How Stock Picking Works

The equity market has benefited from the low interest rate and has attracted many people. Now, anyone who thinks that everyone who invests in the stock market has the same returns is wrong . One of the strategies to seek profitability above the market average is stock picking .

In this article, we’ll look at what this strategy is and what advantages it provides. Follow up!

Contents hide ]

  • 1What is stock picking?
  • 2How does it work?
  • 3What are the advantages of this technique?
    • 1Search for companies with valuation potential
    • 2Choosing companies with lower risks
    • 3Adequacy of investments to the investor’s profile
  • 4What are the principles of stock picking?

What is stock picking?

The translation of the term already gives a good idea of ​​what it is about. In English, stock is action and pick is choosing. Thus, stock picking would literally picking stocks . Basically, the objective of this strategy is to find stocks that have the potential to yield above the market average .

It is, therefore, an active investment management strategy , which is one that seeks to beat the market. This means getting a return higher than the stock market as a whole.

It opposes the passive strategy, which pursues the same performance as the market. Thus, it aims to follow some benchmark index. In the case of the Brazilian stock market, this index is usually the Ibovespa.

How it works?

Stock picking is a strategy used by many big investors, including the revered Warren Buffett. The idea, as we said, is to select those securities that can outperform the market as a whole and, at the same time, have low risk .

Speaking like that, it may sound simple, but believe me, it requires a lot of study. To successfully adopt it, it is necessary to know and deeply analyze the company. That’s because the stock market is like life: you can have some predictability about the future, but there can always be rocks along the way. Thus, it is possible to make less risky choices, but not totally risk-free.

Now, it is not enough for them to be solid companies, well managed and with good prospects. It is necessary that your shares are discounted in relation to their fair value and that there are prospects of appreciation.

In theory, the share price should reflect the company’s value . If the stock is trading below this price, it means that there is upside potential or, as they say in financial market jargon, upside. On the other hand, if the stock is above what is considered the fair price, there is potential for devaluation, or downside.

It is important to note that these calculations embody a certain degree of subjectivity. After all, if everyone agreed which companies have the potential for appreciation, everyone would buy the same shares. This would cause the share price to rise immediately and thus wipe out the upside potential.

However, the analyzes diverge. Whoever has the best quality analysis earns more and manages to find the shares that are actually discounted.

Finally, it is worth mentioning that stock picking is a medium and long-term strategy . This is because it relates to the company’s intrinsic value, not short-term market movements.

What are the advantages of this technique?

The stock picking strategy has several advantages, especially for those who want to keep their money for a long term and want to make money with the evolution of companies. See below.

Search for companies with valuation potential

As we mentioned, the purpose of stock picking is to find cheap stocks , that is, quality corporate stocks traded below their fair price . To ascertain the quality of the company, analysts usually observe three main criteria:

  1. profit margin;
  2. return on equity;
  3. level of indebtedness.

Thus, a company with a high profit margin, a good return on equity and little debt shows signs of being well positioned in the market.

With this analysis done, it is necessary to assess whether the price at which the stock is being traded is fair to the company’s value. For this, the company’s valuation is calculated, mainly using two methods: discounted cash flow and multiples analysis.

The first projects the company’s cash flow into the future and brings it to present value using a discount rate. With this, the fair value of the company is obtained, considering its capacity to generate cash in the future. The second uses market indicators that make it possible to compare the company to others in the same sector.

Choosing companies with lower risks

By choosing solid companies, with a qualified executive staff and that consistently deliver good results, the investment risk is reduced . This creates confidence in those who invest, who are not taken by surprise by bad news.

As this is a more adopted strategy for the long term, normal market fluctuations in the short term do not interfere with investment decisions.

Adequacy of investments to the investor’s profile

Likewise, stock picking makes it possible to adapt the stock portfolio to the investor’s profile. It is possible to form a more aggressive or more defensive portfolio. On the one hand, this makes it possible to adjust the application so as not to expose those who invest to more risks than they tolerate. On the other hand, it makes room for a set that balances risk and return potential.

What are the principles of stock picking?

To summarize, stock picking seeks to find stocks to invest based on a fundamental principle: finding good companies whose stocks are at bargain prices. This last point is very important, since there is no point in having quality if the paper is already expensive and there is no more room for appreciation .

Remember, the goal is to make a profit from the business. There are several ways to achieve this in the stock market. However, here we are talking about capital gain: selling for a higher price than what you paid for the paper.

Now you know how stock picking works and can analyze if it is suitable for your investor profile. It is worth remembering that most equity funds with active management adopt this type of strategy to seek gains above the market average. If you are interested in the subject and want to know more about it, get to know 8 investment books that everyone should read now

by Abdullah Sam
I’m a teacher, researcher and writer. I write about study subjects to improve the learning of college and university students. I write top Quality study notes Mostly, Tech, Games, Education, And Solutions/Tips and Tricks. I am a person who helps students to acquire knowledge, competence or virtue.

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