In this mini series on how one should pick stocks for investment, I had previously provided some general guidelines in the first part, followed by a discussion of the top-down method of stock selection in the second part.
The bottom-up method of selecting stocks for investment is by far the most time consuming and difficult, particularly for people who don't like to play around with numbers.
Why is the bottom-up method of stock picking difficult? Because you have to sift through thousands of listed stocks to narrow down to the hundred odd companies that meet the basic criteria of being truly investment worthy.
After doing that, you will need to check the fundamentals of each and every one of those short-listed companies to separate the wheat from the chaff. Now you know why brokerages and financial institutions maintain expensive research departments!
One way to cut short the time and effort is to combine the top-down method with the bottom-up method. In other words, first select the handful of sectors that you have some knowledge about. Then limit your stock picking to only those few sectors. That would be by far the safest option for picking stocks for your core portfolio.
There can be no better guide for selecting good stocks than the biggest 'guru' of them all - Benjamin Graham. I learned all about stock picking from his book, 'The Intelligent Investor'. Till date, I use the guidelines suggested by him - with suitable modifications for the Indian environment.
'No risk - no gain' is an old saying. The bottom-up method is the only one for choosing the smaller and somewhat riskier bets for your 'mad money' portfolio. Here are Graham's guidelines for stock picking for the conservative investor, suitably modified:-
1. Adequate size. Market capitalisation, i.e. current share price multiplied by the total number of shares issued and subscribed, should be at least Rs 100 Crores.
2. Strong Financial condition. Current assets should be twice current liabilities, and long-term debt should not exceed working capital.
3. Earnings Stability. Positive earnings per share (EPS) for each of the past 5 (preferably 10) years.
4. Earnings Growth. At least 50% cumulative growth in EPS for the past 10 (preferably 5) years.
5. Dividend record. Consistent dividend payment for the past 5 (preferably 10) years.
6. Moderate P/E ratio. Current share price divided by the average EPS for the past 3 years should not exceed 15.
7. Moderate P/BV ratio. Current share price divided by the book value per share should not exceed 1.5.
Graham also suggested that the result of multiplying the P/E ratio by the P/BV ratio should not exceed 22.5 - for cases where either the P/E ratio is higher than 15 and the P/BV ratio is lower than 1.5, or, the P/E ratio is lower than 15 and the P/BV ratio is higher than 1.5.
So there you have it. This is no secret recipe for untold riches. Stocks picked using these guidelines may not perform as expected. Stocks which do not meet many of the above criteria can fly through the roof. That is the nature of the beast.
During bear markets, you may find most of the listed stocks meeting the above criteria. In bull markets, only tiny caps may meet the guidelines. The in-between stage - like now - is a great time to start your research work for identifying strong stocks for the next up move of the bull run. It will happen after the inevitable correction to the 3 months long rally.
A good starting point is to buy a copy of Capital Market magazine, or visit www.moneycontrol.com for checking out the database of companies, and apply criteria numbered 1, 6 and 7 above to prepare a preliminary short-list. Check whether the short-listed companies have positive cash-flows from operations for at least 4 of the last 5 years.
The ones that make the grade can then be run through the guidelines mentioned in 2, 3, 4 and 5 above. You will finally have a 'buy list' that you can start tracking.
Oh! I almost forgot to mention the corollary to the earlier saying. It is 'no pain - no gain'. For readers who do choose to suffer the pain, there will be a guaranteed gain. I will technically analyse your choice of the 5 top picks from your list and give you approximate buy and sell targets. Absolutely FoC (free of charge).
Now, that can be a ticket to decent money-making, if not untold riches!
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