Sanjoy Bhattacharyya is a believer in the philosophy that one always should look for “hidden gems” by looking in nooks and crannies, and turning stones over. This is in sharp contrast to the approach of other stock pickers who believe in buying stocks that are already proven successful, even if they are quoting at a high PE.
Sanjoy Bhattacharyya’s latest article in Forbes (“Understanding the Neglected Firm Effect” part 1, part 2 & part 3) explores the phenomenon of how to identify “neglected stocks” (i.e. stocks that lack analyst coverage and which have no ‘institutional’ ownership), what filters to apply to them and how to create a model portfolio of such stocks.
Bhattacharyya points out that there is a risk and a reward in identifying such stocks. The reward is that because nobody has noticed these stocks, one can buy them at cheap valuations and make a hefty profit later. The risk is that because information is scarce about such companies, there may be hazards that you are not aware of.
Sanjoy Bhattacharyya suggests that the way to eliminate or reduce risk is to put the stocks through a rigorous screening check-list. If the stocks fail the check-list you must not consider them worthy for investment.
He also suggests that risk can be eliminated/ reduced with proper diversification. In practice, a portfolio of 12-15 stocks gets rid of more than 90 percent of ‘diversifiable’ risk, he says.
Sanjoy Bhattacharyya also advices that investors should stay away from over-valued stocks and reject companies that are fairly priced but unlikely to appreciate given the mediocrity of their underlying business.
He recommends that the following filters be applied while short-listing the stocks:
(i) Compounded annual EPS growth in excess of 15% over the past decade;
(ii) Current PE ratio not in excess of normalised PE trading band for the last 5 years;
(iii) Debt equity ratio less that 0.5;
(iv) Consistent growth in revenues during the last 5 years;
(v) Five-year average return on equity in excess of 18%.
Applying these filters, Sanjoy Bhattacharyya has prepared the following Model Portfolio.
|Company||CMP (Rs)||Mkt Cap (Rs Cr)||TTM PE||P/B||5 yr avg ROE (%)||10 yr sales gr (%)|
|Tide Water Oil||6804||592||9.1||1.7||23.2||19.8|
|VST Tillers & Tractors||471||407||7.7||1.7||29.9||21.6|
Surprisingly, FAG Bearings did not qualify to be a part of the Model Portfolio even though Sanjoy Bhattacharyya had called it a “compelling long-term investment” on account of its high margins, growth ratios and debt-free status. Perhaps, the high PE ratio of FAG disqualified it from being considered.
Sanjoy Bhattacharyya also advices investors to have a clearly defined exit strategy without allowing either emotion or ego to get in the way of disciplined selling. He suggests that stocks should be sold when the price momentum is exhausted and begins to reverse or when analyst coverage and institutional ownership begin to trend upwards. He also advices a sale when either the fundamentals begin to decline or the price momentum is worse than the index for three consecutive months.