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5 tips on how to pick a stock

Subodh Karode | March 14, 2006

I am a chemical engineer by profession, work in IT by choice and, frankly, find stocks sexier than Mallika Sherawat.

That's why, when I hear the advice doled out ad nauseam by financial experts like fund managers and stock analysts who feel retail investors should stick to mutual funds, I seethe.

Their reasoning: They devote their entire working hours to analysing stocks. Others (like you and me) can give only around an hour or two a day towards this end. This, according to them, is rather insufficient.

I certainly do not subscribe to the above assertion. A small investor needs to identify and invest in around four to five stocks.

Despite being a non-finance professional, I have made a successful foray into stocks.

Let me tell you the benchmarks I have identified for myself in over more than a decade of stock picking.

1. Look for consistent dividend paying stocks


Well, if you are not getting a high rate of interest on your bank fixed deposit, you might as well invest in a stock that gives a decent dividend yield. But the keyword is 'consistency'; look for companies that consistently give dividends.

Matsushita Lakhanpal declared dividends for 10 years in a row before I picked it up in August 2004. In the years 2003 and 2004, it gave a dividend of Rs 3 per share. This means, at a price of Rs 50 per share, it was giving a 6% dividend yield (dividend yield = dividend amount per share / share price x 100).

Another good buy was Tata Chemicals, which I got a few years ago at Rs 50 per share. Again, what attracted me to this stock was the consistent dividend and high dividend yield. At a 50% dividend, I was getting an annual return of 10% pa.

My first call as an investor is to protect my capital (initial investment). Even if the Tata Chemicals stock had not appreciated, I could have assumed I had put money in a bank fixed deposit and was earning 10% as interest every year.

Most people were not impressed by Tata Chemicals then as fertilisers were out of favour and tech stocks were being wooed.

Eventually, the stock got 'discovered' by the market and now has a 'Strong Buy' recommendation from analysts and broking firms when it is at Rs 250.

Lesson to be learnt

The higher the dividend yield, the better.

In this current bull run, it will be difficult to find good, high dividend yield stocks but one can watch out for corrections (temporary dips) to buy such stocks.

2. Check valuations

Valuation is a process by which the value of a company's stock is determined. This is based on a number of factors like earnings, the market value of the company's assets and the brands it owns.

Before the face value of ITC's shares was reduced from Rs 10 to Rs 1, and before the bonus was declared, I told some colleagues it would be a good buy. But they balked at the price which, then, was Rs 1,600.

But these very same set of investors were game to buy HLL at Rs 160 because they found it cheaper than Rs 1,600.

What they did not realise was that ITC, with a face value of Rs 10, was quoting at Rs 1,600 while HLL with a face value of Rs 1, was quoting at Rs 160.

ITC, due to its valuations, was considered at that price to be undervalued while HLL was overvalued.

In the past few weeks, HLL has surged on the back of FIIs buying the stock, surprising most people. But that is a different issue.

Lesson to be learnt

Don't just look at the price of the stock. Look at its valuations. There is a difference between a pricey stock and an expensive stock.

3. View prices over time

Don't look at just the yearly high/ low price of the stock. Investors make the mistake of assuming that, if a stock is quoting nearer to the year's bottom price, it has a lot of upside (potential to rise in price).

This can be most dangerous when bull markets give way to bear markets and the stocks begin falling like nine pins. Instead, look at a stock's three-to-five year price and its volume chart before investing. It may also be prudent to see what the all time high/ low of the stock is.

In certain cases, a company may begin to do really well and the stock's price keeps moving upward. In such a situation, the historical chart will not have any meaning.

Lesson to be learnt

In this current bull market, it will be rare for a small investor coming across a totally 'undiscovered' stock.

4. Look at the promoter's stake

This refers to the number of shares held by the promoter out of the total number of shares available in the company. Generally, whenever promoters have a stake of 50% or more, it signals they have confidence in their business.

On the flip side, if the promoter's stake is too high, the stock tends to become illiquid as the amount available for trading is not huge. This results in the stock appreciating very slowly.

The best scenario, as far as I am concerned, is when the promoter's stake is between 50% to 65%.

Take the example of Pidilite.

Promoter stake: 71.8%

Institutional holding: 16%

General public: 11.84 %

Many midcaps of lesser quality have appreciated more than five to six times but this midcap blue chip rose from Rs 27.5 in September 2003 to just about Rs 53 or so five or six months ago (barring the short time frame when it went past Rs 90 when the stock split was announced).

Take a look at McDowell. The stake of General Public has fallen from 36% in October 2004 to 23% as of December 2005 and the stock price has gone up more than 10 times.

Lesson to be learnt

When the stake of 'General Public; falls over time, it is an indicator that the promoters, high networth individuals and FIIs are buying it and it would not be long before the stock appreciates.

5. Check who the promoter is

There are many promoters whose companies show losses or very low profits in the bear markets. The moment a bull market begins, they suddenly start turning around. The turnaround lasts only as long as the bull market is alive and kicking. Then they fade back into oblivion. Some disappear.

Some companies themselves do pretty well but they always lend money to group companies/ subsidiaries and the loans are then written off. This is one of the ways for promoters to siphon off funds.

If the group company or subsidiary starts doing very well, it is de-linked/ spun off from the main company and the promoters take full control.

The best example is Indian Organic Chemicals.

This company used to be part of the Sensex in 1990. It had a wholly owned subsidiary called Sonata Software, which was de-merged (spinned off into a separate company) in 1992. The promoters themselves bought 100% stake at a paltry Rs 9 crore.

In the next few years, the tech boom took place and Sonata Software went public (listed on the stock exchange).

None of the shareholders of Indian Organic Chemicals were offered any preferential shares (shares at a discount to the market rate).

Profitable divisions of the company continued to be spun off and whatever remains of the original Indian Organic Chemicals is now called Futura Polyester.

Lesson to be learnt

The importance of the promoter group is clearly visible in the bear markets. Very often, small investors find their 'value picks' turning into 'junk picks' simply because the promoters were not scrupulous or did not keep their shareholders in mind.

Note: These views and the strategy mentioned reflect the author's personal convictions. They are not a sure-fire way to make money in the market.

Disclaimer: While efforts have been made to ensure the accuracy of the information provided in the content, or the author shall not be held responsible for any loss caused to any person whatsoever who accesses or uses or is supplied with the content (consisting of articles and information).

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Read what others have to say:

Number of User Comments: 3

Sub: How to pick stocks

I think the article is too simplistic to be of real use to lay investors. While there is certainly merit in points 1 and 4 ...

Posted by Anil Harolikar

Sub: 5 tips on how to pick a stock

the advise was crisp and clear. an honest attempt to guide small investors against loosing their heads in the stock market

Posted by govindkrishnadas

Sub: Stock Levels

Dear Friend I like your comments & I feel within these parameters UCO Bank is a good buy since the stock is trading at 25Rs. ...

Posted by B L


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