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Thursday, April 16, 2009

How to pick Stocks for Investment - Part II

In the first part of this short series of articles on stock picking, I had given some general guidelines about stock selection for investment. Today's discussion will center around the top-down method of stock selection.

Imagine a timber merchant who wants to lease several hundred acres of forested land. A land broker takes him to a nearby hill, from where he looks down at a forest in the valley below. What would he look for?

Is there a large enough density of trees that will take several years to get depleted? Is the soil conducive to adequate growth of saplings? Is there plentiful source of water nearby? Is the forest reasonably close to a highway system that will aid quick movement of logs? Is there a sufficient variety of trees to enable him to cater to a wider market?

If answers to such questions are in the affirmative, the timber merchant may decide to lease the forest tract. He looked at the 'big picture' from the top of the hill before deciding to invest his money. He will look at the nitty-gritty of exploiting the forest resources later.

Like the timber merchant, you are also a potential investor - but in the stock market. What is the 'big picture' you should see?

What is the state of the economy? Which stage of its up or down cycle is it in now? How is the domestic industry faring? Is the export industry meeting its targets? What is the balance of payments situation? Inflation? Liquidity? Is the Sensex in a bull or a bear phase?

I can almost anticipate your objections: "I'm a software engineer/lawyer/sales executive; this is all about macro-economics. How do you expect me to understand it? There must be an easier way!"

Well, if you wish to make the stock market a long-term source of additional income, you definitely need to learn the rudiments of economics.

At the very least, the concepts of supply and demand, cost and pricing, inflation and its relation to the interest rate scenario, basic accounting principles have to be grasped to have any chance of long-term success in the stock market.

You may have a friend who did nothing but happily follow tips from other friends and now owns a flat in Bandra (or Banjara Hills) and drives a BMW. Don't fall for that trap. He may have just got lucky. Check with your other friends. Most are not rich. Not from the stock market anyway.

So you look at the current 'big picture' and think that the economic and stock market cycles are in sufficiently conducive stages for you to invest some money. How will you decide? You can always take the help of a couple of my earlier blog posts: 'Market cycles and Sectors' and 'Which sectors should you invest in?'

In the first article, I've identified the sectors that come into prominence at different stages of the economic and stock market cycles. You don't have to invest in all those sectors. Choose three or four sectors about which you already have some knowledge (or you may know someone from those sectors who can help you with information). It is of utmost importance that you only invest in sectors about which you can gather adequate knowledge.

If you are still unable to decide on your sector choices, please read the second article mentioned above. I have outlined four sectors and the reasons why I like them for investment purposes.

Are we done yet? Not quite. After identifying three or four sectors (you need solid reasons to like them - not something vague like 'alternative energy is the next high growth area in India'), select three or four of the best known stocks in each sector.

You now have a list of 12-16 stocks from some of your favourite sectors. These need to be analysed in detail to arrive at the final list of 8-10 stocks for your core investment portfolio. (In Part III, I will discuss about the bottom-up method of stock selection.)


Rishi said...

How to identify a small list of stocks for wealth creation was always a struggle. Especially when you have 1000s of stocks listed and hundreds of channels, brokerages, with their recommendations. Finally one ends up with a huge list of stocks to select from without the knowledge of the required details as you have mentioned.
Your approach of selecting stocks based on the knowledge of the sector opens door for a learning investor. Thanks for the thought provoking article.

"When the student is ready, the teacher will appear" - Buddhist Proverb.


Subhankar said...

You are generous with your comments, Rishi. Much appreciated.

My only teacher in the market was experience through making costly mistakes. Guess I wasn't 'ready'!