How to Pick Securities
How to Pick Securities
Securities picking is the most time consuming part in investing. To pick securities properly means a lot of reading and analysis. We can talk about two main types of securities picking:
Bonds (or fixed income securities) are easier to pick, but only if they have credit ratings. Credit rating submitted by rating agency normally shows the riskiness of the creditor (or bond) and what investor is needed to do is to asses risk and reward utility. Of course attention must be paid also to maturity, currency and when the rating was provided (if long time ago then situation might be already much worse).
If there is no credit rating, which can happen for smaller issues and some local companies, it is much harder to assess the risk and you have to be experienced analyst to do that. If you are not one of them, then better to avoid such bonds. One of the choices maybe bond funds or bond ETFs, because fixed income securities always have to very well diversified.
Picking of stocks is even more difficult task because not only riskiness has to be assessed but the potential return too. When investing in stocks, nothing can be for sure. The influence of economic cycles, technological developments, political decisions, or actions of competitors may dramatically affect the value of the stock. That’s the reason why investing in stocks is so risky. But if you have decided to invest in stocks, how to pick the best ones? There are many methods for that, however, some of them are charlatanic. We will focus only on fundamental analysis approach.
Relative valuation is the most popular approach to pick the best value/price targets that can offer highest potential return. Relative valuation is based on valuation multiples that are calculated for valued stock and for competitors. This type of valuation is not very time consuming (a lot of multiples are accessible on the internet for free) and can be used by small investors.
DCF valuation is a next top popular tool for stock picking but this one is more used by professionals. DCF valuation requires a lot of knowledge and is very time consuming which makes it not very suitable for private investors.
However, stock valuation isn’t the only process at stock picking. Stocks must be well diversified in the portfolio (fundamental diversification is preferred), suitable to predetermined risk level and etc. Stocks may be picked bottom-up when they are chosen randomly and then analyzed thoroughly or top-down, when at first regions according macro economical data are chosen, then the most promising sectors and only then the best stocks in those regions and sectors are selected and assessed.