Samaa Money’s checklist for deciding which stocks to buy
Friday, April 17, 2020 will go down as a remarkable day in the history of Pakistan’s stock market. It was for the first time on this day that trading had to be suspended for an hour because the KSE-30 index, which tracks 30 large and most liquid stocks, rose 5% within minutes of its opening.
However, many stocks hit their upper limit, rising 7.5% from their opening price, before the temporary trade halt came into force. This translates to a profit rate you can’t get even in six months if you put your money in a term deposit account.
So a key question to ask here is how do these money managers decide which stocks to buy. Before we attempt to answer it, let’s study five stocks that Pakistan’s top equity funds seem to love the most. (See disclaimer at the end of this story).
If you dig into fund manager reports (March being the latest available) of large asset management companies, you will find Engro Corp., Hub Power Co., Oil and Gas Development Co., Lucky Cement and Mari Petroleum among their equity fund top 10 holdings.
All of these stocks hit their upper circuit on Friday.
There are two ways you make profit from a stock: dividends offered by the company and a rise in its share price. You make the most usually during a rally: when the market continues to perform well over a long period.
Let’s focus on the most recent rally, August 2019 to January 2020.
If you had bought one share each of these five stocks when the market fell to a five-year low or 28,000-point level in August 2019, it would have cost you about Rs1,570. Selling the same shares in January this year when the market surpassed 43,000 points would have earned you Rs970 or 60% in terms of share price gain.
By this ratio, you would have made a Rs60,000 profit on every Rs100,000 invested—and that doesn’t even include any dividend, profits transferred to shareholders by a company.
The above example shows their performance in just five months. Let’s talk about a longer rally: January 2012 to May 2017.
The market was hovering above 12,000 points in January 2012. By May 2017, the KSE-100 index rose past 50,000 points, increasing more than fourfold and investors made fortunes. Samaa Money covered this in videos that you can find here.
You may wonder why fund managers take more exposure in these stocks or others, which are part of their top 10 holdings. We’ll come to that in a bit. Let’s first address another key question: there are more than 530 listed companies, don’t they also offer profit and more importantly are these five stocks the only ones offering higher profit?
To find answers to these questions, Samaa Money went through research reports, mined data, and interviewed about half a dozen security analysts and two top-rated money managers. With the help of these experts, we have come up with a quick checklist for deciding on which stocks to pick for investment.
Diversity: Do not put all your eggs in one basket, goes a famous saying and it holds true in the case of the stock market.
Pick stocks from different sectors as opposed to selecting different companies from the same sector. This diversifies your portfolio and spreads the risk. In fact, this also applies to individual stocks. Take the example from the five shares we have discussed above. Engro has subsidiaries in the food, fertilizer, chemical and energy sectors. It is highly unlikely that all these sectors fail at the same time, which makes it a top pick based on diversity.
Lucky Cement is another example, for it has plants both in the north and south regions. And if local sales fall, it also has a large exports base. More recently, the company has expanded into the auto sector, making it a very diversified stock.
Strong sponsors: Prefer stocks with strong and reputable sponsors. There is a reason why companies owned by Dawood Hercules, the Tabbas, Packages Group, Nishat Group and the like tend to do well.
Efficient management: Companies are run by people and they make profits when managed well. If the management is not efficient, the market loses trust in the company, making its comeback difficult. A recent listing (IPO) of a packaging company is a case in point. According to a market analyst, the company didn’t execute its plans as per expectations and its share has been performing poorly on the bourse.
Ability to make profit: Dig through financial statements and find out if the company is growing its profits and revenues and whether it will continue to do so. As we write, nobody is willing to buy shares of PIA.
Market share: It is important to check if the company has a notable share in the market. If the sector performs well, the company may do better based on its share. Pakistan State Oil and Fauji Fertilizer are two examples in which a company accounts for more than half of the market—both companies hit the upper lock on Friday.
Strong balance sheet: This is the most technical part of your assessment, for it involves some skills in accounting and finance. This is when you check if the company is in too much debt. If so, will interest cost wipe out the entire profit? Does the company have solid cash flows? Does it generate enough cash from day-to-day operations to payback loans? Is there a large unsold inventory or sales made on debt (this could turn into bad assets)? Another key number to look for is debt-to-assets ratio: anything above 20% should be flagged.
Market research: This is the most difficult part when studying a company, for it requires field research. This is why even the best of securities analysts scan financial news every morning. It is possible that there is nothing wrong in the company’s financial statement or balance sheet, but one bad news could change the whole scenario. It could be a government policy, a new regulation or other important developments covered by business journalists that may affect the company’s outlook.
Large market capitalization and free float: The larger the market capitalization (monetary value of total shares based on current share price), the higher the dividend yield and the payout. Similarly, a large free float (volume of shares traded on the bourse) means you can buy or sell that stock anytime you want as long as you are able to negotiate the right price. The five stocks we discussed as a case study in this article have both large market capitalization and free float.
Once you have examined each company based on this checklist, you build a portfolio in which you can invest. For that, you need to see your financial position, ability to take risk, holding power and investment horizon (short-term or long-term).
If you are a 60-year-old, you don’t want to take too much risk nor have holding power because you may need your money back anytime. Investing in oil stocks at the moment may not be worth the risk. If you still include an oil stock in your portfolio, you had better have minimum exposure, say 5% of your total investment. On the contrary, if you are a 30-year-old willing to take risk and have greater holding power, you can take more exposure in oil stocks.
However, it is important you keep rebalancing your portfolio. For example, if a particular sector or stock has a negative outlook, replace it with a stock that has a positive outlook. That’s easier said than done though, for it involves constant monitoring and research.
Never time the market, always buy when it falls and try to sell when you have accumulated decent profit without keeping any date in mind.
Invest long term, is what most experts agree on. It helps you avoid a loss that day hunters often suffer. You end up making decent profit in the long-term because markets perform well over years. Plus, you get more in terms of dividends, save on taxes, commission and fee charged by brokers and fund managers.
The story behind those top five stocks
Let’s come back to why money managers love those five stocks. This is because they are quality stocks and get more ticks on our checklist shared above.
These fund managers have billions of rupees under management so they look for stocks with high market capitalization and free float. The former translates into higher profit in terms of payout, the latter helps because it’s easy to buy and sell these stocks.
Take Engro for example, which has a free float of 317 million shares and a market cap of Rs93 billion.
Brokers say mutual fund assets are ‘passive money’ because they track the KSE-100 index. They take exposure in index heavyweights based on their weights and therefore perform in line with the market. However, they increase the weight of some stocks in their portfolio and decrease that of others depending on the outlook, which is why they often outperform the market.
Take Friday’s trade for example. The five stocks we discussed above alone account for one-third of the KSE-30. When investors started buying these stocks, they rose and pushed the KSE-30 up resulting in a temporary halt.
Interestingly, as many as 19 out of KSE-30 constituents hit the upper lock on April 17. This shows us that there are stocks beyond these five in which investors saw value. A majority of these stocks are found in top 10 holdings under the equity portfolios of large fund managers. Pakistan State Oil and Pakistan Petroleum Limited are two examples.
If you look beyond the KSE-30, many companies from the KSE-100 also hit the upper lock because of heavy buying in those stocks. This certainly indicates that investors look beyond those five companies or fund manager top 10 holdings.
You may be tempted to take a shortcut by buying those stocks that fund managers hold dear, but that could be a terrible idea. Those stocks show money managers positions at the end of March and things may have changed since then. The stock market is forward-looking, which is why it is the first place to react to good or bad news.
Since March end, there have been a lot of important news developments. This includes a construction package offered by the premier to the central bank’s refinancing schemes on cheaper rates and the IMF emergency loan and relief package offered by G20 countries, volatility in exchange rates. Each of these has an impact on the stock market, positive for some and negative for others.
However, the biggest mover of the market was the SBP’s surprise rate cut. The bull run was triggered by Thursday night’s surprise cut by the central bank, which slashed the monetary policy rate by another 200 basis points, resulting in an overall drop of 4.25% since March 17.
This wasn’t really good for banking stocks. For example, Meezan bank, which is part of top 10 holdings of most money managers, fell slightly despite an otherwise bullish trend. Banks may still book profits from their investment in bonds and treasury bills, but their outlook has changed.
By contrast, this rate cut triggered buying in leveraged companies, the ones that had higher debt on their balance sheets.
For example, Hascol’s equity was erased and it was struggling to get a bank loan because it had a debt-to-asset ratio of 60%. The number for International Steel was 50% and Hubco 40%. All three hit the upper lock because the rate cut changed the outlook. DG Khan Cement, PEL, Pioneer Cement, PEL, and PSO are other examples of leveraged companies that became attractive to investors because of this news.
That said, risks are still there as the economy is heading towards a recession, corporate profits are likely to decline and trade to remain suspended because of a lockdown to contain the Covid-19 contagion. If the government is not able to contain it fast, the market may suffer another jolt.
The bottom line: the five stocks we used in the article are a good case study to understand how fund managers manage their assets, but to stay ahead of the lot, you need to go by the checklist shared above and make your own assessment rather than rely on somebody else’s research. It’s your money after all.
If you are not already invested and plan to get started, there are two ways you can do it. Whether you are an overseas Pakistani or reside in the country, all you need to do is to pick a broker for direct trading or an asset management company to invest in a mutual fund that invests in the stock market. Once you have selected your broker or fund manager, they will tell you the entire process.
When selecting, just look for the following: who are the sponsors, market reputation, client size if available, performance, fee or commission, what value added services like portfolio tracking apps, customer service and timely research and advice they provide. You can select your money manager after surfing a few in the market who offer the best package.
Disclaimer: The writer of this article has no direct investment in any of these companies. The purpose of this report is to educate our readers on aspects of personal finance, including the stock market. The information shared in this article is not meant to be taken as financial advisory. You should independently verify all this information before making any financial transaction.