Honing stock-selection skills

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To reap gains in the stock market over the long term, understand what type of investor you are and then make your investment moves accordingly.

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Manish Shah

Investing in equities may seem like a simple business, but more often than not, it is more complex than one would imagine. The moot question is that with all of the hundreds of thousands of stocks available in the market for us to choose from, how does one know which stocks to invest in? Should one pick a stock because it is in an industry that interests him or her? Or should investors let their emotions drive their stock picks?

Here, we look into the mind of a value investor to understand how one should go about investing in the equity markets in order to realise gains on a long-term basis.

But before that, you may have to understand what type of investor category you fit in.

Type I

This class of investors does not have the time or the ability to make judgmental calls on the stocks/sectors. There are investors who have very little time to make judgements and invest in equities, based on the above two approaches. Mutual funds, therefore, assume a significant role here, helping this class of investors invest their money and reap returns.

Professional portfolio managers, who manage the mutual funds, therefore assume an important and responsible role. It is a win-win situation for both the client and the fund manager in that the investor benefits from the ability of the manager to pick good stocks by paying a small fee.

Also, there are portfolio management services (PMS) provided by various wealth management companies that manage the client's fund in equities in a highly efficient manner.

The only difference between mutual fund and PMS is that the units of mutual funds are readily traded on the market and the updated net asset value is available daily for the investor to monitor while, in the case of PMS, exiting the scheme takes more time than the mutual funds.

Type II

These investors do not have the time or the inclination to engage in tracking investment information on a regular basis. For example, the investor here does not have the time to go through the annual reports, keep a track of quarterly numbers, keep a tab on important happenings related to the company. For such investors, it is best to go through the various research reports published by the research and broking houses.

The research-cell analysts have access to key data, management, etc. Hence, they are better placed to present facts and ideas. After going through the fundamental research report, an investor can make up his mind about the sector and stock to be invested in.

Type III

You will fall under the third category if you have both the time and the inclination to monitor your portfolio on a consistent basis. The investor here is interested in going about building his own portfolio commensurate with the risk and returns that he desires. Such an investor purchases investments and continuously monitors activity in the company as well as markets in order to exploit profitable conditions.

What distinguishes such an investor from the other investor classes is his high involvement in the investing activity. The investor possesses the know-how needed to analyse stocks, read and infer annual reports, take cues from various important events, etc. In short, the investor knows how to separate the wheat from the chaff.

It is the last-mentioned type of investor who would have to seriously equip himself with stock-picking skills. Here's how such investors can select their stocks.

Begin by understanding your own risk profile: The most underestimated but probably the most important of all rules for you as an investor is to understand yourself in terms of your risk-taking capability and objectives. Once your risk profiling is clear, you are all set to look at stocks to invest in.

Choose the stock to research from an industry/sector you are comfortable with. You should choose a company you can keep track of. Often, the annual report of a company itself gives a fairly good overview of the industry along with its future growth outlook. Annual reports also tell you about the major and minor competitors in a particular industry.

Time for some ratio analysis: Ratio analysis serves as a complement to the fundamental analysis. Some of the ratios that can be analysed are price-to-earnings ratio and price-to-book-value ratio. While these are not the only ratios, they do help in understanding what the stock price discounts.

Look for management capability, track record: It is often said that there are no good or bad companies, only good or bad managers. Key executives, therefore, are responsible for the future of the company.

Determine fair value and decide what price you want to pay: Based on the fundamental valuation and ratio analysis, you would be in a position to decide about the worth of the company. If you are a value investor, look at the intrinsic worth of the company. Growth investors can accord higher weight to the earning potential.

Make a decision and stick to the rules: Once you have gone through this process, you may have to make the decision to invest in a particular company. But remember that even after deciding on the stock pick, a minor fluctuation in price can influence or even upset the decision.

So, it is absolutely important to have faith in one's own values and principles, on which the investment is made. Never let the small fluctuations in the price of the investment deter/encourage the sell/buy argument.