What it means by fundamentally strong stocks? These are stocks which has a strong underlying business.What it means by underlying business? The Company itself.
What is the underlying business of the stock named TCS? Tata Consultancy Services (Tata Group’s flagship company).
Fundamentally strong stocks represent such companies, which will continue to do business even in worst of times.
There are some inherent traits of their business that makes them stand tall even in tough weathers.
What helps them to do business even in adverse times?
To answer this, we will have to think, what is essential for companies to do business? Capital.
Till there is enough capital flowing-in for the company, it can do business.
The day capital-flow starts to fall below the necessary levels, business operations will also start getting weaker.
Capital flow for business is like “fuel” for the car. Till there is enough fuel, car will run its speed.
#1. Employed Capital…
Taking the analogy of “fuel” one step further…
Suppose there is a person who has his/her own source of fuel. What do you think, his/her car will ever run out of fuel? No.
Similarly, a company which is generating its own capital (fuel) to do business, is necessarily a company with a strong fundamental.
In business terms, the capital used to fund companies business operations is called “employed capital“.
Company use its employed capital to do the following:
- Pay for all expenses.
- Fund its capital purchases.
Let’s see a simplified version of the formula of employed capital. This simplification works wonderfully for me to identify fundamentally strong stocks.
Employed Capital of Fundamentally Strong Stocks = (Share Capital + Reserves) + Low Debt – (i)
How to read this formula?
A fundamentally strong company is one which can run its operations from its “share capital” plus “reserves“. It needs only low debt to do its business.
It means, the company has low debt dependency. The lower will be the debt the better. Zero debt is like a perfect score.
The factor of “low debt dependency” is very important from shareholders point of view. Why?
Because it makes the company more self-reliant and less risky. How? Please continue reading, this point will be further exemplified.
There is another formula which must be used in conjunction with the above.
Employed Capital of Fundamentally Strong Stocks > Total Expense – (ii)
What does this formula signify? Let’s understand it like this:
Suppose there is a company which operates in low debt [see formula (i) above]. Its employed capital is like this:
Employed Capital = Share Capital + Reserves + Low Debt.
But an important question that must be asked is, whether this employed capital is sufficient or not. How to know this?
By using this formula: Employed Capital > Total Expense Requirement.
Lets understand the utility of this formula.
The “employed capital” is that fund which companies use to finance its “total expense requirements”.
The company expends money to produce “goods and services“. These goods and services in turn generate revenue.
It means, before the revenue is generated, the company must first spend money from its pocket.
How much fund is there in companies pocket? Share Capital plus Reserves (equity).
If the equity component is enough, the company will continue to produce “goods and services”, and earn revenue.
If not, there will be shortfall of funds to run operations. Hence revenue will fall.
Fall in revenue due to shortage of funds is a clear sign of “bad fundamentals”.
Hence those companies which cannot fund its “employed capital needs” from its pocket, take debt.
It is essential for investors to realise the effect of debt on companies fundamentals…
#1.1. The debt factor…
If a company does not have sufficient money in its pocket, it can take debt.
So in this case the employed capital will be, Share Capital + Reserves + Debt
Availing debt is not always a bad thing for companies.
But for majority companies, debt is like a short term relief and long term burden.
How it is a short term relief? It immediately provides liquid cash for the company.
How it is a long term burden? Because this debt needs to paid back, from profit, in times to come (principal plus interest).
So generally speaking, the lower is the debt dependency of the company to finance its “employed capital”, the better.
Hence this generalisation will not be wrong, “low debt companies tend to be fundamentally stronger“.
So this brings us to the concept of financially independent companies.
Companies which has virtually zero reliance on debt (to fund its business operations), are financially independent.
These are companies which has enough money in their own pockets.
They need not rely on external debt to meet their needs for cash.
Let’s dig deeper into financially independent companies…
#1.2. Financially independent companies…
If a company is able to generate its ‘necessary employed capital’ by self, it can continue to operate indefinitely.
Companies which are able to generate its employed capital by self can be called as financially independent.
Financially independent companies are fundamental power houses. Lets see how…
What is employed capital?
The employed capital is built from:
- Share capital.
What is share capital? Share capital is a fund raised by the company by issuing shares.
Reserves are retained profits of the company accumulated over a period of time.
Company use share capital and reserves to fund its operating costs.
If “share capital and reserves” is enough to fund the business operations of a company, it can be tagged as fundamentally strong.
Complete reliance on “share capital and reserves” means the following for a company
- Company is using zero debt.
- The company is generating cash flow fast enough.
For a company to become financially independent, along with low debt dependency, it must also have faster cash in-flow.
Cash flow is like blood flowing in the veins of companies. Fast cash in-flow indicates good health. How?
- Cash in-flow will ensure liquidity.
- This ensures payment of “current liabilities“
- Fast cash in-flow also ensures need of lesser debt.
“Share capital plus reserves” is like savings of the company.
Funding operations with own savings is a perfect case of doing a good business.
In this case the “employed capital formula” will be as below:
Employed Capital = (Shareholders Equity) + Zero Debt
[Note: Shareholders equity = Share capital + Reserves]
“Zero debt and high shareholders capital companies” are those companies which are favourite of long term investors.
Few example of fundamentally strong, zero debt companies are these:
- Bata India.
- Bosch India.
- Hindustan Zinc.
- Bayer CropScience.
- Castrol India.
- Colgate-Palmolive etc.
Let’s dig deeper into the fundamentals of these companies to understand the impact of “high shareholders equity and low debt”.
#1.2.1 Bata India:
Its debt level is zero in last five years. Its shareholders equity is Rs.1,478 crore. Its annual expense is Rs.2,333 Crore.
Current shareholders equity to total expense ratio is 0.63.
It means, though Bata is debt free, but its total expense requirement is higher that its equity base.
So how the company is managing its cash-out flows?
Probably the company is able to manage the cash out-flows because of its payment terms.
To buy the products of Bata, majority customers pay for the goods first and then take delivery.
Now, let’s compare Bata with Bosch.
#1.2.2 Bosch India:
In last 5 years the average debt to equity ratio has been 0.01. Which is very low.
Moreover, the average shareholders equity of Bosch (in last 5 years) takes care of 96.88% of its total expense requirement.
Particularly in last FY (Mar’18), its shareholders equity level was as high as 104.44% of its total expense requirement. Which is phenomenal.
So you can see that, though both Bata India and Bosch are debt free, but still Bosch looks fundamentally stronger. Why?
Because Bosch has enough money in its pocket to fund 100% of “total capital needs”.
What we can learn from here?
Comparing shareholder’s equity base with the total expense requirement of the company, is necessary to judge its financial independence.
Only zero debt does not guarantee that the company is financially independent.
Lets take a look at another example of Hindustan Zinc.
This will further deepen our understanding about debt dependency, and capacity of companies to become financially independent.
#1.2.3 Hindustan Zinc:
In FY ending Mar’17, Hindustan Zinc reported a debt of Rs.7,908 crore. This makes its debt equity ratio of 0.26.
Which was way higher than Bata and Bosch’s D/E ratio.
But Hindustan Zinc’s fundamentals still looks stronger than Bata and Bosch. How?
See its Shareholders Equity as % of Total Expense.
- In Mar’17 it was 375%.
- In Mar’18 it is 385%.
It means, shareholders equity capital of Hindustan Zinc is almost 4 times higher than its total expense requirement.
This is another example where we can understand that looking at debt/equity ratio is not enough to judge a companies financial independence (debt dependency).
Comparing shareholder’s equity base with total expense gives a deeper understanding.
Let’s see more examples of fundamentally strong low debt companies:
#1.2.3 Other companies
These are few more example of zero debt companies.
Try to judge their fundamentals by looking at their following ratios:
- Debt / Equity Ratio.
- Equity / Total Expense Ratio.
Hint: Low debt/equity and high equity/expense ratio company is better.
#2. What is the Optimum Equity/Expense Ratio?
Not every company can afford to do business with zero debt.
Means, for every company shareholder’s equity to expense ratio need not be one.
Use of debt to operate business is not always bad.
If debt level is low (compared to its equity base), company can still be treated as fundamentally strong.
So what is the optimum shareholders equity to total expense ratio?
We will use two methods to arrive at the an optimum value for this ratio:
- Optimum Debt-Equity ratio approach.
- Cash Flow approach.
#2.1 Debt-Equity ratio approach…
In some cases, even high-equity companies may have to opt for debt. How?
When their collection (payment from customers) is not fast enough.
It is the nature of their business, where products/services are sold at 60-90 days credit.
Hence all companies that avail debt are not bad.
In some cases, even very profitable companies use debt to increase their leverage.
A reasonable amount of debt use is not bad. But how much debt can be treated as reasonable?
Debt equity ratio of less than 0.5 is a desirable ratio. This is not a hard and fast rule, but for me this ratio works well.
Though the lower is the debt equity ratio the better.
So lets apply the ratio of 0.5 to the employed capital formula:
Employed Capital = Shareholders Equity + Debt = Total Expense
- Shareholders Equity + Debt = Total Expense
- or, Shareholders Equity + 0.5 x Shareholders Equity = Total Expense
- or, Shareholders Equity x 1.5 = Total Expense
- or, Shareholders Equity / Total Expense = 66.67%
For a fundamentally strong company, Shareholders Equity / Total Expense (S/TE) must be more than 66.67%.
From above example (March’2018 results)
- Bata India: S/TE = 63%.
- Bosch India: S/TE = 104%.
- Hindustan Zinc: S/TE = 385%.
- Bayer CropScience = 79.55%.
- Castrol India = 39%.
- Colgate-Palmolive = 49%.
Fundamentally strong stocks will display the following metrics:
- Debt equity ratio < 0.5, and
- S/TE ratio > 66.67%.
#2.1 Cash Flow Approach…
Fundamentally strong companies collects money from customers very fast.
These are companies which may not satisfy the above formula, still they can be treated as fundamentally strong. How?
What is the formula for these companies?
Employed Capital = Shareholders Equity + Debt < Total Expense
Their employed capital is less than their total expense needs. How such companies could be fundamentally strong?
These are those companies, whose expenses are so high that even after taking debt, capital employed is less than total expense requirement of company.
What such companies do to fund their capital needs?
Such companies has two alternatives.:
- They can either take more debt, or
- They can improve their collection (cash flow).
When companies take more debt, their debt equity increases (shoots above 0.5). This is not desirable.
So companies which aims to remain debt-free/low-debt will look for the alternative route.
What is the alternative route? Improvement of the cash-flow. Fast collection of money from their customers.
Most of the companies operating in India, carry debt but still their total expense cannot be funded.
Such companies are dependent on their sales collection to pay invoices/bills.
Companies which has very fast Cash Conversion Cycle are safe companies.
Companies which sell their products and services on long-credit, pose a much big risk for investors.
Example: Engineering and Manufacturing based companies (like L&T etc).
For such companies to remain fundamentally strong, they must follow the below formula:
Shareholder Equity + Debt + EFFECTIVE COLLECTION = Total Expense
What is effective collection? “Net cash flow from operations” minus “CAPEX” is effective collection.
From where to get the “net cash flow from operations” and “Capex” figures? It is in the companies cash flow report.
In financial term the effective collection is also called as free cash flow.
So now the equation becomes as below:
What does the above formula represent?
The total expense requirement of the company is fulfilled using the following funds:
- Equity (E).
- Debt (D).
- Collection (FCF).
But here one must ask that, how much portion of Total Expense is dependent on FCF?
Ideally, total expense requirement should not be heavily dependent on FCF (collection from customers).
So what will be the optimum ratio?
The above infographic suggests that, company should not be more than 20% dependent on FCF to manage its total expense requirement.
Again. there is no hard and fast rule like this, but this screening criteria has worked well for me.
So what does the above rule conclude?
- Shareholder Equity + Debt / Total Expense > 0.8
- Debt / Equity < 0.5
#3. Companies Reserves must also grow…
There are companies which may satisfy the following conditions but they can still be fundamentally weak:
- Debt/Equity ratio < 0.5
- Shareholders Equity + Debt > Total Expense
Example: Sparc Systems of BSE.
- Sparc Systems has raised Rs 4.97 Crore as shares capital.
- But its Reserves has remained negative in last 5 years.
A company which is not able to increase its reserves YOY, is dangerous for investing.
This will happen only when company is not able to generate sufficient profits.
Looking at such companies PAT will show the cause of zero or negative Reserves.
Hence it is important for investors to look at company reserves growth rate as well..
Spark system is showing the below two rations which is excellent:
- Debt / Equity < 0.04 (Avg. last 5 years)
- Equity / Total Expense > 3054%.
But still it is fundamentally super weak. Why?
Because its “Reserves” is not growing. In fact it is in negative since last 5 years. This company is making losses.
Sparc Systems is neither distributing dividends nor increasing its reserves.
This is a clear sign of a sick company.
Hence this proves that, to judge companies fundamentals it is important to look at both the factors:
- Employed Capital, and
- Reserves (or Networth) growth.
Indian low cap stocks with strong fundamentals 2018
(Updated for November’2018)
Screening Criteria used:
- Debt / Equity < 0.5
- Equity / Total Expense > 0.667
- Employed Capital / Total Expense > 0.8
- Net worth Growth (5Y) -high.
|3||Indian Energy Exchange||158||4,766||0||14.5||14.5||10.26|
|4||La Opala RG||224||2,498||0.01||3.34||3.37||45.37|
|7||Suven Life Sciences||250||3,179||0.04||2.23||2.31||38.79|
|9||Dishman Carbogen Amcis||226||3,657||0.21||2.23||2.7||85.16|
|10||Tata Investment Corpn.||708||3,908||0||141.11||141.11||5.2|
|17||Gujarat Alkalies & Chem||594||4,356||0.08||2.57||2.77||16.09|
|18||Bengal & Assam Co.||1,759||1,528||0.17||20.35||23.86||34.13|
|20||Multi Commodity Exchange||706||3,602||0||11.96||11.96||3.57|
|22||Quick Heal Tech||210||1,478||0||4.47||4.47||17.07|
- Price: Price in Rs.
- MCap: Market Capitalisation (Rs.Cr.).
- D/E: Debt Equity Ratio.
- E/TE: Equity to Total Expense Ratio.
- EC/TE: Employed Capital to Total Expense Ratio.
- NWG: Net Worth Growth in 5Y (%)
These are reasonable good stocks. But they have been shortlisted based on a broad screening criteria’s.
Hence, I prefer to do a deeper analysis of my shortlisted stocks using my stocks analysis worksheet.