Hope you are doing well.
Today, I would like to share with you our thought process on how to identify stocks with low downside risk and potential for high pay offs.
I think you will agree with the following two facts:
- All the businesses are cyclical to varying extents and go through lean periods, and
- Best returns are generated when a company goes through both Earnings and PE expansion
Thus, if you combine the two, we get the formula for low risk high reward opportunities:
“Basically, if we can identify Good Companies going through Depressed Earnings Cycle and thereby depressed valuations, the downside risk reduces considerably; while when the cycle turns around, the stock can end up delivering substantial gains on account of both earnings’ expansion and PE re-rating”
The question is how does one know if it’s a good company or not? Well, without complicating much, if one sticks to basics like: a business you can understand, low leverage on the balance sheet, decent past track record, high promoter holding, operating cash flows matching reported earnings (over longer periods), etc, you will easily know if the company is worth considering or to be simply put into avoid basket.
A more detailed checklist can be accessed here – LINK
Now, I would like to illustrate with 2 examples as to how the above strategy helped us identify stocks that ended up delivering substantial gains in an overall tough environment.
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Case#1 – Aarti Drugs
We initiated the stock on 30th Sep’18, i.e. FY 19 around 137 odd levels (adjusted for bonus). We knew that the company is good; however, in terms of earnings it was going through a lean period due to one-off events such as slow demand in Q1 of FY 18 in the run- up to implementation of Goods and Services Tax Act, fire at one of its plants in Q4 of FY 18 and contraction in margins in Q1 of FY 19.
Before Q1 FY 19, the company was consistently delivering 16% operating margins; however, the margins contracted to 14% in Q1 FY 19.
Thus, as a result of slightly depressed earnings and general apathy towards Pharma stocks, the stock was available at 13-14 times earnings against the highs of 20 times earnings a few years back.
What’s important to note here is that lower valuations were on already lower earnings and thereby the probability of any major deterioration in earnings or the stock price was quite low.
Luckily, due to a combination of factors, the earnings have improved and even the PE has re-rated substantially, resulting in ~500% gain on the stock.
Case #2 – Chaman Lal Setia
The company is into basmati rice production and trading which is more or less a commodity business and getting hold of the earnings cycle around lows can be greatly rewarding.
We initiated the stock on 29th Sep’19 around 46 odd levels. Here again, we knew that the company is good and the business is deeply cyclical. So, when the operating margins of the company contracted to 5-6% in Q1 and Q2 FY 20 against the highs of 12-13% a few quarters ago, and combined with that the stock also corrected to 40-50 levels from the highs of 150-200, we thought the further downside is low and initiated the opportunity.
Then, the stock was trading at 7-8 times earnings and that too on cyclically low earnings.
Luckily, the earnings have doubled since then while the PE is still the same and that’s why the stock has also doubled.
It’s important to remember that no strategy is fool-proof and there will always be cases wherein you will incur losses; however, the idea is to have small losses and large gains.
Note: The above examples are only for educational purpose and are neither a recommendation on the stocks or reflective of our current view.
Wish you Good Health and Wealth
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Disclaimer: www.katalystwealth.com (here in referred to as Katalyst Wealth) is the domain owned by Ekansh Mittal. Mr. Ekansh Mittal is the sole proprietor of Mittal Consulting and offers independent equity research services to investors on subscription basis. SEBI (Research Analyst) Regulations 2014, Registration No. INH100001690
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Disclosure (SEBI RA Regulations)
Whether the research analyst or research entity or his associate or his relative has any financial interest in the subject company/companies and the nature of such financial interest – Yes, Aarti Drugs in Father’s and Wife’s account
Whether the research analyst or research entity or his associates or his relatives have actual/beneficial ownership of 1% or more securities of the subject company (at the end of the month immediately preceding the date of publication of the research report or date of the public appearance) – No
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