Picking Stocks - Part Two

Sunday, October 24, 2004

This week we will continue from where we left off last week, and try to zero in, on a methodology to pick stocks. Before getting into it, I would like to respond to a question that came up from one of the subscribers of this newsletter, after last week’s piece:

When I talked of large cap and mid cap stocks in last week’s newsletter, one of the readers wrote to me, to ask about the really low priced shares. Where do those fit in? The reference is to shares whose base (par) value is Rs. 10/- say, and which are being traded at Re 1/- or Rs. 2/- or thereabouts. You can even call these as penny stocks. When one purchases such stocks, the logic is that from Rs. 2/- there cannot be much downward movement, and on the other hand, there is lots of room for that stock to move upwards. Well, I would not recommend that to be a strategy for investing. That there is little room for the stock to go down, and there is a possible large upside, does not make it an automatic choice for investment. Say, you purchase 1000 shares at Rs. 2/-, which makes it a Rs. 20,000 investment. Well, the downside is that this Rs. 20,000 can become zero, because many a penny stock of this kind, sometimes just disappear off the markets. Trading stops. And you are stuck holding shares, which you cannot even sell at a loss. So rest assured that there IS a downside, even at Rs. 2/-. When you put in Rs. 20,000 on an investment, it does not matter if that buys you 1000 shares of Rs. 2/- or 2 shares of Rs. 10,000. Your decision has to be based simply and only on one factor: what appreciation you will get on that investment of Rs. 20,000. This is not to say that there are no good opportunities in such penny stocks. Sometimes there are companies which have been in bad shape, due to which the price has reached such low points, but which is currently going through a serious turnaround. Then its future prospects are good, and in that case, you have a really good buying opportunity. But to pick such opportunities in penny stocks requires more effort, which an amateur investor might find challenging. Hence I recommended only large cap and mid cap stocks, last week.

Okay, having got that behind us now, we will continue the thoughts on picking stocks. I left you with some homework last week. To repeat, I suggested you to shortlist some shares of your choice, and look them up at www.equitymaster.com, especially for the way their graphs were going. Hope that you have done this.

Ideally your starting ‘short list’ could well be around 30-40 companies. For example, you may have chosen 5-6 industry sectors that you feel good about, at this time, and you could have chosen 5-6 companies in each of these sectors. Ultimately, whenever you get down to actual investment, I would recommend a total of 15-20 companies to invest in, but at the beginning, when you set out to do some research, you could start with a larger number. So, say your list included the following companies, viz.

* Engineering PSUs – BHEL, Bharat Electronics
* IT Majors – Infosys, Wipro
* Pharma companies – MNCs as well as Indian – Aventis, Cipla
* Auto Ancilliaries – Bharat Forge, MICO
* Cement – Gujarat Ambuja, Madras Cement

Lets see what key information we would get, if we were to look these companies up, at www.equitymaster.com:

Details of the stocks are given hereunder, in the format: No. / Stock / Industry sector / Price as on 21-10-04 / 52-week HIGH price / 52-week LOW price / Remarks on its graph

1. BHEL - Engg PSU - 629 / 685 / 375 / Rising steadily from May 04
2. Bharat Electronics - Electronics PSU - 538 / 648 / 345 / Risen steadily from July 04; slight drop recently
3. Infosys - IT - 1780 / 1836 / 1031 / Rising steadily from May 04
4. Wipro - IT - 641 / 677 / 396 / Rising steadily from July 04
5. Aventis - MNC Pharma - 849 / 900 / 461 / Gradual rise from July 04; drop in early Oct, and apparent retrieval now
6. Cipla - Indian Pharma - 275 / 302 / 194 / Big spurts from June to July 04, and then from Aug to Sept 04; currently big drop
7. Bharat Forge - Auto Ancilliary - 822 / 890 / 475 / Rising sharply from Jun 04
8. MICO - Auto Ancilliary - 1735 / 1779 / 880 - Steady rise fron June 04
9. Gujarat Ambuja - Cement - 359 / 370 / 220 - Rising steadily from July 04
10. Madras Cements - Cement - 879 / 980 / 551 - Sharp rise from July 04; slight drop in recent times.

Let’s look at the actual graphs of these shares here, for better understanding:












Based on the above graphs and details, here are the few submissions that I will make:

1. If a company is part of the original criteria of selection (heard about, medium or large scale, no negative news about management, etc.), and if the stock price graph is fundamentally headed upwards, there is a very good chance that it will continue to move upwards, and it becomes a good stock pick.

2. Volatility in a share is a concern for an amateur investor. For whatever reason, if a share price moves sharply upwards or downwards few times in a year, there is risk for a retail investor. You may not know why it happens, but a sharp drop could happen, any time, after you invest. You may not have time to react and sell before that. A more stable stock price is a better bet for amateur investors.

3. A 52-week high (highest price the stock has been to, in the past 52 weeks) is a useful number. Compared to wherever the stock price is at this time, if the 52-week high is still a factor away, there is a good chance that the present upward trend will at least reach that level. If the present price is close to its 52-week high, then to continue to rise, the stock has to move to new levels, where there is always a chance of resistance (this will be better understood next week, when we talk of the cyclical movement of stocks).

4. Most of the upward stock movements seem to start at a particular point in time. It would be rare for an amateur investor to get in (get in: purchase the stock!) at that early stage. You probably get in a little later, but still theoretically, if we look at the upward movement, from its current start, we can get an idea of the percentage gain, in the current run. That is a good indicator of its growth prospects, going ahead, especially seeing that in most cases, the slope of the graph maintains a certain level, at least in a particular upward run.

With these thoughts, let’s look at the above stocks, one more time, and conclude which of these may be good stock picks. It may be noted that due to the present bullish phase in the market, all of these stocks seem to be on the rise, and you may find many more of this type, so it’s now a matter of finding the best picks from these. As I have mentioned in earlier weeks, it’s a good time to be in the markets!

We can review these stocks again, and now, the details presented here below, are the following information:
No. / Stock / Rise Start / Start Price / Current Price / Gain % / Annualised Gain % / Volatility / Conclusion

1. BHEL - May 04 - 420 / 630 / 50% / 120% / Steady / Good pick

2. BEL - July 04 - 375 / 538 / 43% / 174% / Reasonably steady / Monitor to see if present drop is start of downturn like it had in Dec 03

3. Infosys - May 04 - 1150 / 1780 / 55% / 131% / Steady / Good pick

4. Wipro - July 04 - 500 / 641 / 28% / 113% / Slightly volatile, esp compared to Infosys / Good pick, but watch for any sharp movements

5. Aventis - July 04 - 720 / 849 / 18% / 72% / Steady / What - only 72%; Better opportunities exist elsewhere!

6. Cipla - June 04 - 200 / 275 / 38% / 113% / Volatile / Avoid

7. Bharat Forge - June 04 - 600 / 822 / 37% / 111% / Scratchy earlier, but steady now / Good pick

8. MICO - June 04 - 1200 / 1735 / 45% / 134% / Scratch earlier, but steady now / Good pick

9. Gujarat Ambuja - July 04 - 260 / 359 / 38% / 152% / Reasonably steady / Decent pick

10. Madras Cements - July 04 - 600 / 879 / 47% / 186% / Slightly volatile, esp compared to Gujarat Ambuja / Good pick, but watch for any sharp movements


It is worthwhile to have compared two companies (in reality, you may look at more than two, from the same industry) to get an idea if a company is behaving very differently from the rest in its industry. Certain movements may affect the whole industry and may be discounted to that extent. You will see in the above graphs that some amount of volatility has affected both companies around the same time.

The above conclusions of good picks do NOT mean that they are worth purchasing right away. We will discuss the concept of cyclical movement of stock prices next week. Then you will understand and appreciate that for a good stock pick also, its best to wait for a good buying opportunity!

Earlier this week, I had a couple of bank deposits that came up for renewal. As I stared at the numbers there, I could barely find a difference between the start amount and the maturity amount, especially after the TDS they deduct. A measly 5.25% does not go ANYWHERE! And look at the above percentages! Are you convinced about stocks yet?!

- Sanjay Mehta