How to Pick the Best Stock

chillibreeze writer — Deena Nair

• The first and most important thing to decide before picking up the best stock is to decide which type of an investor one is? After confirming this, one can take the next step.

There are four kinds of investors, which fall in to four basic categories: Aggressive, Conservative, Disciplined and Absolute. Investing in stocks that nobody else is buying categorizes you as an aggressive investor while staying away from momentum investing shows that you are conservative. Disciplined investors always follow a stock-specific approach and invest systemically and at the right time when the market is down. The last category of investors always looks for absolute returns over a period of three to five years, irrespective of the markets. After you have figured out your category, we can understand the strategy for stock picking.

The biggest mistake investors make is to invest directly in the stock market. They buy individual stocks of which they have very little or no knowledge. On most occasions, it appears that no serious thought has gone into their investment. Retail investors tend to depend on tips or suggestions from others and assume the other person has evaluated that stock, which is often not the case. The investors who do not have the knowledge to buy stocks leave it to the experts and invest in the market via a mutual fund.

Within each stock, we can broadly look at three parameters:

1). the business, 2). Its management, 3) Its valuation

We can't measure all the sectors and companies on the same valuation strip. We use a number of tools like Discounted Cash Flow, Price Equity ratio, Price to Book ratio, and a host of others.

The businesses we are buying today for our mid-cap fund are all potentially large companies of tomorrow. We have a single hypothesis when we buy mid-cap stocks; we believe the business opportunity and the management capability have to be so huge that it can eventually become a large-cap.

But this does not mean we should buy every mid-cap with a vision that it will become a large-cap. In fact, today's portfolio could be almost similar to what it was six months ago.

In large-caps, we break up the stocks into sectors, and then rank the stocks in terms of how much gap there is between the share price and the share value. E.g. we have targets of the P/E ratio or PB ratio, discounted cash flow based valuation or EV / EBITDA. Based on this, we have a list of stocks that will do well in every sector. These stocks are listed in descending order and based on the rankings we pick one or more stocks.

In Mid-caps also, we will not simply invest in such shares that are performing well just because the overall share market is positive and moving up. Instead we should identify stocks that will become much larger companies because of better opportunities, progress and growth.

There are seven important factors in selecting shares and if a stock passes one of these factors then only should it be selected.

Firstly, we have to identify stocks in the growing industry. These are companies who will always have the right strategies in sectors that will do well in the future.

Secondly the selected company should be in a niche business. This throws up companies that operate in a niche area and are the least affected by other competitive players.

E.g. one niche stock that we named is Hexaware Technologies, which concentrates on a particular geography in Europe, where it has become the market leader and operates in HR and IT services.

The third factor to keep in mind while picking up stocks is that the company should be a leader in their own business and have a large capacity in their own sector. When growth happens, these companies will consolidate their position and become large-cap companies. One such company is the courier brand name today, Blue Dart, a leader by far.

The fourth oxygen for the stocks that they should be proxies to large-caps, in the sense that they are from the same industry and if they are mid-sized companies, there is a threat of discount in their valuation. The company's fundamentals do not merit the discount.

The fifth and final important factor is picking globally competitive mid-cap companies, which are doing big things outside India. Since these companies are looking at a wider canvas than India, there is a prospect that as they become more successful in their strategy, they can become much larger corporations. E.g. think of a company like Crompton Greaves, who has proved this right.

In any company, there are three to four critical variables that can make or mar its valuation. And, once you have identified these , a more than half the work is done.

Sixth, don't ever try to time the market. However brilliant or seasoned an investor you are, everyone gets fooled sometime.

Yet, sitting on cash is risky. If you do not need the money for two years, you can comfortably invest it in equity. The best way to do so is to invest gradually. If you have Rs 50,000, don't invest it in the market at one go. This means that, over time, you buy more units when the price is low and less when the price is high. Lump-sum investing at one go is not very efficient investment.

The Seventh point is that in this current bull run, people are blend by the market returns. But investors must always balance their investments and never put all their money in one asset class only.

E.g. a good buy was Tata Chemicals, which I got a few years ago at Rs 50 per share. Again, what attracted me to this stock was the consistent dividend and high dividend yield. At a 50% dividend, I was getting an annual return of 10% pa. Even if the Tata Chemicals stock had not appreciated, I could have assumed I had put money in a bank fixed deposit and was earning 10% as interest every year. Eventually, the stock got 'discovered' by the market and now has a 'Strong Buy' recommendation from analysts and broking firms when it is at Rs 250.

IMPORTANT FACTORS AFFECTING STOCK PICK UP

• The higher the dividend yield, the better:

In this current bull run, it will be difficult to find good, high dividend yield stocks but one can watch out for corrections (temporary dips) to buy such stocks.

• Check Valuations:

Valuation is a process by which the value of a company's stock is determined. This is based on a number of factors like earnings, the market value of the company's assets and the brands it owns.

E.g. before the face value of ITC's shares was reduced from Rs 10 to Rs 1, and before the bonus was declared, I told some colleagues it would be a good buy. But they balked at the price which, then, was Rs 1,600. But these very same set of investors were game to buy HLL at Rs 160 because they found it cheaper than Rs 1,600. What they did not realize was that ITC, with a face value of Rs 10, was quoting at Rs 1,600 while HLL with a face value of Rs 1, was quoting at Rs 160. ITC, due to its valuations, was considered at that price to be undervalued while HLL was overvalued.

Don't just look at the price of the stock. Look at its valuations. There is a difference between a pricey stock and an expensive stock.

• View prices over time

Don't look at just the yearly high/ low price of the stock. Investors make the mistake of assuming that, if a stock is quoting nearer to the year's bottom price; it has a lot of upside (potential to rise in price). This can be most dangerous when there is a bull-market and the stocks begin falling like nine pins. Instead, look at a stock's three-to-five year price and its volume chart before investing. It may also be prudent to see what the all time high/ low of the stock is.

In certain cases, a company may begin to do really well and the stock's price keeps moving upward. In such a situation, the historical chart will not have any meaning.

In this current bull market, it will be rare for a small investor to come across a totally 'undiscovered' stock.

• View promoter's stake

This refers to the number of shares held by the promoter out of the total number of shares available in the company. Generally, whenever promoters have a stake of 50% or more, it signals they have confidence in their business. On the flip side, if the promoter's stake is too high, the stock tends to become illiquid as the amount available for trading is not huge. This results in the stock appreciating very slowly. The best pick is where the promoter's stake is between 50% to 65%.

E.g. take the case of Pidilite: where promoter stake is 71.8%, FIIs holds 16% and general public hold 11.84 %.

• Knowledge of the promoter:

There are many promoters whose companies show losses or very low profits in the bear markets. The moment a bull market begins, they suddenly start turning around. The turnaround lasts only as long as the bull market is alive and kicking. Then they fade back into oblivion. Some disappear. Some companies themselves do pretty well but they always lend money to group companies/ subsidiaries and the loans are then written off. This is one of the ways for promoters to siphon off funds.

If the group company or subsidiary starts doing very well, it is de-linked/ spun off from the main company and the promoters take full control.

The importance of the promoter group is clearly visible in the bear markets. Very often, small investors find their 'value picks' turning into 'junk picks' simply because the promoters were not scrupulous or did not keep their shareholders in mind.

CAUTION FOR PICKING UP STOCKS

Don't just randomly invest. List down a few stocks you like but are not investing in right now because they are being quoted at a high price. When the rates drop, pick them up. Do it because you really believe in them and are ready to hold on to them for the long term. Whenever you find a dip in the stock market, buy them. Always be prepared to stay in for the long haul.

Take a look at your portfolio. Do you have any shares you are waiting to sell? Now is the time. If you have some stocks that, in hindsight, you view as junk, sell them even if you are incurring a loss. The best time to get rid of junk shares is during a bull run.

Don't be ignorant of the risk that the stock market holds. Bull run or no, stocks are risky investments.

Don't be greedy and invest in 'hot tips' that 'assure' you of mind-boggling returns.

Don’t panic and sell your shares soon when the stock market falls or the inevitable correction take place. Wait and analyze all the factors involved.

Be smart and stay disciplined.

Don’t ignore the fact that equity is volatile; this is the nature of equity. But you have to differentiate between volatility and risk.

Risk means:

1. Are we getting into a wrong company? 

2. Are we getting into companies at wrong valuations?

3. Do we have stringent parameters set to ensure we are in the right companies and right managements at the right valuations?

4. These are the key issues one should consider.

The risk comes when you have bought into a wrong company. To take care of that, we have frequent management interactions. We also check on all the stocks we own on a quarterly basis to see if there is any change in the business, its fundamentals or its management and whether that is taken care of in the valuation.

It is easier for a Rs 50 stock to double to Rs 100, than, say, for Infosys to double from Rs 3,000 to Rs 6,000. But there is a catch. More often than not, these penny stocks are manipulated. They do not have a sound business model to support their price. Thus, while it is easy for the stock to double, it is equally easy for it to halve to Rs 25 or even go lower. However, it would really be quite difficult for the Infosys stock to halve to Rs 1,500.

Moreover, if a penny stock is being manipulated, you might find it easy to buy, but when it comes to selling you could experience great difficulty. There would be no buyers and your price would keep getting hammered.

Therefore, for long-term, consistent success in a stock market, buy 'value' not 'price'.

Last, but not least, you need to do your homework and must have a certain amount of basic knowledge. But the job of investing is more than that. It refers to the ability to take a risk, intuition, judgment calls, timing and other such factors which cannot be learnt in a classroom or from any text book. That's what makes it an art.

So, while the basic approach of investing is scientific, one has to apply artistic skills as a final touch to the fundamental approach.

 

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—About our writer: Deena writes for chillibreeze.

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