Stockpicking Part 1 - Top Down

Starting Stockpicking

Choosing your first stocks to trade or invest in can be a daunting task. Why should your stock be the best one? What about the thousands of people out there who will inevitably disagree with you? Generally speaking, 50% of investors will make money, and 50% will lose money. There is always a small portion of the market that invests on a whim, without reliable information and without an exit plan, and usually fall within that losing 50%. Your aim is to not fall into their habits and claw your way into the successful 50%, and the surest way to do that is through hard work and thorough analysis.

If you use a fundamental approach, which is analysing company, industry and economic data rather than previous share price data (this is called technical analysis) then there are two main approaches that are followed: top down and bottom up analysis. Top down analysis will be discussed in this post, with bottom up being reserved for the following post later this week.

Top Down

A top down fundamental analysis starts with the big picture and narrows it down to a particular company. In forming the following views, it is important to read, understand and compare a wide range of reputable sources in order to have an informed view. The first step is often to take a view on whether the broader economy will perform well or badly. As an example, let’s say that we believe global growth will increase. The next step is to narrow that down to a particular industry that will benefit from this increase in global growth. Let’s say that we chose the petroleum (oil) industry, as our research told us that demand for oil increases when growth increases, and therefore the price of oil rises. 

The following step is to choose which part of the oil industry will benefit the most from the increase in oil price. It could be the large producers that already have an established market share, and will win most of the contracts to supply more oil. Or perhaps the increased demand will be met by smaller companies who previously struggled to sell enough oil to stay afloat. Once again, only a serious amount of research into the industry can tell you these things. Sources such as Bloomberg reports, broker research and economic forecasts are useful tools in creating an informed opinion. 

If you chose junior oil producers, you might now have a list of 50 companies to choose from. In deciding which one to choose (some may be more limited by your home countries choice of stocks), you must then analyse each company in order to see which will benefit the most. What will drive the share price the highest? Often the largest gains come from the largest change in expectations, so you may decide based upon the current profit margins. A company that currently has small profit margins may not be worth much on the stock market, but a small increase in the price of oil could see those margins double, and potentially so could the share price.

This is just an example methodology of how to select a good stock, or set of stocks to invest in. Every person has their own method, the important thing is to ensure that it is backed up by as much solid evidence as possible, rather than emotions or desperation.

In the pipeline: Stockpicking Part 2 – Bottom Up

Bullish on: S&P 500 (positive news from Greece will alleviate short term concerns)

Bearish on: US 10yr Treasury Notes (yields are too low relative to the S&P, inflation will rise)

As always, please feel free to leave any comments or suggestions that you may have. If you are looking for more trading strategies, try www.pimmtrading.blogspot.com.