Siddharth Oberoi of Prudent Equity explains how to pick stocks and how interest rates affect stock valuations

Edited excerpts:

What are the key factors that one should keep in mind before picking stocks? What is more critical- the stock’s fundamentals or macro?

One should ensure that the economics of the business is well understood by the investor. 

As Warren Buffet said, if you are unable to write on a piece of paper why you own a certain stock, then it is not worth owning. This is the most important thing to focus on as an investor. 

Certain other things that are important are the capital allocation policies of the company. An investor must observe the way capital is deployed in the business. 

One should also focus on the integrity of the management, to see if management is ready to share wealth with the minority shareholders. If one does not have the ability or the time to study companies, one must take the advice of a professional. 

If you are taking advice from someone, make sure you have confidence in their ability to pick the right businesses. We always remain stock-specific while picking companies and follow the bottom-up approach while investing in stocks. 

We go where the growth and earnings are but at a relatively cheaper price. For us, fundamentals come first before macros.

If we talk about the valuations of stocks, what does the P/E (price-to-earnings) ratio tell about a stock? Should we buy only low P/E stocks?

The P/E ratio is just an indicative parameter to gauge the cheapness of a stock. It in itself is not all-encompassing. 

A company with a cheap P/E ratio may turn out to be an expensive affair if the earnings are going down or if the fundamentals of the company are deteriorating. 

Similarly, a high P/E ratio in itself does not indicate an expensive stock because the earnings may either be rising substantially or are expected to. 

But if you are unaware of the earnings potential of a given company and have to make a decision on the basis of the P/E ratio alone, then it is a disaster waiting to happen. Hence, investors should look at many more aspects, not the P/E ratio alone.

What techniques should one apply to calculate a company’s intrinsic value?

Calculating intrinsic value is an art and not a standard formula which can be used to calculate by anyone. 

The IV (implied volatility) calculated by me for let’s say HDFC Bank will be completely different from someone else. 

Calculating IV is like preparing a very simple dish, anyone can do it but the taste for all will be different. 

Hence in investing, an investor’s returns are determined by how much you are able to buy off the IV. 

The higher the difference between the IV and your purchase price, the larger the returns will be.

Which strategy is better in this market – bottom-up strategy or top-down strategy?

In any market, we believe in the bottom-up strategy only. This has proved to deliver market-beating returns for our investors for decades. For the individual investor as well, my advice will be to focus on studying companies and figuring out their growth potential.

How can investors protect their investments against potential risks and losses?

Risk is eminent in the stock market. You cannot run away from them; you can just try to position yourself to lower their impact. 

You can do so by building a portfolio of 10-15 stocks across different sectors instead of investing in just three-four of them. As the famous saying goes, “Risk comes from not knowing what you are doing”. 

Hence one must be aware of the company’s workings and be able to value the company rationally in some form.

How do changes in interest rates affect stock valuations?

Interest rates are inversely proportional to valuations. 

Covid was the best example, we saw massive rate cuts ever in a short period of time, stocks skyrocketed and valuations became absolutely crazy. The year 2022 began with a rate hike and eventually valuations followed. 

We can see from the data during 2022 the broader market delivered negligible returns and if someone was invested in expensive stocks, he/she must have seen severe wealth destruction.

What are the challenges of valuing high-growth companies?

High-growth companies can be valued using the migration path method. One has to visualise the opportunity available. For example, Godrej Properties is expanding from 14 cities to 21 cities. 

It is also increasing its project size from 35 projects currently to 58 projects going forward. 

One has to see the potential ability to generate large revenues and profits. A valuation metric may not be able to capture this in high-growth companies because the base is expanding very fast.

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Disclaimer: The views and recommendations given in this article are those of the expert. These do not represent the views of Mint. We advise investors to check with certified experts before taking any investment decisions.

Updated: 12 Jun 2023, 02:18 PM IST