When it comes to inflation-beating returns, equity markets are among the best asset classes out of all in India. Due to the exceptional returns, retail participation in Indian markets has been steadily increasing over the last few years, and investors are parking their hard-earned cash into stocks.
Retail investors are always on the lookout for stocks that will provide better returns in the long term. But the most crucial step before investing is choosing the appropriate stock. For long-term investors, picking up the right stock involves an in-depth analysis of the company's financial statements and other parameters.
However, this would be a time-consuming process that would necessitate extensive financial knowledge. Aside from that, financial ratios are another method for researching stocks. Ratios will help investors quickly determine the performance of a stock and will also assist in forecasting future earnings growth.
In a recent story published in the Economic Times, Dr. Vikas V. Gupta described his five-step Graham-Buffet screening process using financial ratios for identifying value stocks.
Step-1: In the initial step, he said, all companies with sales of under Rs. 250 crores should be excluded. Companies with sales lower than this are very small companies and might not have the business stability and access to finance that is required for a safe investment. This eliminates the basic business risk.
Step-2: The other step is to filter out all companies with a debt-to-equity greater than 30%. Companies with low leverage are safer.
Step-3: The third filter is to eliminate all companies with an interest coverage ratio of less than four. Companies with a high-interest coverage ratio have a highly reduced bankruptcy risk.
Step 4: The next step is to calculate the Return on Equity. High ROE companies have a robust business model, which typically generates increased earnings for the company. So filter out all companies with an ROE of less than 15%, he said, since they are earning less than their cost of capital.
Step 5: Here comes the final step in the process. Filter out all companies with a PE ratio greater than 25, since they are too expensive, even for a high-quality company. This enables us to pick companies that are relatively cheaper than their actual value.
Following the Graham-Buffett formula, the ten stocks that became eligible include Zensar Technologies, Coal India Ltd, NMDC Ltd, Cairn India Ltd, V.S.T. Tillers Tractors Ltd, Tech Mahindra, Hexaware, Indraprastha Gas Ltd, Infosys Ltd, and Engineers India Ltd.
Dr. Vikas V. Gupta explains that these 10 stocks illustrate that high-quality companies with strong balance sheets can also withstand the stringent Graham-Buffet screening process.
Meanwhile, four of the ten stocks came from the IT sector, which typically has a low debt-to-equity ratio and a high return on equity.
According to him, using these filters allows us to reduce and even eliminate many fundamental risks while ensuring a strong business model, strong earning potential, and a good purchase price. This is a structured strategy and can be applied by each and every one to ensure basic hygiene in the companies you can think of potentially investing in, he said.
Dr. Vikas V Gupta explains that applying the strategy since 2003 delivered astounding returns with a CAGR of 29.1% and the money growing 20 times in 11 years.
He recommends that investors progressively form a portfolio having exposures to a few of these stocks for the current month after due diligence and discussions with their trusted financial advisors. He also suggested a maximum ceiling allocation of 5% for any stock. He advises that an ideal portfolio should comprise about 20 stocks and not less than 10 stocks.
Note: The above story is for Education purposes only, please speak with your financial advisor before making equity investments.
