What you need to know before you start investing.

Before you open your trading/demat account, the first thing you need to decide is why you’re opening the account in the first place. Is it the term “Investment” that has motivated you? Or you were intrigued by speculators who track the market every hour every minute, selling/buying stocks by predicting where your “speculation” would take you in the next hour? Decide. Decide now. Well if you’re confused, let me help you. If you go for the first option, you’ll spend a good amount of time analysing and continuously learning about companies and narrowing your research down to very few great companies with outstanding fundamentals and a huge potential that you can hold for a long, long, long time and watch your money grow phenomenally. Go for the second option and you’ll most likely lose your money or be satisfied with small profits and it’s your broker who’s gonna benefit at the end of the day.

So if you’re still reading this article, I’m assuming that you’ve chosen the first path. Stock picking is not a list of rules you need to remember. It’s an art you’ll learn over time. You don’t need to be good at mathematics. Just some common sense and willingness to learn is gonna make you a millionaire.

In order to pick outstanding companies with very high potential growth, you need to come up with a sophisticated stock selection procedure.

To start, we’re going broadly to divide our procedure into two stages:

  1. Fundamental Analysis
  2. Valuation Analysis

Fundamental Analysis

The fundamentals include the financial results of a company. Financial reports include a ton of parameters and values which are definitely gonna confuse you. But you being a novice, I’m going to narrow our research down to the following major parameters:

Earnings

Earnings, Earnings, Earnings. This is what drives the company forward and motivates the buyer to trust the company’s growth. Increasing earnings over time have always brought positivity towards the investors and motivated them to buy the stock. Hold on to a stock with increasing earnings and a product with such a strong potential that it’s going to increase further in the future and you’ll definitely get good returns,

Return on Equity

This is probably the most important parameter out of the fundamentals. Return on Equity shows how well the management of the company functions. It is the measure of how efficiently the managers use the company’s assets and equity to maximise their returns in the future. You should always look into companies having a Return on Equity > 15%.

Profit margin

This mostly depends on how efficiently the manufacturing of products is done. I prefer investing in companies where the profit margin of products is greater than 20%. A higher profit margin lets the company reinvest its earnings to get even higher profits and meet the expectations of the customers.

Debt to equity ratio

To avoid companies with a potential for failure and bankruptcy, just reject companies with debt to equity greater than 0.5. Why should you take a risk when you can easily avoid it?

Market Capitalisation

This is your personal choice. If you’re young, and you can take risks, go for small-cap/mid-cap companies. Otherwise, invest in large-cap funds and watch your money grow without any risks and get regular dividends.

1. Large-cap: Companies with market caps that are $10 billion or above. These companies are usually slow-growers. They are the safest stocks and are usually bought since they pay regular dividends and provide stability during recessions. They don’t offer much growth potential but they’re less volatile than small-cap stocks.

2. Mid-cap: Companies that are between $2 billion and $10 billion. Mid-cap stocks tend to be riskier than large-cap stocks. They, however, tend to offer more growth potential than large-cap stocks.

3. Small-cap: Companies with market caps that are less than $2 billion. Many small-caps are young companies with significant growth potential. However, the risk of failure is greater with small-cap stocks than with large-cap and mid-cap stocks.

Valuation Analysis

This step of the investment procedure is to ensure that you buy the stock at a reasonable price and it isn’t overbought when you buy it. You buy low and sell high. But many investors unintentionally do the opposite. To avoid making this mistake, I’ll introduce three parameters for the valuation of the company.

P/E Ratio

P/E Ratio is the measure of the price you pay for $1 earnings from your investments. One potential way to know when a company is overpriced is when the stock’s p/e ratio climbs far above the historical average.

PEG Ratio

Remember, just because a stock is cheap doesn’t mean that you should buy it. Hence, the PE ratio of a company is not the best measure since it doesn’t take the growth of the company in account. PEG ratios higher than 1 are generally considered unfavourable, suggesting a stock is overvalued. Conversely, ratios lower than 1 are considered better, indicating a stock is undervalued.

RSI Indicator

The Relative Strength Indicator is a momentum oscillator that measures the speed and change of price movements. Its value ranges from 0 to 100. Generally, if a stock’s RSI goes under 30, it’s oversold. On the other hand, if it goes above 70, it’s overbought and you should probably wait for the price to go down. It’s always suggested to buy at a discounted rate to maximise your profits. Learn to be patient and never buy a stock in a hurry so that you don’t regret it in the future.

RSI Indicator. Source: fidelity.com

Learn how to save money.

Finally, you’ve come up with a sophisticated screening procedure using the valuation and fundamental analysis and you’re ready to pick stocks to attain amazing returns in long term.

But before you invest you should learn how to save money. Personally, the easiest way to increase your savings and assets is to pay yourself before spending your salary on anything else. As soon as you get your monthly salary, leave around 40% of your income aside for your investments. Strictly hide that money and transfer it to a remote bank account that you’ll not use for your regular expenses. Out of the money you’ve saved, invest no more than 60% of it. Leave the rest of it for recessions when you’ll get great opportunities to invest at discounted rates.

Reduce your expenses to increase your savings. Don’t spend on anything you don’t need. I’d prefer buying a coffee machine to spending 6 Dollars on a cup of coffee at a Starbucks. Why would I 6 Dollars when I can make one for 50 cents? I’d never do that no matter how rich I get.

Designing your portfolio

After executing a screening process of fundamental and valuation analysis as explained above, classify the stocks on the basis of market capitalisation and sectors.

Since it’s rarely possible to know exactly when the market will favour large-cap, mid-cap, or small-cap stocks, it’s a good idea to include a mix of different sized stocks in your portfolio. The ratio of each investment is your personal choice based on the amount of risk you can take. Similarly, when you classify your shortlist into industries, try to invest in equal amounts into the various industries to avoid losses in case of a crash of a particular industry.

Don’t ever invest in more than 10 different stocks. Come up with a list of 5–10 stocks by rejecting hundreds using the screening process above. Reject as many companies you can to minimise your losses.

Before buying a stock, try convincing yourself by preparing a 2-minute monologue explaining why it makes sense to invest in this company. Would you hold on to it for another 5 years? Or you’re planning to sell it off if it goes down or up by 10%? Be honest to yourself before every transaction and you’ll definitely succeed in your investment career. Spend maximum time analysing companies including the ones you’ve invested in and keep looking for great investment opportunities. And finally, never stop learning.