/How to Screen for Stock Ideas

How to Screen for Stock Ideas

While I am not 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, Capital Line – I find a few free screeners to be very effective when it comes to the value I can derive from using them.

In this post, I explain the few steps you can use while running once such free screener – Screener.in – to do basic analysis on companies and screen for high quality ideas. Let’s start right away.

Step 1: Visit Screener.in, create a free account, then login into your account, and start creating your first screen. You may start with these key numbers (or may add more screening criteria from those available) –

  • 5-year sales growth > 10%
  • 5-year profit growth> 10%
  • Average return on equity over 5 years > 20%
  • Average return on capital employed over 5 years > 20%
  • Debt to equity < 0.5x
  • Market Capitalization > Rs 1000 crore
  • Price to Earning < 25x

Here is how the sample search query looks like on Screener –

And here is the output of this query –

Note: The above images are for representation purpose only

Step 2: From the list of companies you get, exclude those outside your circle of competence – businesses you “know” you don’t understand (like I would exclude commodity businesses like metals and mining, pharma, banking, and oil & gas businesses).

Step 3: Use Safal Niveshak’s Stock Analysis Excel that uses data from Screener.in to study the last 8-10 years’ financial performance of the remaining companies in your list. Look for trends in –

  • Sales and profit growth – Check for rising and stable growth
  • Proft margin – Stable / rising margin. Be wary of margin that is falling
  • Return on equity and return on capital – Stable or rising. Be wary of falling ROE/ROCE
  • D/E – Nil or small debt is fine.
  • FCF change – Free cash flow tells you if the company is generating cash or burning it. Look for businesses that have generated positive FCF over the past few years

Step 4: While you may use Screener.in to study the past 5/10 years’ performance of companies that you get from the steps mentioned 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 when you are doing deeper research, but rather generate them yourself through annual reports. This way you get into the habit of reading annual reports and also get to learn what numbers you need to focus on.

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.

Step 5: 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 a few questions that, I believe, would help me do an 80% analysis of a business, they would be the following. Note that these are just the questions you must focus on answering in your pursuit of identifying a few good and great businesses for your portfolio and avoiding the gruesome ones.

Here’s the checklist –

  1. Is the business simple to understand and run? (Complex businesses often face complexities difficult for their 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 company’s products/services)
  4. Does the company have a sustainable competitive moat? (Pricing power, gross margins, lead over competitors, entry barriers for new players)
  5. How good is the management given the hand it has been dealt? (Capital allocation, return on equity, corporate governance, performance against competition)
  6. Does the company require consistent capex and working capital expenditure to grow its business? (Companies that must spend continuously on such areas are like running on treadmills, which is not a good situation to have)
  7. Does the company generate more cash than it consumes? (Cash generators have a higher probability of surviving and prospering during bad economic situations)

As I mentioned above, 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.

Before I conclude, here is a broad framework I use for selecting stocks – which includes the screening process mentioned above – that has mostly worked well for me over time –

Click here to download a larger image
Ultimately, successful investing is all about doing your own research carefully and buying good businesses.

If you know a company well and you’ve done your homework, you can take advantage of situations when Mr. Market offers them on a platter, which he occasionally does.

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