On This Day - 2 JULY 2018
The 5-Point Checklist to Save You from Toxic Stocks
At a time when companies are being caught out in unethical practices at an alarming rate, causing their stocks to tank, taking investor wealth with it, you, dear reader, MUST pay attention to the goodness of the companies you choose to invest in.
Which, of course, raises the question: How?
How do you figure out whether a company is cooking its books?
What are the signs of bad financial reporting?
In my years of scanning annual reports and analyzing financial statements, I usually found the devil in one or more of the following details... keep an eye out for these issues - and if you spot them, put some distance between you and the stock.
Inconsistent Depreciation Rates: Watch out for companies where there is a huge variation in depreciation rates as a percentage of Gross Fixed Assets (GFA). This is usually a sign of shenanigans used to make earnings look good and an effort to delay huge depreciation expenses.
Inconsistent Tax rates: It's fine if a company is paying lower taxes as a percentage of profits. But there has to be some consistency in tax rates. I get suspicious when companies paying 30% tax rate in one year suddenly bring it down to 10 or 12%. Huge variations like these is a sign something may be amiss.
Sound Dividend Policy: Dividends are real while earnings are fictitious - so goes the adage. I like to see consistency in dividend payouts. I don't mind low payouts as the company could be investing in growth. But if there are no dividends at all even after years of making profits or if there are payouts but they are highly volatile, I consider this a sign of weakness.
| --- Advertisement ---
Beating the Market Has Never Looked This Easy
Since February 2014, research analyst Rahul Shah has beaten the Sensex 2.3x!!!
Subscribers have gotten the chance at several breakthrough double and triple digit returns …
And most of them within a 2-year time period.
Today, you can see just how amazing Rahul's research is by giving Microcap Millionaires a test run…
At only 5% of the normal price!
So, go on, you have nothing to lose…
Start your trial of Microcap Millionaires today
Capital Work in Progress as a percentage of GFA: I would love to penalize companies where there is a huge variation in capital work in progress as a percentage of GFA. I am fine if this ratio is consistently high or consistently low. But the higher the volatility, the higher the possibility that the management is trying to underreport expenses and overreport earnings.
Contingent Liabilities: As the name suggests, these liabilities turn real only when the event they are contingent upon does so. They are not a part of a balance sheet in the normal course of things. However, I tend to get uncomfortable if they account for a large part of the company's net worth. For if they turn real, they could land the company in serious trouble by wiping out a huge chunk of its net worth.
By themselves, these parameters may not yield much information about the quality of financial reporting of a business. But combine them and you could be well onto something.
Well, I will let you figure it out for yourself. Here are the top 20 companies in our share market that scored the best and the worst in my forensic accounting stock screener comprising of the above five parameters.
I simply ranked them on their consistency across all these parameters and arrived at a cumulative score.
Data Source: Equitymaster, ACE Equity
|The Safe Territory
||The Dangerous Territory
|Hawkins Cookers Ltd.
||Manugraph India Ltd.
|Pidilite Industries Ltd.
||HCL Infosystems Ltd.
|Excel Crop Care Ltd.
|Nestle India Ltd.
||Opto Circuits (India) Ltd.
|Relaxo Footwears Ltd.
||Petron Engineering Construction Ltd.
|Mahanagar Gas Ltd.
||United Spirits Ltd.
|Divis Laboratories Ltd.
||Nagreeka Exports Ltd.
|Castrol India Ltd.
||Mcnally Bharat Engineering Company Ltd.
|Apollo Hospitals Enterprise Ltd.
||Garware Polyester Ltd.
|Transport Corporation Of India Ltd.
||Pioneer Investcorp Ltd.
|Ratnamani Metals & Tubes Ltd.
||Vaibhav Global Ltd.
|Orient Refractories Ltd.
||Shriram EPC Ltd.
|Godfrey Phillips India Ltd.
||JMC Projects (India) Ltd.
|Power Grid Corporation Of India Ltd.
||Asian Hotels (West) Ltd.
||TVS Electronics Ltd.
|LIC Housing Finance Ltd.
||Bajaj Hindusthan Sugar Ltd.
|Jubilant FoodWorks Ltd.
||Emmsons International Ltd.
|Bharti Infratel Ltd.
||Jindal Photo Ltd.
|Bharat Electronics Ltd.
||AGC Networks Ltd.
This is a study that was done for the five-year period between FY13 and FY17 and the universe was more than 900 companies with revenues of at least Rs 3 bn.
For someone familiar with the Indian stock market and its hits and flops over the last few years, the names above do inspire confidence in the screening criteria.
There are a lot of quality names out there in the category marked as 'safe'. Likewise, the stocks labeled 'dangerous' have names that have been in the news for all the wrong reasons.
Here's another data point in favour of this five point checklist.
Bucket Wise Returns Over Last One Year
If you put all the stocks in the universe in five equal buckets such that B1 bucket contains the stocks with the best scores, B2 second best and so on, investing in the top three buckets i.e. top 60% stocks would have given much better returns than the bottom 40%.
Mind you, this is even without considering other factors like quality of the management, the soundness of the business model and valuations. Focusing on these five parameters alone would have helped you stay from the so called poisonous stocks where either the fundamentals are broken or financial shenanigans are being resorted to.
I think this checklist is a great tool, especially in the current times where a lot of cockroaches are being discovered from the financial kitchens of small and mid-sized companies.
When used along with other research tools, this checklist will alert you to their presence much before these creatures slither out of their holes and make investors run for cover.
Rahul Shah (Research Analyst)
Editor, Profit Hunter
PS: For someone who sifts stocks through multiple filters before cherry-picking the absolute best for his subscribers, follow Ankit Shah, the Equitymaster Insider, by subscribing here.
Copyright © Equitymaster Agora Research Private Limited. All rights reserved.
Any act of copying, reproducing or distributing this newsletter whether wholly or in part, for any purpose without the permission of Equitymaster is strictly prohibited and shall be deemed to be copyright infringementDisclosure & Disclaimer:
Equitymaster Agora Research Private Limited (Research Analyst) bearing Registration No. INH000000537 (hereinafter referred as 'Equitymaster') is an independent equity research Company. The Author does not hold any shares in the company/ies discussed in this document. Equitymaster may hold shares in the company/ies discussed in this document under any of its other services.
This document is confidential and is supplied to you for information purposes only. It should not (directly or indirectly) be reproduced, further distributed to any person or published, in whole or in part, for any purpose whatsoever, without the consent of Equitymaster.
This document is not directed to, or intended for display, downloading, printing, reproducing or for distribution to or use by, any person or entity, who is a citizen or resident or located in any locality, state, country or other jurisdiction, where such distribution, publication, reproduction, availability or use would be contrary to law or regulation or what would subject Equitymaster or its affiliates to any registration or licensing requirement within such jurisdiction. If this document is sent or has reached any individual in such country, especially, USA, Canada or the European Union countries, the same may be ignored.
This document does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual subscribers. Our research recommendations are general in nature and available electronically to all kind of subscribers irrespective of subscribers' investment objectives and financial situation/risk profile. Before acting on any recommendation in this document, subscribers should consider whether it is suitable for their particular circumstances and, if necessary, seek professional advice. The price and value of the securities referred to in this material and the income from them may go down as well as up, and subscribers may realize losses on any investments. Past performance is not a guide for future performance, future returns are not guaranteed and a loss of original capital may occur. Information herein is believed to be reliable but Equitymaster and its affiliates do not warrant its completeness or accuracy. The views/opinions expressed are our current opinions as of the date appearing in the material and may be subject to change from time to time without notice. This document should not be construed as an offer to sell or solicitation of an offer to buy any security or asset in any jurisdiction. Equitymaster and its affiliates, its directors, analyst and employees will not be responsible for any loss or liability incurred to any person as a consequence of his or any other person on his behalf taking any decisions based on this document.
As a condition to accessing Equitymaster content and website, you agree to our Terms and Conditions of Use
, available here. The performance data quoted represents past performance and does not guarantee future results.SEBI (Research Analysts) Regulations 2014, Registration No. INH000000537.
Equitymaster Agora Research Private Limited (Research Analyst) 103, Regent Chambers, Above Status Restaurant, Nariman Point, Mumbai - 400 021. India.
Telephone: +91-22-61434055. Fax: +91-22-22028550. Email: firstname.lastname@example.org. Website: www.equitymaster.com. CIN:U74999MH2007PTC175407