[Updated: 05-Jul-2020] What it means by fundamentally strong stocks? These are stocks which has a strong underlying business. (check list of strong stocks here).
What it means by underlying business? The underlying business for a stock is the “company” which it represents.
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 is the company’s fuel.
Taking the analogy of “fuel” one step further. Suppose there is a company which is owned by a wealthy people like Jeff Bezos, Warren Buffett, or Mukesh Ambani. Such companies will ever ran out of fuel? It is unlikely.
Similarly, a company which is generating its own capital (fuel) to do business, is necessarily a company with a strong fundamentals. In business terms, the capital used to fund company’s ‘business operations’ is called “employed capital“.
Company use its employed capital to do the following:
- Pay for all expenses.
- Fund its capital purchases.
Employed Capital & Debt
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 = (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.
Employed Capital & Total Expense
There is another formula which must be used in conjunction with the above (i). This formula highlights the important for the companies to keep their ’employed capital’ greater than their total expense requirement.
Employed Capital of Fundamentally Strong Stocks > Total Expense – (ii)
What does this formula signify? Suppose there is a company which operates in low debt [see formula (i) above]. [Its Employed Capital = Share Capital + Reserves + Low Debt.]
But whether this employed capital is sufficient or not. How to know this? By using this formula (Employed Capital greater than Total Expense Requirement). Let’s understand the utility of this formula using the below 3 parameters:
- Use of Employed Capital: 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. Read more about Return on Capital Employed (RoCE).
- Equity Financing: Share capital plus reserves is called equity. Before the revenue is generated, the company must first spend money from its pocket. How much fund is there in company’s pocket? Share Capital plus Reserves (equity). If the equity component is enough (more than total expense requirement), the company will continue to produce “goods and services”, and earn revenue. Read more about how to calculate Return on Equity (ROE) .
- Use of debt: If equity is not enough, 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. Read more about whether debt is good or bad for companies.
It is essential for investors to realise the effect of debt (positive or negative) on companies fundamentals.
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’s a short term relief: It immediately provides liquid cash for the company. This enhanced liquidity helps in managing immediate working capital needs. Read more about valuation of company using net current asset (working capital) model.
- How it’s a long term burden: All the debt that is availed by the company needs to be paid back (principal + interest). This is an extra expense. How to pay it? From the company’s profit. Read more about analysis of debt free companies.
So generally speaking, the lower is the debt dependency of the company, higher will be its net profits. Hence this generalisation will not be wrong that, “low debt companies tend to be fundamentally stronger“.
Financially Independent Company
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.
If a company is able to fund its ‘total expense’ by self, it can continue to operate indefinitely. Such companies are fundamental power houses. How?
Total Expense can be financed from where? From the employed capital. The employed capital is built from three entities.
- Share capital: What is share capital? Share capital is a fund raised by the company by issuing shares.
- Reserves: These 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. Read more about retained earning of companies.
- Debt: When reserves and share capital is not enough to fund the total expenses of the company, debt financing is the alternative. Read more on how debt effects the enterprise value of companies.
For a company to be financially independent, they must reduce their dependency on debt. But only reduced debt dependency is not enough. They must do more.
Cash Flow of Fundamentally Strong Companies
All companies which has managed to earn the tag of being ‘fundamentally strong’, has worked hard to manage their cash flows. How? Here cash flow is not only cash-out (payments to vendors etc), but also cash-ins (collection from customers). Emphasis is more on collection.
Complete reliance on “share capital and reserves” means two things for the company: (a) First is the obvious, company is using zero debt, (b) and the second is, the company is collecting cash fast enough.
For a company to become financially independent, along with low debt dependency, it must also have faster cash in-flows. How fast cash flow helps?
- It ensures liquidity.
- Hence current liabilities can be paid on time.
- As current liability is taken care, debt can be eliminated.
Examples of a Fundamentally Strong Company
Here we will discuss business fundamentals of three Indian companies. What we will discuss? We will compare their employed capital with their total expense requirement. In the process of this comparison, we will also check their debt levels. By this way we will try to judge which of the three is fundamentally strongest.
1. Bata India
|Bata India||–||Mar’19||Mar’18||Mar’17||Mar’16||Mar’15||Average (5Y)|
|Employed Capital (EC)||E=C+D||1,746.53||1,478.71||1,325.28||1,156.23||995.35||1,340.42|
|Total Expense (TE)||F||2,533.68||2,333.37||2,215.89||2,133.85||2,469.68||2,337.29|
|EC as % of TE||E/F||69%||63%||60%||54%||40%||57%|
Its debt level is zero in last five years. Its employed capital is Rs.1,746 crore. Its annual expense is Rs.2,533 Crore. Hence, employed capital is 69% of the total expense requirement. What does it mean?
It means, though Bata is debt free, but its total expense requirement is higher than 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. Hence we can say that cash flow need is taken care by quick-payment-collection model.
2. Bosch India
|Bosch India||–||Mar’19||Mar’18||Mar’17||Mar’16||Mar’15||Average (5Y)|
|Employed Capital (EC)||E=C+D||9,126.20||9,981.30||8,799.60||9,549.80||7,402.50||8,971.88|
|Total Expense (TE)||F||10,279.71||9,557.40||8,594.50||7,740.80||10,171.10||9,268.70|
|EC as % of TE||E/F||89%||104%||102%||123%||73%||98%|
Compared to its equity levels, the company has managed to keep its debt levels very low. It is almost like being debt free.
Moreover, the average employed capital of Bosch (in last 5 years) takes care of 98% of its total expense requirement.
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 almost 90% of “total capital needs”.
3. Hindustan Zinc
|Hindustan Zinc||–||Mar’19||Mar’18||Mar’17||Mar’16||Mar’15||Average (5Y)|
|Employed Capital (EC)||E=C+D||36,143.00||35,932.00||38,713.00||37,385.00||43,353.07||38,305.21|
|Total Expense (TE)||F||10,512.00||9,314.00||8,210.00||8,627.00||7,514.26||8,835.45|
|EC as % of TE||E/F||344%||386%||472%||433%||577%||442%|
In FY ending Mar’19, Hindustan Zinc reported a debt of Rs.2,538 crore. This debt level is way higher than that of Bata and Bosch. But Hindustan Zinc’s fundamentals still looks stronger than Bata and Bosch. How?
Check its ratio of employed capital and total expense. In Mar’19 EC/TE raotio was 344%. On an average, in last five years, EC/TE ratio was 442%.
It means, shareholders equity capital of Hindustan Zinc is almost 3.5 times higher than its total expense requirement. The company is too cash-rich. In near future, there is almost negligible chance that Hindustan Zinc will run out of cash.
Cash Flow Analysis
There are also companies which has lower employed capital compared to its ‘total expense requirement’, but are still fundamentally strong. How?
Because these companies collects money from its customers very fast. Hence, such companies can enjoy the luxury of keeping their employed capital lower than their total expense requirement.
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.
But companies which sell their products and services on long-credit, pose a big risk for investors.
How to identify such companies?
The above discussed companies follow this formula [Shareholder Equity + Debt + EFFECTIVE COLLECTION = Total Expense]
What is effective collection? “Net cash flow from operations” minus “CAPEX” is effective collection. 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 equity (E), debt (D) and payment 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. This is not a hard and fast rule, but this screening criteria has worked well for me.
Reserves must also grow with time
There are companies which may be debt free, and also has employed capital more than their total expense, but they can still be fundamentally weak. How? This will happen if the company’s reserves are showing negative growth.
Why it is an indicator of bad fundamentals? Because negative reserves growth is an indicator that the company’s PAT and EPS is negative.
Hence this proves that, to judge companies fundamentals it is important to look at the following in tandem:
- Debt levels.
- Employed Capital vs total expense.
- Reserves (or Net worth) growth.
Stocks with Strong Fundamentals
- Mcap: Market Capitalisation (Rs.Crore).
- D/E: Debt to Equity Ratio (DE < 0.5).
- EQ/TE: Equity to Total Expense Ratio (EQ/TE > 0.667).
- EC/TE: Employed Capital to Total Expense Ratio (EC/TE > 0.8).
- NWG: Net worth Growth (5Y) is high.