Choosing Stocks

Choosing stocks is tricky. Nobody can predict the stock market trends & you should be prepared to suffer losses if you invest in stocks. Stocks give you better returns than debt instruments in the long term.

These are among the many opinions, perceptions or maybe facts about investing in the stock market. So if the waters are so unpredictable why are so many willing to jump in them? Is it the sheer thrill?

Obviously no; there is money and mostly hard earned money involved in it. Are there some tools that can help us wade through these turbulent waters or maybe just float on calm waters?

Where to Begin?

It is not possible to individually analyze thousands of companies listed on stock exchanges. So it is a good idea to go through newspapers, media reports to find about which sector or stock is expected to do well and then you can choose accordingly. This can be a first step to narrowing down your search.

Another useful idea is to consider the tips offered by your broking house; do not follow them blindly but at least these tips give you an idea where to start looking.

Choosing stocks which have a good trading volume is also a good idea. If you are a regular at investing by now you would probably figured out a strategy or a pattern that works for you.

A friend of mine never bothers with any figures or analysis. She just goes ahead and buys a blue-chip from a different sector each time she wants to invest. So is it a good or a bad approach?  It is an approach which she feels works for her so, that’s that.

Go With the Trend

Be it fashion or the stock exchange, choosing stocks based on the current trend is a good idea. But the problem is that stocks do not move in smooth lines that depict a rise or a fall. These lines are generally jagged with ups and down all mixed up.

So how do you identify a trend? When a stock price chart shows “higher highs” and “higher lows” it means that the stock is showing an upward trend. This must be co-related to industry or company specific news to reach a conclusion.

Moving Averages:

It is one of the commonly used techniques to identify a trend; the most commonly used is the 200-day moving average price chart. If the price of the stock is above the moving average trend then it is denotes a buy signal for the stock and vice-versa.

A lot of sites provide you option where you can track the price of a stock by looking at the patterns of past six month or a year.

For example news that the government plans to provide extra subsidy to the fertilizer sector you will see an upward trend in the stocks of fertilizer companies.

Use The PE Ratio

Using ratios to understand and estimate the financial health of a company is known as fundamental analysis. Fundamental analysis maybe used individually or along with other approaches to analyze a stock. There are many ratios that form part of this approach but the most popular amongst them is the PE ratio.

The PE Ratio or the Price to Earnings Ratio as suggested by the name compares the price of the stock to the per share earnings of the company. P/E = Price of the Stock/ Earnings Per Share

The ratio tells you how much an investor is willing to pay per unit of company’s earning. PE is generally used by taking the figures of last four quarters but sometimes it may be calculated using estimated earnings for the next four quarters; in such a scenario obviously it will not be very accurate but will be futuristic.

PE not only not only measures a company’s past performance but also takes into account the investors’ perceptions about the company as the price of stocks is affected by investor perceptions.

A high PE indicates that the market has high expectations from the company; some investors feel investing in a good company with a lower PE makes more sense as this indicates that the company has a potential for growth and is already not overvalued.

At what PE are you willing to invest is an individual decision; it is a good idea to compare the PE of a company with those in the same industry to get a fair idea.

A start-up which had a very high PE ratio might have a lower PE ratio once it establishes itself and its operations stabilize; so the ratio must be used along with considering other factors like the company life cycle, industry projections, inflation etc.

PE ratio for various companies and industries is easily available on various sites and a few sites may also provide lists of companies which exhibit a growth potential but have a low PE ratio.

Beta is a Good Indicator

This is a tool that measures the volatility of a stock in comparison to the market. The price movement of the stock is tracked against the movement of an index thus the Beta measures the response of a stock to systematic risks in the market.

A high beta stock indicates higher risk with higher return potential. Beta is often criticized on its historic approach; it tracks the past performance of the stock and does not incorporate future or current information. Beta is a useful tool which helps in choosing stocks as per your individual risk appetite.

ROA: A Measure of Profitability

ROA or Return on Assets is one of the important indicators for the profitability of a company. This ratio tells you how efficiently a company’s assets are being utilized.

The capital pooled in by the investor is used to buy assets which are in turn used to generate profit and this profit is returned to the investor; so a company which can make more money for the investor is better than a company which makes lesser for them. ROA should be compared between two companies within the same industry. ROA = (Net Income + Interest Expense) / (Average Assets during the period)

Another important measure for profitability is Return on Equity, ROE is affected by the company’s choice of equity and debt mix but this is not the case for ROA.

Conclusion – Choosing Stocks

There is no guaranteed or the right way to invest in the stock markets; it is a risk that an individual takes as per his/her risk appetite. It is a good idea to take a calculated risk and use data and information to reach a conclusion.

A few tools have been discussed here but these are not the only measures; Debt to Equity Ratio, ratings by various agencies, stock yield, company management, macroeconomic conditions etc are amongst the many other parameters that can be considered.

Which tool(s) you use to help you with choosing stocks is up to you but data should always be co-related to non-statistical information to reach a sound conclusion.