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How to pick a stock for investing?

  • Marisha Bhatt
  • Nov 22 2021
  • 9 minutes
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Stock markets have been an attractive investment option for millions of investors. Especially in the post Covid 19 pandemic scenario, there has been a huge increase in the number of investors that have entered the markets. Nearly 2.37 crore investors have joined the stock markets just between the period of March 2020 to September 2021. While entering the stocks markets is quite easy, picking the right stocks and maintaining a profitable position is quite difficult. The primary question concerning new as well as seasoned investors is how to pick a good stock for investing?. 

Let us discuss some of the basic tips or tricks in picking stocks while investing to have a profitable portfolio.

What are the primary requirements before investing in stocks?

Before selecting the right stocks for investment, investors have to first understand certain primary conditions before taking the plunge into the stock markets. These prerequisites have been discussed below.

a. Setting investment budget

The first and foremost requirement for investment is capital investment. Investors have to decide their investment budget based on which they can decide the category of stocks or the volume of stocks that they would want to invest in. Also, while setting the investment budget it is important to note that investors should initially invest with only surplus funds. This is to ensure that their routine financial obligations are not disturbed. 

b. Identifying risk appetite

Investment in stocks is never risk-free. However, there are various categories of stocks that have different risk profiles. For example, large-cap stocks have relatively lower risk as compared to mid-cap stocks while small-cap stocks have the highest risk. Investors can assess their risk appetite and invest in their preferred category of stocks. Having a diversified portfolio with varied categories of stocks also reduces the overall risk of the portfolio and ultimately benefits the investor with better returns at relatively manageable risks.

c. Setting returns expectations

The returns expectations of the investors play a major role in picking the stocks. Having a profitable portfolio is every investor’s expectation, however, the expectation related to the degree of returns (for example-high, moderate, or low returns) is another crucial factor in stock selection. Usually, stocks having high returns have a higher risk factor too and this has to be duly considered by investors while picking stocks.  

d. Setting the financial goals 

Investors have to define their financial goals to pull together a portfolio that is in line with such goals. For example, investors in their 20s and 30s who are planning to build a retirement fund can invest in small-cap or mid-cap stocks as they have time on their hands. On the other hand, an investor in their 50s with only a few years away from retirement cannot afford to take risks with their capital, hence should invest in less risky stocks.  These stocks have a proven track record and stability as well as low to moderate returns. It can help grow the portfolio as well as provide better capital stability. 

What are the top tricks in picking the best stocks for investment?

After considering the above prerequisites for entering the stock markets, let us discuss some of the basic tips or tricks for selecting the best stocks for investment. 

a. Set the investment strategy

Firstly, investors have to decide their investment strategy. This involves selecting the type of stocks that the investors want to focus on. Stocks can be classified based on many broad categories, investment strategy being one of them. Investors can pick value stocks, growth stocks, or dividend stocks.

  • Value stocks are stocks that are undervalued as compared to their competition but have strong fundamentals making them a lucrative investment opportunity. These are ideal as long-term investment options.
  • Growth stocks provide higher returns as compared to their peers and provide high growth potential. These stocks are an excellent addition to the portfolio to increase the overall returns. 
  • Dividend stocks on the other hand are suitable for investors who are relatively risk-averse and looking for a steady source of income.

b. Select the target sector or industry

There is an array of investment options for investors in the stock markets. But it is difficult to keep track of all the latest developments in every industry and their impact on all the stocks. Hence, it is advisable that the investors should select their target sectors or industries for investments and focus on the movement of prices and the latest development in such sectors making it easier for them to manage their portfolio. 

c. Undertake thorough research and analysis of selected stocks

Investment in stock markets requires a thorough understanding of the markets and individual stocks. The prices of the stocks are a reflection of the demand-supply forces of the market as well as the performance of the company. Investors, therefore, need to carry out basic fundamental analysis as well as technical analysis of the stocks to ensure that they make an informed decision and reduce the risks of investment.

d. Consider the stock performance in relation to its competition 

The performance of the stocks also has to be reviewed in comparison to its peers along with its relative performance as per industry average. This will give an idea about the position of the company in the industry whether the stocks have the potential to sustain for the long term.

e. Consider the debt-equity position of the company

While conducting the fundamental analysis of the company, it is important to pay attention to its debt-equity position. The debt-equity ratio of the company should be favourable and has to be compared with the industry average. It is to be noted that if the company has high levels of debt, it should have corresponding resources to service such debt levels failing which can also lead to bankruptcy. Apart from the debt-equity ratio, several other ratios need to be considered by investors as part of their fundamental analysis. Some of the important financial ratios and their relevance are given below.

RatioMeaning/ Relevance
PE ratioIt is the ratio between the market price and the earnings of a company. A higher PE ratio could be interpreted as the share being overvalued or high growth expectation of the shareholders,
PB ratioIt is the ratio between the price of the stock and its book value. A higher PB ratio could also indicate the stock being overpriced. The ideal PB ratio varies from industry to industry and is influenced by many factors.  
Earnings Per Share (EPS)EPS is the share of the net profits that are earned by the shareholders per share after deduction of all the expenses of the business. A higher and constantly increasing EPS translates to the stock being preferred by shareholders and the business is considered to be highly profitable with good growth prospects.
Interest coverage ratioIt is the measure of the company’s ability to pay its interest commitments. A higher interest coverage ratio assures the shareholders and investors of the company’s financial health whereas a lower interest coverage ratio indicates a higher debt burden possibly leading to bankruptcy or insolvency. 
Return in equity (ROE)It is the measure of the return earned by shareholders on the net assets. A higher or increasing ROE reflects the optimum usage of capital and the ability to generate more returns at existing capital. On the other hand, a lower or decreasing ROE can be interpreted and excess capital need of the business or inefficient usage or allocation of capital. 

f. Pick stocks having strong sales and growth projections

Another key factor in picking stocks is the strong sales and growth projections of the company. This will ensure the survival of the company in trying times as well as ensure better growth of the company in comparison to its peers. 

g. Consider the dividend history of the company

Dividends are part of the profits of the company that are shared with the shareholders. A growth-oriented company prefers investing the dividends back into its business while the dividends stocks focus on providing regular returns to the shareholders.

It is also prudent to not rely heavily or solely on the dividends paid by the company as a measure of its profitability as there could be a case of window dressing of the company position. It is therefore necessary to keep track of the dividend history as well as other fundamental ratios to make an informed investment decision.

Conclusion

Picking profitable stocks is the key to having a successful; portfolio. However, with the multiple options available in the market, it is quite difficult to select stocks that can perform consistently well and prove to be a safer bet against market volatility. Investors can follow the above tips and tricks to have a relatively better portfolio. On the other hand, new or risk-averse investors can also focus on the portfolio of top mutual funds and make it their basis to select stocks for investment. 

FAQs

Is a Demat account necessary to start investing in stocks?

Yes. It is mandatory to open a Demat account to start investing in stocks.

How can a new investor invest in stocks?

A new investor can invest in stocks by purchasing them directly through stock markets or by hiring a broker who can invest on their behalf.

What type of stocks are a good option for novice or risk-averse investors?

Large-cap stocks are relatively stable and hence provide decent returns with relatively lower risks. These stocks can be a better option for risk-averse or novice investors while starting their investment in stock markets.

What are the categories of stocks that aggressive investors can select?

Aggressive investors can select mid-cap or small-cap stocks. These stocks have higher risk but provide relatively higher returns than large-cap stocks and can be a good addition to increase the overall profitability of the portfolio.

Is technical analysis sufficient while picking stocks?

No, Technical analysis alone can provide only short-term analysis of a stock. Fundamental analysis is also crucial in portfolio building to select stocks that can provide better returns in the short term and long term. Hence, technical analysis alone is not sufficient while picking stocks.

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