Question

A friend has approached you for advice because they know you are in an investments class. The friend’s grandfather has made a gift to the friend of $25,000 with the requirement that the money be used to invest in a minimum of 5 individual stocks. (The grandfather is an old-school stock investor and feels strongly that investing in stocks will help your friend understand the markets and the economy and will improve your friend’s decision-making skills.)

What are the three things you would want your friend to understand before they begin investing? In addition to those three things, how would you advise your friend to go about evaluating what stocks to choose? (You are not recommending a stock, you are advising them how they can choose a stock.) Finally, would you suggest they go about executing their transactions?

Answer 1

Suggestion 1: To diversify the portfolio. That is investing in multiple stocks.

Diversification means a reduction in the overall risk of the portfolio when 2 or more stocks are present in the portfolio. The overall risk of the portfolio is less than its weighted average risk of Individual stocks in the portfolio.

how can an investor have a diversified portfolio?

As per modern portfolio theory. There is a Benefit of diversification of risk when non-perfectly correlated stocks are added in the portfolio.

The benefit of diversification is when non perfectly correlated stocks are added then if the stock return of stock falls then it's offset by a rise in the stock return of another stock.

Suggestion 2: To do the fundamental analysis of the company.

General guidelines:
1. Debt to equity should be less 1.
2. Interest coverage ratio should be more than 3.
3. P.E ratio is less than twice of the last three years average EPS growth rate. (valuation purposes)
4. Last three years average Return on Equity (ROE) and Return on Capital Employed (ROCE) both are greater than 20%.
5. Promoters pledge less than 10% of their total shareholdings, or there is a clear indication that it will fall below 10% soon. (better if it is NIL).
6. Last three years CAGR sales growth rate is more than 10%.
7. Last three years CAGR profit growth rate is more than 12%. I.e EPS Growth.
8. There must be High ROE & low P/B value Ratio. P/B below 3 is acceptable. It's it sector-specific. Like that of Auto sectors is different from IT sectors(intangible assets).

Suggestion 3: calculate the intrinsic value of the stock.

Invest in the stock if it's the current market price is below its intrinsic value.