It is good that we now understand the broad logic of stock pricing based on the fundamental mechanism of supply and demand. However, for an individual investor what is more important is the right price at which he buys a stock. This can be made quite complicated due to the following reasons.
- The stock or the sector you are trying to buy into, may or may not follow the trend of the index. So it is possible that the index is falling and your stock is rising despite being a constituent of the index.
- The indices only cater to a few stocks and the stocks outside of these will have their own patterns of movement.
- Normally stocks within the same sector behave in a similar manner but there are exceptions to this rule. So two Pharma companies that you want to buy may be moving in the opposite directions.
Before we get into some mechanisms of getting to the price determination, let me point out some of the things that are absolutely of no use. You may have read them at many places and others may have told you so but avoid them anyway.
- While you do need to know about the industry and the specific business of a company you are trying to invest in, there is no real use of plodding through Balance sheets and trying to calculate all kinds of ratios for yourself. There are much more knowledgeable people than you who do this as a profession and you can simply use that data.
- When buying a stock it is important to understand that while you do want to buy it as low as possible, unless you are a trader and investing for a very short term, the price is not that crucial a deal.
- Review is important but once you have decided to buy a stock, stick with it for some time and don’t jump constantly.
So how do you decide on the price of a stock to buy it at? Well, there are several theories which you can read up yourself and as always I do not want to reinvent the wheel here. So, I will just point out some of the mechanisms that I use.
- I first identify the sector that I want to invest in by looking into how they have done historically, but more importantly what is their near term and long term prospects. For example, Pharma companies have great near term and long term prospects both from a domestic consumption point of view as well as research potential they have.
- In general, any consumption based theme is a good idea for a country as populous as India. Some of the industries to benefit will be FMCG, Tourism, Travel, Utilities, Construction etc.
- I look at 2 sets of companies within the sector – first the market leaders in the sector and secondly the emerging companies that may not be doing very well but have a far greater potential for the future. Typically, I will select a minimum of 3 and a maximum of 5 companies from a sector.
- The first indicator I look at is the PE ratio. While it can be misleading at times, I have found this to be the most logical way to judge the price. In general I try to avoid anything above 20 and would be keen to buy something below 15.
- The second indicator to decide on what price to buy at can be decided by the Moving Average price. Typically, I look at 200 day DMA, though at times of serious volatility the time frame can be shortened. If the stock can be bought at a price less than 200 DMA, I would seriously consider buying it. If it is significantly higher I would wait.
Have I always done it like this? Absolutely not as my understanding and knowledge have improved over time and I do things in a much more systematic way now than before. Identifying the right sectors, deciding on a shortlist of leading and emerging companies in those sectors to invest in, finalizing the companies based on their PE ratios and trends and deciding on the appropriateness of the price by looking at 200 DMA etc is a pretty solid method to get started.
Are there other ways of doing this? Definitely yes. Is my way a guaranteed success? Definitely not. Has it worked for me most of the times in terms of the desired results? This one is a definite yes again.
If you are going to start a portfolio use this or some other methods without over complicating it. And no, I have not read the Balance sheets of all the companies that I have invested in, only their analysis. In fact, the only Balance sheets I have read are for companies where I was the CEO.