A beginner’s guide to stock picking — How to remove the clutter and focus on finance fundamentals?

10 min readMay 21, 2021

I’ve been investing in stocks now for about a year. My father, who’s been investing for over 25 years, gave me the necessary initial learning to get started and always warned me against three things:

Never time the market
Don’t invest on tips
Don’t day-trade

Being the rebel I am, I tried doing all three! And lost initially.

Within the last 12 months, I’ve spent my weekends experimenting with value investing, day trading, futures trading, and very recently algorithmic trading. And I realized that unless you’re a full time stock market player, you can make sizable gains only through value investing. And when I say sizable gains, I mean getting about 2X returns when compared to the stock market index.

Recently, when I was sharing my experiences with a friend, he intrigued me by asking if all the principles I’ve been using to pick stocks can be converted to an algorithm that automatically picks and manages my portfolio. I did just that over the next couple weekends, and while it’s not been much time since I put it to action, it’s been consistently yielding double the returns when compared to the index.

This article speaks more about the fundamentals I use to pick value stocks, which now my algorithm does for me!

Finance 101 — The physics behind stocks

Let’s start by first understanding a few terms that are pre-requisites to understanding value investment. If you’re already familiar with these basics, skip to the next section:

Index — Index is basically the collection of stocks that helps investors measure the performance of the stock market. For example, Nifty50 is the index of the top 50 highest valued companies in the Indian stock market. Similarly, the SENSEX is composed of 30 high value and commonly traded stocks of the Bombay Stock Exchange that cover almost all industry sectors in India. Investors usually compare their gains against the gains/losses in the index

Index Fund — An index fund is a fund that mirrors the index, i.e. this fund has the same stocks as the index and the investment weightage between all these stocks is the same as it is on the index. Anyone who wants to have a no-brainer investment in stocks, should simply invest in an index fund. To give you an idea, the BSE Sensex was valued at Rs.100 on April 1, 1979. It was valued at Rs.50,029 on April 1, 2021. That’s a 50X gain in 42 years, which is equivalent to a 16% compounded return over 42 years! Almost no private mutual fund in the country can boast of such a consistent performance

Earnings Per Share (EPS)— This is for a particular stock and it means exactly what it says. It is simply:

Price to Earnings Ratio (PE) — This number is basically a measure of the how much investors are valuing the stock when compared to its earnings. The higher this ratio, the higher the company is being valued by investors.

Book Value (BV) — Book value is the value of the share or stock as per the company’s financial statement. You can calculate this as follows:

Let’s take an example here:

Reliance has about 6430 Million Shares. Every individual that owns even 1 share in Reliance is considered a shareholder. The money available in the company is through two sources — equity & debt. Equity is the money that is deployed by shareholders, whereas debt is the money invested in the company by banks.

The money deployed by shareholders (Equity Share Capital) is the amount given to the company by shareholders against purchasing shares of the company. By investing this money in the business, the company makes profits or losses. Whatever profit is retained by the business is hence also owned by the shareholders and is recorded in the financials as Reserves and Surplus.

Hence the total equity deployed in the company is equal to the sum of equity share capital and reserves/surplus. In the case of Reliance, it is INR 4,744,830 Million. You divide this by the number of shares, and the book value comes to INR 738/share.

Return on Equity (RoE) — When you hear someone tell you that they will deliver a return of 12% on your investment, it means that your invested money will grow by 12% each year. Similarly, RoE is rate at which the equity deployed in the company is growing each year due to the profits being made by the company. Hence, you can calculate the RoE of any company by the formula below:

Considering that one can get a reasonably secure return of 6–8% from a fixed deposit in an Indian bank, it’s always a good idea to only pick stocks that are delivering at least double this return because investing in a company’s stock is a much riskier investment than investing in a fixed deposit.

Value Investing — Value investing is basically the concept of investing in stocks that will deliver high returns to the investor in the long term. Stock trading, futures/options trading and short term (1–2 months of investing) are NOT the same as value investing. While there is speculation involved in any type of investing, value investing depends on strong financial fundamentals of a company and not simply on market trends.

Wrong notions about value stocks

In the limited time I’ve spent investing in the stock market, I’ve realized that if anyone, including your stock broker/investment advisor, suggests a stock to you based on the following points, you should NOT invest in it:

“This stock is cheap, so you should buy it” — Stock price is no measure of it’s value. A stock priced even at Rs.100K per share might be a great value stock whereas a stock priced at Rs.10 per share might be of no value at all
“Everyone’s talking about this stock or everyone’s buying this stock, so you should buy it” — Remember what happened to GameStop stock in Wall Street? Or if you’ve seen the web series Scam — 1992, you’ll know what I’m talking about! Following a frenzy is not scientific and will burst at some point. It’s not value investing
“This stock has a very high PE. It’s overvalued, so don’t buy it” — We’ll talk about this in a bit, but the PE of a stock is not a sole indicator of it being overvalued. If a company has a justifiably high PE, it might still be a great investment

In short, just like you won’t buy a car or computer without studying it or trying it out yourself, buying stocks without studying their fundamentals is nothing short of gambling!

How to pick the right stocks

Now that you know the fundamentals and what not to do, let’s discuss how to actually pick the right stocks. A value stock is a combination of the following factors:

1. Return on Equity > Price to Earnings Ratio

The PE ratio as described above is the basic indicator of a company’s valuation by the market. Usually, mature stocks that are consistently performing will have their PE ratio pegged at a number similar to it’s RoE, i.e. a mature good company with a 30% RoE will justifiably have a PE of 30. A PE number higher than 30 will mean that the market is being quite bullish on the stock and the stock might go down the minute there’s some troubling news. A PE number below 30 for such a company will mean that there’s a strong upside and the stock has not yet caught the eye of most investors. Hence, a good buy.

So when evaluating a stock, calculate the ratio — RoE/PE. Let’s call this the stock’s value factor. A factor < 1 means the stock is overvalued and a factor >1, means its undervalued.

2. Company’s Profit Growth > Return on Equity

Now, stocks appreciate because of growth. A great company that does not grow, is not considered a great company by the stock market. Hence, growth in profits is an important factor to incorporate to the value factor when picking stocks.

I do this by calculating the net-growth in profits. A company’s profits must grow by it’s RoE without much effort. Let’s say a company today has Rs.100 Crore in total equity deployed. It has an RoE of 20%. This means it will generate Rs.20 Crore in profits and it’s total equity deployed will become Rs.120 Crore next year. However, if the profit increases by more than Rs.20 Crore, it means that the company will have used it’s available equity more efficiently to deliver a higher RoE. Hence, when I consider growth, I look at growth in RoE and not simply growth in profits.

Net Value Factor

We now combine the above two factors to come up with, what I call the Net Value Factor

Fundamentally, companies with a Net Value Factor > 1 are undervalued and those less than 1 will have limited upside due to them being overvalued.

3. Debt:Equity Ratio is less than 0.5

Another factor to look at while picking stocks is their debt:equity ratio. A company with high debt is a risky bet as paying interest on debt eats into the company’s profitability. More importantly, in a time of crisis, say times like COVID when the company’s revenues might take a hit, the debt will need to be repaid from the company’s reserves or equity. A company with low or no debt on the other hand gets to retain all its profits and is in a stronger position to weather storms like COVID.

I generally pick stocks that have debt which is less than 50% of its equity base. This ensures that even in times of trouble, the company has enough money to pay its lenders and will not go bankrupt.

What the algorithm does

You might have noticed that all of the above parameters are pure numbers. There’s no subjectivity to this analysis. This is both a strength and weakness of this approach. Strength, because it allows me to pick stocks in an unbiased manner, and even more importantly write code to do the job for me. Weakness, because it does not take into account any market trends or specific news about a stock. However, I’ve realized that if I let my code pick 20–30 stocks and create a portfolio from it, the noise created by news and trends all tend to average out and the returns still turn out pretty good.

So the code I wrote basically does the following:

Scrapes online webpages of 100% of India’s stocks (roughly 4000 of them) to collect multiple data points for each stock
It then calculates the net value factor (NVF) of each stock based on the above formula
Next, it filters the stocks that have an RoE greater than 20%, NVF above a certain threshold based on market cap and debt:equity ratio of less than 0.5.

In small cap (stocks with market cap less than Rs.5000Cr), I generally don’t pick stocks with a market cap less than Rs.200Cr, out of personal preference since those tend to be super flaky companies and it’s difficult to expect consistency in growth from them.

Lastly, this algorithm is run once a quarter since that’s when the the quarterly results of companies come out. Based on the new list generated, the algorithm changes the stocks in the portfolio — this is called reshuffling.

How to decide how much to invest in which stock

Now, there’s no right answer here. This really depends on one’s risk appetite. My division is usually done as follows:

20% portfolio in small cap
30% portfolio in mid cap
50% portfolio in large cap

Once the identified stocks are grouped by market cap, I do equal allocation within the stocks in the respective groups. So if the algorithm picked 5 stocks in large cap, I would split 50% of the portfolio equally between the 5 stocks.

Current Value Stock List

In my latest run of this algorithm — April 26th 2021, the following 28 stocks were picked up:

As can be seen, only 2 out of 28 stocks are losing. Also, since the 26th April, the Sensex has gone up by 4.45% till 21 May 2021. This portfolio on the other hand has jumped by 9.9%, exactly 2X!

If you’re interested to get a list of these stocks each quarter, please let me know through a comment below

Happy investing!