Investment criteria that have worked exceptionally well in the past…

Over the years of my investing experience, I have had my share of successes and failures — both have inevitably offered valuable learning (in hindsight of course). A popular saying in investor circle goes, give your money to the market and you are bound to get a lesson or two in “return” (pun intended). May be this is why the secret to investment excellence is “time in the market” rather than “timing the market”. In this article, I have decided to share some of the investment selection criteria and characteristics that paid out handsome returns in the past. What I find quite amazing is that most of my really successful investments have had at least one, and, more frequently, several of the simple investment characteristics which are described below.

Low Price in relation to Earnings: Stocks bought at low price/earnings ratios (i.e. price per share divided by net profit of the company per share) are cheaper than stocks bought at higher ratios of price-to-earnings. Almost all of my multi-baggers (stocks that multiplied in value) were purchased at a price/ earnings ratio of less than 15. Paying a low price for a stock in relation to its earnings means you don't overpay for growth in earnings of the company. So when growth does happen, it leads to a non-linear increase in the share price. Included under the broad umbrella of low price to earnings are “high dividend yield” stocks and “low price in relation to cash flow” stocks.

Low Price in relation to Asset Value: Stocks priced at less than book value can often be purchased on the assumption that, in time, their market price will reflect at least their stated book value (value of all assets in the balance sheet). During a few rare occasions, I have also been able to find stocks selling at discounts to net current assets (i.e., cash and other assets which can be turned into cash within one year, such as accounts receivable and inventory, minus all liabilities) — a measure of the estimated liquidation value of the business. This was a stock selection technique successfully employed by the founder of the Value Investing concept, Benjamin Graham (the guru of Warren Buffett).

Significant purchases by one or more insiders: Officers, directors and large shareholders often buy their own company's stock when it is depressed in relation to the estimated intrinsic value of the company. Insiders often have special “insight” about the company and the industry, which they believe will result in an increase in the true underlying value of the company. Often such insider buying happens in companies, whose stock is available at low price/earnings ratios or at low prices in relation to book value. Using knowledge of insider purchases (available in exchange filings) with fundamental stock evaluation criteria makes a powerful combination that's hard to beat.

Significant decline in share price: A decline in price is often accompanied by a decline in earnings or an earnings that failed to meet expectations. Reversion to the mean is almost a law of nature with respect to company performance. More often than not, companies with a strong balance sheet (and promoter track record) but whose recent performance has been poor, tend to perk up and improve.

Small market-capitalisation: Most publicly traded companies are small in terms of their market capitalisation (total number of shares multiplied by share price). In fact if you remove the top 100 firms (by size) from the stock market, the combined market capitalisation of the others contributes only to a third of the overall market capitalisation of all listed firms in the exchange. Small and mid-cap companies, if selected prudently, often display higher rates of growth and may be more easily acquired by other corporations, providing a double benefit for shareholders who buy cheap.

Each of the above characteristic is loosely connected to the other. A confluence of all the above characteristics is a strong pointer to an undervalued stock that has potential to yield high returns.

The writer is a finance specialist. He can be reached at shyamscolumn@gmail.com or www.shyamscolumn.com