Investing

How to Determine Which Shares to Buy the on the NSE

January 11, 2018

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What shares should I buy? I get this question a lot.

Before we delve knee-deep into this, you need to understand that when you are buying shares, someone else is selling it. Understanding this dynamic will guide you when picking winning stocks on the stock market. Additionally, you need to learn how to read a financial statement and understand the basic ratios that used weed out bogus stocks trading on the stock market.

There are numerous strategies out there to help you determine which shares to buy. However, I will only introduce one simple system you can use to filter and narrow down your stock market options:

Step 1: Invest With A Purpose

Why are you investing? Write down the reasons why you’re looking to make this investment.

It is alright to have many reasons to invest but not having one, is a big problem. Categorize your goals into the main investment goals. There three main identifiable goals for investing in the stock market: growth, value, and speculation. The growth approach only seeks to increase capital value, while value stocks seek stocks that yield in income. Speculation is a whole different ballgame, where the investor is seeking to make a profit from predicting future prices. It is important to note that, a steady investor will be looking to increase the capital value or income, while an adventurous risk-taker will be speculating in the market.

Back to your purpose, are you leaning more on increasing wealth, having a steady income or speculating for rapid capital appreciation?

Step 2: Filter the Growth/Value Stock Selection Approaches

Depending on your goal, the selection for both growth and value-based goals is different.

The growth-based approach utilized a broader approach, while the value-based utilized ratios and other financial statement information. There are about 75 companies on the Nairobi Stock Exchange (NSE) and you will need a way to narrow them down.

Decide Between a Top-Down /Bottom-Up Approach to Select Growth Stocks

Top-down and bottom-up selection approach is used to select growth stocks. In both approaches, we basically seek to narrow down our selection by looking into the company, sector, and industry.

In the bottom-up approach, you will first filter your company based on either the growth or value approach. Scroll down to read more on how to filter growth and value stocks. After that, you will need to validate your selection to confirm the growth approach to the sector. This means that the sector must be a growing sector to validate your choice. Then double confirm with the industry. This way, you will be able to pick companies with strong potential and perhaps even be able to identify companies that can withstand sector declines. While you’re at it, do not ignore the fact that larger economic influences can impact the stocks you select. No company is unshakable.

[bctt tweet=”No company is unshakable, no matter how big or strong it may appear to be. ” username=”beyondsixzeros”]

In the top-down approach, you will do away with industries/sectors that are not performing. With the big picture in mind, select industries with favourable trends i.e. growing and expanding. Then select favourable stocks from your favourable industry. It is advisable to select a single stock or spread your investment across several attractive companies in various favourable industries. This method will help you make strong selections, with no preconceived ideas, producing diverse results.

Value-Based Approach

Essentially, value investors do not bank on the future potential of stocks. These stocks aren’t cheap either but you can find real gems among the stocks that have hit a 52-weeks low. These stocks are however bargains, as the market has undervalued the stock for some reason and the investor is seeking to capitalize on that before the stock price is corrected.

Value-Based Stock Screen

Here is a simple fundamental stock screener that you can use to filter for high growth companies while ensuring a certain return on investment and stability requirements are met:

Size: At least KES. 10 billion in market capitalization.

High Dividend: All pay a yield of at least 10%
Price to Earnings Ratio (P/E): 9.0 or less to ensure only stocks selling at a bargain pass the filter. Low P/Es usually eliminates high growth companies.
Current Ratio: It is the current assets divided by the current liabilities to find companies with a current ratio of over 1.50. Particularly great of investment services firms ensures that companies enough cash and other current assets to weather any further declines in the economy.

Reasonable Valuation: Find all stocks that have a P/E ratio to growth ratio (PEG ratio) of 1.75 or less. This will provide stocks that are reasonably priced and growth expectations are moderate. This filter seeks to remove all companies whose dividends are artificially high due to deteriorating earnings fundamentals.
Price to Book Value (P/BV): 1.20 or less
Low Volatility: All stocks with a beta of less than 1 (which means that they have traded with less volatility than the overall market.

Debt load: For a low debt load have a stock with a Total debt to asset ratio of less than 1.10 particularly now that we have tight lending in a fragile economy.
Sector Diversification: Have a basket of stocks from different sectors to minimize certain market risks inherent in individual sectors within the economy.

Growth-Based Approach

Here is a simple stock screener that you can use to help you filter for high growth companies trading on the stock market while ensuring a certain return on investment and stability requirements are met:

Strong historical earnings: Companies that display good growth in the last 5 to 10 years are likely to continue doing so moving forward. Depending on the size, we are looking for consistent strong growth of over 5% – 7% for large companies and 10% and over for small companies.
Strong profit margins: Compute the companies pretax profit margin by deducting expenses (without tax) from sales and dividing by the sales of the year. This indicator helps filter companies with poor management practices that may hinder growth. Therefore, pick stocks with pretax profit margins that are greater than the average of the last five years.
Strong Return on Equity: Return on equity (ROE) is computed by dividing net income by shareholders equity. Compare the companies ROE with the average ROE of the last five years. A stable or increasing ROE shows that the company’s management is doing a great job at increasing shareholders investment.

Strong Stock Performance: Investing for growth means that you would probably want to double or triple your investment. Therefore, purchase stocks with a growth rate of 15% or more to ensure that your investment doubles in 5 years or less. This is particularly possible for young companies in rapidly growing industries.

Final Thought

A lot of people say that diversification is for those who do not know what the heck they’re doing. That is why I advocate for it. If you’re not super conversant with conducting both fundamental and technical analysis on stock, do not place all your eggs in one basket. Also, do not speculate on the stock market. Leave that to the experts who understand it. A well-diversified portfolio will contain both growth and value stocks. So if you’re just starting out, have a good mix of both value and growth.

Happy Investing!

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Disclosure: This information is provided to you as a resource for informational purposes only. It is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal. This information is not intended to, and should not, form a primary basis for any investment decision that you may make. Always consult your own legal, tax or investment advisor before making any investment/tax/estate/financial planning considerations or decisions.