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How to select stocks to get good returns

Last updated on: May 20, 2013 13:45 IST

Image: Bombay Stock Exchange.
Photographs: Arko Datta/Reuters. Ashish Pai

There is no sure-shot formula to succeed in the stock market. Here are some factors that may help you take investment decisions.

Stock market investments are risk prone. There is no sure shot formula to succeed in the stock market.

Hence, investors at times invest in the market based on broker recommendations, research report, tips from friends or family, rumours, trend or by gut feel.

Identifying and investing in good stocks, although not easy, is a must to create long term wealth.

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How to select stocks to get good returns


Photographs: Uttam Ghosh/Rediff.com

Since the stock markets have come into existence, investors have always faced a dilemma in selecting good stocks.

Many a times, a stock that is cheap could be undervalued, or it could be nearly worthless and overvalued because of some traders betting on a miracle and some hoping to sell to those people before the company collapses.

Similarly, when a stock is highly priced, it may be due to over expectation or hyping on factors not fundamentally right.

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How to select stocks to get good returns


Photographs: Uttam Ghosh/Rediff.com

In case of stocks which saw a hype, investors have lost heavily believing in their growth story and trying to ride on the price momentum. For instance, a couple of years back, realty stocks were touted to be the next big story based on their land banks.

Many of the overhyped sectors have actually delivered superlative returns over a period of time. But now many of these stocks have fallen from their peaks and investors have suffered losses.

Investors must study and analyse before choosing stocks. For those who are not financially savvy, here are some tips on how to do it.

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How to select stocks to get good returns

Image: Bombay Stock Exchange.
Photographs: Reuters.

The first and most important thing for any investor to do is, to look at the company's financial statements.

It is also advisable to pick stocks from sectors and markets that you know and have experience in. This can give you an added advantage.

Some of the factors investors must look at before picking a stock are:

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How to select stocks to get good returns


Photographs: Uttam Ghosh/Rediff.com

Earnings Per Share: When you research a stock, the first thing you should look at is the Earnings per Share (EPS).

This is the amount of profit the company is making on a per share basis.

Market appreciates stocks which have a growth in EPS while it reacts negatively for stocks with stagnant or reduction in EPS.

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How to select stocks to get good returns


Photographs: Uttam Ghosh/Rediff.com

Dividend yield: A dividend is a cash payout to shareholders, usually an annual payout by profit making entities. A stable or increasing dividend means the company has good cash flow and a positive outlook for the future.

A decreasing dividend usually means the company is trying to keep some cash on hand for other expenses, possibly a sign of tough times ahead. One indicator of a good stock to buy is a high dividend yield. The yield is the yearly dividend as a percentage of the stock price.

A high yield means you are getting a larger dividend for your investment. Stocks which have a higher dividend yield have better valuation in the market as compared to those with a lower yield. infrastructure stocks like power or telecommunication which normally have a lower dividend yield have a lower valuation as compared to multinational companies' stocks. 

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How to select stocks to get good returns

Image: Bombay Stock Exchange.
Photographs: Reuters.

Debt: Stay away from companies with high amounts of debt when looking for good stocks to buy.

As most investors have found out recently, it can be very difficult for companies with large amounts of debt to survive, especially in recessionary times. In recent times, we have seen the fall in Kingfisher Airlines due to high debt. Pharmaceutical company, Wockhardt, too had similar issues on debt repayment, but it saw a turnaround after restructuring its debt.

The profitability of companies with overleveraged balance sheet more often than not are affected by the high interest outgo. These can have cash flow issues too. Any downgrading in credit rating resulting due to cash flow issues can have an adverse impact on stock price. 

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How to select stocks to get good returns


Photographs: Uttam Ghosh/Rediff.com

Future prospects: Understanding future prospects is important as part of financials. You can identify the factors that may influence the future performance of a stock.

For instance, good monsoons should help stocks in the fertilizer sector.

Future prospects of the company can be enhanced or marred by policy decision. For instance, opening up for FDI can have a positive influence in anticipation of increased capital inflows.

However, factors like technology changes can have either a positive or adverse impact. Some of the stocks have been badly affected due to changes in technology and non adaptation to market realities.

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How to select stocks to get good returns

Image: Indian brokers engage in trading on their computer terminals at a stock brokerage firm in Mumbai.
Photographs: Punit Paranjpe/Reuters.

Peers: Compare your identified list of stocks against its peers in the same industry or sector. Looking at competing companies and their fundamentals can be a great way to size up a potential investment.

It is advisable to invest in a market leader than the second or third rung stocks. Peer comparison is required as the same will help in relative valuation of the stock.

Say a stock like Hindustan Unilever may look expensive on a standalone basis but if compare it with the valuation of other stock in the same industry it may look to be attractively priced.

Price earnings ratio is usually used for comparing the valuation of a company vis-a-vis its peers.

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How to select stocks to get good returns

Image: Bombay Stock Exchange (BSE) building is reflected on a glass window as people look at a large screen displaying India's benchmark share index on the facade of the building in Mumbai.
Photographs: Arko Datta/Reuters.

Strong brand: Companies with strong brands are likely to perform better in the long run even if they may be less profit making in the short run.

Market puts a value to the brands too while valuing a company with strong brands. A classic example of this is a company like Bata India where inspite of muted growth, the share price is high on account of brand value.

Conclusion: Doing proper analysis and due diligence is an important part of investment process. It is an activity that needs to be done before investing. Once you get the methodology, identifying good stocks will not be difficult.

The writer is a freelancer.

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