3 tips to be a smart stock picker

By Morningstar |  25-07-17 | 
 

When it comes to the subject of wealth, stocks take precedent in any conversation. And many mistakenly assume it to be an exhilarating ride. But if you don't get your basics right, you could lose all your savings. While you cannot control the market, you can control your movements. Keep these 3 points in mind to stay grounded.

1) Have an investing thesis.

Amay Hattangadi, MD, and Swanand Kelkar, ED, at Morgan Stanley Investment Management believe that investors must have an investing thesis. While you can read it in detail here, below is their essential thought process:

There is a Chinese saying that the faintest ink is more powerful than the strongest memory. This is a simple truth about writing things down so that one does not have to rely on memory alone for recollection. Yet, this is lost on many, especially in the investing world.

We were fortunate that early on in our careers we worked under bosses who made us write down stock investment theses, ideally not extending beyond a few bullet points. To borrow a line from Warren Buffett, “this is simple but not easy”.

Ideally, a stock rationale should have three parts.

First, there should be a description of the key business advantages. Some people call this the moat around a business and the description should also include a view on sustainability of these advantages. Deep distribution reach, low cost of production, sustained pricing power or Intellectual Property Rights on a product or service are some examples. One should also look for metrics that reinforce this description of moat like market share and change in market share, superior profitability or return ratios.

Second, there has to be a description of the business drivers for next 12–18 months. If the moat is about the structural advantages, this part is more about cyclical changes that one is expecting. Again this has to be quantified with measurable metrics like expected sales growth, operating margin, earnings, return on equity etc.

Third, it should be clearly defined where one differs from consensus market expectations. If the rationale reads like a consensus report then it is quite likely that all the good things are in the price. An ideal investment opportunity comes along when a solid moat is clouded by short term challenges and the market decides to focus more on the challenges than the structural advantages.

Rationales should end with a ‘review’ price, as opposed to ‘target’ price, which is one’s estimate of what the fair value of the stock should be, based on current information. The emphasis here is on review price rather than a target price because the latter merely denotes an exit price for the stock, whereas often the process of evaluating an existing investment involves periodic review, as and how goal posts are achieved.

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2) Give the balance sheet utmost importance.

Don’t buy a stock simply because earnings are good (they could be volatile, they could be manipulated) or the stock price is low. Fundamental analysis is about using concrete information about a company's business to arrive at the stock’s intrinsic value. And that is what a smart stock picker must do.

Buy a stock only after adequately analyzing the balance sheet. A balance sheet is a financial statement that summarises an organization's assets, liabilities, and shareholders' equity. It gives viewers a snapshot of what's owned and what's owed. It points to the foundation upon which the company stands.

In the short term, stocks tend to be volatile, bouncing around every which way on the back of the market’s knee-jerk reactions to news as it hits. Trying to predict the market's short-term movements is not only impossible, it's maddening. It is helpful to remember what Benjamin Graham said: In the short run, the market is like a voting machine--tallying up which firms are popular and unpopular. But in the long run, the market is like a weighing machine--assessing the substance of a company.

Yet all too many investors are still focused on the popularity contests that happen every day, and then grow frustrated as the stocks of their companies--which may have sound and growing businesses--do not move. Be patient, and keep your focus on a company's fundamental performance. In time, the market will recognise and properly value the cash flows that your businesses produce.

Don’t avoid equity because of volatility

3) Pay wisely for quality.

The difference between a great company and a great investment is the price you pay. There were many fantastic businesses around in 2000 or 2007, but very few of them were attractively priced at the time. Finding great companies is only half the equation in picking stocks; figuring out an appropriate price to pay is just as important to your investment success.

Always have a margin of safety built in to any stock purchase you may make--you will be partially protected if your projections about the future don't exactly pan out the way you expected.

Having said that, don’t buy a stock based on its price alone. What you need to work out is the value of a stock, from which you can then decide if the price is cheap or not. For example, when Warren Buffett first bought Coca-Cola stock many thought it was expensive, yet the price he paid turned out to be cheap.

Seth Klarman in his book Margin of Safety, explains that the real success of an investment must not be confused with its success in the stock market. A rise in the stock price does not ensure that the underlying business is doing well or that the price increase is justified by a corresponding increase in underlying value. Likewise, a price fall does not necessarily reflect adverse business developments or value deterioration.

Hence his advice: Value in relation to price, not price alone, must determine your investment decisions.

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AASHISH TRIVEDI
Jul 28 2017 09:27 AM
True, how are stocks screened, whete can we find standard performance benchmarks? Or a range. Thanks for replying.
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