Techniques to Choose Stocks
Choosing stocks from the list of hundreds of companies can be tricky and a daunting task. So how do you choose a stock? How do you differentiate between the stocks of ICICI Bank or HDFC Bank for example? Past performance, future prospects, market buzz, directors, returns and so on can all be used to make decision.
Broadly speaking there are two approaches to analyzing a company :
- Fundamental Analysis
- Technical Analysis.
Fundamental analysis though generally used to evaluate equity stocks can be used to predict the performance of any security. This method tries to measure the intrinsic value of the security.
Intrinsic value is described as the actual value of a stock or a security vis-a-vie its market or book value. The intrinsic value is based on the perception about its true value and takes into consideration both tangible and intangible factors like brand name, trade marks (the value for them is difficult to calculate).
No mention of fundamental analysis can be complete without talking about Warren Buffet the great champion of this approach; he became a millionaire by choosing the right stocks for investment with the help of fundamental analysis.
The approach takes into account the effect of all possible factors on the stock of the company ranging from industry trends to the general economic conditions to facets like company management etc. It is known as fundamental analysis because it looks at fundamentals to evaluate the stock. Data like company revenue/expense, competitor performance, past performance etc are used in this approach.
The result of performing fundamental analysis is to arrive at the intrinsic value of the stock. If the current market price is below the intrinsic value then it is a cue to buy the stock else and if the market value is above the intrinsic value then the stock should be sold.
The method or the techniques used to predict the price movement of scrip based on studying the past data trends like price and volume is known as technical analysis. This approach is based on three basic beliefs:
- The market price of any stock is an indicator of all the information available: While technical analysis is often criticized for not taking into account fundamentals factors but this approach is based on the approach that stock prices are an indicator of everything including company basics, macroeconomic conditions and market sentiment.
- Price movements follow a trend: This means that once a trend has been identified; the future price of the stock will be most likely follow the trend.
- History repeats itself: Market sentiment (based on tangible and intangible information) dictates the price of a stock. Usually price move in patterns that are repeated over time as investors tend to react in a similar fashion when presented with the same kind of market stimuli. Charts used in technical analysis help in identifying these cyclical patterns.
As opposed to fundamental analysis technical analysis lays no emphasis whatsoever on calculating the intrinsic value of a share. So the users of technical analysis instead of focusing on the real price of the stock try and use the historical price and volume movement data to predict its future price. Here the emphasis is on forecasting the future price.
What to Use
Fundamental and technical analysis offers two approaches very diverse from each other to choosing stocks. While proponents of each approach talk about the superiority of their chosen technique there are those who believe that market price or the performance of a stock cannot be predicted.
The Efficient Market Hypothesis states that the current market price is reflection of all the information which includes price movement in the past and other qualitative and quantitative factors so neither fundamental nor technical analysis can say what the future price would be.
Fundamental analysis looks at balance sheet, cash flow statement, and income statements and qualitative factors like the business model, the management, competitors, market share, laws that govern the industry etc to arrive at conclusion. Analysis of some factors especially the qualitative ones can be tricky.
Technical Analysis uses tools like charts that depict stock trends, moving averages, relative strength index, moving average convergence divergence, Fibonacci retracement, and support and resistance to identify profitable stocks for investment.
Read more at : How to Invest in Stock Markets in India
While the jury is out on the efficacy of either of the approaches; a lot of investors just like to combine both to reach a decision. Avoid choosing stocks that are moving in the downward trend. Assess P/E ratios along with many other numbers. Avoid investing in companies you don’t know and investments you don’t understand .
Choose stocks wisely for intelligent investing !!