Picking Stocks

“I have a full year’s savings with me and equity investments look attractive at this stage. Tell me, what stocks to buy?” I was surprised when my friend shot this question at me. But my friend isn’t the only one eyeing the equity plunge.

With markets beginning to look up again, such enquiries are on the rise. So, how do you decide which stocks to buy, that too in a market that has already run up considerably?

Granted, picking stocks is not as easy as shopping for a pair of jeans. But then, certain basic aspects of making a choice hold good for both. For instance, the value-for-money proposition or the “would-it-fit-me” question still remains the same.

Broadly, there are two ways of selecting a stock — top-down approach and bottom-up approach. The top-down style involves identifying sectors first and then getting down to stock specifics — akin to getting the ‘big picture’ first.

The bottom-up approach, on the other hand, entails a stock-specific approach to investments, giving higher weightage to a thorough analysis of the company, while remaining relatively uninfluenced by macro-economic trends or concerns relating to that sector. Whichever of the two you opt for, note that there are some basic tests that the stock you eye should clear before it becomes a part of your portfolio.
Financial filters

Compounded growth

The compounded annual growth rate (CAGR) in sales and profits of a company would give you a picture of the historic performance of that company over a longer time frame.

This becomes more relevant as the CAGR also irons out the lumpiness in the growth numbers of a company during that time.

For instance, while the year-on-year sales or profit growth would tell you how the company has performed in that particular fiscal year, the yearly performance, however, may be prone to seasonality.

So, to that extent, it could be misleading. CAGR, on the other hand, may help give a perspective on the average sustainable growth rates.

For instance, take the case of Hindustan Unilever and Marico. While for the last fiscal year, Marico grew its sales by 25 per cent, HUL reported a sales growth of about 46 per cent.

This growth picture, however, would change considerably if we consider the compounded growth rates over the last five years. While HUL reported a sales growth of 14.11 per cent, Marico expand its sales by 21.87 per cent during the period.

Operating profit margin

Operating profit margin denotes the sales margin left with a company after meeting all its operating expenses. This is different from operating profit.

For example, Hero Honda posted an operating profit of Rs 692.60 crore for the quarter ended June 2009 while Bajaj Auto, for the same period, posted an operating profit of Rs 454.54 crore. While on the face of it, it may seem that Hero Honda made more money from its operations, the story changes if you consider operating margins for comparison. Despite a lower operating profit, Bajaj Auto has a higher OPM (21.12 per cent), while that of Hero Honda stood lower at 18.17 per cent.

Price earnings ratio

Price to earnings multiple of a company indicates the price the stock market is willing to pay for every rupee of earnings generated by a share of the company.

Typically, stocks with high PE ratios indicate that their stock price is at a premium to their earnings, whereas ones with lower multiples are believed to be a discount.

On the whole, the general perception is that stocks with low PE offer better growth potential. For example, between Maruti Suzuki and Mahindra and Mahindra, while Maruti Suzuki trades its trailing four quarters earnings at a PE ratio of 33 times its peer M&M trades lower at about 24 times.

But even as the general idea is to spot stocks that are trading at a discount to their intrinsic value, note that a lower PE doesn’t necessarily mean that the stock has a potential to appreciate. In some cases, the market accords a lower multiple to certain stocks in keeping with the overall business dynamics of those companies. On a similar line, a higher PE also doesn’t necessarily mean premium valuations.
More to go

While these filters will help you line up a list of suitable stock candidates, know that these tools by themselves aren’t enough to spot the right stock.

You may need to employ other filters and take a closer look at the company-specific financials, its balance sheet strength, cash flows and management bandwidth before making an investment.

via Business Line