How to choose a Stock for your Portfolio

Something that everybody wants to know these days is "How to choose a Stock". Buying shares is something that requires lot of careful analysis and selection if we want our money to get good returns. Since market instruments come with a RISK attached to them, it is all the more important to choose our stocks carefully because after all it is our hard earned money that we Invest. Investments made out of impulse or out of tips from friends or colleagues may work out in a Bull Market but may seldom workout in Bear Markets. During such testing times one thing all of us need to know is "How to Choose a Good Stock"

This article just elaborates on a few criteria that you need to check while selecting a stock for your portfolio.

Stock selection criteria is one in which an investor uses a systematic form of analysis to determine if a particular stock constitutes a good investment and should be added to his/her portfolio.

The objective of stock selection criteria is to:

1. Maximize the total return on investment (appreciation plus any dividends received)
2. Limit risk (according to an individuals risks tolerance levels)
3. Maintain an appropriate degree of portfolio diversification.

It is a widely known fact that a disciplined stock selection approach is one of the primary factors behind the success of well-known investors like Warren Buffet.

Selection Components

Stock picking can be an extremely difficult and complex process there is no foolproof method for reliably forecasting a stock’s future price movements. However, by carefully examining numerous factors, an investor may get a better sense of future stock prices rather than relying on unsubstantiated speculation such as advice from friends etc. Some of the most common criteria that any investor may have to consider while picking a stock for his portfolio may include:

1. Sector Analysis
2. Fundamental Analysis
3. Management Capability
4. Technical Analysis
5. Financial Analysis
6. Market Capitalization
7. PE Ratio
8. Company's Earnings growth
9. Company's Debt Ratio
10. Institutional Ownership
11. Dividend Yields

Sector Analysis

Sector analysis involves identification and analysis of various industries or economic sectors that are likely to exhibit superior performance when compared to the other sectors in the economy. The health of a Stock's sector is as important or even more important than the Stock's health. In other words even the best stock located in a weak sector will often perform poorly because that sector is out of favor. When the industry is heavy weight (Meaning one that is expected to perform well in the next few quarters) the increase in price of good companies in that sector is usually more than average. For example during the IT industry boom, the growth in price of shares of Infosys, TCS etc were way too high when compared to other great companies. Each industry has differences in terms of its customer base, market share among firms, industry growth, competition etc. Learning how the industry operates provides a deeper understanding of a company's financial health. One method of analyzing a company's growth potential is examining whether the amount of customers in the overall market is expected to grow. In some markets, there is zero or negative growth, a factor demanding careful consideration. Additionally, market analysts recommend that investors should monitor sectors that are nearing the bottom of performance rankings for possible signs of an impending turnaround.

Currently financial experts are heavy weight on Manufacturing Industries, Power sectors. They are very much skeptical about the IT & Banking sector due to the economic crisis now.

Fundamental Analysis

Fundamental analysis considers past records of assets, earnings, sales, products, management, and markets of a company in predicting future trends in these indicators and how they may effect a company’s future success or failure. By analyzing a firm’s prospects, we can determine a stock’s intrinsic value and assess whether a particular stock or group of stocks is undervalued or overvalued at the current market price. If the intrinsic value is more than the current share price, then this stock would appear to be undervalued and a possible candidate for investment. There are a few ways that we can use to identify the value of a stock. They are

1. Price-earnings (P/E) ratio - The PE ratio, also called the multiple, gives investors an idea of how much they are paying for a company’s earning power. The higher the PE, the more investors are paying, and therefore the more earnings growth they are expecting. High PE stocks "those with multiples over 20" are typically young, fast-growing companies.
2. Price-Book (P/B) ratio - P/B is the ratio of a stock’s price to its book value per share. A stock selling at a high PB ratio, such as 3 or higher, may represent a popular growth stock with minimal book value. A stock selling below its book value may attract value-oriented investors who think that the company’s management may undertake steps, such as selling assets or restructuring the company, or acquisitions to unlock hidden value on the company’s balance sheet.
3. Earnings growth which may be reflected in measures like the Prospective Earnings Growth (PEG) ratio. The PEG ratio is a projected one-year annual growth rate, determined by taking the consensus forecast of next year’s earnings, less the current year’s earnings, and dividing the result by the current year’s earnings.

Management Capability

The strength of a company lies in the Strength and capability of its management. A company with a sound management that follows strategies to boost the sales and revenue is definitely a good investment when compared to one where the management is not so sound and innovative.

This involves examining perceptions about management and perceptions by management. It includes various qualitative judgments regarding the competence of current and prospective company management, as well as issues related to insider buying, future strategies to increase operations and market share.

The fundamental goal of any public listed company is to "Enhance Shareholder's Wealth". If a company's management is committed to keeping up their goal then it would definitely make a good pick.

Investing in companies with a management team that is committed to controlling costs is a good strategy. Cost-control is reflected by a profit margin exceeding those of competitors. Superior managers "attack costs as vigorously when profits are at record levels as when they are under pressure." Therefore, be wary of companies that have opulent corporate offices, unusually large corporate staffs and other signs of bloat. Such companies are trying to boast of exuberant facilities for staff. Instead this money could have been used effectively to improve the financial balance sheet of the company. Invest in companies with honest and candid management, and always avoid companies that have a history of using accounting gimmicks to inflate profits or have mislead investors in the past. Such companies are bound to affect your portfolio's earning potential.

Technical Analysis

Technical analysis involves examining how the company is currently perceived by investors as a whole. Technical analysis is a method of evaluating shares by researching the demand and supply for a stock or asset based on recent trading volume, price studies, as well as the buying and selling behavior of investors in the recent past. In Technical analysis, we do not attempt to measure a company's intrinsic value. This analysis is usually done for a short term. Based on the demand and supply for a share, we can predict the future growth in price of a company's stock.

In Technical Analysis, we make use of technical indicators that can help us predict the short term price growth of any stock. Some common technical indicators include Relative Strength Index, Money Flow Index, MACD etc.

Relative Strength Index is an indicator of the strength of a security in relation to its sector or the overall market

Money Flow Index is an indicator that uses the Money flow to calculate the strength of a company.

money flow = typical price * volume traded (On any given Trading Day)

Positive Money Flow days are when the price of the share has increased when compared to the previous days closing price. Negative Money Flow is vice versa.

Money Flow Index = (Positive Money Flow / (Positive Money Flow + Negative Money Flow)) * 100

The MFI is a % value and a value of > 80 means the share is being over bought and a value of < 20 means the share is being over sold.

Technical indicators do not analyze any part of the fundamental business, like earnings, revenue and profit margins. Technical indicators are used extensively by active traders, as they are designed primarily for analyzing short-term price movements.

Technical Analysis also helps long term investors. These indicators can help a long term investor identify good entry and exit points for a stock.

Financial Analysis

In Financial Analysis, we consider the balance sheet of the company or the Profit & Loss statement and compare it with the same of other companies in the same sector. If the values in the statements of the company under consideration is stronger than companies of similar size in the same sector then this company would make a better investment option than the others in the same sector.


Market Capitalization

Market Capitalization is one of the indicators that can help us favor a particular stock. Market Capitalization is nothing but the product of the Total No. of outstanding shares of that company and its share's end of day trade price.

Say For e.g., XYZ limited has 1,00,00,000 (1 Crore) shares in the market and the price of a share in the market today was Rs. 65/- then the market capitalization of XYZ limited is 65 crores.

There are 3 different categories in Stocks.

1. Large Caps - Companies with market capitalization of of a few thousand crores
2. Small Caps - Companies with market capitalization of a few hundred crores
2. Mid Caps - Companies with market capitalization that fall these 2 categories

Usually Large caps are the most favorite stocks because they are the stocks of companies that have built a reputation over years with consistent performance and great profits.

The Market capitalization of any company is also an indicator of how much investors value a company and its future prospects.

Price to Earnings Ratio

The PE ratio is a valuation metric that compares a company’s price-earnings ratio with its projected growth rate. Small, high-growth stocks generally trade at higher PE's compared to the Large-caps. If the PE ratio is around 1, the company is considered fairly valued. A PE ratio that is much higher than 1 indicates an overvalued company, and a PE below 1 indicates an undervalued company. While the PE ratio can effectively provide insight in certain evaluations, it is limited by its overriding focus on earnings growth. Revenue growth, cash flow, dividends, debt, and numerous other factors are also critical in determining value. Additionally, while PE is useful for smaller companies it may be misleading for big-caps, since sustained growth is less important to their total returns. PE is most useful when supplementing a thorough discounted cash flow analysis or relative valuation.

Company's Earnings Growth

In investment terminology, earnings growth refers to the annual rate of growth of earnings, or the amount of profit a company produces during a specific period, usually defined as a quarter (three calendar months) or year. Earnings typically refer to after-tax net income. When the dividend payout ratio is same, the dividend growth rate is equal to the earnings growth rate. Earnings growth rate is a key value that is needed for stock valuation.

Usually companies that can sustain their earning's growth between 15 to 30% year on year are considered good investments.

Companies that exceed a 30 percent earnings growth rate are confronted with two fundamental problems:
1. Sustaining a high growth-rate over the long term is extremely difficult; and
2. Stocks growing that rapidly are usually already being actively bought/sold by investors. Hence exposure to these counters may pose an added risk of going down if the company does not live up to investor expectation.

Debt Ratio

Debt-to-Equity (D/E) ratio is one of the key indicators of a company's strengh. If a companies debt levels are excessive, it often proves extremely difficult for managers to raise sufficient cash to finance continued expansion. Without expansion into new markets, corporate growth eventually slows down. Companies with lower debt often have better prospects for future expansion. Additionally, in the event of an economic slowdown, these firms should be in better shape to weather any storms.

Usually companies with lower Debt ratios are better investments. A 25% debt and 75% equity proportion is something very normal for large corporations. Any company with > 35% debt exposure would make a bad choice for investment because they are the most vulnerable lot in case of any economic slow down.


Institutional Ownership

Institutional investors are organizations that trade large volumes of stocks. Percentage institutional ownership is the percentage of outstanding shares that are owned by mutual funds, pension plans and other institutional investors. Most well-known stocks have at least 40 percent institutional ownership.

More than 70% of the trading that happens on large caps in the stock exchanges are on behalf of these institutional investors. When institutional investment in a company crosses 65% it poses unusual levels of risk associated with it. If those investors decide to sell on a particular day the price of the share may bottom out. Hence preferring stocks with relatively smaller levels of institutional participation is preffered. These companies have a greater return potential than ones with extensive institutional investment.

Though companies with high levels of institutional participation may provide breathtaking returns when they are buying, it may not be able to sustain the returns.

An ideal institutional ownership in terms of % would be somewhere between 5 and 65%

Dividend Yields

Dividend is nothing but a periodic sharing of its profits by a company with its investors. Most successful companies have been good dividend payers in the past.

As a rule of thumb, any company that has consistently been paying good dividends over the past few years make good investments for the long term investor.

Companies with high dividend yield may not provide extraordinary capital appreciation, but they would provide a regular additional income to its investors.


Stock Selection Effectiveness

Stock Selection Effectiveness is something that determines the returns on our portfolio. Our stock selection and asset allocation must be balanced. Over Exposure to any particular stock or segment should not be there. Investing more than 10% of our portfolio's worth in one company's stock is considered a very bad idea.

Our portfolio should be balanced with exposure to all sectors. Some sectors may over perform and some may under perform. But a balanced portfolio would always outperform a portfolio that is heavyweight in one particular sector. The returns on such a portfolio is entirely based on the performance of that particular sector and may not match the returns in a balanced portfolio.

For example, Banking & IT stocks were the most sought after stocks in the past few years in the Indian stock markets. They have been providing excellent capital appreciation over the past 2 to 3 years. But, with the current economic crisis they have been the ones that have taken the worst beating in terms of price. Portfolio's that were over exposed to these 2 sectors would have lost more than 50% of its value. But there are some sectors like FMCG and Pharma that have not lost so much like these 2 sectors. So portfolio's that had a balanced sector allocation with adequate exposure to FMCG and Pharma stocks would not have lost that much. Of course these stocks too lost a lot of value but this was limited to around 20% which is far lower that what the Banking and IT sector stocks lost.

A Well Balanced Portfolio is always the best investment strategy....