Stocks that investment gurus would buy for Diwali 2018

It is that time of the year when stock analysts, brokerage houses and research firms come out with their Diwali picks. Some base their selection on technical charts, which examine the trading activity in the past few weeks and identify stocks that are likely to move up.

Others look at the basic fundamentals of the stocks to name their picks. However, if you are looking for stocks that can create wealth in the long term, a deeper fundamental analysis of a stock is necessary. It is considered imperative for stock selection and offers a number of financial tools and ratios to judge the quality of a stock.

However, there is no single parameter that works in all situations. The best way to conduct fundamental analysis of a stock is to run a permutation and combination of different ratios and select those that work well in most situations. But there are numerous ratios, and there could be countless combinations, making the exercise practically impossible. At the same time, volatility leads to fear and anxiety among investors.

Apart from company specific or internal factors, the swings in stock prices are mostly due to external factors such as developments in the domestic and global economy, changes in inflation and interest rates, government finances, currency movements and global oil prices. These external factors can drag down even fundamentally sound stocks and contribute to the poor performance of retail investments in direct equities. The anxiety forces investors to exit good stocks that are meant for long-term capital appreciation.

The behaviour of investors vindicates the theory of random walk which states that the markets move in an unsystematic manner and it is almost impossible to predict or beat the market. Even professional fund managers and seasoned investors have at times failed to beat the market.

How to beat the market
With so many factors influencing the stock markets, how can one identify stocks that will ensure success? One way is to follow the strategies of famous investors. These people believe that no matter how volatile the market is in the short term, in the long run the market moves around its intrinsic or fair value. They strongly believe that there are inherent inefficiencies in the market and one can beat the market by recognising and buying stocks that are trading below their intrinsic values.

The intrinsic value is defined as the price derived from the firm’s fundamentals such as sales, earnings, dividends and its assets. The investment strategies devised by these guru investors are based on years of research and analysis and their investment track record is outstanding. All of them have successfully demolished the random walk theory by generating market beating returns from their strategies.

ET Wealth has used the strategies of four top guru investors to identify the Diwali stock picks for you. These stocks have passed the stringent quantitative filters that are based on the series of profit and loss and balance sheet variables.

Historical returns of stocks picked by gurus
The stocks have outperformed the BSE 500 by a wide margin

*Covered by Bloomberg analysts out of the shortlisted universe. BSE 500 index grew 22.74% in three years and 78.6% in five years. Returns are absolute returns. Data as on 26 Oct 2018. Source: ACE Equity & Bloomberg

Although these strategies are devised for developed markets like the US and UK, we have replicated it in Indian markets. The financial data used for the study is the consolidated data for 2017-18.

We also back-tested and found that these stocks have delivered supernormal returns in the past three and five years. The Growth Strategy of James O’Shaughnessy has given average returns of 1,015% in the past five years, beating the BSE 500 by 936 percentage points. But our study does not take the names thrown up by the filters as the last word.

The shortlisted stocks were then assessed on the basis of the recommendations by analysts on Bloomberg. Stocks not covered by Bloomberg analysts were ignored. Before we proceed, a small caveat for investors. These strategies only work in the long run and are meant for longterm investors. Short-term investors or day traders may not derive satisfactory benefits from these strategies.

I. JAMES O’ SHAUGHNESSY (FOUNDER & CIO OF O’SHAUGHNESSY ASSET MANAGEMENT)

"Go for large-cap stocks with high cash flow, sales, dividend yield"

James O’Shaughnessy is famous for his United Cornerstone strategy which is a purely quantitative technique. O’Shaughnessy studied international economics and business diplomacy at the School of Foreign Service of Georgetown University and has a degree in economics from the University of Minnesota. His investment strategy stresses that if you want to beat the market, you need to pick a strategy and stick with it, no matter what.

Emotions are perhaps the greatest enemy of the investor because feelings like fear, anxiety and excitement can cause an investor to shun his long-term plans. He is a firm believer of the buy and hold approach but unlike Warren Buffett, he doesn’t hold stocks for years. Instead, he holds stocks for a year and then rebalances his portfolio.

By doing so, O’Shaughnessy makes sure that he is not holding stocks that no longer meet his criteria. This guru investor’s stock picking approach, the United Cornerstone is a combination of two quantitative models: the Cornerstone Value and the Cornerstone Growth. The first model focuses on large-cap stocks whereas the second model looks at mid-sized stocks. The second model is more volatile as compared to the first model.

O’Shaughnessy’s filters for United Cornerstone (Value)

* Look for large-cap stocks. Only stocks with a market capitalisation of more than Rs 10,000 crore are included.

* Cash flow per share in the current year should be greater than the market average. For determining the market average, we have used the average cash fl ow of BSE 500 companies.

* The number of shares outstanding (or shares issued) in the current year should be greater than the market average. For determining the market average, we have used the average shares outstanding of BSE 500 companies.

* Trailing 12-month (TTM) sales should be greater than 1.5 times the market average. For determining the market average, we used the average TTM sales of BSE 500 companies.

* After applying the above fi lters, the stocks need to be ranked on the dividend yield in the descending order. Higher the dividend yield, better the stock.

To identify stocks using the Cornerstone Value model, O’ Shaughnessy looks at large, well-known market leaders with above average sales. He uses not only market cap as the filter for identifying large stocks but also includes the number of outstanding shares and sales revenue. Both these variables should be above the market average.

Another predictor is the cash flow of the company. The higher the cash flow, the better it is. Finally, he ranks stocks that pass all the previous criteria on the dividend yield. This is because O’ Shaughnessy found that dividend yields were excellent predictors for large, wellknown stocks. His study showed that market leaders with high dividend yields tend to outperform during bull markets but do not fall as much as other stocks during bear phases.

Stocks picked by O’ Shaughnessy’s Value Strategy

*Also in Joel Greenblatt’s list | Data source: ACE Equity & Bloomberg. PE estimates are for 2018-19. ROE estimates are based on 12-month forward projections. Estimates, recommendations and target prices are from Bloomberg. Current price as on 26 Oct 2018. BSE 500 estimates are for the year ending December 2019

The second model, the Cornerstone Growth looks at stocks with low price to sales (PS) ratios, which is a ratio developed by Kenneth L. Fisher. He looks for stocks that have a PS ratio of less than 1.5.

However, to keep weak stocks out, he also applies the earnings criteria. According to him, the earnings or EPS of a stock in the past five years should be consistently rising. Finally, he ranks the stocks that pass all other criteria on the relative strength that measures how a stock has performed, pricewise, compared to all other stocks over the past 12 months. Shaughnessy asserts that the more one trades, the higher are the chances of loss. Therefore, have a strategy and let it work. Disciplined implementation of active strategies is the key to performance.

O’Shaughnessy’s filters for United Cornerstone (Growth)

* Look for mid-sized companies. We have included companies with market capitalisation between Rs 1,000 crore and Rs 5,000 crore.

* The earning per share (EPS) should be consistently rising for the past fi ve years. EPS measures the earnings of a company on a per share basis.

* Price to sales ratio should be less than 1.5. The ratio measures the amount of money that one is willing to pay on every rupee of sales generated.

* From the stocks that passed the above fi lters, choose them in the descending order of their 12-month relative strength. Relative strength is a technical indicator that measures the speed and change of price movements.

Stocks picked by O’ Shaughnessy’s Growth Strategy

Data source: ACE Equity & Bloomberg. PE estimates are for 2018-19. ROE estimates are based on 12-month forward projections. Estimates, recommendations and target prices are from Bloomberg. Current price as on 26 Oct 2018. BSE 500 estimates are for the year ending December 2019.

II. WARREN BUFFETT (CHAIRMAN, BERKSHIRE HATHAWAY)
"Be patient. Buy with care and hold for a long time"

Warren Buffett, arguably the greatest investors of all time, strictly follows a conservative investment philosophy. A student of Benjamin Graham, Buffett attended the University of Pennsylvania’s Wharton School but later transferred to the University of Nebraska. A proponent of the buy and hold strategy, he prefers firms that are in straightforward businesses and manufacture products that people can’t or don’t want to live without.

Filters used by Buffett

* EPS should be consistently rising for the past 10 years with no negative EPS in any year. Long-term debt in current year should not be more than fi ve times its net profit.

* 10-year average return on equity (ROE) should be greater than or equal to 15%. ROE is a measure of return for the equity shareholders.

* 10-year average return on total capital (ROTC) should be greater than or equal to 12%. ROTC is a more effi cient measure of return as compared to ROE, as it accounts for the company’s debt.

* Free cash flow in the current year should be greater than zero. It is the cash available to all stakeholders of a company and a measure of company’s financial strength

Companies with a lot of hype are often disregarded. Buffett’s primary concerns are the financial stability, quality of management and simplicity of business. He also sees whether the company has the ability to pass on its costs. The company should have the ability to adjust its prices to inflation because this enables it to make profits in varying economic climates. Apart from these, Buffett also looks for an enduring moat in a company. This is any quality that makes it almost impossible for a competitor to overtake the company regardless of how much money the competitor is willing to spend.

Stocks that Warren Buffet would buy

*Also in Joel Greenblatt’s list | Data source: ACE Equity & Bloomberg. PE estimates are for 2018-19. ROE estimates are based on 12-month forward projections. Estimates, recommendations and target prices are from Bloomberg. Current price as on 26 Oct 2018. BSE 500 estimates are for the year ending December 2019.

Coca-Cola, whose stock is a long-time holding of Buffett, is a good example of an enduring moat. Coca-Cola has such a strong brand recall that a new company will find it impossible to dislodge it from its market leadership, regardless of how much it spends on advertising and marketing.

The other important aspect that Buffett looks at is the market position of the company. He likes “consumer monopolies”—companies that have a dominant market share which gives them the power and leverage in the market place. To identify solid companies, Buffett uses a series of fundamental indicators like stability of earnings, level of long-term debt to earnings, return on equity (ROE), return on total capital (ROTC), free cash flows and return on retained earnings.

As mentioned earlier, Buffett believes in buy and hold. He does not buy a stock for a week, a month or even a year. Small, day-today market movements don’t bother him. His strategy will suit investors who have the patience and are willing to wait.

III. JOEL GREENBLATT HEDGE FUND MANAGER, ACADEMIC AND WRITER

"Use return on capital, earnings yield to find bargain stocks"

Joel Greenblatt is known for his exceptional two-variable strategy known as the Magic Formula. His investment strategy identifies companies available at bargain prices using only two fundamental variables: the return on capital (ROC) and earnings yield.

Greenblatt believes that companies generating a high ROC have an advantage over their competitors. ROC is calculated by dividing the EBIT or earnings before interest and taxes by the tangible capital employed. The ratio figures out how much capital is actually needed to operate the company’s business. The second variable, the earnings yield looks at the return one could expect if he buys the entire business, including its debt. Generally, earnings yield is the inverse of PE ratio. For example, if a stock’s PE ratio is 25, then its earning yield is 4%(1/25).

However, Greenblatt does not use the conventional earnings yield formula because it ignores the company’s debt. Instead, he calculates the earnings yield by dividing the EBIT by the enterprise value. Both components are weighted equally in identifying bargain stocks. The companies are ranked in descending order of ROC and earnings yield separately.

The two rankings are then combined and those with the lowest combined ranks are considered superior stocks. One important aspect of the Magic Formula is that it does not work for small cap stocks, utilities and financial companies. Also, the Magic Formula needs a holding period of at least one year to work. Greenblatt also asserts that the strategy may not beat the market every year, but over a long period of time, the formula will result in market beating gains.

Filters used by Greenblatt

* Include only largecap companies. We included companies with a market cap of more than Rs 10,000 crore

* Calculate ROC by dividing EBIT* by tangible capital employed that determines the capital required to operate the business

* Calculate earnings yield by dividing EBIT* by enterprise value. It gives an estimate of the return that one can expect after buying the entire business, including debt

* Rank the companies on ROC in descending order, that is, companies with large ROC will be ranked higher than the companies with small ROC

* Rank the companies on Earnings Yield in descending order, that is, companies with large earnings yield will be ranked higher than companies with small earnings yield

* Combine the ranks by adding the two ranks together. For example, if XYZ Ltd is ranked 13th on ROC and 25th on Earnings Yield, the combined rank for XYZ Ltd is 38th.

* Sort the companies on the combined rank in ascending order and select the ones with the lowest ranks. The lower the combined ranking, the better.

Stocks that Joel Greenblatt would buy

Also in Warren Buffett’s list **Also in James O’ Shaughnessy’s Value Strategy list | Data source: ACE Equity & Bloomberg. PE estimates are for 2018-19. ROE estimates are based on 12-month forward projections. Estimates, recommendations and target prices are from Bloomberg. Current price as on 26 Oct 2018. BSE500 estimates are for the year ending December 2019.

IV. JOSEPH PIOTROSKI PROFESSOR AT STANFORD UNIVERSITY AND SENIOR FELLOW AT ASIAN BUREAU OF FINANCE AND ECONOMIC RESEARCH

"Pick stocks with solid financials that are trading below intrinsic value"

Joseph Piotroski focuses on companies that have high book to market (B-M) ratios and are unpopular due to any reason, such as financial distress. Using a series of balance sheet and accounting measures, Piotroski developed a methodology to identify high B-M stocks that are unfairly overlooked by the market. He defines high B-M stocks as the ones that appear in the top 20% of the market. Such quality high B-M stocks can be great investment opportunities, because their share prices are likely to jump once the market recognises their potential.

Filters used by Piotroski

* Look for companies with high B-M ratio. We have calculated the same by taking the inverse of price to book value ratio.

* Return on assets (ROA) should be greater than zero. Moreover, ROA in the most recent year should be greater than ROA of the previous year. ROA shows how much money a company is generating on its assets and is a measure of fi nancial soundness.

* Cash fl ow from operations (CFO) should be greater than zero. CFO measures the strength of the business.

* CFO should be greater than net income. Net income or net profi t is the residual profi t left after charging depreciation and payment of interest and taxes.

* Long term debt to Assets ratio (LTD/A) in the current year should be less than LTD/A in the previous year. The ratio measures the fi rm’s fi nancial fl exibility.

* Asset turnover in the current year should be more than asset turnover in the previous year. The ratio measures how much sales a company is making in relation to the amount of assets it owns.

* Shares outstanding in the current year should be less than or equal to shares outstanding in the previous year.

* Gross margin* in the recent year should be more than gross margin in the previous year. The ratio shows how much money a company is generating on its sales.

To seperate the chaff from the grain, Piotroski recommends some accounting and balance sheet tests that look at profitability, financial leverage and operating efficiency. The profitability test looks at companies that have the ability to generate funds internally. Financial leverage deals with changes in capital structure and the ability of a company to meet its future debt obligations.

The final test on operating leverage measure how much money a company generates on its sales or its assets. Piotrosoki emphasises on fundamental improvement. Most of the filters he uses require improvement over the previous year. Piotrosoki asserts that the strategy works with a holding period of 1-2 years.

Stocks that Joseph Piotroski would buy

Data source: ACE Equity & Bloomberg. PE estimates are for 2018-19. ROE estimates are based on 12-month forward projections. Estimates, recommendations and target prices are from Bloomberg. Current price as on 26 Oct 2018. BSE500 estimates are for the year ending December 2019.

*We have used operating profit margin (OPM) instead of gross margin while selecting stocks