Amazon deals

Friday, June 5, 2009

How to pick Stocks for Investment - Part III

In this mini series on how one should pick stocks for investment, I had previously provided some general guidelines in the first part, followed by a discussion of the top-down method of stock selection in the second part.

The bottom-up method of selecting stocks for investment is by far the most time consuming and difficult, particularly for people who don't like to play around with numbers.

Why is the bottom-up method of stock picking difficult? Because you have to sift through thousands of listed stocks to narrow down to the hundred odd companies that meet the basic criteria of being truly investment worthy.

After doing that, you will need to check the fundamentals of each and every one of those short-listed companies to separate the wheat from the chaff. Now you know why brokerages and financial institutions maintain expensive research departments!

One way to cut short the time and effort is to combine the top-down method with the bottom-up method. In other words, first select the handful of sectors that you have some knowledge about. Then limit your stock picking to only those few sectors. That would be by far the safest option for picking stocks for your core portfolio.

There can be no better guide for selecting good stocks than the biggest 'guru' of them all - Benjamin Graham. I learned all about stock picking from his book, 'The Intelligent Investor'. Till date, I use the guidelines suggested by him - with suitable modifications for the Indian environment.

'No risk - no gain' is an old saying. The bottom-up method is the only one for choosing the smaller and somewhat riskier bets for your 'mad money' portfolio. Here are Graham's guidelines for stock picking for the conservative investor, suitably modified:-

1. Adequate size. Market capitalisation, i.e. current share price multiplied by the total number of shares issued and subscribed, should be at least Rs 100 Crores.

2. Strong Financial condition. Current assets should be twice current liabilities, and long-term debt should not exceed working capital.

3. Earnings Stability. Positive earnings per share (EPS) for each of the past 5 (preferably 10) years.

4. Earnings Growth. At least 50% cumulative growth in EPS for the past 10 (preferably 5) years.

5. Dividend record. Consistent dividend payment for the past 5 (preferably 10) years.

6. Moderate P/E ratio. Current share price divided by the average EPS for the past 3 years should not exceed 15.

7. Moderate P/BV ratio. Current share price divided by the book value per share should not exceed 1.5.

Graham also suggested that the result of multiplying the P/E ratio by the P/BV ratio should not exceed 22.5 - for cases where either the P/E ratio is higher than 15 and the P/BV ratio is lower than 1.5, or, the P/E ratio is lower than 15 and the P/BV ratio is higher than 1.5.

So there you have it. This is no secret recipe for untold riches. Stocks picked using these guidelines may not perform as expected. Stocks which do not meet many of the above criteria can fly through the roof. That is the nature of the beast.

During bear markets, you may find most of the listed stocks meeting the above criteria. In bull markets, only tiny caps may meet the guidelines. The in-between stage - like now - is a great time to start your research work for identifying strong stocks for the next up move of the bull run. It will happen after the inevitable correction to the 3 months long rally.

A good starting point is to buy a copy of Capital Market magazine, or visit www.moneycontrol.com for checking out the database of companies, and apply criteria numbered 1, 6 and 7 above to prepare a preliminary short-list. Check whether the short-listed companies have positive cash-flows from operations for at least 4 of the last 5 years.

The ones that make the grade can then be run through the guidelines mentioned in 2, 3, 4 and 5 above. You will finally have a 'buy list' that you can start tracking.

Oh! I almost forgot to mention the corollary to the earlier saying. It is 'no pain - no gain'. For readers who do choose to suffer the pain, there will be a guaranteed gain. I will technically analyse your choice of the 5 top picks from your list and give you approximate buy and sell targets. Absolutely FoC (free of charge).

Now, that can be a ticket to decent money-making, if not untold riches!

Related posts:

Market cycles and Sectors
Which sectors should you invest in?

12 comments:

ssharma said...

Subhankarji thanka a million for writing a very useful article.this will undoubtedly be the one of your best article.I request you to please consider combining all your articles on this blog and put them in a book form so that it has mass reach and can benefit more people.I can guarantee you that it will be in the list of bestsellers.
With kind regards,
sujoy sharma

Subhankar said...

Thanks, Sujoy. As usual, you are very generous with your feedback.

Appreciate your suggestion. I have been thinking about collating the blog articles into an e-Book. Not to sell it, but to give it away to interested readers, like you.

The stock market has given me a lot. I would consider the e-Book as a very small contribution towards giving some thing back to the market.

Doctor Universe said...

Dear Subhankar

I have been reading a bit of TA since Jan 2008. I have begun to understand a little of all these terms OBV MACD etc. I have a question..quite pertinent to the prevailing conditions in our markets..

How do we know that distribution is taking place? is my question.

Thanks & Regds

Looking fwd to your answer.
Rajeev Juneja

Subhankar said...

Very pertinent question, Rajeev.

On-balance volume (OBV) is a good gauge of accumulation or distribution. OBV should normally track the index chart or share price pattern.

Any divergence between the index or price and the OBV gives us clues to accumulation (positive divergence) or distribution (negative divergence).

Nagesh Jain said...

appriciate your time for enriching stock market for a pro like me.
Thanks
nagezh

ssharma said...

Subhankarji what about ROCE ,dont you think its an important criteria as i read in an article in THE HINDU that a company should hace consistent ROCE of 20%.this ratio has een called as GODS RATIO bu Buffett.
2.Wher can i get ROCE of last 10 years of the companies.
3.What is the difference between ROCE and return on net worth.Are they same or different.
4.Regular reading of a good financial newspaper like THE HINDU BUSINESS LINE is also important to know the overall picture.I have learnt a lot from THE BUSUNESS LINE as well as your BLOG.
Thank you.
With regards,
sujoy

Subhankar said...

@Nagesh: Feel free to ask any specific questions - like Rajeev and Sujoy have done. I'll try to answer to the best of my ability. I believe that knowledge increases with discussions.

@Sujoy: There are lots of ratios to consider for detailed financial analysis of companies. RoCE is an indication of how profitable the company is. RoNW gives an idea about what returns you can expect on your investment in the company.

Rediff Money site carries 5 years data and has a report on various ratios. As individual investors, one rarely has time to do detailed analysis of every stock on one's buy list. I use ratios if I'm undecided about which stock to pick from the same sector.

BusinessLine is my favourite financial newspaper in India. I read it on-line, along with the Wall Street Journal.

ssharma said...

Thank you subhankarji for your valuable guidance.While I am able to get last 5 years ROCE of companies on moneycontrol.com, 10 years data is unavailable.
I stick to 8 to 10 stocks in my portfolio as an individual investor cant monitor more than 10 companies.I am glad that BUSINESS LINE is also your favourite newspaper.I have subscribed to it as physical feel of paper is different from e version plus there is less strain on eyes.I also have the satisfaction that I am promoting a good newspaper in these times of recession when newspaper industry is facing a tough time.
with regards,
sujoy

income.portfolio said...

Subhankar,

Nice summary. The seven you mentioned captures the essence. What do you think the importance of Cash Flow (i.e operating cash flow and/or Free cash flow)?

Regards,

Subhankar said...

Positive cash flow from operations in at least 4 of the past 5 years is the litmus test for every company that is selected for investment purposes. This was mentioned in the article.

Doctor Universe said...

Part 3 sums up your former information making this piece a very highly educative article. I guess these are some of the things that explain why one stock does not fall so much as the others when severe corrections come in. Thanks. We love your writings. Whenever you get time sir please write on Colgate.

Subhankar said...

Appreciate your comments, Rajeev.

Colgate will be featured next Wednesday (July 8, '09). Thanks for the suggestion.