How to make a Stock Selection Decision?

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Traditionally, investors do an EIC approach before choosing a stock. This is a top-down approach where analysis is done from economy to industry and then to company. However, the economy, industry and company are under pressure due to the adverse impact of COVID-19 pandemic, hence considering this condition investors are suggested to think twice before investing in any firm. So how to choose firms during this economic crisis becomes a question for investors.

Along with EIC approach, investors should try to select resilient firms, that is firms that been resilient to economic shocks. What are resilient firms? How can they be identified? A Resilient company is one that can overcome disruptions of any form, they are sustainable to emerging economic downturns. In simple terms firms that are adaptable to economic changes and can overcome situations threatening to their survival. 

There are some firms which continue to make profit and maintain market share compared to its competitors amidst the challenges. Such firms can be identified by looking at certain metrics like leverage, contribution margin and qualitative factors.

Initially, investors have to check the debt ratio of the company, every company have debt in their balance sheet and compare to that of the industry average, every industry has got optimum leverage. Further, it is important to assess the cash flow generated by the firm and the repayment of debt. To ensure solvency a test by scenario analysis can be conducted by investors. Next important factor to look upon is contribution margin. Deducting variable expenses from sales gives the company surplus. Higher contribution margin allows the company to invest in various business activities and take up a new business, that increases the cash flow to company and shareholders. Another key metric is qualitative factors, like business agility, whether the company can adapt to new changes internally and externally. Ensure that company is affiliated to a business group, check on the management of the company and board of directors etc. A culture that operates in a rapid learning and fast decision cycles with new technologies are highlights of an agile firm. A company with an independent and professional board of directors is an indicator of good governance.

An investor should spend time studying the qualitative aspects of firms which aren’t readily available but are important especially when the economy is going through a challenging period. Companies like HUL, Nestle India are immune to economic concerns and manages to improve their revenue margin. Investors by considering all the above-mentioned factors can choose firms/ stocks and create a well-diversified portfolio for better returns.

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