What does it mean by fundamentally strong stocks? These are stocks that have a strong underlying business. As an investor, what parameters we must investigate to determine whether a business is strong or weak? This is what we’ll discuss in this article.
List of Fundamentally Strong Stocks in India
|SL||Name||Price||D/E||ICR||Current Ratio||OP Margin (5Y)||ROE (5Y)||GMR Score|
Introduction: What Makes A Business Strong?
Fundamentally strong stocks represent companies that will continue to do business even in the worst of times. Some inherent traits of their businesses make them stand tall even in tough weather.
What helps them to do business even in adverse times? What is essential for companies to continue doing business? Three things – financial capital, quality management, and in-demand product or service. These three things in combination build a loyal customer base that eventually gives a business its fundamental strength.
On a macro level, a company that is run by quality management can build its fundamentals even from scratch. I’ve written a separate article on the quality of management. It talks about how we (retail investors) can judge the quality of management from the financial reports.
On a micro level, a company that has sufficient financial capital to fund its operations and growth requirements is fundamentally strong.
But for a business to stay strong, only capital will be insufficient. It must also have an attitude to survive and grow. From where this attitude will come? It will come from the characters and personality of its top management. We can also call it a leadership personality.
Building such a character and personality is easier said than done. It cannot be built in a day. Years of smart work and training help people to grow from being an employee to a leader.
Suppose there is a company that is owned by wealthy people like Jeff Bezos, Warren Buffett, or Mukesh Ambani. Such companies will ever run out of fuel (capital)? It is unlikely.
Similarly, a company that is generating its own capital (fuel) to do business, is necessarily a company with strong fundamentals. In business terms, the capital used to fund a company’s ‘business operations’ is called “total capital“.
The company uses its capital to do the following:
- Pay for all current expenses – to generate current revenue.
- Fund its capital purchases – to ensure future growth.
- Other activities.
Total Capital vs Debt
The above is a schematic representation of the break-up of total capital. It highlights the three sources of funds available for a company to raise capital for its business. In terms of formula it will look like this:
Total Capital = (Share Capital + Reserves) + Low Debt – (i)
How to read this formula? A fundamentally strong company is one that 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.
The factor of “low debt dependency” is very important from a shareholder’s 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.
Total Capital vs Expenses
There is another formula that must be used in conjunction with the above formula (i). This formula highlights the importance for the companies to keep their ’total capital’ greater than their total expense requirement.
Total Capital > Total Expense – (ii)
What does this formula signify? Suppose there is a company that operates in low debt [see formula (i) above]. [Its Total Capital = Share Capital + Reserves + Low Debt.]
But whether the total capital is sufficient or not. How to know this? By using this formula (Total Capital greater than Total Expense Requirement). Let’s understand the utility of this formula using the below 3 parameters:
- Use of Total Capital: The companies use their capital to finance their “total expense requirements”. The company expends money to produce “goods and services“. These goods and services in turn generate revenue.
- 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 corpus is there in the company’s pocket? Share Capital plus Reserves (equity). If the equity component is enough (more than the 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 a shortfall of funds to run operations. Hence revenue will fall. A fall in revenue due to a shortage of funds is a clear sign of “bad fundamentals”. Hence those companies which cannot fund their “capital needs” from their pocket, take debt. Read more about whether the debt is good or bad for companies.
It is essential for investors to realize the effect of debt (positive or negative) on companies’ fundamentals.
The Debt Component
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.
Resorting to debt is not always a bad thing for companies. But for many 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.
- 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? From the company’s profit. Read more about the analysis of debt-free companies.
So generally speaking, the lower the debt dependency of the company, the higher will be its net profits. Hence this generalization will not be wrong that “low debt companies tend to be fundamentally stronger“.
A Financially Independent Company
This brings us to the concept of financially independent companies. Companies which has virtually zero reliance on debt (to fund their business operations), are financially independent. These are companies that have 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 itself, it can continue to operate indefinitely. Such companies are fundamental powerhouses. How?
Total Expenses can be financed from where? From the total capital.
For a company to be financially independent, it must reduce its dependency on debt. But only reduced debt dependency is not enough. They must do more.
The Concept of Cash Flow & Financial Independence
All companies which have managed to earn the tag of being ‘fundamentally strong’, have 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 obvious, the company is using zero debt, (b) and the second is, that 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 of, short-term debt can be eliminated.
Cash Flow Analysis
There are also companies that have lower employed capital compared to their ‘total expense requirement’, but are still fundamentally strong. How?
Because these companies collect money from their 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 a very fast Cash Conversion Cycle are safe companies.
But companies that sell their products and services on long credit, pose a higher risk for investors.
Screening Fundamentally Strong Companies
Our stock screener uses the following parameters to filter fundamentally strong stocks from the ordinary. It uses the following algorithm (logic) to do the filtering:
Industry Leaders: There are about 195 number industries in our stock market. Each industry has a group of companies operating within it. We pick only the industry leaders. The choice is made based on their revenue. Top companies in the industry are selected. What is the logic? The logic is that the top company of an industry can be assumed as one with a wide moat.
Capital vs Expenses: As explained above, we also analyze the selected market leaders in terms of their capital base. We compare their total expense requirement vs their equity base and total capital. All companies that are not capital-starved are picked for further analysis.
At this stage, we have a list of only a few hundred companies. Now, we apply the following logic to generate a score for each of these companies.
- Debt Dependency: We use two parameters to determine if the company has excess debt dependency. Low debt-to-equity ratio (D/E) and high-interest coverage ratio (ICR) is our pick. All companies that do not match our debt levels are screened out.
- Liquidity Position: This analysis is easy and quick. We check the current ratio, current asset vs current liability, and level of each company. All companies that are sufficiently liquid are given a higher score.
- Profitability Analysis: At this step, we check how well the company is using its capital to yield profits. We use two ratios, Return on Equity (ROE) and Return on Capital Employed (RoCE) to check the profitability levels. All companies that display a higher ROE and ROCE are given higher scores.
- 10-Year Return: A company that is fundamentally strong may not perform for its shareholders in short term, but in long term, they do deliver above-average returns. With this logic in mind, we check the last 10-Years returns of the companies. All companies that have not performed as per a minimum threshold are given a lower score.
Once the checks are done based on the above parameters, the algorithm scores each company based on a predefined weighted average method. The final score is displayed as the GMR score in our stock screener.
It is essential for retail investors to invest only in fundamentally strong companies. These companies are sufficiently funded and are run by able top managers. These are not only profitable companies, but they also maintain balanced debt and cash positions. Such companies are not too debt-dependent nor do they starve to manage their current liabilities. Moreover, these companies have maintained an optimal capital structure that is not only sufficient to fund the working capital but also their CAPEX requirements.