Sunday, November 19, 2006

Stock picking

After dabbling a bit in stocks, I think following set of criteria has worked to pick and choose some investment grade securities. I stress 'investment grade' and not 'speculative'. These rules also have helped to decide when to sell and when to buy. This basically comes down to 'buy low, sell high'. It has been very difficult to put this rule in practice because not much attention has been paid regarding what to use to determine low and high and low and high of WHAT. It certainly is not the price but VALUE. Price is what market has priced it to be. Value is what fundamentals indicate.


1) Always make sure that the price you are paying is not outrageous. If you buy something at an outrageous price, you are most likely to incur loss because greater fool theory does not work. Look at Price to Earnings ratio for trailing twelve months (ttm). Cap P/E (ttm) ideally at 15 and no more than 20. If stocks do not meet this criteria, do not even go further. However attractive these stocks may be, they are priced too high if P/E is above 20. Market will provide sufficient opportunities in the future to buy these stocks at right prices when euphoria dies down and stock's trading price is in line with P/E (ttm) less than 20.

2) You want to make sure the company has little or no debt.

3) Cash is king. You want to make sure that company is generating plosive cash flow from 'operating activities'. I stress 'operating' because you want the company's operations generating cash flow and not investing and financing.

4) Increasing revenue and net income. At least not erratic.

5) Preferably dividend paying. Cash in handed over today is uncertain market appreciation in the future.


1) There is only one rule. Sell when P/E (ttm) exceeds 25. Don't hold back thinking it will keep going up. At least have a plan to sell some number of shares when you have locked in 15, 30, 50 % profits.

2) Why it makes sense to sell stocks that P/E (ttm) 25 or more. For the very reason you do not buy those stocks. They have been priced for more than they are earning for you. However much you like the stock, sell it and buy it back again when the price falls if and only if fundamentals are strong. If fundamentals are strong and if the stock is priced reasonably, you can buy it regardless of what market has priced it to be. For fundamentals - refer to 2,3,4 and 5

This is nothing but time tested principles of value investing. I had to prove it to myself with some trades of my own.

Great buy opportunities - TM (Toyota), TXN (Texas Instruments). Great companies trading at unbelievable P/E of 15 and 11 respectively.

Sell if you have in portfolio - HDB (HDFC bank), WIT (Wipro) trading at too high P/E.

Watch and sell some portion - MSFT (Microsoft) has nicely appreciated over last few months. P/E has moved to 22.

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