How to screen companies for investing?

PP left the following comment on my investment cycle post:

PP November 8, 2013 at 5:43 pm [edit]

Hi Manshu,

Good post. Could you do a post on how you go about screening / evaluating companies (and deciding if its share price is under or over valued), and recommend steps that one should follow while doing it themselves?

Thanks!

My screening technique is very simple and inspired by Peter Lynch’s One Up On Wall Street where he talks about using the power of your common knowledge, and investing in companies you deal with every day.

Following these techniques has been profitable and fun for me. I believe it’s important for this to be fun because if you’re not a professional, you won’t be able to practice these techniques if they aren’t fun.

Who makes this great product?

I watched “Thor: Dark World” in 3D yesterday, and enjoyed it quite a bit. I have seen the last Thor movie as well, but at that time I didn’t notice  Thor is a Marvel character. Before the movie, they played trailers of other upcoming movies with Marvel characters, and I made a mental note to look at Marvel to see if it may be a good buy.

Two other companies that caught my eye were IMAX, and I have bought and sold IMAX at a profit in the past, and RealD, which is the company that makes the 3D glasses for these movies. I have screened RealD earlier and avoided it because of the competition they face, and also the emphasis on re-use of 3D glasses.

Earlier in the day I spent a long time in the snaking queues of Banana Republic, and window shopped a Prada store because I can’t afford anything there. Both these companies seem to be excellent stock picks, and just keeping an eye out for popular products is a great way to screen companies.

You also read about trends like 3D printing and drones, and it is a good idea to see if there are any good companies operating in those areas. When I first learned about 3D printing, I thought it was a very new field, and it would be difficult to find any profitable companies operating in this area but then I discovered 3D Systems which has also been a very profitable stock for me.

Another way to screen companies is to see what enterprise software you use, and if there are any good companies operating in that field.

I was a regular reader of Business India and Business World, and they feature a lot of good companies that you can analyze further. I remember reading a glowing review of Jain Irrigation Systems in Business India many years ago and thinking about buying the stock — I never did, and the stock was a multi-bagger in the years to follow.

Reading about investments from others is also a good way to identify stocks. You can do this easier than ever before by using Twitter, and following people who are interested in investments.

Good ideas are all around you when you are actively seeking them.

Is it listed? 

That’s the question I ask myself often. Yesterday I learned that Marvel is owned by Disney, and both Banana Republic and Prada are private companies that you can’t invest in.

That will be the case with a lot of companies but you have to go through them to find the ones that are listed and could be potential buys. If it is listed then you can go to the “Investor Relations” section on their website and read more about the company, if not, you move to the next idea.

Currently, I own seven stocks and one ETF. I’m a customer of six out of the seven companies, the only one that I don’t knowingly use the products of is Huntsman Corporation, which I bought a couple of years ago because it had a dividend yield of 4%, and steady financials. This stock is over 100% of my purchase price today, and I felt like this would be a good buy when I chanced upon it.

You obviously make mistakes in this process as well, and one good example is Primo Water that I sold at a 50% loss sometime last year. This is a company that sells water, and they ran into financial troubles last year.

Evaluating a company

Not every company that makes a good product will be a profitable company, and not every profitable company will result in a profitable stock. HLL and Infosys are good examples of these. These two stocks were the darlings of investors some years ago, but after a while they lost their favor with investors and were never able to give the returns they once did. They are still good companies that own great brands, and provide great service, but due to other factors they haven’t been great stocks for the past few years.

This is an important thing to understand because it is not very intuitive. My own understanding of this concept became very clear in running OneMint. OneMint is a good product that has benefited a lot of people, but at the same time it has a non existent business model and if it were a stock I wouldn’t invest in it. Just providing value to people is not enough, there has to be a good business model and a way to monetize that value or else the business will never be profitable.

Even if a business is profitable, you have to look at its valuation to see if that justifies the current price, and leaves room for growth.I’m going to do a follow up post on this sometime this week, and share some of my ideas on how to measure this.

15 thoughts on “How to screen companies for investing?”

  1. Good tips Manshu. To add to your last point, stock may look good, but if the stock price already shooted up, there is less room for investor to get further appreciations. We should know whether stock is over priced or not before investing in any stocks.

  2. Thanks Manshu!

    I’ll be really interested in your follow-up post, if you could elaborate the next step, which is once you think of a stock, how you do your research – how (and where) to look at company’s financials and make sense out of balance sheets and profit & loss statements to decide if company is in good financial health and ultimately a profitable stock..

  3. Your post makes good reading.Having burnt my fingers time and again with stocks, am a bit wary now. Tried paid research,free tips, investment ideas by professionals on TV Business channels ( sometimes the same guys who had recommended a long term “buy” on a stock were quick to change it to a “hold or “sell” as soon as the stock or the sector fell out of favour:)), also tried a bit of research by studying the company’s financial ratios etc.. In the end, I have concluded that though there are value stocks and multibaggers, shortlisting them from the entire universe is not an easy job!

  4. Based on my casual observations, I believe water filter manufacturers will have a good future. Almost every middle-class household buys one. It has a replacement life of 8-9 years only. There is recurring money made by company through AMC, installation, and servicing. And it has a “fear” factor- “what happens if you don’t use one” – which makes it a mandatory purchase.

    Now if you can please look up the numbers and suggest 1-2 stocks in this space 🙂 ?

    Thanks !!
    Ashok

    1. Not to sound sceptical but I come from a city where almost everyone buys water cans. We did consider a water filter as it would save costs but we are so acclimatized to the canned water taste the water even after purification no way comes near this taste.
      I assume this is one reason why Water filters are still not a hit!

      1. Canned water is also purified (or whatever they do). So it is just moving one step upstream. So we also need to look at industrial scale water purifier manufacturers.

  5. Many people follow this method for buying a company.

    I had my friend buying Suzlon in 2009 as he was hearing a lot of go green !

    1. I love that you brought that up Suzlon because it used to have a very high percentage of shares pledged by its promoters, which is a big red flag for me and I have written about avoiding such stocks in the post.

      So I would have also looked at this stock but then avoided investing in it.

      1. Somehow stocks which are over hyped in media tend to fizzle out. Suzlon, Ashtavinayak, Reliance Power and many of the infra stocks are prime examples

  6. Jain irrigation, a multi bagger?? It went up from around Rs 70 in 2007 to Rs 258 in 2010 and is now back at Rs 70 in 2013. All the tailwind has been lost. Actually the system you have mentioned to pick stocks is a risky one. It gives rise to a lot of selection biases. The individual would start extrapolating his choices to the whole world resulting in a lot of positive bias to his selection. Its like going to the pizza house , paying Rs 350 for a medium pizza and assuming that every customer out there in the city is willing to pay the same amount for the pizza and then rushing to buy Jubilant foods share. A DLF house owner would think the world about DLF share, oblivious to the underlying problems facing the company. Again, positive bias.Even I used to follow the system you have mentioned and noticed the mistakes it was leading to. It is always better to assume a third-person, neutral stance when buying stocks.

    1. That’s why this is the starting point, and not the end in itself.

      You find things that you like and see how well the company is doing by looking at its numbers.

      The problem occurs when you ignore what I said in the last paragraph which is that not every good product results in a profitable company, and not every profitable company will be a good stock. In your case I think you jumped from finding a good product to buying the stock and skipped all the other steps in between 🙂

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