Stock Picking Skills: How to select between 2 stocks? – Part I

This article is a bit off the track, as till now I’ve been talking about NOT to directly invest in stocks :- ) But this blog is for information and knowledge purpose, so let’s see what should be kept in mind when selecting between 2 stocks.

Analysis of any stock selection technique falls into 2 categories:
• Technical Analysis
• Fundamental Analysis

Technical Analysis:
Almost all of us have bought stocks, sometimes or the other in our life – that’s the reason you are reading this blog :- )

So how did you decide to buy it? Well, some of us started by applying for stocks through IPO. Rest of us started looking at the charts as the one presented below.

I started my stock trading business by looking at charts. (This chart is borrowed from Yahoo Finance)



The above chart is for a 5 day period of Reliance. It is showing a downward trend. Hence, I, as a novice trader, believe that whatever is coming down today should go up after some time, so I go ahead and buy this stock. The biggest assumption that I make while buying this stock is “Going down followed by coming up” concept. The problem is that it may not be true, in the short term, in the long term or to talk about the extreme case, the company may even go bankrupt (as happened with the US Subprime mortgage mentioned in my previous article)

This, and any other type of analysis which is based upon trend, patterns and charts, is known as technical analysis. In the case mentioned above, we are going “against the trend”, believing the concept whatever goes down comes up. Opposite to this is what is known as the momentum strategy or Go with the trend strategy: Whatever goes down continues to go down and whatever goes up continues to go up (atleast in short term trading and mid term trading). A typical example of this is IFCI – over the past few months, this stock has risen consistently from the level of 12 Rs. to 65 Rs.

There is some evidence of both these strategies working properly, but without any guarantee. Usually, the opposing strategy works for long term – when we look at investments for long tenures like ALEAST 3 to 4 years. The momentum strategy is found to work in the short term, when the investment horizon is in months, upto a maximum of 3 months (like IFCI).

However, the success rate for both these strategies is found to be around 50% only – meaning it is nothing better than placing a bet. The reason is that within an ocean of stocks and mutual funds, which stock or MF would an investor choose and which theory he will apply to which stock - is the question that makes this theory a failure. Applying long terms strategy to the so-called bluechip stocks or momentum strategy to the midcap stocks, nothing has a success rate better than 50% - as calculated on historical data. Take the transaction costs and brokerage amounts in consideration, and the success rate will come down further.

A simple example that I can quote here is about the last 6 years of Bull Run in the Indian stock markets. So many small cap stocks have become mid caps, while so many mid caps have been promoted to large caps. Applying momentum strategy to any of them for just 2 to 3 months would have been a failure, as you would have lost on the long run gains. Similarly, the stocks like Pieco, Mukund Iron, Premier, etc. which were once a part of Index, no longer exists. Applying long term strategy for this would have been another case of loosing strategy.


Continue to Part II of this article