Do You Know How To Pick A Good Stock?

Our job, as analysts, is to find stocks that will give us reasonable and positive returns, regardless of the macro market environment. Why "just reasonable", you ask.

The stocks we choose may not necessarily give the highest returns, as these usually entail a high degree of risks. Whilst the goal of investing is to maximise profits, an even more important objective is to avoid making losses. And that means not taking on excessive risks.

"Rule No.1: Never lose money. Rule No. 2: Never forget rule no.1" - Warren Buffett

How to pick a good stock

Picking a good stock is, often times, part science and part art. There is no absolute right or wrong. But having more information on the company will always serve you well. As they say, knowledge is power.

Critically, picking stocks with solid underlying fundamentals will limit your losses, in case things do not turn out the way you expect. And there will be times when you will be wrong and expectations go awry. Losses are an inevitable part and parcel of investing. The key is to minimise such occurrences.

Equally important, when it is clear that the prospects you expect is no longer viable, cut loss. Do not hold on to losers. It will be painful but you will be better off recycling your money into another stock with potentially better returns. To be clear, we are not talking about buying or selling based on short-term market sentiment, emotion and herd mentality.

Here are some of the common attributes we look for when evaluating stocks.

Fundamental and Valuation Scores

The company's earnings are the main driver for stock prices over the longer-term.

Stocks has simplified the task by condensing key metrics such as profit margin, return on equity, gearing, liquidity and gearing into a Fundamental Score for each company. The score ranges from zero to 3. The higher the score, the stronger the underlying fundamentals.

A company with good fundamentals would still have to be attractively valued, which could determine how much gains there are to be made. Again, Stocks has simplified this search down to a Valuation Score, taking into account current share price relative to growth and ROE, yield and book value. This score also ranges from zero to maximum of 3. The higher the score, the more attractively valued is the stock.

Earnings, cashflow and balance sheet

Historical financial track record is important. Although the past does not guarantee the future, it usually provides good guidance.

You must, however, ask yourself if there is any structural change – whereby the past is no longer a good guide to the future. For instance, a major change in industry outlook, key management change, change in business direction, the emergence of new competitors, substitute products or services and so on so forth.

Look at the trend in sales over the last 5 years and past 8 quarters. Are sales growing or slowing? Consistently falling sales must raise a red flag.

Look at the trend for Ebitda margin and net margin. Again, are they expanding or narrowing over the recent quarters and years? Falling margins suggest competitive pressure and lack of pricing power.

Are pre-tax profit and net profit rising or falling? Is the growth/decline short-term in nature or chronic? If profits have fallen, what is the probability of an imminent turnaround?

Profits are important. But cashflow means the life and death of a company. Look at the annual cash from operations and free cashflow (FCF). Is it positive or negative?

Positive FCF means leftover money to pay dividends. Negative FCF means there is a funding shortfall that has to be bridged, either by taking on more debt or making cash call to shareholders.

Companies undergoing big expansions (net PPE) will likely have negative FCF in the short-term; borrowings and gearing may rise. Expansion is generally positive as it leads to higher future sales and earnings.

However, consistently higher borrowings is not sustainable long-term without corresponding rise in sales and cashflow as interest costs will eat into profits. The company may even run into financial trouble and bankruptcy. Be wary when gearing is overly high and current ratio, cash ratio and interest cover start to decline from year to year.

Other metrics to consider include trade debtors/receivables and stocks/inventories. Rising levels mean tying up more cash (as working capital) and higher risks of bad debt and obsolescence.

Look at the increase/decrease in working capital. Rising working capital as sales expand is to be expected but the reverse must raise caution.

All these financial statistics, and more, are available on Stocks.

10 years of historical share price

One must also take into account the historical share price movements. Is the share price moving steadily higher, lower or demonstrate unusual levels of volatility?

Compare share price performances for up to 5 stocks. Has a company done better or worse than its peers/competitors? Often times, past winners will continue to be future winners.

Historical P/E and P/NAV bands

Is the stock currently trading at a premium or discount to its historical averages? This could be an indicator of whether the stock is 'cheap' or 'expensive' relative to its past.

What is the average daily traded volume? This would tell you if the stock is liquid or otherwise. Generally, we would prefer a stock with reasonable liquidity.

Does the company pay dividend?

Dividend income is a very important component of total returns to investors over the longer-term.

Look at the company's historical annual dividend per share. The best stocks are often those that pay not only consistent dividends but critically, growing dividends.

What is the payout ratio? This will determine the magnitude a company can potentially up dividends. For instance, if the payout ratio is 80%, there is limited room to raise dividends substantially compared to say, if payout ratio is only 20%.

Is there an upcoming dividend? Buying a stock before the ex-date means you will be entitled to the dividend payment. What are the dates, historically, where the company has declared and paid dividends?

Good luck in your investing!

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