Portfolio construction: Part 2

What are the stocks that would help you achieve your goal

Part 1 of my blog can be found here:

Portfolio Construction: Part 1

I had mentioned in my previous post that the construction of the portfolio is as important if not more than picking the stocks that you want in it. In this one I’m going to pick my first set of stocks.

You could use both quantitative as well as qualitative parameter to pick stocks but I always start with the former to control my biases. As someone who’s spent 15+ years in the market my mind gets clouded by a variety of biases that could hamper my stock picking. So, the first thing to do is to accept my failings and find a solution and that is where quantitative filters work.

My first set of stocks would be screened using the following parameters:

1. I start off with a universe of non-BFSI (Banking, Financial Services and Insurance) 403 companies for which clean data is available for the last 6 years and have had good listed history

2. 5 yr Sales CAGR > 0% - the reason why I have taken 5 years is because this horizon captures the COVID period as well and shows us if companies have gotten back to their pre-COVID levels in terms of market presence

3. 5 Yr EBITDA CAGR > 10% - this shows that EBITDA has grown faster than Sales and there has been margin expansion either through very good cost management or pricing power or sustainable demand

4. 5 yr total Operating cash flow > 0 - this shows id the business has been able to generate surplus cash after working capital requirements to meet its capital requirements, mainly

5. Operating Cash Flow/EBITDA > 0.5 for the 2 previous consecutive years - this tells if the business has been able to convert its accruals into cash or not. (will do a detailed post on “why accruals are important but cash is king”)

6. Debt/Total Capital > 50% for the 2 previous consecutive years - this shows that the company is able to meet its capital requirements internally and also shows that the company isn’t being prudent when it comes to its capital structure

7. 5 Yr average RoE > 12% - This is a slightly relaxed rule because we are coming from a regime of low interest rates to almost an exponential increase in the rates and now the central banks are talking about cutting rates. Your cost of capital will be impacted by all of this and if a business is able to deliver an RoE of 12%+ I think it will perform well in the long run.

When I applied all of this, some really interesting names popped up:

A few observations:

1. ~33% of the companies are at least 10% away from their 3 year lows

2. ~35% of the companies are at their 3 yr highs

3. PE expansion has happened in 23 of the 32 stocks and the 5 yr stock returns is higher than the 5 yr PAT growth

4. Except IOC and Varun Beverages, all other companies have reduced debt

5. 12 out of 32 companies have seen contraction in EBITDA margins over the last 5 years but it has to be noted that the margins have started expanding over the last 2 years. Some big names are HUL, Mphasis, Trent, Coforge and Alkem Labs

6. The RoE trajectory of all the companies are up after a dip during & post COVID

Out of these 32 companies in my first set, the stocks that I would be further interested in will be the ones that have delivered returns lesser or close to the PAT CAGR for the last 5 yrs as there could be potential for PE expansion. The stocks that fall in this category are and deserve further research:

1. IOC

2. Godrej Agrovet

3. HUL

4. Dr. Lal Pathlabs

5. Trent

6. Chambal Fertilizers

7. Amara Raja Energy & Mobility

8. CoForge

9. Alkem Labs

10. Pidilite

This would be my first set where I would start my deeper research as I come up with another set of companies using different set of parameters. My effort is run this quant screener as much as possible till I have a list of 50 to 75 companies that would become my investment universe. These 50 to 75 companies will be tracked closely and be brought into the portfolio and taken out depending on how the valuations play out.

Stay Tuned for my next list!

Disclaimer : I am not a SEBI registered investment analyst; none of the securities discussed here are investment recommendations; the views expressed are my own and are not that of my employer or their associates; I can not endorse the veracity of the data that I have pulled out from databases