Monday, November 29, 2004

Investing in Stalwarts

According to Peter Lynch, stalwarts are large and established companies that have the ability to grow at a steady annual rate of 10-12%. I’d say the equivalent companies in India would show returns of about 15-18%, especially if bought at the right price. These are a very special group of stocks due to their ideal blend of growth potential and predictability and hence these stocks form the backbone of my stock portfolio – after all a growth rate of 18% would have these investments doubling every 4 years!

I believe ‘stalwart’ companies should have shown consistent and significant EPS and book value growth over the past 10-15 years. My method for finding a good purchase price for such companies is to calculate anticipated share price using 3 approaches and then take the lowest. To do this, the following are necessary:

Step 1
Calculate the average share price, EPS and book value growth rates over the past 10 years at least and then extrapolate these over the next 10 years (my expected holding period for stocks of stalwarts). In this manner I can find the expected share price, EPS and BV after 10 years.

Step 2
One can easily derive the stock price from these:
- Expected stock price using EPS = future EPS * lowest historical PE
- Expected stock price using BV = future BV * lowest historical return on net worth * lowest historical PE

Step 3
Take the lowest expected value from among these three methods and then work backwards to find the price at which the share should be bought in order to achieve the targeted returns

Step 4
Have the patience to wait for the target price to be reached.

What does this achieve? Well, for one you are confident of having taken the most conservative estimates for growth and can be fairly sure of meeting your targets, barring extenuating circumstances. At least there is little need to monitor these stocks’ performance on a daily basis. Further, there is a bit of a bonus, as dividends have not been considered in the above calculations.

Using these methods I was able to identify companies like Infosys and ITC as candidates for my portfolio and then had a bit of luck when the market crashed immediately after the elections and allowed me to buy both these companies at prices below my target price. These investments are currently doing well.

2 comments:

Anonymous said...

Extremely well written article. the most difficult thing i have faced as an investor is to get out at the price target i have set ! Ended up moving the price target up or have fallen in love with the stock to not 'exit' out ! Always have compared myself to Abhimanyu.... learnt how to get in to the Chakra Viyuga... never learnt how to get out !!!

Ashish said...

Thanks for your informative post. I am new to investment world. I was wondering if I need to know about basic fundamentals (BV, EPS, CMP, ROI), where do I start ? Do you have any excel template or website to help us automate above steps to arrive at target price.