How to pick stocks

What is an investment portfolio?

We can describe it as a grouping of financial instruments, engulfing one or several asset classes, which will seek an optimal balance through risk reduction and return maximization.

While investment portfolios may vary in composition or dynamism — depending on your investment horizon, risk aversion, and personality — external factors such as macroeconomic events, market valuations, inflationary expectations or foreign currencies’ fluctuations will have a significant influence on its conformation.

One of the first definitions should be the weighing of the different asset classes that will form a portfolio or Asset Allocation. Here an investor should choose its exposure to fixed income, local or international equities, commodities, among others. Look here for more info on diversification.

At this point a macro analysis can shed some light regarding how much exposure would be adequate for: stocks, sovereign bonds, corporate bonds, international indices, gold, oil, etc.

Now, when deciding which stocks will be selected for your exposure to equities, it is important delve into the companies’ fundamentals that will ultimately reflect on their market performance.

Through fundamental analysis, we get to know the company. We delve into its financial statements to assess its wellbeing, identify what are its strengths and prospects, and to understand what are the factors that drive its industry’s performance.

From a fundamental point of view, you should probably seek to be invested in companies with solid balance sheets, competitive advantages, cash generation capacity and attractive valuations.

A firm with a solid balance sheet should be able to meet its obligations and will have some protection against headwinds. While using credit might be cost-effective from a capital cost point of view, having a moderate net debt-to-EBITDA ratio is advisable.

The competitive advantages, or moat, usually come along with higher levels of profitability or less volatility in performance. Higher entry barriers support this thesis as they hinder the process of substitution.

“Cash is king” is a reality in the stock market, companies that have the capacity to generate cash usually hold healthier balance sheets or attractive returns for its investors. Proven ability to generate cash would support the growth of the company without compromising its liquidity or solvency.

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Attractive valuation refers to a favorable relationship between what a share “costs” and what “is worth”.

One way to determine a fair value for a company is through “discounted cash flows”. Here, you should forecast the company’s results and bring these flows to a present value, using a proper discount rate that reflects its cost of capital. Here we can see again the importance of being able to generate cash flow.

There’s always people looking to acquire assets at bargain prices, yet it is usually hard to find them. Charlie Munger himself has recognized that he “prefers to buy a wonderful company at a fair price than a fair company at a wonderful price.”

These are just a few key factors that can guide your stock selection process. There are advanced methods and models to determine the weight of the different assets in order to reduce overall risk.

Investors periodically update their models to determine if it is appropriate to rebalance or even change the composition of their portfolios.

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