“One of my friends, Mr. Kishore, asked me, “Tell me about four or five stocks that can provide at least 20% returns in the next year.” Small investors typically ask such questions, and they have the impression that some mantra or magic formula exists to attain success in the stock markets. Market analysts or gurus are sometimes believed at face value in the same way that people believe and follow spiritual gurus. Given the fact that stock selection and portfolio management are highly complex, no “one size fits all” approach or formula exists.
I had to explain to Kishore that stock selection is a science as well as an art and requires research, time, and effort. Stock selection is one of the key components of managing a portfolio. It is not just about picking and buying a few stocks. Stock selection entails understanding an investor’s financial situation, income requirements, risk appetite, investment horizon, financial goals, and personal commitments.
Once the investor’s profile is understood, we also need to look at the country’s economic situation and industry trends, and then develop a shortlisted set of stocks after evaluating the market situation. Out of the shortlist, one actually purchases a few stocks and holds them in one’s portfolio.
Why a Process?
When you buy a laptop, you have several parameters to consider, including cost/budget, screen size, RAM or memory, hard disk capacity, type of keyboard, weight, monitor, accessories, and others. Moreover, you compare prices at different retailers and speak to friends, relatives, or other folks to understand their experiences or get advice.
This entire research process takes a few weeks or months before you actually buy the laptop of your choice. Why not apply the same process for selecting stocks? Doing so takes time and effort but it is not very difficult and the results are worthwhile”
Various factors can influence your selection of stocks, which include:
- Personal Financial Situation
- The Economy
- Industry Trends
- Company/Stock-specific Factors
The combination of economy, industry, and company-specific factors is also popularly known as fundamental analysis. If you have a fundamental understanding of the previously discussed points, you can use them as a guide to selecting stocks. However, select your stocks gradually by adding one or two stocks at a time rather than designing a portfolio at one shot. Fundamental analysis and studying your personal financial situation will help you identify the right stocks for you.
Personal Financial Situation
The first step is to asses one’s own financial position. If you are not able to assess your situation, please start by preparing a budget to track your monthly income and expenses. Once you do this, you will know how much you save and how much you can afford to invest. If you have too many commitments and loans to service, you will not have significant savings and very little left for investing.
Hence, before you start investing, be sure that you are able to save a sizable portion of your income (say. 35–40%). Once you do that, you can keep three months of funds on the side as a reserve for emergencies and use your remaining savings or surplus to invest in different avenues, such as fixed deposits, stocks, property, gold, and others.
The progress of the economy decides the fate of several industries and their companies. For instance, a slowing economy that results in many people losing their jobs affects sectors such as housing, automobiles, and durable goods purchases.
Why? Many people tend to postpone their home or car purchases during difficult economic times. Further, in an uncertain economy, taking out loans can be risky and people may panic, which can negatively affect the business performance of car manufacturers such as Maruti and Tata Motors and, thus, the stock prices of these companies.
Several economic indicators can have an effect on the markets. These include:
- Gross domestic product (GDP) in India
- Inflation rate (wholesale price index / consumer price index)
- Per capita income or household / family income
- Index of industrial production
- Other economic indicators
Several industries, such as agriculture and consumer goods, are closely linked to economic growth and trends. For example, if the country’s GDP grows, a higher demand will exist for groceries such as rice, wheat, and vegetables and greater demand will exist for personal care products such as soaps and shampoos. Hence, companies in the fast-moving consumer goods (FMCG) sector obviously do well. Similarly, increases in per capita income positively influence demand for several products and services. For example, Mr. Arun may buy shares in Hindustan Unilever and Godrej Consumer Goods given the strong demand for FMCG products.
To understand how a country’s economy is performing, you just need to understand current events and trends within that country, including political stability and government policies. However, you do not have to be an economist or hold a PhD; you simply need to be aware of the state of the economy as a whole and how its status affects markets.
Economic Cycles: An economy goes through boom periods and recessionary periods. During boom periods, people are confident and positive about their future and tend to spend more and consume more. During a recession, people cut back on their expenses, which halts economic growth and leads to lower demand for products or services. Like economic cycles, industry/business cycles also exist.
Certain trends may be common across two or more companies within an industry. High fuel prices that affect auto industry sales, the high fuel costs and taxes that affect the airlines, or the strike at the Maruti plant and other manufacturing units are examples of certain events or the general industrial environment affecting different industries. Similarly, some industries are tightly regulated, such as banking and public transport.
“Investing in two companies with complementary business cycles provides diversification to the portfolio. For example, Mr. Kumar invest in two stocks, A and B, in which A produces and sells sunscreen products, whereas B produces and sells moisturizers.
During the summer and warmer months, stock A’s company will sell more sunscreen products and make money, but sales and profits will slow during the winter. However, stock B’s company will do well in the winter and perform badly in summer.
In a nutshell, Kumar is sure that depending on the season, one of his stocks should do well (making good for the other). This small example shows how diversification helps you reduce the risk of holding a single stock. However, many other ways exist for diversifying your portfolio”
Business or Industry Cycles (Seasonality): Some industries have a seasonal trend or pattern. For instance, auto (car) sales during the months of August, September, October, and November are generally high. Such a trend may not be mathematically perfect but it tends to show some growth during these months. Similarly, during the months of April and May, greater demand exists for domestic travel and vacations, which is a positive for travel companies and the hospitality industry (hotels).
Company/stock-specific factors may be divided into two buckets: qualitative and quantitative factors. This classification is used simply to promote conceptual clarity; however, in reality, some areas may overlap between both qualitative and quantitative heads.
Qualitative: These factors include quality of management, business practices, a company’s strategies, and corporate governance practices.
Quantitative: These factors are related to a company’s financial performance and typically include the following:
- Balance Sheet
- Income Statement (Profit & Loss Account)
- Cash Flow Statement
In addition, various other reports, such as presentations and annual reports, give investors a glimpse of the company’s performance. Sometimes, comparative data on peers and the industry are used to show how a company is performing relative to its peers.
On the surface, qualitative information appears to be simple, but it is more complex because it involves making a subjective judgment about a company’s management, their capabilities, and past track record, among other information. Although making such judgments is difficult, one can still intuitively understand the analysis from the news and the latest company press releases, media news or investing portals.
If you want to know an expert’s view on specific stocks, visit www.insiderinvestments.in (Disclaimer: Readers are advised to use their personal judgment and take professional advice before acting on the recommendations provided on this site).
This discussion clearly shows that an investment portfolio needs to be well balanced and diversified to provide stable returns across different economic/business cycles. Stocks from complementary industries with a strong brand franchise and track record have to be a core part of the portfolio.
Companies in the portfolio have to be strong financially in terms of sales and growth in profits, and must have good quality leadership or management. Because these factors are a mix of quantitative and qualitative aspects, investing is naturally a science as well as an art. If you select stocks using the previously mentioned parameters with a clearly defined process, you can generate stable returns in the long run.