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Two approaches to select stocks
India’s financial services sector is huge. It is not just comprised of commercial banks, but also non-banking financial companies (NBFCs). These firms offer a wide array of financial services like loans, chit-funds, and are different from banks. NBFCs are often small players that largely go unnoticed. However, they are still important to the economy, especially in a developing country like India where 70% of the population lives in rural areas.
Given this, how do you choose a stock from among the 5,000? Here are two approaches towards stock selection:
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Top-down approach:
Every company works within the overall economic environment. As a result, what affects the economy will impact the companies too either positively or negatively. As a result, the top down approach first involves identifying the trends in the economy like consumer demand, inflation, interest rates, rupee exchange rate, etc. These could be both domestic as well as international factors. Depending on the trend, you narrow down the sectors are performing well and are likely to do so in the near future too. Even within a sector, the extent of the impact of different factors changes from business to business. This could be because of a multiple reasons like consumer segment it caters to, business model, supply system, and so on. For this reason, even within a sector, there will always be outperformers and laggards. The next step is, thus, to identify these and then choose your pick. The best example for this is when rupee fell against the dollar, IT and pharma sector stocks outperformed, while most other sectors dragged the markets. Even within these sectors, a few companies like TCS and Sun Pharma outshined the rest of the companies.
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Bottom-up approach:
“This is the exact opposite approach. Here, you do not look at the overall economy. The idea here is that, even if the economic environment is poor, there will always be a few companies that will do well. The investing strategy, thus, involves identifying stocks with very strong fundamentals like a healthy balance sheet, sound management, and effective business model. As a result, this approach requires a lot of research into the company’s past performance as well as the stock’s track record. However, it is important to take into account future factors that may affect the company. So, the broader economy should not be completely ignored. This approach works best when the overall market sentiment is negative. You will then try to find hidden gems in an underperforming sector like auto or realty, and bet on its prospects for future growth.
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44%
If you are a top down investor, you are likely to bet on IT stocks. These companies earn in dollars and other foreign currencies, and thus, benefit from rupee’s devaluation. As a result, the BSE IT index, which tracks these stocks, has outperformed the BSE Sensex in the last one year. The BSE IT jumped 44% as against a 3% rise in the Sensex.
