There is no certain method in choosing stocks but many investors use some well-known strategies, for example, Bottom-Up or Top-Down. Then, they can utilize a range of approaches with these two strategies. Let’s understand how to do it. You can also read our 10 Minute Investment Guide.
Top-Down strategy
Top-Down strategy starts from a look at the big picture first, how the market is going as a whole, what is Gross Domestic Product, what is the interest rate and inflation are, etc. After analysing the market, investors will pick a suitable asset sector or a location. Then they will look at the specific stock in these sectors.
For example, the market as a whole is down (a Bear market). Investors will look for stocks that are predominantly in a safe sector such as utilities. Then they will analyse some utility stocks in the index and look for some key indicators of good stocks.
Some analysing tools for Top-Down Strategy:
- GDP
- Interest rate
- Inflation
Bottom-Up strategy
The bottom-up strategy focuses on specific stocks in the market and tries to see their hidden potential to outperform the market. One method is Value Investing. Investors will look for stocks that are undervalued by the market using some stock indicators. Another method is Growth Investing. Investors will search for growth stocks or companies that continue to grow at above-average stock prices compared to their market or Index piers. There is also a mixed-method called GARP (Growth at a Reasonable Price) Investing. GARP investors combine both methods together and look for companies that are growing and continuing to grow, but they are not the companies at extreme growth.
Below are some indicators you can use to look for stocks that fit your portfolio:
- Company’s revenues, growth, and cash flow
- P/E (Price to Earnings) ratio
P/E is the ratio of a company share price to the company’s earnings per share, which basically tells you how the market values the stock. However, you need to compare P/E of stocks in the same sector as stocks in different sectors have different P/E benchmarks. For example, a new technology company may have a high P/E ratio due to the fact of fruitful prospects while a mature utility company may have a low P/E ratio. Alternatively, you can also compare P/E of the same stock with its past ratio to see the stock performance and its trend. This method is used by some of the great Investors and famously used in the book by Benjamin Graham.
PEG (Price to earnings growth) ratio
PEG is ideally you would want to look for one of less than 1. This attempt has some key aspects when used to value investing it can be less volatile.
The sharp Ratio – This is a risk, adjusted return and measure how well a stock or fund is doing compared to its given benchmark rather and then a risk-free one that is measured towards a risk-free rate of return that is usually a stable 10-year AAA-rated bond.
Although this is not without its critics as of some of the ways that it is distorted at extreme measures due to using standard deviation, therefore, if a fund has a lot of high values in consecutive periods and then a minor negative period it will penalize the fund manager (or stock) and not take into consideration about the overall mean effect results.
With this, it is a useful metric due to the reason above that it is the return that is given from a measured risk-adjusted standpoint. Also to evaluate a fund you need to know what the fund is?
There are two major types of different funds one is a closed-ended investment fund- this is called an investment trust.
Closed-ended fund. It means that it is limited to the number of investors that it can have therefore the price of the fund is based on supply and demand rate than the value of the share in the fund this means that you can only buy shares that are available as there is a limited supply and if not you will have to wait for them to sell the shares for them to become available.
Investment trusts also have the ability to invest in a wider range of asset classes that are not regulated in Open-ended funds and can borrow more money (gear) on the investment as well thus making them somewhat more complex and riskier than opened ended.
Open-ended- There are three types. An ETF that mainly tries to track a given index and follow the pricing of that by a way of methods such as picking a few key stocks or matching the risk profile or sector representation of the index. These are based on the NAV and are normally low cost and easy to manage and can track many indexes from the S&P 500 to some more niche indexes such as health care or developing areas such as India.
Open-Ended Funds are funds that must be regulated to be marketed to the public. They are only allowed to invest in certain funds and are single price around the Net Asset Value of the funds.
This is an example of an equity fund facts and will break down the key points
First, it can enable you to look and do some research on the fund manager and look at what has he done before, how have the funds performed, is he well know and what are his qualifications.
Dividend dates are the dates that the dividends are paid. And here it says that it is rationed so therefore this will be included in the year total percentage or when you withdraw the fund.
Key Fact sections
This tells you how big the fund is, normally if you are looking for a big global equity fund you will want a significant fund size, however, if you are looking at a more niche sector this will normally be a lot less. Here you can see that the size is 16.6bn showing that the fund is popular and can take a bigger portion size in the share amounts.
The number of holdings – You will ideally want no more than 50 as this will give diversification but too many may impact the gains.
Market Cap – This is the size of the average company you are investing in terms of market capitalization. Ideally, if you were looking for a stable more secure fund as a general rule (although you need to factor in other aspects) you will usually want to invest in companies with a large market capitalisation.
Geographical Split- If you are looking for a stable fund look for funds more in the west such as Western Europe, US & Japan rather than the emerging markets.
What you are looking for here is a balanced portfolio and is not too heavily invested in one area. This means that not all the stock funds are based in Europe or the US this will give it some diversification and not be inflicted with a negative impact if a certain country is impacted by a negative outlook.
The Sector Split – This shows you how the fund is split up. Although there is some generalisation in terms of Technology and Health Care Technology, these will potentially generate higher returns than that of traditionally more stable holdings such as Utilities or water companies. What you want to look for regardless, is that it is showing diversification between the sectors. This will impact your fund if one large sector goes down and you do not want a knock-on effect of the rest of the sectors so for a balanced portfolio, look at how diversified the sectors are within a fund.
The fund will give you a number of the top 10 holdings, this will be a bit of research to look at the stocks as these are the ones that the fund holds most of. Look at the stocks, this can be done on Bloomberg or Google and look at the analysis is saying. How have they performed so far year to date what are the key metrics (PE ratio EPS) and how is it performing to its relative sector and index.
Once you have judged the stock, its year to date, its previous performance, at its future, the directors of the company and the fund manager and once you have done all this, then you can make your decision on whether it is a good investment or not!
Please note that you should always seek financial advice before investing and previous performance is not an indicator of future performance.
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If you have any questions about stocks, picking stocks, your investments or you would like to speak to a financial advisor, please email me at info@investmentsforexpats.com.
