Dixon Tech Up 60% in 6 Months. More Gains Ahead? 

Hello everyone, Rahul Shah here trying to make investing accessible and profitable for the average investor.

Is it possible to give a view on a stock without even looking at its fundamentals or the business model?

A lot of investors would consider this as ridiculous. Some may even call it blasphemy.

After all, one needs to have a thorough understanding of the business model and the financials before one can make a sound judgement on a stock. This is easier said than done though.

For e.g., if we consider that there are 1,000 stocks worth investing in India and spend no more than 2 days understanding each stock, the exercise of knowing the entire universe of stocks will still take 2,000 days. That's almost 6 years.

Besides, even if you manage to complete this mammoth task, fundamentals of a lot of the companies may undergo a structural change due to the dynamic business environment.

And then you are back to square one, re-analyzing a lot of the same companies.

Well, the only way out of this vicious circle is having a rubric or a framework, which restricts your universe of stocks to a manageable few.

In fact, this brings to mind the famous Steve Jobs quote:

• People think focus means saying yes to the thing you've got to focus on. But that's not what it means at all. It means saying no to the hundred other good ideas that there are.
  
  You have to pick carefully. I'm actually as proud of the things we haven't done as the things I have done. Innovation is saying no to 1,000 things.

Just as innovation is saying no to 1,000 things, successful investing is also saying no to 1,000s of stocks out there and investing only in a select few. However, you can't be analysing each stock and then rejecting most of them. This, as we just discussed, is practically impossible.

So, how to decide whether you need to dig deeper or give the stock a pass, in say like 5 minutes? What should a 5-minute test of the company look like?

I don't know about others but here's what I do.

Here's the historical financials of a popular company.

Would you invest in this stock? Now, some of you would say that although the stock's historical financials are a mess, we need to check out its future prospects and only then take a call?

Well, not me. I like to jump over a 1-foot bar and not a 7-foot one. If the company has racked up losses for many years in the past, I won't consider it no matter how great the prospects. Unless it turns profitable and churns out profits on a regular basis, I am not interested in doing any further analysis on the stock.

By the way, these financials are of none other than the popular fintech giant PayTm. The stock that has more than halved from its peak price of close to Rs 1,800 per share about a year and a half ago.

Now, here are the historical financials of another company.

What about this? Does this stock merit a further look? I think it does.

Profits are stable if not growing and therefore, the business model does seem strong and sustainable. I will then head over to the balance sheet and if the company has manageable debt, I will finally check out the valuations. Well, a year ago, this stock was available at an attractive PE of close to 9x.

Now, this set up i.e. strong financials, strong balance sheet and attractive valuations does sound good enough for one to take a deeper look at the stock.

And it did not take me more than five minutes to figure out it.

It is simple. If the company has a sound financial track record, if it does not rely on too much debt and if the valuations are not very expensive, I get interested. Absent any of these factors and I drop the stock and move on to the next one.

By the way, this second stock that we discussed was none other than Mazagon Dock Shipbuilders and it is up a whopping 500% in the last one year alone. Looks like our set up does work after all.

Let's take a look at another company.

Hmm.......the numbers look interesting. In fact, more interesting than Mazagon Dock Shipbuilders. The company has grown its profits almost 20x between FY14 and FY23 on the back of a close to 12x growth in topline. What is more, the debt-to-equity ratio is also well under control with debt being just one sixth of equity. So, that's a second tick mark against its name.

Now, let's check out the valuations. Well, the stock trades at a PE ratio of almost 100x.

Yes, that's right. Mr Market is extremely bullish on the stock and is valuing at almost 100x its earnings.

Is this acceptable? Well, this makes it 11x mor expensive than the valuation of Mazagon Dock a year ago.

Agreed that Mazagon Dock was trading at very attractive valuations back then and the businesses of both the companies are as different as chalk and cheese.

But even then, is the current PE multiple of Dixon Technologies justified? Yes, that's correct, this company is none other than Dixon Technologies, one of the most popular stocks around.

Well, it is here that the story gets really interesting. One way of figuring out whether the stock deserves a multiple this high is to take a detailed look at its future prospects, project its earnings many years out and then apply a suitable PE ratio to it.

However, this approach is fraught with risks. How do you know that your brain isn't working in reverse?

In other words, it is really difficult to figure out whether one is trying to arrive at a rational valuation or a rational PE multiple for the stock or whether one is working towards rationalising the current PE multiple i.e., making projections just so that the current price can be justified.

And trust me, even the most brilliant minds fall prey to this bias.

Instead of making realistic projections and assigning a realistic PE multiple, they end up making projections that makes the current price look undervalued.

One of the ways out of this trap is to fix an upper limit to how much you are willing to pay for any stock, no matter how good the quality or how good the prospects. Yes, that's right. This upper limit will save from the trouble of overpaying for stocks.

This number for me is not more than 25x-30x and in rare cases, slightly more than that. Anything more than that and I like to keep the stock on my watchlist and come back to it again once the price corrects.

How do I know that this multiple of 25x-30x is the right one?

Well, experience. I haven't seen a lot of wealth being made in stocks where someone has paid significantly more than 25x-30x on a consistent basis. Yes, there will always be some exceptions. But paying significantly more than 25x-30x is not the path that leads to market beating returns over the long term.

Therefore, this is a rule that I don't like to mess around with. Therefore, even without taking a detailed look at the fundamentals, Dixon goes straight to the watchlist because of the PE ratio that I am uncomfortable with.

So, that's my bird's eye view of the stock and it does not look good to be honest.

Of course, you may have a different valuation limit than mine. But whatever it is, do keep it realistic and try and back it up with sound logic.

Without this limit, you may quickly get lost in the jungle that is the stock market.

Well, that brings me to the end of this session. Goodbye and happy investing.