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Fundamental Analysis Of Stocks - What Not To Do?

In the previous article, you got introduced to fundamentals analysis and why it is important. Everyone does a bit of fundamental analysis knowing and unknowingly while picking stocks for their portfolio. But there are some common misconceptions and bad practices that need to be avoided even while analysing.

1. Don't ignore market cycles.

The market moves in cycles, where few years are more rewarding than others. The macro economics, which is the underlying economics conditions of the nation and sometimes the entire world, drives the market cycle. It is ultimately a supply and demand cycle. The stock market as a whole could under-perform during a down cycle caused by poor demand. Though the valuation parameters of the company remain lower than historical valuation, it can keep under-performing until an up cycle commences. Hence it is important to understand where we are currently to set expectations on the investment period.

2. Don't invest in stocks of business sectors which you don't understand

Not all businesses are the same in terms of applying fundamentals. Some sectors are easy to analyse, while others are difficult. That would arise from your own knowledge about the sector. For example, it would be easy for you to read sales figures of a car manufacturer and understand the consumer demand to determine their performance, but you might not have the expertise to read the inventory data of a secondary chemical manufacturer and the demand for the chemical they produce. If you find it difficult to understand a company's business, even though you get positive external feedback, avoid investing in it. Because, once invested you would not be able to track the performance of the company to take further action on your holdings.

3. Don't hold stocks forever

“Buy and Forget” doesn't always work. Like how an unprofitable company could turn around and become profitable, the opposite can happen too, where there is no benefit to remain invested in such a company. With ever changing business dynamics, the reason why you invested in a company might no longer be valid. Re-analysing your portfolio from time to time will help in cleaning up your portfolio and tune it for better performance. It should be a continuous process.

4. Don't have too many stocks in your portfolio

Portfolio management is time consuming work. Analysing all the companies on your portfolio regularly takes time. Having too many stocks on your portfolio will become counterproductive if you are unable to track them effectively. The ideal number of stocks to keep on your portfolio would depend on how comfortable you are while tracking the stocks.

5. Cheap stocks are cheap for a reason

A stock having low valuation as compared to historical or sector average using parameters such as P/E ratio, is valued cheap for a reason.A temporary valuation drop could be due to macroeconomic factors, but consistent cheap valuation indicates under-performance and low preference among investors. The stock could continue its under-performance for a long time and can become a big wealth destructor. So, while hunting for value stocks, you have to be thorough and should have convincing reasoning on the business to outperform for you to add it to your portfolio.

6. Don't compare financial ratios across sectors

Comparing financial ratios of a company with financial ratios of the sector where it operates in or with its competitors.provides a strong reasoning to buy the stock. But comparing across sectors will not work because the metric changes. For example P/E of the FMCG sector commands higher valuation than that of a PSU dominated sector. This is because, the business model, the industry specific performance parameters and the end consumer demand could lead to varied benchmarks. Always compare companies within sectors or with competitors to accurately identify companies which have higher potential of earnings growth in the field it operates in.

7. Don't ignore qualitative analysis

Though qualitative analysis tends to be vague, it is highly important and shouldn't be discarded while picking stocks for your portfolio. Parameters such as shareholding pattern and promoter pledge ratios give great insight to investor participation and the risk involved. These can be very evident after you realise you had made a bad investment decision when earnings results are announced in the future. Hence make use of these qualitative indicators to avoid possible bad investment choices.

8. Don't apply for all IPOs, FPOs, Rights Issues and Buybacks

Corporate actions are undertaken to manage cash flows. Reasons for companies to raise cash could vary. It could be to service debts or to provide exits to angel investors or to fund CapEx etc. Each of these reasons could be a positive or a negative in terms of investor interests. Understand the reason for the corporate action before taking part in it.

9. Don't invest blindly on tips

Lastly, investment tips from known and unknown sources have led to more heartburn than happy endings. It may not be because of lack of genuineness of the tip, but due to the lack of suitability to you. An investment decision made by another person for their portfolio is not necessarily suitable for your style of investment, investment horizon and risk. Each investor has their own parameters and tolerance to risk and time. Instead of turning tips into actions directly, explore more about the company yourself and take a decision to invest, if it meets all criteria for your portfolio. Tips aren't entirely bad, as it introduces you to an opportunity or a stock which might have been unknown to you.

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1 Comment

LiLaGopal Krishna
LiLaGopal Krishna
Jul 26, 2020

Good one and the need of the hour

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