Flipping Through Pages to Hunt Value!

My every day process of last 3 years with the New Approach

During the Covid pandemic, after losing quite a bit of money in F&O, I realised I had some decent (or maybe just lucky) success with equities. It all started with building quantitative screens and spotting some obvious cheap or fast-growing stocks, and making a fast 2X-3X. Now that I have realised that it was just Dumb Luck, I decided to put up a more elaborate Process than just expecting random Outcomes.

“The thing I like to say here is the idea of process versus outcome. The world looks at outcomes but really should look at the underlying processes that produce those outcomes” - Prof Bakshi

Warren Buffett, both young and old, has spent years flipping through pages of Moody's manual to find good, quality, and mispriced bets. His followers, like Li Lu, Joel Greenblatt, and many others (including me!), do the same thing every day.

Today, I want to share my new (and evolved) process for shortlisting good investments before diving deeper. As I write this, I hope to either improve my process or get some feedback from you, my readers. 😊

Step 1: Screener (Modern-Day Moody's Manual for the Indian Market)

To my knowledge, there's no exact alternative to Moody's printed manual for the Indian market. However, several websites provide historical financial information and company details. My favourite is Screener.in. It's clean, simple, and no-nonsense.

I've created an "Investible Universe" based on some basic metrics (mostly borrowed from Joel Greenblatt & Nalanda) - around 600 stocks appear here from time to time. I don't apply any valuation criteria yet because I've learned that doing so too early can lead to missing out on good opportunities (Errors of Omission).

I then sort the exported table by Avg RoCE, Sales Growth, Low D/E, High Interest Coverage, and EV/EBIT or Price to Sales or PE, depending on the industry. For today's lunch, I have 10 companies ready; 10 minutes each; roughly 1.5 hours a day.

Step 2: Reject Everything Based on Forensic Accounting

I've reordered my Excel sheets and put Forensic Accounting first. Cheap valuations have often distracted me from overleveraged balance sheets and promoters siphoning off cash in Capex. What's the point of finding something cheap if the company is fraudulent or not shareholder-friendly?

I look for the basic survival of the company and the nature of the promoters:

• Is the company overleveraged?

• Is the debt manageable?

• Is there repeated debt or equity dilution because operations aren't generating cash?

• How are accounting profits converting to cash?

• Is the promoter taking money out through Capex or depreciation practices?

This isn't exhaustive, as there are more dangerous things like high promoter salaries, auditor fees, resignations, board constitution, etc. But it's enough to start with; the rest can be found in the last 10 years of annual reports.

Step 3: Reconstitute Cash Flow Using the Indirect Method

I don't trust only the P&L; nobody should. Cash is the ultimate reality. Promoters have learned new ways to manipulate cash flows, so I create cash flow statements using the indirect method, avoiding one-offs, creative entries, and other non-cash adjustments.

You'll notice a difference between what Screener (and the company) reports as cash flow versus what I calculate. Why the difference?

• Non-cash adjustments in the reported CFO are excluded from mine.

• In my case, Working capital is excluding Current Assets & Liabilities.

• My CFO excludes interest/dividends, but the reported might include.

Capex is approximated at this stage. I shift to annual reports and Con-Calls to determine if the Capex is for growth or maintenance, later.

The main conclusion at this stage is to filter out companies not making money from the CFO or where there's a huge difference between the CFO and PAT. I also get a sense of the company's product/service strength and its stage in the business cycle.

The below exhibit from Michael Maubussin`s paper does a fantastic job of giving an easy route for identifying the stages, for me to build expectations.

Step 4: Evaluating the RoIC Tree Briefly

In my corporate strategy days, I learned about the Economic Value Creation model (from McKinsey itself). If a business doesn't make a return on invested capital (RoIC) higher than its weighted average cost of capital (WACC), it doesn't create value.

A simple way to understand RoIC from the image below from this article.

Sounds cryptic? But trust me, this funda is very well known to local Kirana store owners (albeit, in their version), but largely misunderstood by most of the Corporate world.

I plot my own RoIC metric to do a quick check against the WACC. I prefer businesses with high asset turnover over high margins, as they create longer runways, less competition, and scalable franchises (may be a post later on this topic)

Ignoring total invested capital for now is okay, as I'm focused on the core business.

The company above is making a healthy RoIC over ~12% WACC, generating surplus cash for future growth, buybacks, debt reduction, or dividends.

Very few companies would pass this stage, unless I have some really strong/ differentiated insight into whether a business is going to go through, Explosive Growth or Margin Expansion is coming up; otherwise, it would be a pass!

Last & The Final, Step 5: Valuation - Are They Cheap Enough?

No single metric is perfect, so I look at all metrics and use some reasoning to decide if a company is worth my attention. The company below looks optically cheap by all metrics: PE, P/S, P/B, and EV/EBIT. The dividend yield is 0%, suggesting it's in a high-growth phase (same as I assumed looking at Cash Flow before)

If I build a simple DCF for the next 3 years with ballpark assumptions, it should become 3X soon. Voila!

Finally, after rejecting ~20 companies over the last two days, I've found something worth studying. I'll review all financial statements one last time before diving into the annual reports for a weekend of deep dive.

Investing is simple but not easy, isn't it?

P.S

1. The company above is WTI Cabs (and this is not a recommendation)

2. This post is also written to convince my wife that this is what I do after work and on weekends :P

   Some reading material, if you like the concepts covered -

   The Corporate Life Cycle: Managing, Valuation and Investing Implications

   McKinsey's First Principles of Valuation

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   DISCLAIMER: I AM NOT A SEBI-REGISTERED ADVISOR OR A FINANCIAL ADVISER. ALL THE VIEWS ARE FOR EDUCATIONAL PURPOSES. I MAY OR MAY NOT HAVE INVESTED IN THESE STOCKS. PLEASE DO YOUR DUE DILIGENCE YOURSELF. THIS IS NOT A STOCK RECOMMENDATION.