This article is a part of the series of articles “Selecting Top Stocks to Buy“.
If we read about the experiences of successful investors, we will find that each one of them had their own specific methodology of picking stocks. They in turn, might have been inspired by other successful investors. However, there is not any one specific approach of stock picking, which has made them successful.
Benjamin Graham focused on investing in stocks that were selling at a discount to their fair value. This is an example of Value Investing approach. Philip Arthur Fisher (Phil Fisher) focused on investing in stocks that were capable of growing at a faster pace as compared to their peers. He justified paying a premium for such high growth stocks and did not stress too much on finding stocks selling at a discount to their fair value. This is an example of Growth Investing approach.
Warren Buffett studied under Benjamin Graham during college and therefore focused more on value investing in the initial stages of his career. However, later on, he incorporated guidelines of Phil Fisher in his investment philosophy. Now, as per Buffett, his investment methodology is a mix of about 85% Graham and 15% Fisher.
So we can see that there is not only one single defined approach to achieve success in stock picking. In fact, it is rightly said that ‘All roads lead to Rome’. However, each one of these approaches has their own pros and cons. These stock-picking approaches might differ in terms of the types of the stocks they focus on. These approaches might also differ in terms of the amount of time & effort required from investors and in many more ways. A stock-picking approach, which is suitable for one investor may not be suitable for another. However, it is easy to find the stock-picking approach or a mix of the approaches, which will be suitable for an investor. This article would help the readers in find such a suitable stock-picking approach.
I have discussed various approaches to stock picking below. We, as investors, should learn a bit about these different stock-picking approaches and then select the approach or the mixture of approaches, which appeals to us.
Fundamental Analysis vs. Technical Analysis
Fundamental analysis of a stock involves understanding the underlying business of a company. While doing fundamental analysis, the investor tries to find out a company, which has a very good product, well-known customers, stable suppliers, honest & capable management etc. Once the investor finds such a company, she can invest in its stock and expect to benefit from the future growth of the business of the company. Fundamental analysis is very similar to the in depth analysis, which an entrepreneur will do before starting a new business. I believe that the fundamental analysis approach to stock picking is, in fact, a form of entrepreneurship.
Technical analysis involves analyzing charts of the past movements of a stock’s price and its trading volume over the different time periods. It involves understanding the patterns in the charts containing data of a stock’s price movement in the past. The investor then tries to predict future price movement of the stock based on these past patterns. Once the investor finds a stock whose price is expected to move higher, she buys it and holds it until the chart patterns indicate that the price is expected to fall or become stable. The investor following technical analysis is concerned only with the past prices and trading volume data of the stock. The investor is indifferent to whether the stock is of a manufacturing, an agricultural or a financial services company.
Most of the successful stock market investors have followed the fundamental analysis. Fundamental analysis treats stock investment as a way of having ownership in a company’s business. This approach allows an investor to benefit from the enormous wealth, which is generated by owning a successful business over a long period of time. On the other hand, Technical analysis tries to predict the next ‘up move’ in a stock’s price and is indifferent to the company’s business.
In fundamental analysis, once an investor has found a good company, she stays invested in its stock for decades. Hence, if the investor was able to make at least a few good stock investing decisions in her life, she will be able to earn a great amount of wealth. In technical analysis, the investor buys a stock just before the next ‘up move’ in its price. She sells the stock after the up move has happened or if the up move does not occur and the buying decision has been proved wrong. In technical analysis, the investor keeps the stock with herself only for a few days or weeks. Many a times, investors try to buy and sell stocks with a few minutes during a day. Such kind of investment behavior requires the investor to keep finding right stocks every few minutes/days/weeks.
Almost all the successful investors say that finding good stocks for investment is difficult. Therefore, if an investor has found such a stock, then she should stay invested in it for long periods. Selling a good stock only after one ‘up move’ in its price is not a winning decision in long term. Stock markets are very volatile and the periods of up & down moves in a stock’s price are going to be very frequent. Therefore, an investor should not fall prey to greed and she should not sell her stock when the prices move up immediately after she buys it. Moreover, the investor should stay invested in the stock until the company keeps on growing its business consistently.
I started stock market investing in 2006 by learning technical analysis. However, with the continued reading and personal experiences in stock picking, I realized that fundamental analysis is a better approach to stock picking. Therefore, I have been selecting stocks by using fundamental analysis since 2008. I have written about my reasons to shift from technical analysis to fundamental analysis in detail here.
Different sub-approaches under Fundamental Analysis:
Fundamental analysis has different sub-approaches to stock picking. All these sub-approaches focus on underlying business of the companies. However, they differ in the methods of selecting stocks for detailed analysis and the features of stocks, which are focused for future gains.
Top Down and Bottom Up approaches:
Top Down approach:
Top down approach to the fundamental analysis is also called EIC (economy-industry-company) approach. In top down approach, an investor tries to identify those economies (countries) of the world, which are expected to grow at a faster pace than other economies. Once the investor has found such economies, she studies them in detail. Within these economies, the investor tries to identify the industries, which are expected to witness higher growth than other industries. Once the investor has identified high growth industries in selected economies, she tries to find out the companies in these high growth industries, which are expected to benefit the most from such expected growth. Once the investor has finalized the list of such companies, she buys stocks of these companies. The investor expects to benefit from the higher earnings, which these companies are expected to create over next many years.
Bottom Up approach:
Bottom up approach to the fundamental analysis involves identifying companies, which are expected to grow their business without restricting the stock-picking search to any particular industry or economy (country). All the stocks listed in all the stock exchanges in the world, irrespective of country or industry of operation, are open for selection to the investor. The investor uses various selection criteria to search for the best stocks. Such selection criteria help an investor find out the companies he likes e.g. the fastest growing companies across all sectors or the companies, which are selling at a discount to the cash in their bank accounts. Once the investor finds a good company, he buys its stock and expects to benefit from the future growth of the business of the company.
Comparison between Top Down and Bottom Up approaches:
Top down approach limits an investor’s analysis to stocks of only a few countries and a few industries. However, bottom up approach does not have this limitation. Bottom up approach provides an investor the option of investing in those companies, which are doing very good but are in industries, which are currently not doing well. Such companies are known to make huge wealth for investors. Peter Lynch, fund manager of Fidelity Magellan Fund from 1977 to 1990, has recommended investing in such companies in his book One Up on the Wall Street.
Thus, we can see that bottom up approach gives an investor more options to choose his stocks for investment.
Growth Investing and Value Investing approaches:
In growth investing approach to fundamental analysis, the investor tries to find such companies, which are expected to witness a very high growth in business performance in future. Once the investor has found such a company, she buys its stocks. The investor expects to benefit from future high growth of the business of the company.
The investor following value-investing approach of fundamental analysis tries to find the fair value of the stock of a company by analyzing various business and financial parameters of the company. After calculating the fair value of the stock of a company, the investor compares it with the current market price on a stock exchange. If the investor finds that the current stock price of the company is lower than the fair value of its stock as per her calculations, she buys the stocks of the company. The investor expects to benefit from the increase in the stock price after market discovers the discount in the stock value and increases the stock price to its fair value.
Comparison between Growth Investing and Value Investing approaches:
In growth investing approach, the investor puts more focus on future growth of the company and ignores the current valuation levels of its stock as compared to ongoing/past performance of the company’s business. The investor buys its stock at whatever price it is currently available in the stock market.
Value investing approach of stock picking is equivalent to finding goods selling at a discount in any market place e.g. a grocery store. A value investor will not buy the stock of a company, which is expected to show good business performance in future, if its stock is currently selling at a price higher than its fair value. The value investor would think that the current expensive valuation has already increased the price of the stock of that company to such an extent that the potential of increase of the stock price in future is limited. The investor would ignore this company and start the search for another company whose stock is priced at a discount to the fair value.
If an investment decision goes wrong, then the risk of suffering losses, is much more in growth investing, as it does not focus on the current valuation of the stock price. If a company selected by growth investing approach does not grow as expected or its growth slows down a bit, the stock market will punish its stock. In such a case, the stock prices will fall very fast and the investor might lose a lot of her invested capital. However, in case of companies selected by value investing, if the stock market does not realize the discount available in the stock of a company soon, then its stock price might not increase in the short term. However, it would provide the investor with an opportunity to accumulate more stocks of this company. Thus value investing approach has a higher “Margin of Safety” as described by Benjamin Graham.
It is said that the market may keep ignoring the discount available on a stock for a very long time. Therefore, stock investing should have a very long-term investment horizon. It is similar to investment in family land or real estate. You do not sell the land or property for every day-to-day financial need. Similarly, it is recommended not to sell stocks for day-to-day financial requirements and look at them from a very long-term perspective preferably in decades.
My approach to Stock Picking
We have discussed the major approaches to stock picking. We have also seen comparative features of different stock picking approaches. It was mentioned in the beginning of this article that every investor should choose an approach or a mix of approaches, which she likes. After reading books of various successful investors, who had followed different stock picking approaches mentioned above and after personal experience of about 8 years of investing in Indian stock markets, I have found the following mix of stock picking approaches, which I like:
As previously mentioned, I prefer fundamental analysis for stock picking as compared to technical analysis. I like fundamental analysis because it treats an investor as an owner of the company and the fundamental investor needs to make only a few right investment decisions in her life to make significant wealth as compared to a technical investor. On the other hand, the technical investor needs to be on the lookout for right stocks almost daily.
Bottom Up approach:
I prefer bottom up approach as compared to top down approach. If an investor follows top down approach, she would find that the stocks of the companies, which are expected to do good in high growth industries of such economies (countries), which are expected to outperform other economies, are already overpriced. This limits the choice of stocks available for her investments unless she decides to overpay for them. In bottom up approach, the investor focuses on the good companies irrespective of the industries and economies. Therefore, she is able to select stocks of good performing companies from all the industries whether these industries are growing at a fast or at a slow pace. If the investor follows bottom up approach to stock picking, she would have better chances of finding out companies, which are growing at a fast pace but whose stocks are priced at a discount currently.
Mix of Growth Investing and Value Investing approach to Fundamental Analysis:
I follow a mix of growth and value investing approaches. I search for companies, which have grown their earnings at a good pace in past and their earnings are expected to keep growing in future. Once I have prepared a list of such high growth companies, I try to find out the companies from this list, whose stocks are currently selling at a discount in the market. This is like having best of the both worlds and many readers might think that it won’t be easy to find such companies.
However, Indian stock markets are under-penetrated and only a few well-known stocks are well researched by market analysts. Most of the large investors like FIIs, mutual funds etc. focus on only about 400-500 stocks of large companies out of more than 5,000 companies listed on Indian stock exchanges. An investor can find the hidden gems among these balance 4,500 stocks, which are not getting analyzed by stock market analysts. These hidden gems offer an opportunity to invest in high growing companies, which are available at very reasonable stock prices. I focus on this under-analyzed segment of Indian stock markets to find potential stocks for my portfolio.
Thus to summarize, I follow a bottom-up fundamental analysis approach in which I look for high growing companies available at attractive stock prices.
Any person who wants to be an investor can learn about these approaches for stock picking. The investor can focus on the approaches which she finds suitable for her according to her temperament, work schedule, life style etc. The investor can choose to pick the best of the characteristics of various stock picking approaches and mix them to create an approach of her own.
Once the investor has decided about her stock picking approach, she should start searching for companies whose stocks meet her criteria. The investor should keep on improvising her approach by incorporating lessons, which she would learn from further readings and personal experiences in stock picking.
At the start of Warren Buffett’s investing career, no one could tell whether he would be the most successful investor of all times. No one could predict about the success of Benjamin Graham, Peter Lynch or Phil Fisher. Similarly, no one knows whether you and I are going to become successful & wealthy investors. However, the current requirement is to put in the necessary effort in stock picking and wait for the future to unfold the results. Various investors have become successful in the past. I believe that I can be successful at stock picking and so can be anyone else who is willing to put in the required effort.
This concludes the second part of this series of articles about the process of Selecting Top Stocks to Buy. Please let me know how you think about stock investing and the process that you follow.
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In the next article in this series, I will elaborate on individual stock analysis. I will highlight the characteristics, which make any company investment worthy. The article would help the reader select companies, which she can trust with the investment of her hard-earned money. Further, in this series of articles to find top stocks to buy, I will write about the avenues to search for stocks and to get the required information for analysis. I will discuss the steps to analyze the gathered information and to make investment decisions based on such information.