On Picking Stocks

Here we are on one more Sunday when we will be looking to the important task of picking stocks to invest in. But before that, a quick look at the markets, in the week gone by. Last week was an example of the reality of markets – that they also go down and not just up. Yes, if you were invested in the markets, you would have seen your stocks, or in other words, you capital, go down anywhere between 5 to 15%, depending on what your portfolio was like. These are the times when your convictions get tested. Do you panic and start selling, or do you believe that this is only an aberration? Or you do not worry about overall market segments, as long as you have your own stock game plan, with set targets for buy and sell? Well, if I were to tell you this, I would be jumping the gun, as we will come to this later.

For now, let’s get down to the very interesting topic of learning how to pick stocks that you can invest in. Well, there are many technical methods involved, but as this newsletter is aimed at amateur retail investors, and as I promised at the outset that I will not get into technicalities, I am going to suggest simple methods that all of us can understand.

Let me repeat a few tips from last time:
1. Avoid companies that you do not even recognize by name. This is a very simplistic filter to eliminate stocks that you do not purchase. There may actually be gems out there, which you may not have heard of. But as a simple and general rule, staying away from small and unknown companies will be worthwhile.
2. Avoid stocks where the companies or its promoters have negative factors associated with them. Here again, it is a method of elimination. Why take a risk with such stocks, where there may be more chances of random and unpredictable manipulation? There are other fish in the sea, and there are other stocks to pick!
3. There is often a temptation to pcik stocks on basis of one-off specific news about the stock. E.g. good financial results, some news that the company has bagged some business contract, and the like. While such factors do have a relationship to the stock price, it is dangerous for an amateur investor to pick stocks on basis of such one-off factors. The reason being that such news may easily be known to select audiences like financial analysts and certainly, ‘insiders in the company’, before hand. Chances are that the impact of the news has already happened, on account of that, and by the time the amateur retail investor hears of it, it may be too late to purchase the stock then. On the other hand, more generic news like “it being good times for infrastructure industries and hence cement companies should do well” is worth taking into account, as its impact is not one-time, but rather an ‘ongoing basis’ type.

Other than these factors, you can pretty much pick any other stock, and use other guidelines that I explain below.

At the outset, it is necessary to understand a couple of ways in which stocks can be typically categorized: a) Size of company and b) Industry sector. In terms of size of company, there are the very large companies (also referred to as large cap stocks) such as ONGC, Indian Oil, Reliance, Tata Steel, etc. Then there are the medium sized companies (also referred to as mid-cap stocks) such as Thermax, Exide, Sundaram Fasteners, etc. The other way is to classify stocks as per industry sector that they belong to, e.g. Information Technology, Steel, Cement, Auto, Auto Ancilliaries, etc. Due to the special treatment that they get, Public Sector Units demand special attention as well, as a separate group, in their own right.

Now some guidelines with regards to these classifications:
1. While large cap stocks would appear to be more stable and secure, there is no rule to say that you should only invest in large cap companies. In fact, if you do so, you may miss out on the most exciting growth opportunities in mid-cap companies. A mix of large cap and mid-cap stocks in your portfolio, would be quite ideal.
2. While there are investors who invest in few stocks(with large funds committed to those) and stay put, I would not recommend that strategy at all, to retail investors. As a retail investor, with limited research, limited homework, there is just that much confidence that you can have, in a particular stock, or a few stocks, or even in a single industry. Therefore it is important for you to have enough hedges in your stock portfolio. So that if 1-2 do not do as well, you can at least ride high on the other picks. Also the markets have a tendency to rotate their fancy towards industry sectors. In other words, if there is a big demand for say, cement stocks, which raises their prices, it is typically accompanied by some other industry going out for favour, for the time being. So you may well see at that time, that pharma stocks are being sold and prices going down, at that time. This happens cyclically, with tremendous regularity. Which are the industries in favour at a time, and which have lost fancy for the moment is something that keeps changing. However due to this phenomenon, if you have a reasonably diversified portfolio of stocks in terms of industries, you will get the periodic highs in specific sectors, and the losses in some stocks will even out with the gains in some others.

To give you an example, last week, the metal stocks did very badly. I lost a lot of ground in Hindalco and Tata Steel. But then, the markets favoured IT stocks last week, and because I also have TCS in my portfolio, and which went up, my total portfolio had a sense of balancing done.

At this stage, let me recap the specific points made so far, with regards to picking stocks:
• Avoid small, unknown companies; avoid shady promoters / companies,
• Do not pick stocks on basis on one-off news; but do look at industry trends,
• Have a mix of large and medium sized companies (large cap, mid-cap stocks),
• Have reasonable diversification in terms of industry sectors.

Let’s move closer to making the actual selections. To get there, I am going to assume that you read regular newspapers (a financial newspaper would be even better), even if it is only to look at headlines. With that knowledge base, and your own experience (say in the business or profession that you are in), can you pick some industries that are likely to be doing well, in coming months and years? Say, for example, you read that the government is going to invest significant amounts in infrastructure like roads and bridges. That would normally mean that industries like cement, steel, and construction, should do well. Or you read about the BPO wave and how its going to benefit Indian companies, and simultaneously you also see regular and good results from Indian IT companies. You may conclude that its good times for the IT companies. You may pick up other news like how auto ancilliary companies have made inroads into the global auto manufacturers’ markets and how their businesses are doing so well. You might read that Public Sector Units are fast improving efficiencies and its making a big difference to their bottomlines. Etc.

Based on these factors, if you have a gut feel on some industries, you may actually be on the right track to start with. Write down the names of such industries that you short list. Also list out the few top companies in these industries that you can remember. Say, for example, your selection of industries was: Cement, IT, Auto Ancilliaries, Engineering. Then, your further short list of companies could well include ACC, Gujarat Ambuja Cement, Madras Cement, Wipro, Infosys, TCS, Exide, Bharat Forge, Sundaram Fasteners, MICO, Thermax, BHEL, Siemens, ABB, etc. Your short list may well be 15-20 names.

To go further from this point, I am going to introduce you to a typical website, which you can use for reference. The one that I use is http://www.equitymaster.com. If you go to this site, you will see at the top, a field where you can enter a stock name and get a quote (price) for the same. In fact, once you see that price, you also see a link for ‘detailed quote, graph’. The graph is what I find most interesting.

But instead of telling you why, let me leave you this week, with the following ‘homework’:
1. Make the short list of shares as explained above,
2. Look up each of these on equitymaster.com, as explained above,
3. Put stock name and its current price in a small Excel spreadsheet,
4. Besides that, note your observations regarding the graph of that stock movement. This is most critical. So note down what you see here. Is the graph flat? Is it headed upward, broadly? It is headed downward, broadly? Note that you can see the graph over 1 week / 1 month / 3 months / 6 months / 1 year / 3 years. Seeing the graph over 3 months or 6 months gives a fair idea of its current potential. Note your observations for the stocks that you short listed, and we will take it ahead from this point onwards, on next Sunday.

Picking stocks is one of the most crucial areas to learn and understand. So it will take more than the one week’s article. Hence we have to continue this topic next week too!

Till then, take care.
- Sanjay Mehta
Sunday, October 17, 2004