Key factors for selecting most rewarding stocks

TANZANIA: HAVE you ever found it challenging to select the most appropriate and rewarding stock in the market?

Questions about which stocks to buy for different time horizons and which stocks hold the most value are crucial before making a purchase decision.

A prudent investor considers the following factors before deciding to purchase a stock:

Investment Goals

The first step in selecting a stock is to determine your investment goals. Three primary investment objectives are income generation, capital appreciation and capital preservation.

Income Generation: Investors seeking income generation should select stocks with strong dividend yields, robust cash flow, and stable profits. Capital Appreciation:

Investors focused on capital appreciation should consider stocks of young, growing companies with promising revenue and profit growth.

Capital Preservation: Investors looking for capital preservation, with a low-risk appetite, should prefer mature, stable blue-chip stocks with steady and predictable profits.

Investment Horizon You can adopt either a long-term or short-term investment strategy: Short-Term Investment Strategy:

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Also known as active investing, this approach involves taking advantage of market swings to capture capital gains. Active investors, generally more risk-tolerant, thrive during periods of market volatility.

They aim to outperform the market by generating higher returns than the average market return.

However, in developed and efficient markets, this strategy often proves futile as market-relevant information travels rapidly, causing markets to react instantly.

According to the SPIVA Scorecard, 84 per cent of active managers underperform their benchmarks over five years in developed markets.

Despite the challenges, active investors have better chances of success in emerging and frontier markets, where data lags and market reactions are slower.

Long-Term Investment Strategy: Known as passive investing, this approach involves either tracking an index or selecting stable stocks and holding them for an extended period.

This strategy suits investors seeking income generation and capital preservation. While passive investors primarily use fundamental analysis to pick stocks, active investors focus more on technical analysis.

A blend of both analyses is advisable for all investment strategies. Fundamental analysis examines economic and financial factors to determine a business’s prospects and value, whereas technical analysis uses historical price movements to predict future price patterns.

It is recommended to use fundamental analysis to determine what to buy and technical analysis to determine when to buy. Another factor to view is the fundamentals of a specific company you want to invest in. Some of the fundamentals to watch are as follows;

Profitability

Assess the company’s performance over at least the last five years to gauge the stability and trend of its profitability.

Although past performance does not guarantee future results, companies that have performed well historically are more likely to continue doing so.

Key questions to consider include: Is the company profitable? If so, for how long? What is the profit growth trend over time? Investors prefer companies with growing profits and should be vigilant in assessing the likelihood of continued profitability.

Revenue

Evaluate the sustainability of the company’s revenue by examining the products or services it offers and the factors influencing them in the market, including competition trends and market expansion prospects.

Consider how these factors might affect the product or service over time. Improving Operational Efficiency A key indicator of a company’s potential for sustained profitability is its operational efficiency, measured by profit margins. Companies with growing profit margins are becoming more efficient, using fewer resources to generate revenue.

Assess the company’s future plans and how they might impact direct and operational expenses.

Company Cash Flow

While profits are important, the ability to generate cash flow from normal operations is crucial.

A company with high credit sales may report net profits but suffer cash flow issues, leading to increased finance costs from overdrafts. In case of defaults on receivables, the company might struggle to meet obligations.

A healthy company maintains sufficient and sustainable cash flow for obligations and shareholder returns. Dividend payments, determined by profits, are made from available cash flow.

Liquidity

Liquidity refers to the ease with which a stock can be sold without affecting its market price. When investing in equity, select stocks that can be easily traded.

One measure of stock liquidity is the turnover ratio relative to the company’s size over a certain period.

For example, CRDB, the most liquid counter on the DSE, has a turnover ratio of 3.2 per cent, compared to 1.1 per cent for the entire market.

Stock illiquidity can be influenced by factors such as poor business performance and significant mismatches between market price and stock fair value.

Volatility

Volatility is the rate at which a share’s price changes over a specific period. Shares that rise and fall sharply in a short time are considered volatile.

While volatile stocks offer opportunities for active investors, passive investors focus on long-term fundamentals, making short-term price movements less relevant to their strategy.

Active investors rely more on technical analysis to time the market, though timing the market—acting on information before it is reflected in the stock price—is challenging.

Conclusion

While it is essential for investors to have a thorough understanding of the stocks in their portfolio and the stock selection process, consulting licensed investment advisors before making major investment decisions is advisable.

Investment advisors are trained to analyse and value investment instruments, thus relieving investors of this burden.

However, investors should remain inquisitive and seek to understand the advice provided to a comfortable level.