How to pick stocks?
Simple Finance Weekly Newsletter (Week 16)
We have already seen how to choose Mutual Funds in earlier article, Link for the article
I believe that an Index Mutual Fund is all that is needed, it is sufficient and suitable for almost everyone. Still if you wish to try your hands at direct equity investing, you may like to do research on the stock before investing and not invest because someone has recommended the stock or you have received a tip from someone regarding the stock, especially never rely on SMS, Telegram groups etc. Do not have a fear of missing out if your friend has a stock which has given him multibagger return.
(Spoiler alert- I will not be naming any stocks in this article but the concepts discussed in this article will help you identify good stocks on your own.)
How many?
Identifying a stock takes time, building conviction to hold the stock despite ups and downs requires patience.
There is no ‘one size fits all’ answer to how many stocks you should hold in your portfolio. If you have decided that you will invest 70% in Equity and 30% in debt instruments then Equity portion will include both stocks and mutual funds. Stocks are not going to be in addition to the 70:30 ratio.
As a thumb rule, you should not invest more than 5% of your entire portfolio into one stock. Ideally the core of your holdings may consist of an Index fund and as a means to “diversifying”, you may go for maximum 10 stocks. Do not accumulate too many stocks as your index fund has enough diversity of shares.
It would be advisable that the stock selection should be from the Large cap category of companies. These companies are having a market capitalisation of ₹20,000 crore or more. (Market Capitalisation is the value of total number of shares outstanding multiplied by the current market price of the share). Large caps are well established companies, information about them is easily available and there are a lot of buyers and sellers for their shares, making it easy to sell your holding when you need money. This makes them less risky and less volatile compared to some small obscure company.
It is important to look at qualitative aspects of the company like ethical and reliable directors and corporate governance, transparency in sharing information. Having a monopoly business with higher entry barrier (economic moat) is as important as innovation and staying relevant in changing times.
You can easily identify quality stocks by paying attention to the goods and services you use in a day, how long you have been using them and how long do you think you will keep using them.
What is Fundamental Analysis?
There are a few Financial Ratios that can be used to identify good stocks. Financial Ratios make analysis of Financial Statements of a company. Keep in mind that the ratios of a company are to be compared with companies of the same sector or with its own past performance. Stand alone study by using a screener may not add much value. You will find all the relevant data required in these ratios from the Financial statements of the company and ready made screeners as well.
P/E ratio- tells us whether a stock is overvalued or undervalued. It is calculated by dividing Current Price of the Stock by Earnings Per Share. Generally Higher the better but it should be compared with the P/E of its peers in the sector and the wider market (Nifty or Sensex). If it is comparatively too high then it may become due for a fall. A Value investor looks for undervalued stocks as far as it has potential to grow.
If the market price of a share is high, this does not signify that the share is overvalued and a penny share costing less than ₹50 is cheap, undervalued and will grow exponentially. Further, it is advisable to avoid penny stocks altogether.
Earnings Per Share-
EPS of a company can be arrived by dividing the Profit after Tax (PAT) by total number of outstanding shares of the company.
EPS=PAT/Total shares
EPS tells how much money a company makes for each share, higher EPS indicates greater value.
PAT is arrived by removing all the expenses from total revenue of the company. These expenses include depreciation, interest, Tax etc.
Return On Equity (ROE) is similar to EPS. EPS considers earning per share whereas ROE measures the return shareholders are getting. It is arrived at by dividing the Net Profits of a company by shareholders equity. ROE of 20% or more is a good indicator. Keep in mind if a company takes lots of loan and less equity from shareholders then also its ROE will be higher.
ROCE- Return on Capital Employed is earnings before interest and taxes (EBIT) divided by the capital employed. Here capital employed included both equity and debt. It is an indicator of efficiency of the company in using capital to achieve its profitability. If two companies are showing 10% profit margin but first company is using twice as much capital as the second, then the second company will have more ROCE and signifies better efficiency.
PB ratio
Book value of a share- If a company is to close down and liquidate all its operations then how much rupees per share it will be able to return to its shareholders. Book value of a company which has less loan and more assets tends to be higher.
PB ratio is market price of a share divided by book value of a share. Hence ideal PB is 1 but values up to 3 are acceptable. PB ratio can be used to find out if the share price of a company is going higher without any substance.
Debt to Equity ratio is used to find out if a company is using loan (debts) rather than its own funds to run its operations. The interest payment reduces the profit of the company and a company may find it difficult to pay off their debt. Hence lower the better, ideally it should be less than 2, it is considered healthy as well, which means in one rupee the company has taken 66 paise as debt and 33 paise as equity. Similarly low Debt to asset ratio is also a positive factor.
Debt Service Ratio- This ratio applies to Individuals, companies and nation-states also. It is arrived at by dividing Earnings before tax and Interest by Interest Payments. Higher the better.
Be aware of pledging of shares by promoters of a company, they pledge their shares as collateral to raise funds when all other avenues seem to have been exhausted.
For a manufacturing company, Inventory Turnover ratio which signifies how fast the inventory is sold (ITR of 2 tells us that a company sells its inventory twice in a year), Higher the better, means the products are selling like hot cakes. Along with ITR Inventory Number (IN) is also important which quantifies days taken by a company to convert its inventory into cash.
Business diversity- stick to the companies that operate in 1 or 2 segments, avoid clutter. Standalone Financial Statement can be misleading if a company has multiple segments, hence always consider consolidated statements for analysis.
Valuing the Intangible like goodwill, trade names, proprietary software, patents etc. is important as many times they are contributing to the growth of a company but at the same time a company has to have positive cash flow from operations if the intangibles are valued too high.
Investing directly in stocks requires knowledge and experience, achieving diversification with small amounts is difficult (since fractional share buying is not yet allowed in India), timing the entry and exit from a stock Is crucial, you can not simply buy and forget, you need to devote time and efforts to stay updated with the news which may turn into noise and persuade you to make wrong decision, then there are charges and taxes involved for frequent buying and selling. An investor eventually turns into a trader. These requirements can be shifted to a Mutual Fund Manager and reliance on him or her can be further reduced by choosing a passive fund (Index fund).
You may go for paper trading to gain experience where you do not use real money.
A study has found that best returns have been received by investors who were dead, since dead do not have impulse to book profit, switch funds etc. They have eternal patience.
“If investing is entertaining, if you’re having fun, you’re probably not making any money. Good investing is boring.” ~ George Soros.