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Warren Buffett’s knack of spotting potential early is legendary. It has made him one of the most successful stock investors of all times. How does he manage to identify multibaggers? What is the secret mantra that he follows to pick winners? Actually, it’s no secret. Buffett’s stock picking is based on a strict conservative philosophy that he has followed for decades. He prefers to invest in businesses, which manufacture products that people can’t or don’t want to live without, such as toothpastes, soaps, soft drinks, cars and computers. The companies that are given to speculation or hype are often disregarded.
Buffett’s primary concerns include a company’s financial stability, quality of management and simplicity of business. He also checks whether the company has the ability to pass on its costs to its customers. He believes that a company should be able to adjust its prices to inflation because it enables it to make profits in varying economic climates.
There is another critical quality that Buffett looks for in a company—the enduring moat. This is the USP of a company, the one quality that makes it almost impossible for its competitors to overtake it regardless of how much money they are willing to spend. Coca-Cola, whose stock is a long-time holding of Buffett’s company, Berkshire Hathaway Investments, is a good example of the enduring moat. Coca-Cola is such a recognisable brand that it is difficult to imagine a new company being able to dislodge the market leader regardless of how much money it might be willing to spend on advertising and brand building.
The oracle of Omaha is now on the prowl in the Indian markets. Last week, he told reporters in Bangalore that he was “a retard to have come to India so late”. Even as he trawls the markets for winners, we decided to run the very filters that are used by the guru to find out which Indian companies can pass his muster. Let us look at the seven fundamental parameters Buffett uses to zero in on potential stocks in the US. We will then use the same to identify the Indian companies that are worth investing in. STABILITY OF EARNINGS: This can be checked by considering the earnings per share (EPS) for the past 10 years. EPS is derived from the residual profit left after payment of all expenses, taxes, depreciation, interest, preference dividends and belongs entirely to equity shareholders. A company should not have a negative EPS in the past 10 years. If the EPS is lower than that in the previous year, the dip should not be more than 45%. DEBT TO EARNINGS RATIO: The second variable is the level of long-term debt to earnings ratio. Buffett likes conservatively financed companies. He prefers the long-term debt of a company to have been paid off from its net earnings in less than five years. This implies that the long-term debt to earnings ratio should be less than or equal to five. RETURN ON EQUITY (ROE):The third variable measures how much money a company earns on its equity. The ratio is generally expressed as a percentage. For a company to figure on Buffett’s radar, its 10-year average ROE should be greater than or equal to 15%. RETURN ON TOTAL CAPITAL (ROTC): This variable can sometimes give an incorrect picture. It’s because some companies have a high debt content in their capital structure in relation to their equity. Still, they will show a high ROE because of the low equity base. However, a high debt content makes the company risky as the debt needs to be serviced, irrespective of the company being profitable or not. ROTC overcomes the limitation of ROE. Buffett prefers the companies whose 10-year average ROTC is greater than or equal to 12%. FREE CASH FLOW: Buffett does not pick stocks of companies that indulge in major capital expenditure. Free cash flow is the difference between operating cash and capital expenditure. Therefore, free cash flow should be a positive. A company with a positive free cash flow is generating more cash than it is consuming and this is a good sign. RETURN ON RETAINED EARNINGS: The next variable is the return on retained earnings. Buffett uses this to assess the management’s performance. The variable gives an indication of theability of the management to use retained earnings for shareholders’ wealth creation. To be eligible for investment by Buffett, a company’s 10-year return on retained earnings should be greater than or equal to 12%. After we applied these six filters, we zeroed in on 45 companies. Buffett uses one more filter while identifying companies—market share. He prefers the companies that have an overwhelming market share and are dominant players in their fields. Market share is an important consideration because it ensures sustained profits for the company. BASF India and ONGC have a staggering market share of 98% and 85%, respectively, in their industries. In the past 10 years, these two companies have delivered annualised returns of 21.7% and 28.6%, respectively, in comparison to 17.58% returns generated by the BSE Sensex.
We sorted the shortlisted 45 companies on the basis of their market shares and selected the top 10 firms. These are the stocks that the master investor would be likely to pick when he goes shopping on Dalal Street.
A caveat is in order. Buffett is also a strong proponent of the ‘buy and hold’ strategy. He does not buy a company’s shares for a week, a month or even a year. He likes to remain invested for a very long term. Small, day-to-day stock market movements don’t bother him too much. Therefore, if you want to follow his investments, you must also copy his strategy. It suits only the long-term investors. Short-term to medium-term investors may not derive adequate benefits if they follow in Buffett’s footsteps.
The Warren Buffet stock selection guide
Look for companies with commanding market shares. Make sure that the company has a long history of increasing EPS. Ensure that the company has been conservatively financed. Assess the management performance by evaluating ROE, ROTC and return on retained earnings. *From the book titled The Guru Investorby John P. Reese, published by John Wiley & Sons, Inc.
Data based on March 2010 annual results. The seven filters used for stock selection are taken from the book The Guru Investorby John P. Reese. Analysts’ views are from Bloomberg.
Data source: Capitaline
IF YOU are sitting on unrealised losses on equity investments made less than a year ago, here is some consolation. Those unrealised losses can be used to lower tax liabilities for the current financial year.
Tax experts are advising investors to book their losses on or before March 31 this year and buy back those shares in the next financial year, beginning April 1.
By doing so, the tax on short-term capital gains, if any, can be set off to the extent of short-term capital losses. It may be noted that tax on short-term capital gains was increased by 15% from 10% with effect from 2008-09.
Brokers say this could trigger volatility in some stocks over the next couple of weeks, as investors try to balance their account books.
“Short-term capital losses for the year can be set off against any capital gains, short or long-term, reported under the head, income from capital gains,” said Jain Ambavat and Associates partner Vinod Ambavat.
“In case, the gains are lower than the losses, the excess short-term capital losses can be carried forward and offset against capital gains for eight successive assessment years,” he said.
However, Mr Ambavat said long-term capital losses on security transactions liable to securities transaction tax cannot be offset against any income, and cannot be carried forward for offsetting against any future gains. “These losses can also be offset against short-term as well as longterm gains of non-equity assets like real estate, jewellery, debt mutual fund units, gold ETFs, etc. Investors have to bear in mind that short-term capital losses first have to be adjusted with any short-term capital gains, and only then with longterm capital gains on transactions not liable to STT (like sale of gold, real estate, etc),” added Mr Ambavat.
Investors in many other countries like the US book temporary losses for lowering tax liability subject to fulfilment of certain conditions. But there are rules that prevent investors from selling and buying back the same stock within 45 days for tax purposes.
In India, there is no such restrictions that forbids investors from benefiting from this. So, many small-cap stock holders look for ways to avoid being taxed on their non-profitable investments.
Analysts Feel MNC Parents Face No Compulsion To Raise Money From India
LISTED Indian arms of MNCs may not be the best bets in a raging bull market. But in troubled times, these stocks may not just be safe havens in terms of relative outperformance, but could be the best bets from an absolute return point of view. “Investing in MNC stocks (Indian arms of the MNCs) quoting near multi-year lows, and which look like potential delisting candidates makes sense,” said the head of a domestic financial services firm. Companies that fit into this category include that of Honda Siel, Blue Dart, Esab, Ingersoll Rand, Bayer CropScience, Merck, Abbott India, etc.
Equity analysts believe MNC parents of these companies see no compelling reason to raise capital from India. “Also, they have easy capital available outside India. A weak market will provide them an opportunity to increase their stake at a much cheaper rate, although their offer price will be at a substantial premium to current market price,” said an analyst tracking MNC companies.
Brokers maintain that this strategy will yield good returns from a 12-18 month timeframe, even if the delisting does not materialise. This is because majority of these firms are fundamentally sound. “Most MNCs are debt-free companies and are cash rich. In many cases, they have cash on book of almost 60-80% of its market cap. Almost all have a strong business model and good financials. Additionally, prices of all these stocks are ruling at near their lows, thereby reducing downward risk,” said the head of research of a broking firm. Some of the aforementioned companies have at some time or the other, sought to delist or have come out with an open offer for increasing the promoter’s stake.
In case of Esab India, the 55.56% subsidiary of Charter, UK, the parent made an open offer at Rs 505 for an additional 20% stake but got a response for only 15%. With Ingersoll Rand, the 74% subsidiary of Ingersoll Rand-USA, the exit price offered by the parent did not enthuse shareholders while in the case of Blue Dart — the 81.03% subsidiary of DHL group — the price of Rs 900 arrived through the reverse book building process price was not acceptable to DHL.
Bayer Crop Science, or BCSL, the 71% subsidiary of Bayer Ag, Germany and Honda Siel, a 67% subsidiary of Honda Motor Corporation (HMC) have not come out with open offers in the past. Yet market watchers believe that once these companies sell off their properties in Thane and Rudrapur, respectively, offers for delisting are likely.
Market watchers estimate that 50-60 companies are likely to delist over the next one year. “The global scenario being what it is, many parent companies are for the time being, not focused on their Indian subsidiaries. But the situation could reverse once the overall sentiment improves. These stocks, which are currently available at throwaway prices, could see their valuations soar then,” said a BSE broker.