The stock market is full of frills and thrills.
Stock market investment, just like any other investment, comes with its ups and downs. However, investors desire the ups without the downs, hence the need for stock-picking strategies. The objective of every investment is to achieve as much returns as possible taking into consideration a set of selection criteria. In the stock market, investors seek stocks that outperform the general market over a period of time. It is therefore necessary to have a proper strategy in place to select good stocks, while avoiding bad ones that can lead to erosion of investment.
The Ultimate Strategy
Many investors believe that there is a surefire strategy to selecting stocks which if adhered to would by all means guarantee higher returns. This is a misconception, or perhaps, a myth, since so many factors come into play in the performance of a stock. There is, therefore, no definite strategy in selecting stocks. However, knowledge of some of these factors could go a long way in guiding an investor towards making that key decision which will ultimately earn the investor success.
The performance of a stock in the market ordinarily symbolizes the health of a company. Since a lot of factors influence the health of a company, it is almost impossible to design a perfect formula that will predict success. It is one thing to assemble data that you can work with, but quite another to determine which numbers are relevant. A lot of information is intangible and cannot be measured. The quantifiable aspects of a company, such as profits, are easy enough to find. But how do you measure the qualitative factors, such as the company’s staff, its competitive advantages, and its reputation and so on? This combination of tangible and intangible aspects makes picking stocks a highly subjective, even intuitive process. Also, for reason of the human element inherent in the forces that move the stock market, stocks do not always do what you anticipate they will do. Emotions can change quickly and unpredictably.
Stock-picking can also follow scientific method of thinking where carefully thought through processes are followed up with testing the validity of such techniques through a procedure known as investment analysis.
Since the stock market follows the random walk hypothesis, there is no clear cut strategy in picking stocks. Rather, you should consider other factors that could help determine your preferred strategy – your personal outlook, time frame, risk tolerance and the amount of time you want to devote to investing and picking stocks.
Fundamental Analysis & Stock-Picking
Most investors are used to hearing the phrase “strong fundamentals” or “weak fundamentals”. What exactly does this phrase mean? Fundamental analysis involves getting a value of a company using fundamental valuation techniques and comparing this value to the price of the stock in the market. At the end of a valuation, a value known as “intrinsic value” is obtained for the stock and where this value is lower than the stock market price then the stock is overvalued and should be sold. Where the price is higher than the stock market price then the stock is undervalued and is a good buy. The fundamental analysis makes use of various valuation techniques and some of these include the Dividend Valuation Model and Analysis of Free Cash Flows. The former is useful for companies that pay dividends while the latter is useful for those companies that do not pay dividends.
Fundamental analysis might appear very technical and bogus to you as a random investor but it is not far from being the most important strategy to be adopted in picking a stock. You might not have the technical know-how to do some of these analyses and so you should consider seeking advice from your financial adviser, investment manager, or broker. You might be interested in finding out the going concern of a company; hence you should do some fundamental analysis. Next time you desire to make an investment in a stock, remember to ask the question, “Does the company have strong fundamentals?”
However, fundamental analysis involves much more than quantitative analysis in which you obtain a value for a company. It also subsumes some qualitative aspects that impact on the performance of the company in the industry in which it competes.
Knowing the Company Management
A vital part of qualitative fundamental analysis is figuring out the management of the company. You should ask the following questions concerning the management. “Who are those at the helm of affairs of the company? Who is the Chief Executive Officer (CEO)? Who is the Chief Financial Officer (CFO)? Who are the Vice Presidents (VPs)? Also you should ask where these people come from especially their educational and employment backgrounds. Then you need to find out what the management philosophy is and when they took over helm of affairs in the company. Also important is why these people have been selected as managers of the company.
What drives the Company
In addition, you should be interested in knowing how the company makes money, that is, the nature of its business. Knowing how a company’s activities will be profitable is fundamental to determining the worth of an investment. If you aren’t sure how your company will make money, you can’t really be sure that its stock will bring you a return.
Knowing the industry in which the company operates would enable you determine the growth potential of your investment. A mediocre company in a great industry can provide a solid return, while a mediocre company in a poor industry will likely take a bite out of your portfolio. For instance, the Textile Sector suffers from numerous challenges including power; as such an investment in this sector is not expected to generate as much returns compared to investment in a company quoted in the Food/Beverages & Tobacco Sector where demand for these products are continually on the increase.
A company that has a higher market share can take advantage of economies of scale to stifle smaller companies while a valuable brand name also helps a company to stand out from its competitors. In all of these, you do not need a Ph.D. in Finance to identify a good company. When you see a little-known company doing well and expanding, ask around, for you never know the growth potential inherent in the company.
Technical Analysis & Stock-Picking
Technical analysis involves selecting a stock based on analysis from past trends recorded in the stock. Some of these trends may include price, volume, market activity, and so on. The rationale for technical analysis is that past performance symbolizes future performance, which may not necessarily be true.
Technical analysis is not a long-term strategy; rather it is a strategy adopted by investors who desire to capitalize on fluctuations in trends in order to post short-term profits. Technical analysts are usually very short term investors and are guided by a set of principles which enable them to make their decisions. Some of these decisions include – setting entry and exit prices, stop-loss prices and support and resistance levels.
Technical analysis unlike any other stock-picking strategy – has its own set of concepts, and it relies on a completely different set of criteria than any strategy employing fundamental analysis. However, regardless of its analytical approach, mastering technical analysis requires discipline and know-how, just like any other strategy. You should consider your investment options including your holding period before you make a decision on a stock using technical analysis since it is a purely short-term strategy.
There is however no completely consistent strategy for selecting stocks. Depending on your investment objective, it is necessary to consider all of these strategies in unison and not in isolation. Fundamental analysis should rightly be your starting point while following through with other strategies.
Let me close this discussion with CANSLIM strategy as described by William J O’Neil in the book How to Make Money in Stocks: A Winning System in Good Times or Bad.
What is CANSLIM? Each letter in CANSLIM stands for common characteristics that are found in the greatest stock market leaders over the past 50 years.
C: Current earnings per share
This figure can be found in the company reports (quarterly). It tells you how much profit the company has made for each share given to its shareholders. As per this strategy, earnings per share should at least increase by 15- 18 per cent every year.
A: Annual earnings
That is, the net profit made by a company. This should have increased by 15-25 per cent or more consistently for the last three years. Annual earnings can be found in the company Annual Report
N: New management/Services or Products
The company should be under new management ( the management should have new strategy), have a new product or have a new service.
S: Shares of common stock outstanding
As far as possible, this figure should remain small. It tells you how many shares a company has issued to investors like you. If this figure is small, the earnings per share discussed above increases. One can get this number after a look at the company’s balance sheet.
The company should be a leader in its industry, or at least in the top three positions in the sector/ industry/ segment it operates in.
I: Institutional sponsorship
Look at the institutions that are buying this particular stock or holding this stock for a sufficiently long period. If well-performing institutions (Pension Funds, Mutual Funds, or other Institutional Investors) are holding your stocks, then your chances of making money are good.
M: Market trend
In a falling market, even the best stock will not be able to perform. Try and enter the market when stock prices have bottomed -out. That is, buy a particular stock when the share market is reaching the support level.