Stock picking involves analysts systematically analyzing individual companies to select stocks to include in an investment portfolio. They research factors like financial statements, ratios, litigation, patents, and industry outlook. Analysts may take long positions by buying stocks they expect to rise or short positions by selling stocks they expect to fall. Actively managed funds employ stock picking strategies like bottom-up analysis of individual company performance or top-down analysis of macroeconomic factors. While stock picking is challenging given uncertain stock prices, examining multiple factors can improve prospects over guessing.
2. Introduction
A key part of active investment management, stock picking denotes the process of an
analyst or investor qualifying a particular stock as a good investment and including it in
the investment portfolio after conducting a systematic analysis. Contingent upon the
analyst or investor’s perspective on the stock’s price, they may opt for a long or short
position. A long position relates to when investors buy stocks that they expect to increase
their value, while a short position refers to when investors sell stocks they don't own
intending to repurchase them at a lower price in the future.
3. Actively managed funds employ teams of investment analysts who perform stock picks
and continuously rearrange the portfolio following changes in the market conditions and
the company. They can choose from several strategies to do so. For example, they can opt
for a bottom-up or top-down strategy. The first analyzes the stocks focusing on an
individual company’s performance, like revenue or earnings, as opposed to the overall
economy or industry situation.
4. The bottom-up strategy practitioners assume that companies' outcomes will remain
relatively good even in an underperforming industry. On the other hand, the top-down
strategy concentrates on macroeconomic factors like taxation, employment, and interest
rates, among others, before considering specific companies or a sector's performance.
5. Often, actively managed funds offer a “high conviction” fund comprising a small sample of
stocks that analysts have selected as best high-performers in the medium term. The
number of stocks is typically from 20 to 40, which is a significantly smaller number than
that of an average active fund or a passive index-tracking fund.
6. Active management differs from its passive counterpart that seeks to replicate an index and
lacks significant portfolio turnover. Passive management does not involve any teams of
analysts that select individual stocks. When investors buy passively managed exchange-
traded funds (ETFs) or mutual funds, they automatically invest in the latter’s investment
basket of stocks.
7. A basket of stocks is a collection of securities that share some common criteria. These may
be a sector like health care, technology, and so on, or an index like the S&P 500 Index.
Short for the Standard & Poor's 500 Index, the S&P 500 weighs the total market value of
500 publicly traded companies in the US.
8. Thorough analysis underlies stock picking. Analysts and investors peruse a company’s
financial statements to examine their balance sheet and income and cash flow. They also
consider the realized revenues and profits and incurred costs. In addition, analysts and
investors check the company’s cash and debt levels and study financial ratios, including
debt-to-equity (D/E) and price-to-earnings (P/E).
9. The D/E equals a company’s total liabilities divided by its shareholder equity. It measures
the company’s financial leverage, or the amount of capital comprising debt and whether it
can fulfill its financial obligations. The P/E evaluates the current share price of a company
in relation to its earnings per share.
10. After carefully analyzing all of these metrics, analysts and investors compare them with
those of other industry players to determine where the company is standing. Besides
studying the company’s financial statements, they also have to be familiar with company
litigation or upcoming patents, if any. Furthermore, they need to look into the entire
company’s sector and industry to grasp any potential strengths or weaknesses and its short
and long-term outlook.
11. Finally, the lack of a sure-fire way to predict how a stock's price will behave in the future
makes stock-picking an extremely challenging activity. But by closely examining multiple
factors, investors may have a better prospect of future stock prices than simply guessing.
Forecasting is not an exact science - analysts and investors that apply forecasting
approaches must accompany their calculations with a margin of error.