One day I got a call from a teenage son of my former colleague. He wanted to know about a strategy to pick stocks for long-term holding. On the face of it, the question looks simple, but it has a lot of depth.
The challenge was to explain the stock basics to a teenager without making it sound too complicated. So I decided to start with a simple but effective statement.
One cannot pick any random stock for investing.
It must have a few specific attributes. What are those attributes? One logical feature of that stock must be its capacity to yield the expected returns.
So, for example, let’s assume that our expected return is 15% per annum. Any stock which has the potential to yield returns of 15% or more will be our pick.
What do we mean by the “potential” of a stock? How to identify the potential in a Stock? It is what we know in the next section.
Allow me to give you a five (5) point strategy to pick stocks for long-term holding.
#1. Identify Potential Stocks
How to know if a stock will give the desired returns?
There is a simple explanation. A fundamentally strong stock that is trading at a discount to its intrinsic value has the potential to yield the expected returns. The bigger will be the discount, the higher will be the return.
What do we mean by a fundamentally strong stock?
These are stocks that have their business aligned in such a way that, in time to come, their EPS will grow. With EPS growth, the market price of the stock will also respond with the same intensity.
What do we mean by a discount to intrinsic value?
A stock whose current price is, say, Rs.85, and its intrinsic value is Rs.100. This stock is trading at a price that is at a 15% discount to its intrinsic value. We also call them undervalued stocks.
#2. Overvalued Stocks Are Dangerous
Starters must engage defensively in the stock market. But it is even more important to avoid catching a falling knife, like an overvalued stock.
What are overvalued stocks? There can be two types of stocks that trade at overvalued price levels:
- Weak: These are such stocks whose underlying business has weak fundamentals. Few such indicators are falling sales, reduced profits, negative working capital, sub-zero free cash flow, among others.
- High Demand: These are stocks of such companies whose fundamentals are super strong. Hence their Stocks are always in high demand (like blue-chip stocks). Due to their high demand, they often trade at overvalued price levels.
What to learn from the above two points? It is necessary to buy stocks of strong businesses only. But it is equally important to steer clear of overvalued stocks.
The problem is that popular stocks of the market often trade at overvalued price levels. Hence a starter may get confused and buy them, thinking it is a good buy.
So, always remember the rule: pick stocks of strong business whose current price is low (undervalued).
#3. Look for Strong Business
Picking stocks of companies that invariably represent a strong business is a basic rule.
How to quantify strong business?
Different people may use contrasting parameters to confirm the business fundamentals of the company. But for the sake of explaining it to a teenager, I’ll use the following two parameters:
- #1. Profitability: It is a measure of how much profit a company generates for every rupee of its capital. Suppose there are two companies (A & B). They have Rs.100 each to do business. A & B generates a profit of Rs.15 and Rs.18 respectively. B is a stronger company. How? For the same capital, B is generating more profits than A.
- #2. Growth: A growing company is the investor’s favorite. No matter how small is the company today, if it is growing, it will eventually gain market share. Investors will bank on such companies. They will even pay a premium to buy growth stocks.
A safe strategy to pick stocks for the long-term is to be on the lookout for a strong business. How to find it? It is a combination of profitability and growth.
#4. Check Market Share
Checking market shares gives an idea of the competitive advantage of the company. In this step, we will compare companies within a sector. It will make one aware about which are the top three companies of the lot.
How to do it?
To make things easier, one can use my blue-chip stock screener. It will give a fair idea. Select the screener from the drop-down list as shown below.
Next, pick a sector and an sub-sector (industry) from the drop down list. See below:
After a pair of sectors and industry is selected, a list of all stocks will appear (of that industry). The purpose is to know, out of all the companies, which one has the largest market share. Check their details.
One of the detail in the table is “Income” (represents market share). Pick the biggest three companies in terms of their income.
These three companies are the market leaders of that Sector/industry. As an investor, we would like to buy stocks of these companies.
#5. Check Price Valuation
Intrinsic value is that number that converts the qualitative value proposition of the company into a quantifiable number. A more colloquial name for the Intrinsic Value is “fair price.”
The conversion takes place using valuation models (like NCAVPS, DCF, etc) developed by experts. These valuation models quantify the strengths and weaknesses of a company and bundle them together to estimate the intrinsic value.
How intrinsic value helps?
An investor can compare the estimated intrinsic value of a company with its stock price. If the estimated intrinsic value is higher than the current price, the stock is undervalued. These are what we call potential stocks.
It is also true that the application of valuation models is not easy for beginners. Such people can use my stock analysis worksheet. The worksheet can estimate the intrinsic value of its stocks upon the click of few buttons. It is an automated process.
The theory says we must only buy stocks of strong business at a low price. To do this, we must analyze stocks.
But a practical problem with this theory is that our market consists of more than 5,000 number stocks. It is not possible to do a fundamental analysis of all Stocks.
What is the way out?
A starter must keep these two limitations in mind. First, one cannot buy stocks without analysis. Second, there are about 5,000 number stocks in the market. We cannot analyze all.
How to deal with it? First screen and then analyze. Check the below two steps:
- #1 Screen: Analyzing 5,000 stocks is not possible. So we must first know how to prepare a shorter list of potential Stocks. Adding only profitable and fast-growing stocks to the list is the trick. We can also consider adding companies with a high market share within their industry. Quick Tip: Check our stock screener.
- #2 Analyze: Once we have a shorter list of stocks, we can go about analyzing them. But how a starter (newbie) can analyze stocks? The probability is that they know virtually nothing about stocks. For such people, I’ll suggest reading my stock basics series. It will help to build the basics.
A reliable strategy to pick stocks is developing ones own know-how of value investing. This is a fool-proof investment strategy. What we have discussed in this article are extracts from the total theme of value investing. Go for it, you will not regret the step.
Thanks for reading. Have a happy investing.