Six key steps to follow when selecting stocks

Having decided to follow fundamental analysis in investments, it is wiser to get the support for your valuation figures by computing Piotroski score.

By N Sivasankaran

Market crashes offer several valuable investment lessons for all investors. Young investors in their thirties need to learn the following lessons.

The market is inefficient
Market crashes provide a lot of strength to the belief that the market is inefficient, i.e, market rises and falls on irrational hopes, emotions and sentiments and the indices and individual share prices do not reflect information efficiency. Information traders and speculators could drive the indices either upwards or downwards on their beliefs and desires. Hence the market does not price the securities fairly.

What goes up will fall and vice versa
The price of the share is not constant. It shall take an up-down or a down-up journey. One should not take a bullish or bearish view because the price showed an increasing/decreasing trend in the near past. Most of the time, share prices move on collective beliefs and sentiments of the market participants. Therefore, movement of prices does not tell us anything about the intrinsic value of stocks.

Fundamentals are to be believed
We should select a stock based on its fundamentals such as dividend payout ratio, return on equity, net profit margin, competitive advantages, nature of business, operating leverage, and financial leverage. One should not decide on the basis of one quarterly or annual report as it is possible for a firm to perform extremely well or poorly on an extraordinary period and hence, going by the five-year ( or a reasonable period) average figures may be prudent.

Get support from Piotroski’s Score
Having decided to follow fundamental analysis in investments, it is wiser to get the support for your valuation figures by computing Piotroski score. It is computed for a stock based on 9 sub-parameters such that a stock gets a score on a scale of 0 to 9. If a stock gets a score of 8 or 9, then it is strongly recommended to invest in it and if its score is less than 2, it is a definite reject and if the score is between 3-7, it is a doubtful case.

Pass the M score
Firms follow earnings management practices. Therefore, it is better to approach the valuation of a stock with skepticism and remove the fear of losing money by running the Beneish M Score or any other manipulation detective exercise. One should not pick up a stock which fails in the manipulation test.

Value is in the range
Valuation is never a precise single figure. We cannot state that the share price of a firm is worth Rs 500. This is because valuation output is the outcome of several assumptions considered by the valuer. Therefore, it is a good practice to perform a sensitivity analysis and conclude stating that the value of this stock is in the range of Rs 350 to Rs 600 with a median value of Rs 400.

We may go wrong in our assessment even after following the above stated precautions. Therefore, it is pragmatic to construct a portfolio of stocks with promising fundamentals rather than investing the entire corpus in a single stock.

The writer is associate professor, Finance, XLRI School of Management, Jamshedpur