Monday, February 28, 2011

6 Criteria You Can Use to Pick Winning Stocks (Part 1)

First, some qualifications and disclosure. Most of you know that I'm not really too keen on stock picking since I'm more of a passive, long-run, fully-diversified kind of investor; most of what I know about screening stocks and fundamental analysis, I've learned through formal training and self study in the past five years. But since I arrived in Hong Kong six months ago, I've had an opportunity to apply investing theory to a richer sample of stocks traded in the Hong Kong Stock Exchange. Therefore, everything that you see here is a result of both what I have learned as a student and teacher of finance, and as an investor in the past six months.

Having said that, most likely, other investors would not agree with some or even all of my points. Also, these criteria may only be used filter stocks from the population of stocks available to investors (~250 stocks listed in the Philippine Stock Exchange), which is just one dimension of the stock investment decision; this post does not talk about investment horizons or the timing decision, for example. The main objectives of this approach are to consistently earn higher returns than the appropriate benchmark (e.g., the PSEi) and not to get wiped out during market shocks (e.g., financial crises). If you're aiming to earn 5 or 10 times your investment in a few days or weeks, this approach is not for you. Finally, for what it's worth, from October 29, 2010, when I first bought shares of a HK stock, to the end of this day's trading, my portfolio is down by 0.8%, after costs; in the same period, the Hang Seng Index benchmark is up 1.04% and the PSEi down by 11.8%.

1. Stock quality

Avoid mining stocks where stock price movements are heavily dependent on speculation and not on performance; it means the only way to win is to have first access to high quality information, something the average investor does not have (and is illegal, anyway). Investing in these kinds of stocks may give you a better chance of earning higher returns, but you're also more likely to lose your shirt in times of crisis. Stick with component stocks of the PSEi, and a few others that you know have actual businesses; all the rest are trash. Read annual reports at least once, just to familiarize yourself with an unknown stock. The unavailability of the latest annual reports of a particular company on the PSE website is a definite red flag, a possible sign of lack of transparency and straightforwardness.

2. Profitability

Stick to stocks with business models that work (or make sense) and have been consistently profitable during "normal" times (i.e., not recessions or crises). Yes, you would have to know the bare essentials of business management and understanding annual reports and financial statements (you can start by reading some of our past posts).

3. Dividends

Constant, stable dividends tell you that the company is capable of sustainable profitability. It's also a significant and reliable source of returns for investors. Theoretically, there is an inverse relationship between dividends and growth: low or no dividends may mean the firm is using its earnings to fund expansion projects for additional value. But this only works if there are value-adding uses for earnings, like for new product development in a high-tech industry or expansion a new, unsaturated market. So unless the firm is Apple or Google, most probably "low or no dividends" just means "low or no profit."

Click here for Part 2

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