How to identify Stocks?

Stock selection is a very tricky job. The euphoric rise of the markets for the past 2 years till January 2008, gave an opportunity to make easy money on the markets. The steep fall of the past 2 months has again brought to fore the importance of proper stock selection for steady long term gains. In the past one week we have seen a sharp decline in the price of some blue chip stocks like BHEL and L&T. Does it mean that these stocks do not merit investment? There is no doubt that these stocks are excellent stocks with huge growth potential, but their prices had run-up too far as compared to their fundamental strength, hence the steep correction in their prices. Let us examine a few parameters of selecting value stocks for ones portfolio:

• HISTORIC DATA: Book Value represents the net worth of the company, comprising its paid up capital plus free reserves and surpluses. Companies with a high book value instill confidence among the investors, and are viewed as potential bonus candidates. Although declaration of bonus does not materially effect the balance sheet of the company, it often gives a fillip to the stock price as the liquidity improves. Another way to look at the strength of a company is the Replacement Cost of its assets and liabilities. To establish a new manufacturing plant is a capital intensive proposition, so it gives advantage to the existing established players over new players. However, one must take into account the 'technology obsolence' factor while evaluating companies on the replacement value parameter. Another related benchmark is the Price to Book Value ratio (PBV). A higher earning capabilty in terms of return to equity (ROE) tends to increase PBV. Let us take an example: L&T for most part of 2007 was quoting at a PBV ratio of over 25, and a company like HPCL was quoting at a PBV of around 1. But in the long run a very high PBV is not sustainable unless the growth is spectacular. So the moment maket got the signal that L&T's growth is slackening its stock started declining, giving it a discounting of a more reasonable PBV of around 20. On the other hand HPCL merits investment both on the low PBV ratio and a strong replacement cost scenario, but the stock remains subdued because of the govt. policy on pricing of petroleum products.