-supply dynamics |
| 04 | How many plants do they have and where are they located? | To get a sense of their geographic presence. Also at times, their plants could be located in a prime location, and the value of such location could go off-balance sheet, making the company highly undervalued |
| 05 | Are they running the plant in full capacity? | Gives us an idea on their operational abilities, demand for their products, and their positioning for future demand |
| 06 | What kind of raw material is required? | Helps us understand the dependency of the company. For example, the raw material could be regulated by Govt (like Coal) or the raw material needs to be imported either of which needs further investigation |
| 07 | Who are the company's clients or end-users? | By knowing the client base, we can get a sense of the sales cycle and efforts required to sell the company’s products |
| 08 | Who are their Competitors? | Helps in knowing the competitors. Too many competing companies means margin pressure. In such a case, the company has to do something innovative. Margins are higher if the company operates in – monopoly, duopoly, or oligopoly market structure |
| 09 | Who are the major shareholders of the company? | Besides the promoter and promoter group, it helps to know who else owns the company’s shares. If a highly successful investor holds the shares in the company, then it could be a good sign |
| 10 | Do they plan to launch any new products? | Gives a sense of how ambitious and innovative the company is. While at the same time a company launching products outside their domain raises some red flags – is the company losing focus? |
| 11 | Do they plan to expand to other countries? | Same rationale as above |
| 12 | What is the revenue mix? Which product sells the most? | Helps us understand which segment (and therefore, the product) is contributing the most to revenue. This in turns helps us understand the drivers for future revenue growth |
| 13 | Do they operate under a heavy regulatory environment? | This is both good and bad – Good because it acts a natural barrier from new competition to enter the market, bad because they are limited with choices when it comes to being innovative in the industry |
| 14 | Who are their bankers and Auditors? | Good to know, and to rule out the possibility of the companies associated with scandalous agencies |
| 15 | How many employees do they have? Does the company have labour issues? | Gives us a sense of how labour-intensive the company’s operations are. Also, if the company requires a lot of people with a niche skillset, then this could be another red flag |
| 16 | What are the entry barriers for new participants to enter the industry? | Helps us understand how easy or difficult it is for new companies to enter the market and eat away the margins |
| 17 | Is the company manufacturing products that can be easily replicated in a country with cheap labour? | If yes, the company may be sitting on a time bomb – think about companies manufacturing computer hardware, mobile handsets, garments etc |
| 18/ | Does the company have too many subsidiaries? | If yes, you need to question why? Is it away for the company to siphon off funds? |
These questions can be used as a starting point for understanding any company. As you begin to search for answers, new questions will be posted that you will need to answer. This Q&A framework doesn't matter what company you're looking at. Your understanding of the company will increase dramatically, I am certain. Because the Q&A process requires that you read and find so many information about the company, you will begin to understand the company better.
This is only the first step of the equity research process. I recommend that you stop researching the company further if you discover red flags or other issues about the company. If you find red flags, it is not worth continuing to stage 2 equity research.
Based on my experience, stage 1 of equity research (i.e. It takes approximately 15 hours to complete 'Understanding The Company'. After going through the process, I try to sum up my thoughts on one sheet of paper. This would allow me to capture all the key information I have learned about the company. The information sheet must be concise and clear. This information sheet must be concise and to the point. If this is not possible, it means that I don't know enough about the company. Stage 1 is completed. I now move on to stage 2, which is the "Application of Checklist" stage of equity research. Keep in mind that the equity research stages should be performed in the same order.
Now we will move on to stage 2 in equity research. You can best understand stage 2 by actually implementing it on your company.
Throughout this module, we have been working with Amara Raja Batteries Limited. (ARBL). Therefore, it seems sensible to evaluate the checklist for the same company. Remember that the equity research framework is the same regardless of whether the company is different.
We will be discussing ARBL in detail as we get to know the company better. This is not intended to demonstrate how awful ARBL is but to provide a framework to what I consider to be a fair and adequate equity research process.
The equity research process's Stage 1 helps us to understand the how, what, who and why. This helps us to get a complete picture of the company. But, they say that the proof of a pudding is in its eating. So, no matter how attractive a business may look, the numbers should be equally attractive.
The 2 nd stage in equity research's goal is to help us understand the numbers and evaluate whether the nature of the company and its financial performance are complementary. If they don't complement one another, the company won't be considered investable grade.
We have seen the checklist in the preceding chapter. I will reproduce it here for your quick reference.
| Sl No | Variable | Comment | What does it signify |
| 01 | Net Profit Growth | In line with the gross profit growth | Revenue growth should be in line with the profit growth |
| 02 | EPS | EPS should be consistent with the Net Profits | If a company is diluting its equity, then it is not good for its shareholders |
| 03 | Gross Profit Margin (GPM) | > 20% | Higher the margin, higher is the evidence of a sustainable moat |
| 04 | Debt Level | The company should not be highly leveraged | High debt means the company is operating on high leverage. Plus the finance cost eats away the earnings |
| 05 | Inventory | Applicable for manufacturing companies | A growing inventory, along with a growing PAT margin is a good sign. Always check the inventory number of days |
| 06 | Sales vs Receivables | Sales backed by receivables is not a great sign | This signifies that the company is just pushing its products to show revenue growth |
| 07 | Cash flow from operations | Has to be positive | If the company is not generating cash from operations, then it indicates operating stress |
| 08 | Return on Equity | >25% | Higher the ROE, better it is for the investor, however, make sure you check the debt levels along with this |
Let's take a look at each item on the Amara Raja Batteries checklist and analyze the results. We will first examine the P&L items: Gross Profit, Net Profit and EPS.
Revenue and Pat Growth
The rate at which a company is growing is the first indicator that it may be of an investment grade. We need to assess the company's growth by looking at its revenue and PAT growth. Growth will be evaluated from two perspectives.
I prefer to invest in companies that are growing (Revenue or PAT) at a rate of 15% CAGR.
Let's see how ARBL does here...
| FY 09 -10 | FY 10-11 | FY 11-12 | FY 12 -13 | FY 13 – 14 | |
| Revenue (INR Crs) | 1481 | 1769 | 2392 | 3005 | 3482 |
| Revenue Growth | 19.4% | 35.3% | 25.6% | 15.9% | |
| PAT (INR Crs) | 167 | 148 | 215 | 287 | 367 |
| PAT Growth | (11.3%) | 45.2% | 33.3% | 27.8% |
CAGR revenue growth for the 5-year is 18.6% and CAGR PAT growth for the 5-year is 17.01%. These numbers are interesting and can be considered healthy. We still have to assess the remaining numbers on the checklist.
Earnings per share (EPS)
Earnings per share are the per-share profitability. The company's earnings per share and PAT growth at a similar pace indicate that it does not reduce its earnings by issuing more shares. This is good news for existing shareholders. This can be viewed as an indication of the management's abilities.
| FV Rs.1 | FY 09 -10 | FY 10-11 | FY 11-12 | FY 12-13 | FY 13 – 14 |
| EPS (In INR) | 19.56 | 17.34 | 12.59 | 16.78 | 21.51 |
| Share Cap(INR Crs) | 17.08 | 17.08 | 17.08 | 17.08 | 17.08 |
| EPS Growth | -11.35% | – 27.39% | 33.28% | 28.18% |
For FY14, the 5 year EPS CAGR is 1.90%.
Margin of gross profit
As a percentage, gross profit margins are calculated as a.
Gross Profits/Net Sales
Where?
Gross Profit = [Net Sales - Price of Goods Sold]
The cost of making finished goods is called the cost of goods sold. We discussed this calculation as we were analyzing the inventory turnover ratio. Let's see how ARBL's Gross Profit margins changed over time.
| In INR Crs, unless indicated. | FY 09-10 | FY 10-11 | FY 11-12 | FY 12 -13 | FY 13 – 14 |
| Net Sales | 1464 | 1757 | 2359 | 2944 | 3404 |
| COGS | 1014 | 1266 | 1682 | 2159 | 2450 |
| Gross Profit | 450 | 491 | 677 | 785 | 954 |
| Gross Profit Margins | 30.7% | 27.9% | 28.7% | 26.7% | 28.0% |
The Gross Profit Margin (GPM), is clearly impressive. According to the checklist, a minimum GPM requirement of 20% is required. ARBL can do more than meet the GPM minimum. This means that ARBL has a few things to consider.
Debt level - Balance Sheet check
The checklist's first three points were mostly related to the company’s Profit & Loss statements. Now we will look at a few items on the Balance Sheet. The Debt is one of the most important lines on the Balance Sheet. A high level of debt is indicative of high levels of financial leverage. Growing at the expense of financial leverage can be very dangerous. Remember that a high level of debt on the balance sheets can lead to a significant financial cost charge. This reduces the firm's retained earnings.
Here's how ARBL's debt looks.
Debt (INR Crs) Evaluation
| FY 09-10 | FY 10-11 | FY 11-12 | FY12-13 | FY 13-14 | |
| Debt | 91.19 | 95.04 | 84.07 | 87.17 | 84.28 |
| EBIT | 261 | 223 | 321 | 431 | 541 |
| Debt/EBIT% | 35% | 42.61% | 26.19% | 20.22% | 15.57% |
The debt seems to be stable around 85Crs. It is actually encouraging to see the debt have fallen in comparison to FY 2009-10. Apart from checking the interest coverage ratio, which we discussed earlier, I also check the debt percentage as a percent of 'Earnings after interest and taxes' (EBIT). This is a quick overview of how the company manages its finances. It is evident that the ratio of Debt to EBIT has been decreasing.
ARBL did a great job managing its debt levels efficiently, which I believe is a credit to them.
Inventory Check
If the company being considered is a manufacturer, it makes sense to check for inventory data. We can use the inventory data to help us in many ways.
Let's see how ARBL does on the inventory data.
| FY 09-10 | FY 10-11 | FY 11-12 | FY 12-13 | FY 13-14 | |
| inventory (INR Crs) | 217.6 | 284.7 | 266.6 | 292.9 | 335.0 |
| Inventory Days | 68 | 72 | 60 | 47 | 47 |
| PAT (INR Crs) | 167 | 148 | 215 | 287 | 367 |
The inventory number of days is more stable than it used to be. It does show signs of a slight decrease. We have already discussed how to calculate the inventory number of days. Both PAT and inventory are showing similar signs of growth, which is a positive sign.
Sales vs Receivables
Now we will examine the sales number together with the company's receivables. It is not a good sign to have a sale that is backed up by receivables. This is a sign of credit sales and raises many questions. Is the sales team selling products on credit? Are suppliers offered attractive, but not sustainable credit by the company to help them sell?
| FY 09-10 | FY 10-11 | FY 11-12 | FY 12-13 | FY 13 – 14 | |
| Net Sales(INR Crs) | 1464 | 1758 | 2360 | 2944 | 3403 |
| Receivables (INR Crs) | 242.3 | 305.7 | 319.7 | 380.7 | 452.6 |
| Receivable at a% of Net sales | 16.5% | 17.4% | 13.5% | 12.9% | 13.3% |
Here, the company has demonstrated stability. The table shows that a significant portion of their sales are not backed up receivables. This is very encouraging. The receivables percentage as a percentage of net sales has shown signs of decline just like inventory days. This is quite remarkable.
Cash flow from Operations
This is actually one of the most critical checks to make before investing in a company. Cash flows should be generated by the company. This is where the proof of the pudding. Any company that is stealing cash from operations is a red flag.
| In INR Cr | FY 09-10 | FY 10-11 | FY 11-12 | FY 12 -13 | FY 13 – 14 |
| Cash flow from Operations | 214.2 | 86.1 | 298.4 | 335.4 | 278.7 |
Although cash flow has been volatile, it has remained positive over the past 5 years. ARBL's core operations are able to generate cash, so they can be considered successful.
Return on Equity
In chapter 9, we have had a lengthy discussion about Return on Equity. If you need to review it again, I encourage you to do so. The company's return on equity (ROE), measures the percentage of the return it generates, keeping shareholders' equity in perspective. ROE is a measure of how successful company promoters have been in investing their own money in the company.
This is how ARBL's ROE performed over the past 5 years.
| In INR Cars | FY 09-10 | FY 10-11 | FY 11-12 | FY 12 -13 | FY 13 – 14 |
|---|---|---|---|---|---|
| PAT | 167 | 148 | 215 | 287 | 367 |
| Shareholders’ Equity | 543.6 | 645.7 | 823.5 | 1059.8 | 1362.7 |
| ROE | 30.7% | 22.9% | 26.1% | 27.1% | 27.0% |
These numbers are amazing. Personally, I prefer to invest in companies with ROEs above 20%. Remember that ARBL has very low debt. The good return on equity is not supported by excessive financial leverage. This is another highly desirable feature.
Remember that we are currently in stage 2 equity research. ARBL is able to meet all of the requirements in stage 2 and I believe that they are very competitive. You must consider the outputs of stage 2 and your findings from stage 1 when you are an equity analyst. After these two stages, you will be able to form a reasonable opinion based on facts. The business is likely to have investment-worthy attributes.
But, before you purchase the stock, ensure that the price is correct. This is what we do in stage three of equity research.