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The Art Of Stock Picking

Building your own portfolio of direct equity investment is an exciting and challenging process. When you are buying shares of a company, you are buying a part of their business itself. For that reason, your decision to buy the share should be well thought out, about the prospects of the company for the period you want to be invested in. Every investor would do the first step correctly by identifying the business sector and future potential for growth in that sector. Based on that, stocks of the favourable sectors are bought. Even though this is a common knowledge on portfolio building, still investors end up with bad investments accumulated over time. It could either mean that they are picking the wrong stock or they are picking the right stock at the wrong time.

There are 2 schools of thought for stocks analysis, Fundamental and Technical. Fundamental Analysis (FA) of stocks involves analysing certain parameters and financial ratios that gives us insight on how well the business is run. Technical analysis (TA) of stocks involves analysing the price action and volume of the stocks traded to gauge the direction and momentum of the stock prices. There is always a conflict of opinion on which school of analysis is best suited for stock picking between practitioners of both types. Both methods has its own benefits and drawbacks. That gives us the opportunity to use the best of both worlds to pick stocks for our portfolio.

Fundamental analysis provides details about the profitability of the business. P/E ratio, EPS, P/B ratio, D/E ratio, EDIBTA, ROCE, PEG etc are some of the fundamental parameters that help in evaluating a stock. Quarterly results and Annual results help us to determine if the company's sales, revenue and profit are expanding. These form the basis of forecasting the expected profitability of the company based on it's prospects. Shareholding patterns and promotor's pledged ratio of shares also give an unique insight on the health of the company. A QoQ evaluation of shareholding ratios and pledged shares will help you understand the institutional and insider outlook on the company.

"Build Your Watch-list With Fundamentals."

But more importantly, fundamentals can help in peer comparison. Assuming you have shortlisted a stock based on these parameters which says the company's financials are healthy, how do you know if this company is better positioned than its competitors? The goal is to buy into the most profitable stock from a list of competing stocks in the same sector. For that reason, comparing the fundamental parameters with the sectoral average/benchmark or a direct comparison with the competitors is necessary. Comparison of stocks can only be done via fundamental parameters and not via technicals. That is the true advantage of using fundamental analysis. It helps as an elimination criteria and thereby investing in a company that has the most potential and probability to generate higher returns.

Does that mean technical analysis is not useful for stock picking? No, it has an equal importance in the process. Let us say, you had shortlisted a stock from a promising sector by eliminating all competitor's stocks from your watch list. You choose to buy the stock on the very same day you had shortlisted it. But due to external factors and overall direction of the market, if the stock is on a down trend, you would have bought the stock at the higher end of the price range. A down trend could last anywhere between a few days to few months, thereby the effectiveness of the investment is lost as it gives a negative return for the time until the direction of the price reverses.

Technical analysis can mitigate this problem of capital erosion until the stock is conducive for investment. Technical analysis methods like Candlestick patterns, Trend lines, Support and Resistance, Volume Profiles, Moving Averages, MACD, RSI, Stochastics Momentum Index etc, can help in buying the shortlisted stock during an uptrend instead of being stuck on a downtrend. It helps you to understand the direction and momentum of the stock. If the stock is on a down trend, the money can be parked on a different asset which is appreciating, to make optimum use of your capital. Thus making use of technical analysis can help you avoid losing money in-spite of selecting the right stock.

"Buy The Stock With Technicals."

Once a stock is added to your portfolio, occasional evaluation is required to check if the fundamental parameters are still favourable to remain invested in the company. Businesses are very competitive and dynamic. The underlying conditions for the business in a sector could be cyclical and the fundamentals could change for the sector as a whole. Or, a competitor could improve their business model to capture the market share away from the company you had invested to become the market leader. In either case, the fundamental reasons for which you invested in the stock would have changed and there is no incentive to remain invested. This provides the trigger for you to exit the stock. But, fundamentals do not drive the stock prices in the short term. Fundamentals are for the long term. Fundamentals could be deteriorating, yet the stock prices could be appreciating in the short term. This is caused due to the inherent bias and greed of investors, which drives the upward momentum in the stocks. But eventually the fundamentals take control to push the stock price lower on the long term. This anomaly can be exploited to exit the stock at a higher price by making use of technicals, which alone helps you to determine the momentum.

Stock picking shouldn't just be a process, but a blend of multiple criteria which makes it an art. For both fundamentals and technicals, a good understanding of the basics is required to appreciate the value it adds to the process. Both types of analysis provide numerous parameters and indicators to choose from, which makes it challenging. But with experience, the right decisions can be made and a healthy equity portfolio can be built.

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