Which stocks to buy? Techno-Fundamental research and analysis

Many retailers invest in companies without knowing their products/services or their CEO or their past track record. But, a well-informed investor looks into a company’s annual report to know about its management, prospects, and enhancement in products/services. All these factors come under the fundamental analysis of a company.

However, fundamental analysis alone does not grant success to investors. Because the above-mentioned factors do not change often. Change in the top management happens once a year or more. Results are announced quarterly, and growth prospectus would also be announced along with quarterly results. Hence, the right time to initiate a long position in a company is a problem for an investor. That’s where technical analysis helps.

According to our methodology, we would study a company’s annual reports to get a picture of its growth prospects and its past realizations. Once we are sure about a company in terms of its earnings and revenue growth rates, we would wait for a technical buy signal to initiate a position in the scrip.

Fundamental Analysis:

Your first task in analyzing a stock is to understand the company behind it. What are its main products or services? Who are its customers? What advantage does the company have over its competitors? The better you understand a company, the better you’ll be able to make sound investment decisions and stick through normal market corrections. Growth investors will want to pay particular attention to what is new about a company’s story. Large stock moves are almost always driven by a compelling new product or service, or by new management that brings new ideas, or by new industry conditions that positively affect an entire industry group. In our study of the greatest stock market winners from 1995 through 2001, we found more than 95% met at least one of those criteria.

You’ll next want to take a closer look at the fundamental data. An overarching concept to keep in mind is that the biggest winners in the stock market tend to be the number one companies in their fields. Your goal is to identify the present-day leaders, the companies that have the best economics in their respective areas.

In our studies of the biggest winning stocks of all time, we identified several characteristics that were common to those companies before their stocks went on to tremendous gains for their shareholders. One of the first things you’ll want to focus on is the company’s earnings history. Growing earnings are the lifeblood of almost all major stock moves. Without increased earnings, there is little reason for a stock to advance in price.

We identified three major parameters to use to analyze stocks:

Earnings per share in the latest quarter should show a major percentage increase versus the same quarter a year ago. At least 18% or 20% and preferably much more. Earnings growth should be accelerating in recent quarters compared with earlier rates of change. Annual earnings for the last three years should be increasing at a rate of 25% per year or even more. If you are looking at a younger company that recently had its IPO, you might accept the last five or six quarters being up a significant amount.

In addition to earnings growth, you’ll want to see an accompanying increase in sales. A company can cut costs only so much to increase earnings. Big profit gains must eventually be accompanied by sales growth. Use the following sales-related parameter during your analysis:

Sales should be up 25% or more in one or more recent quarters or at least accelerating in their percentage change for the last three quarters.

Finally, you should analyze how efficient a company is at generating returns given the amount of capital it employs. Return on equity (ROE) measures how much net income (earnings) a company generates compared with the amount of shareholder equity it has. The very best companies will generate consistently high ROEs. Keep the following parameter in mind:

Return on equity should be 17% or higher.

Following are some of the common mistakes retailers commit:

Averaging down: “If you let a stock go down 50% from where you bought it, you must make 100% on the next stock just to break even. Now, how often do you buy stocks that double in price?”

Investors are often reluctant to sell when stocks go down in price from what they paid for them. To add to the harm, many investors tend to average down and buy more of the stock that already shows a loss. Our strategy turns the concept of averaging-down on its head, and we suggest adopting the pyramiding or the averaging-up technique. This strategy ensures that the losers are weeded out, and the capital is instead deployed to winning stocks – resulting in averaging-up your initial buy price. In general, three out of four stocks follow the market direction.

Simple math shows it is easy to get trapped

If a stock falls 10%, you need a gain of 11% to break even
If a stock falls 20%, you need a gain of 25% to break even
If a stock falls 30%, you need a gain of 43% to break even
If a stock falls 40%, you need a gain of 67% to break even
If a stock falls 50%, you need a gain of 100% to break even

Buying low PE stocks

You Can’t Buy a Mercedes for the price of a Maruti; At a car dealer or in the stock market, higher quality costs more. If you won’t buy growth stocks at a 25–50 P/E (or higher), you’ll miss the best investments!

Other common mistakes: Comparing P/E within the industry.

Avenue Supermarts: PE was 70 at the time of listing, which was considered too high from a conventional approach. However, the stock advanced 210% within three months of listing.

Technical Stock Analysis

Once you’ve identified the very best stocks on a fundamental basis, you’ll need to determine the optimal time to buy these stocks. This is the point when the stock stands the greatest chance of increasing in price soon and becoming a big winner. In our experience, the best way to identify the best buy points is to use stock charts. MarketSmith India offers detailed Daily, Weekly, Monthly, and Intraday price-volume charts to aid you in this process.

Following are a few most commonly observed base patterns are cup-with-handle, saucer, double-bottom, flat base, ascending base, among others.

The Pivot of a base corresponds to a previous area of resistance. In the case of a cup (or saucer) with handle, it corresponds to the peak price of the handle. In the case of a double-bottom, the Pivot corresponds to the top of the middle peak of the W shape. In the case of a cup, flat base, consolidation, or IPO base, the Pivot corresponds to the left side high that began the base. When a stock breaks above this level of resistance, it may be poised to move higher.

It’s important to wait until the pivot point is reached to execute your purchase. Buy too early, and in many cases, your stock will never get to its breakout point, leaving you with a stock that has stalled or may actually decrease. You want a stock to prove its strength to you. At the same time, if you buy more than 5% to 10% past the pivot, you are buying late, and you will likely get shaken out in a normal price correction or could suffer a sharp loss if the breakout fails.

Some of the other key technical buy signals are:

A stock retaking its key moving average 50-/200-DMA on above average volume
A stock making a new high after trading in a tight area for a few weeks
A stock forming a new high on above average volume

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Author's Bio: 

Marketsmith India, One stop solution for all your Stock Market needs. Get stock market ideas and stock predictions all at one place. A proprietary tool by William O'Neil India following the CANSLIM method of investing.