Tuesday, October 19, 2010

How to pick those winning stocks - Overview (I)

Wouldn't be wonderful if you could master the techniques for picking those mutli-bagger stocks.
Many investors believe that there is some elusive stock picking strategy that would allow them to identify the sure winners. The truth is that there is no such sure-fire method for picking stocks. What we have are some strategies to improve our chances of making a profit. Some of the well known stock picking strategies are:
  • Fundamental Analysis
  • Quantitative Analysis
  • Value Investing 
  • Contrarian Investing
  • Growth Investing
  • GARP Investing
  • Income Investing
  • Dogs of the Dow
We are starting a series of blogs that explains these stock picking strategies. This will go in parallel with the series on technical analysis. To start with, lets take a look at an overview of these investment strategies before we jump in to dig deeper. We have split the overview into two parts, this is the part 1 on the overview.

Fundamental Analysis
Fundamental analysis is used to identify the intrinsic value of a company's shares. A stock that is priced below its intrinsic value can be bought as there is a good chance that the price will rise to the at least the intrinsic value. A stock that is priced above the intrinsic price is costly and should be avoided. The intrinsic value of a stock is the sum of all future profits of the company discounted to the present. The discounting to the present is done to adjust for the fact that the value of Rs 100 that you receive 5 yr from now will be less than the value of Rs 100 that you receive now. The issue here is that it is very difficult to reliably predict the future profits of a company. One can use the companies financial results to see the historic cash flows and profits and then try to predict the future cash flows and profits. Financial results of a company can give some measures, like EPS, P/E ratio, Growth rate, Price earning to growth (PEG), Return on invested capital (ROIC), Price to Sales (P/E) ratio, Market cap, Enterprise value(EV), EBITDA etc, that can be used to value a stock. Also there many theoretical models, such as the Gordon growth model, that can be used to value a stock.

Qualitative Analysis
Qualitative analysis tries to ascertain the quality of a company by judging the strength of the management team of the company. In order to understand the quality of a company, one should ask 5 Ws: 
  1. Who: Who are occupying the leadership posts such as CEO, CFO, CIO, and COO.
  2. Where: Where did these people come from, i.e. educational and employment background.
  3. When: When did this team start leading the company
  4. What: What is the companies management philosophy
  5. Why: Why have they become managers
Next in line is understanding the business model of the company, i.e. what are their products or services and how do they make money? This understanding is critical in judging whether the company is viable or not and also its growth potential. We also need to understand the competition for the company in the market.

Fundamental analysis and qualitative analysis are the cornerstones of stock analysis. Almost all other stock-picking strategies use various aspects of either or both of these strategies. We will look into the other stock-picking strategies in the next part of this series. 
cont. in part 2