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16 October, 2021 21:44 IST
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Choosing Stocks

There are many theories and techniques about how to choose a winner, how to separate the wheat from the chaff. Some are homegrown, others are technically sophisticated. But beyond the jargon, there are three basic factors to look for while picking a stock:

1. The company itself

2. Its external environment

3. The behaviour of its stock

What happens to the company affects the price of its shares on the stockmarket and, hence, your investment. The legendary investor Warren Buffet (incidentally, once the second richest man in the world) says that he never invests in a company whose business he doesnít understand. As investors, we will do well to follow his practice.

So, knowing about companies is the first essential step in investment. You will need to know the business a company is in, and how is it doing both in absolute terms and in comparison to other companies in the same business. To do that, you have to look at the financial performance of companies and pick up the star performers. You will also need to look at the future of the business itself. Is it nearing the end of its life cycle? As investors, we hope to participate in a business with a lot of scope for growth.

We also need to look at the performance of the entire sector. Whatever for? After all, we arenít investing in sectors. Weíre putting our money in companies and we can get to know them by looking at their performance. Right? Well, look at it this way. Take your own profession. Doesnít what happens to others in the same profession affect you too? If you are a banker and you see other banks laying off employees, you bet your last rupee youíll start worrying whether your bank is the next in line to start downsizing. So, what happens in the banking sector concerns everybody with a stake in that sector.

Just like employees, investors too have a stake in the sector in which they have invested. As an investor, you wish to know the risks your company faces. These are of two types -- one that is peculiar to the company and can be controlled by it (called a unique risk), and the other which is more pervasive and often beyond the companyís control (called a systemic risk). We need to know about both kinds of risks to plan our investment strategy. For example, if the steel sector is not doing too well at the moment (a systemic risk), you may wish to move your investment out of a company in this sector.

A company operates within the broad framework of the economy. Its future is closely linked with the performance of the economy. This is due to the interdependence among various industries and sectors of the economy. Take the steel industry again. To do well, it needs a good demand for its products. Now, suppose the automotive industry or the construction industry is not doing well. Will that affect the steel industry? Of course, it will, because both automobiles and construction industries use steel. If these sectors are not doing well, the demand for steel will drop, affecting the performance of the steel industry. The indicators on the economy allow us to track general trends in the economy. If they donít look very healthy, we ought to be cautious as investors.

Professional stock pickers adopt different processes to analyse stocks. Some adopt a method in which they begin at the general and then zoom in to the specific i.e. they would probably begin with an analysis of the economy. While analysing the present state of the economy they would look at interest rates, what economic outlook the finance ministry projects for the short term and other political events that might have a bearing on the economy. Having reached a conclusion about the economy, the professional will choose industries that he expects will perform well under the given economic conditions. Next, he hones in on some of the companies in the industry, sees how the companies are performing and then evaluates their stocks. The end product of such an analysis is to convincingly answer one question for his investors: Is the price at which the stock is currently selling worth it? The other method works in the reverse way in which the professional analyst picks up a stock, looks at the current and historic performance of the company, then studies the industry and finally takes an overview of the economy.

 
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