Demystifying the dilemma – Which shares to buy?

We all have goals in life. One of them is to get our daughter well educated. Esteemed Universities and Premier Institutes cost a lot. How do we accumulate so much money from just one salary? Or should we say NO, to our kid when she wants to study?

 

 

At 11:15 p.m. on a recent weeknight, I was turning off the lights in my apartment to start winding down for sleep when I heard yelling from upstairs. It was different from the sound of the children who live directly overhead playing, being rambunctious, stomping around, being annoying. These were angry voices. I was in pajamas, but I opened my front door so I could hear more clearly, and I was greeted with a flurry of f-bombs. There I was in my hallway, doing a cost/benefit analysis of intervention—a familiar position. I could hear two distinct voices screaming at each other, and then a crash. More screaming! My roommate and I peeked out down the hall, wondering what to do.

As I listened carefully it became clearer to me that this fight is about money. That night as my fight – or – flight adrenaline kicked in; I gave in to flight. Next day I got a call from my neighbor. When I met Pulkit he was downhearted. They needed money for their daughter’s higher studies. But no matter how hard he tried, whatever he could save, was not going to be enough.
“Have you ever invested in stocks?” I asked.
“Nope, I don’t know which stock to buy,” he said.

I am not an investment guru. But my investment in the Nifty stocks has given me 21% returns in the last couple of months. Suddenly, I felt that I can help him.

Mostly people get confused when it comes to the big question, “which shares to buy?”. This is because there are too many stocks. So how do we know which is the best share to buy? Pulkit was looking at me as if I can make his nightmare disappear. So, I continued.
“In my view best stock means the stock that will yield my expected returns. To me 25% is a good return in a year. Therefore, any stock that has the potential to yield 25% or more is my best stock.”

You guys must be thinking, what is a potential stock? Stock which has the ability to yield expected returns are the “potential stocks”. Such stocks can also be broadly classified as undervalued stocks.

How to know if a stock is set to give the desired returns?

To understand this let us first look at the two schools of thought:

1. Fundamental analysis.
2. Technical analysis.

I am just an ordinary person with no professional qualification. So, I first choose a stock which is a part of the top 10 holdings of a mutual fund. This is a shortcut to find a strong company. Then I check the following:
Undervalued stocks – This, I leave to the analysts on TV, websites or popular magazines to decide. Once they have declared a stock as undervalued, I pick that.
Strong business fundamentals – This is again a mix of my understanding of the industry and analysis of experts. Different people use different parameters to confirm business fundamentals of company. I use the following screeners:

a. Company size: Large company also represents a large market share. For example, there is a market which has 100 consumers, and four companies operating in this space. Out of these 4 companies, one company serves about 40% consumers. In terms of size (market share), fundamental of this company is stronger. I never go for small caps. It is not because they are bad, but because their stock price is often controlled by bigger market participants. These stocks can become traps. So, I put a filter for the Market Cap in my screener.

b. Profitability: What is profitability? It is a measure of how much profit a company is generating for every Rupee it is spending. Suppose there are two companies (X & Y) spending Rs.200 to run its business. X & Y generates a profit of Rs.10 and Rs.15 respectively. In terms of profitability, fundamental of Y is stronger. Why? Because for the same Rs.200 (cost) Y is generating more profit than X. I use ROE, RoCE, Operating margin and net profit as screeners here. You can check these from free websites like moneycontrol.com or your brokerage sites.

c. Growth Rate: A growing company is every investors favorite. No matter how small the company is today, if its growth attributes are visible, investors will bank on them. In fact, growth is such an important factor that even highly profitable companies tend to underperform (in stock market) as compared to growth stocks. This is something I check from the Earning per share (EPS) figures. The higher the EPS the better it is. Also, I would like the EPS to be growing consistently on a year on year basis.

d. Price Valuation: As of today, for valuation check I look at P/B ratio, Dividend Yield, PE ratio, PEG ratio and also the debt equity ratio. If the stock is overvalued as compared to its industry average then it is a costly stock. If it has a high debt burden, then interest adds to the cost of the company. Even if the company has a high growth, if it is paying too much interest then it’s not really capitalizing on the benefit of growth. Whatever it earns goes to the lenders!

This is how far my fundamental research goes. At this stage I move on to the charts. This where I start my technical analysis. Now this is something I do pretty well and let me tell you, that technical analysis is not a tough job. YOU CAN LEARN IT! YOU CAN DO IT!
I look at daily, weekly, monthly charts and finally take a call focusing on the long term. As I explained to Pulkit the idea is to buy a fundamentally strong stock at the opportune moment where there is minimum downside risk and more of upside potential. Since I have a full-time job just like my dear neighbor, I cannot do trading. Thus, it is only for the long term. Does this mean that I do not sell stocks after a few months? Of course not. If I suspect that it may fall, then holding on to it just because I have pledged that I will be an investor, is a donkey’s act.
Dear Pulkit, “You may call me an opportunist,” I laughed.
Now to my dear readers, how I do my technical analysis is another day’s story.

Things to remember:

1. Choose a company which is fundamentally strong and buy when the charts give a buy signal.

2. Check Market Cap to determine market size.

3. Look at ROE, RoCE, Operating margin and net profit as screener for profitability parameter.

4. Look for consistent growth in Earning Per Share (EPS).

5. To determine ideal price valuation check, P/B ratio, Dividend Yield, PE ratio, PEG ratio and also the debt equity ratio.

6. Learn technical analysis.

7. If you do not have access to all the updated data of a company and the industry look at research done by experts, fund houses etc.

8. Consider the top 10 holdings of top performing mutual funds to create a watchlist.

Conclusion:
I hope you found this article an easy guide for fundamental analysis. Frankly speaking there is no single way of finding the best stock. However, it is easier to make money from stocks when you have a long-term view. So be patient, be agile, learn from your mistakes and market will reward you.