Stock selection: How investors can identify resilient companies

Published: July 21, 2020 5:40 AM

Investors should compare a company’s debt ratio to the industry average and also check its contribution margin. Business agility, promoter shareholding and board composition are other important factors that should be considered

This basically indicates the surplus after deducting variable expenses from the sales.This basically indicates the surplus after deducting variable expenses from the sales.

By P Saravanan & Manas Mayur

Investment science literature generally advocates the top down approach for stock selection which percolates from the economy to industry and then to companies. This approach is known as the ‘Economy, Industry and Company’ (EIC) approach. However, due to the Covid-19 pandemic and its impact on the economy, industries and companies, investors have to think twice before investing in anyfirm. In this scenario, along with the ECI approach, investors should select firms which are resilient in nature. Let us discuss the characteristics of resilient firms and how to identify them.

Resilient companies
Resilient firms are those firms who have a capacity to perceive, avoid, absorb, adapt to and recover from environmental conditions that could threaten their survival. This explanation fits perfectly with the current Covid-19 pandemic. Investors need to identify companies with the above characteristics which have the potential to deliver strong and sustainable returns.

Characteristics of resilient companies
Majority of the companies are currently operating in a challenging environment. However, some of these companies continue to grow revenues and profits, gain market share compared to their competitors by means of focusing on innovation, cost cuts, etc. Such companies may not have been the fastest to grow in terms of valuations but have found a way to build value over the long term. Let us look at certain specific metrics to identify such firms.

Leverage
Vast majority of the firms have debt in their balance sheet. Each industry has its metric as optimum leverage. So, investors should compare the company’s debt ratio with that of the industry average and not assess independently. Further, it is important to assess the cash flow generated by the firm to check its debt repayments and other operating expenses to avoid a cash crunch scenarios. Investors can do a stress test by scenario analysis to ensure solvency.

Contribution margin
This basically indicates the surplus after deducting variable expenses from the sales. Companies which have a higher contribution margin can invest in innovative activities and embark on new business ideas and thus generate more free cash flow to the company and to the shareholder.

Qualitative factors
Investors should also focus on qualitative factors such as business agility, whether the company is affiliated to a business group, what is the promoter shareholding in the company, management of the company (family members or outside professionals), board composition, etc. A company with an independent and professional board of directors is one of the most important indicators of good governance. Company board with a good composition of directors can offer expert advice to run the business efficiently and sustainably for the long run while ensuring checks and balances in the short and medium term.

Often, most of the quantitative numbers are readily available to investors. But they need to spend more time studying the qualitative parameters, which may not be available directly. Investors can obtain such qualitative factors from various sources such as annual reports of the companies, filings with stock exchanges, registrar of companies, etc.

To conclude, investors should create a checklist based on the above parameters and develop their own investment framework to identify resilient companies to add in their portfolio.

P Saravanan is a professor of finance & accounting at IIM Tiruchirappalli. Manas Mayur is an associate professor at Goa Institute of Management

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