Different people use different kind of analysis to select the stock. Some people use only fundamental analysis where as some use only technical analysis. But I have seen many people who use a combination of both fundamental and technical analysis to judge whether individual stocks are attractive for purchase or not.
I would try to explain how one can use fundamental and technical analysis together to buy a good share by just following below three rules. Please remember below mentioned rules are based on principles of stock pricing.
Rule 1: Look for those companies which are expected to have above average earnings growth for upcoming five or more years:
In the success of stock investments the most important role is played by an extraordinary long-run earnings growth rate. Picking stock which can give you fruitful returns in long run is not at all an easy job, and you must pick the stock whose earnings is growing continuously and is expected o grow for coming 5 years. It indicates that company has future plans in place and they are progressing to achieve them by taking right action towards it. You must check their progress regularly to keep yourself updated with the company and can invest continuously in it at the suitable opportunity.
Growth is one of the most important point to look while selecting a company, it improves the earnings and dividends of the company. It might be the case that if you bought the company at the right P/E multiple then this multiple keeps increasing with the growth as the market might be willing to pay more for those earnings. Hence, such companies have a chance to get potential double benefit: both the earnings and the P/E multiple.
Rule 2: While buying, never cross firm foundation of value:
I have stated many a times that you can never judge the exact intrinsic value of a stock but many people feel that you can roughly guess when a stock seems to be reasonably priced.
One of the best benchmark for the investor is: Earnings multiple (P/E ratio) for the market as a whole. One can look for such stocks which are selling at P/E in line with or not very much above the market multiple. This often represents that stock contains good value.
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It is always suggested that buying a share at very reasonable earnings multiples plays a added advantage for investor. If your growth estimate turns out to be correct, you may get the double bonus as mentioned in the above point. As the earnings goes up the price will also reflect the same, with that multiple will also likely to expand in recognition of the growth rate that is established. Hence, you might get double bonus.
For example, you buy a stock whose Earning per share is Rs. 1 and share is selling at Rs. 10. Now if the earning per share grows to Rs. 2 and at the same time price-earnings multiple increases from 10 to 20; you don’t just double your money you quadruple it. That’s because your Rs. 10 stock will be worth Rs. 40 (20, the multiple, times Rs. 2, the earnings) now.
Now lets have a look at the other side of the coin- There are special risks involved in buying such kind of share which I usually call as ”Growth Stocks”: The major risk comes when market has already recognized the growth and has boosted up the price-earnings multiple to a hefty premium. The problem arises now as the very high multiples might be reflecting the growth that is anticipated, and if the future growth does not materialize and in effect earnings go down (or even grow more slowly than expected), you will have very unpleasant experience.
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On the similar lines: If the earnings of low-multiple stocks grow you will get double benefits whereas if the earnings of high-multiple stocks decline you will experience double damage.
The multiple is very likely to fall if earnings decreases. But to be on safer side is multiple was not that high then the crash won’t be so loud.
One can adopt this strategy:
Buy unrecognized growth stocks whose earnings multiples are not at higher premium in compare to the market multiple. Of course, it is very hard to predict growth for any share. Even if the growth does not materialize and earnings decline, the damage is likely to be lower if you bought the share at lower multiple, whereas if the things turn out as expected then you will have double benefit. This is an extra way to put the odds in your favor.
One of the very successful investor Peter Lynch, used this technique to great advantage. He used to calculated each potential stock’s growth-to-P/E ratio and would only buy for his portfolio those stocks with high growth relative to their P/Es. This was not simply a low P/E strategy, because a stock with a 50 percent growth rate and a P/E of 25 (growth-to-P/E ratio of 2) was deemed far better than a stock with 20 percent growth and a P/E of 20 (growth-to-P/E ratio of 1). If one is correct in one’s growth projections, this strategy can produce tremendous returns. But remember these returns will be in your favor if you have understood the company well and projected its growth well.
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We can summarize the discussion so far by restating the first two rules: Look for growth situations with low price-earnings multiples. If the growth takes place, there’s often a double bonus both the earnings and the multiple rise, producing large gains. Beware of very-high-multiple stocks in which future growth is already discounted. If growth doesn’t materialize, losses might be double: both the earnings and the multiple drop.
Rule 3: Look for stocks on which investors can build castles in the air:
I have stressed the importance of psychological elements in stock price determination. Investors are not computers that calculate price earnings multiples and print out buy and sell decisions. They are emotional human beings driven by hope, greed, gambling instincts, and fear in their stock-market decisions. This is why successful investing demands both psychological and intellectual acuteness.
Stocks that produce “good feelings” in the minds of investors can sell at premium multiples for long periods, even if the growth rate is only average. Whereas you find the shares who are not so blessed might sell at low multiples for long period of time, even if its growth rate is above average.
So Rule 3 implies to ask yourself whether the story about your stock is one that is likely to catch the fancy of the crowd or not. Is it a story from which tremendous returns can be generated? Is it a story on which investors can build a castle in the air but remember to build that kind of castle in the air that really rest on a firm foundation?
You don’t have to be a technician to follow Rule 3. You might simply use your intuition or speculative sense to judge whether the “story” on your stock is likely to catch the fancy of the crowd particularly the notice of institutional investors.
Although the rules I have outlined seem sensible, the important question is whether they really work. After all, lots of other people are playing the game, and it is by no means obvious that anyone can win consistently. Therefore you need to develop your own investment philosophy.