How to pick the right stock for investment – 5 Selection Tips

The share market is one of the lucrative investment options among millennial investors. It is indeed one of the best ways to build wealth, but the basic groundwork needs to be done by the investors. Also, there are chances of losing money, if you blindly invest in any stock without your homework.

Investing in equities requires a diligent and process-driven approach to selecting good companies. There are various methods by which one can select the right stock for investment.

In this article, we will explain 5 factors that should be looked upon before selecting good companies. The list is not exhaustive but gives a roadmap of selecting the right stocks:

1.  Business Growth

Companies that can grow sustainably are often the value creator for an investor. Growth in volume and price along with improvement in margins of a company leads to higher profitability. Investors like growth and it increases their desirability which leads to the appraisal of the company’s equity value. Equity is a growth asset. Consistent growth in key metrics like revenue, profit, and cash flows should be analysed by an investor while selecting the right stock for investments.

2. Company’s Market Share

Companies which can grow their market share are good for investment. Companies have different type of competitive advantages over their peers that helps them maintain or increase their market share.

In the investment world, the competitive advantage is often used interchangeably with the term “Moat”. Moat could be in any form like brands, patents, distribution networks, a superior product, superior services network, low-cost production, etc. Market share often acts as a good indicator for better future visibility and profitability of a company. Hence while selecting the stock, this parameter becomes of utmost important.

3. Low Financial Leverage

Leverage is a double-edged sword and cuts both ways. While selecting good stocks for investments one should carefully evaluate them. Leverage can be categorized into two broader categories: Operating Leverage and Financial Leverage.

Higher operating leverage helps generates extra-ordinary profit during an improving business cycle but deeply cuts a company if the business cycle turns unfavorable. Financial leverage or debt helps a company to accelerate the profitability in the up-cycle by doing expansion but becomes a drag on profitability in the down-cycle when interest cost eats it substantially. Hence you should always try and identify companies with low or no debt.

4. Capital Allocation Policies

Capital allocation policies are a reflection of management’s ability to generate wealth for its shareholders. A company generates profit from its business operations and what it does with that profit is part of capital allocations policies.

Companies either re-invest the profit back in the business or distribute that profit in form of dividends or buy-back to its shareholders. Companies also embark on a merger and acquisition route to increase their scale and the geographical presence or diversify in unrelated business. Before selecting a company for investment, you should look deeply at the capital allocation track record of the company.

5. Industry Dynamics

Industry analysis is an important part of stock investing. One should look at the industry growth rate and its future visibility before investing. Excess competition decreases the profitability of every company in the industry in the long run.

Industry tailwind is very important for generating good profit for the companies in the sector. Policy stability and regulation around the industry should also be considered before selecting a company for investment. One should also look at the penetration level of the industry to assess the scope of opportunity and industry maturity stage.

Also Read: Common mistakes which you should avoid while investing

Few tips which you should remember while picking the right stock

  • Cheap stock doesn’t always mean it is a good stock
  • The past performance of a company doesn’t guarantee the future outlook
  • Always consider building a diversified portfolio
  • If the company is popular in news and media, it doesn’t mean it is a good company.
  • Do not get emotionally attached to any stock

Bottom Line

Many people invest in the stock market with the expectation of earning extraordinary returns. But you should remember that the market is volatile in nature and thorough research is important before investing in the equity market. Using the investing strategies effectively and staying invested for the long term can help you reap the benefits of the stock market.