Stock Selection

I.1 - Large-Cap Companies

These firms have a market value of $10 billion or more. This segment of market caps is not to be taken lightly at all as such stocks account for at least 70% of US stock market stocks. In fact, some of the best known US stocks are large-cap stocks that include household names.

I.1.1 - Risk

These firms are usually perceived as less risky than small-cap firms for several reasons. They tend to have a well-established brand or product, a solid reputation built over several years and a stable growth. They also tend to be major players in strong industries. Unlike small-caps, they tend to be more scrutinised by regulators. All these factors make them appealing to more conservative investor, who tend want to assume high risks.

I.1.2 - Return

Large-cap companies generally tend to have built their products and brands over many years until they have reached steady growth; however, this means that they will grow less aggressively than small-caps and will more likely offer less returns. They are more likely to offer dividends though, which appeals to investors looking for a steady income.

I.1.3 - Market Price

The stock price of a large-cap company is usually less subject to large volatile swings as can be the case for a small-cap. Large-cap stocks are also more commonly researched and so their market values are usually fairly priced, making it harder for an investor to find a bargain.

I.3 - Small-Cap Companies

These companies have a market value between $250 million and $2 billion. About 10% of the US stock market is approximately made up of small-cap stocks.

I.3.1 - Risk

Small-cap companies are the riskiest of all three. In fact, they are perceived to be much riskier than large-cap and, to a certain extent, mid-cap companies. They tend to be start-ups or small companies trying to gain an edge in a niche or unchartered markets, with relatively inexperienced management (sometimes, few people do most things) and a myopic mix of products. 

Their natural evolution, IF they succeed, is to transition to a mid-cap and then a large-cap company. However, a small-cap company’s future is uncertain as it can fail or go bankrupt. A lot of these companies operate in emerging sectors characterised by intense competition. Lack of economies of scale means that such companies are also more vulnerable to downturns and recessions especially that they do not usually hoard enough cash to weather such storms. Due to their small size, they are not scrutinised by regulators like large-caps are, which makes investing in their stocks even riskier.

I.3.2 - Return

Small-cap companies enjoy aggressive growth, much more than that of large-cap and mid-caps, so they offer higher returns. Most of them do not offer dividends though, preferring instead to plough their profits into company operations that fuel further growth. Usually, the board owns most of the shares so members have a personal interest in making things work and generating higher returns.

I.3.3 - Market Price

Stock prices of small-cap companies tend to be very volatile especially during market turmoil. They also tend to have illiquidity issues, leading to wide bid-ask spreads and making them hard to sell especially during high market volatility. However, they are not scrutinised by regulators nor heavily researched, which makes it possible to find bargains.

This approach relies on intrinsic characteristics of the company. It brings different numbers from the balance sheet and the income statement, and puts them together to better gauge the profitability of a business.

II.1 - Earnings

This factor can be crowned as “the king of factors” for fundamental analysts. As an investor, when you buy a stock, you are effectively buying a share of the company’s earnings. Companies with consistently solid earnings will always perform exceptionally well in the long run. Since companies can manipulate their earnings, it is important that you study this factor alongside other factors too, perhaps also dig into income statements yourself, bearing in mind that earnings are subject to manipulation and it is not unusual for some companies to publish misleading earnings. 

This factor is best studied by analysing its performance over time. You want to own stocks of companies that have consistently generated large and increasing earnings. You may have to account for seasonality for some stocks in which case you need to compare each quarter to the same quarter in the previous year instead of comparing consecutive quarters. You also need to look at the annual performance of earnings and revenues as well as compare a company’s earnings to the industry average and to those of competitors. Some investors like to analyse earning surprises in order to spot a trend early on.

II.2 - ROE

Return on Equity is calculated by dividing Net Income by total shareholders equity. It is often quoted in percentage terms, so an ROE of 20% means that the company has generated 20 cents in profitability for every $1 investors have put into the company.

It is a very important measure of a company’s success because it measures how successful the company has been in generating profits using shareholders money. Usually, a high ROE is more preferable, 10% or above is good (some investors require a minimum of 20%: this decision depends on your investment objectives). It is also advisable to compare it to the industry average and those of competitors as well as its historical growth pattern. If it is increasing, then you know the company is on the right track; on the other hand, if it is decreasing, then there maybe trouble somewhere and you need to look further into other factors.

However, do not exclude a company just because it has a low ROE: it may well be that the company has invested in assets that have pulled its net income down but may well contribute to giving the company a competitive edge in the future, hence allowing for higher profitability and, subsequently, ROE in the future.

II.3 - Net Profit Margin

Recall that the net profit margin ratio is calculated by dividing net profit by revenues. Net income is the most important measure of profitability. Investors like it because it can give them an indication of what to expect in earnings. They like the net profit margin ratio because it is indicative of how well the management of a company is controlling its costs. Therefore, a high net profit margin is more desirable than a lower one. To determine how “high” is high, it can help comparing a company’s profit margin to those of competitors and industry average as well as to historical values.

However, this ratio is rarely considered on its own when picking stocks. It is commonly analysed alongside EPS (Earnings per Share) growth, which can help in putting a broader picture on how consistent management has been in creating profitability for the firm.

II.4 - Intrinsic Value

We have seen how to use DDM and DCFM to estimate an intrinsic value of the stock. This intrinsic value is assumed to be the fair price of the stock and so if it is greater than the market price, it means that the stock is cheap and should be bought. On the other hand, if it is less than or equal to the market price, it means that the stock is expensive and should be sold. However, there are few assumptions at the heart of both models so always approach their outputs with an open mind, using them in conjunction with other factors rather than on their own.

II.5 - Dividend Yield

Some investors like dividends because they represent income. A high dividend yield is always more favourable; however, it should not be too high because then it means that the company is not investing in its growth like it should. A dividend yield between 3% and 6% is a common choice but this again depends on your investment objectives. Some investors like to go for this yield alone when they screen market leaders. 

II.6 - Price to Earnings Ratio (PE Ratio)

This is one of the more popular ratios as it directly ties up market value to a company’s earnings. It indicates how much investors are paying for every $1 of earnings. For example, if a company’s PE ratio is 10, then you will be paying $10 for every $4 of earnings. Therefore, a low PE ratio is perceived to be more favourable to a higher one. Nevertheless, some industries, such as technology, have a high PE ratio as an industry average. Therefore, a company’s PE ratio should be compared to the industry average: if it is lower, the stock is considered a bargain.

II.7 - PEG Ratio

This ratio is calculated as Price to Earnings (PE) divided by the expected (profit or earnings) growth rate. The importance of this measure is that it sheds more light on the PE ratio of a company and, hence, it takes the PE ratio one step further. A company can have a high PE ratio; however, if it is expected to grow at a rapid rate, then its PE ratio will not be high in a year’s time. In general, a PEG ratio that is less than or equal to 1 is more favourable because it can indicate an undervalued or a cheap stock; a PEG ratio greater than 1 is less favourable because it can signal an overvalued or expensive stock. As with other measures though, this ratio should be compared to its historical values as well as to those of competitors and the industry average, rather than considered on its own, because that will paint a more transparent picture of the stock valuation. 

II.8 - Price to Sales Ratio

It is hard for companies to manipulate sales, which is why some investors like this ratio. It tells you how much you will be paying for one unit of sales. If it is less than 1, it means that you are paying less for more. For example, some investors look for a Price to Sales ratio that is less than 0.50, which means for every $1 in sales, they are paying 50 cents. However, the Price to Sales ratio varies by industry so it is better to go for a Price to Sales ratio that is less than the industry average instead of an absolute number. It is also advisable to look at this ratio in tandem with the PE ratio.

II.9 - Price to Book Ratio

This ratio has been celebrated in academic literature, especially by Fama and French whose main findings have been that firms with low Price to Book ratio perform better than the rest of the market in the long run. In brief, a Price to Book ratio that is less than 1 is considered low.

Recall though that book value attempts to measure the total net worth of a company. However, it is not without its flaws and it needs to be matched against the industry standard before using it to make a decision. It is better then to look for a stock that has a Price to Book ratio that is less than the industry average if you can, instead of choosing one that is less than 1.

As usual, always consider this factor alongside others. It can be that the company has a low Price to Book ratio because of inherent weaknesses in its earnings and this can spell trouble. 

Using this approach, you would measure a company’s performance by the growth of key profitability statistics over a particular time period.

III.1 - Revenue Growth

Analysing a company’s revenue growth over a period of time is a preferred starting point for some fundamental analysts. Their argument is that if a company is not able to generate revenues consistently in the first place, then it is not worth investing in. Moreover, issues with revenues spill over into other fundamental analysis concepts, for example, profitability ratios and EPS growth.

When analysing revenues over a period of time, care should be taken not to base decisions on the average for that period because averages iron out fluctuations and, most times, all the relevant details lie in these fluctuations; a better and more transparent approach is to divide the period of time into shorter intervals and analyse revenue growth between one interval and the next. For example, if you are looking at revenue growth for the last 5 years, it is advisable to analyse revenues year-on-year. Moreover, you also need to measure the growth of costs in the same way you measure revenue growth because this will tell you whether the firm is actually able to control its costs and, hence, materialise revenues into profits.

Having said all the above, it is important to note that the rate of increase in revenues is industry as well as business dependent. At some stage, the growth of revenues slows down especially as the industry matures. In this case, your expectations about revenue growth need to be adjusted accordingly.

III.2 - EPS Growth

A company may be enjoying increasing revenues but it can also be struggling with increasing costs that are hindering it from generating profit. This is where earnings per share (EPS) growth plays an important part. One quarter of explosive earnings is not a convincing story to buy a stock. You need to see earnings consistently appreciating over a period of time: a good benchmark is to look for a consistent 25%-50% increase over a period of 3 too 5 years (at least 3 years). You may also like to analyse this measure in conjunction with the ROE and sales growth. 

III.3 - Sales Growth

Again, you need to analyse sales growth over a period of time, the same period over which you analyse revenue growth and EPS growth. Sales growth and EPS growth need to tell the same story because it is possible for a company to manipulate its earnings but not its sales. If sales growth is decreasing but EPS growth is increasing consistently over a period of time, then you need to look into the reasons behind this: it can be the company is controlling its costs well but its sales are going down. Eventually, lower sales are going to impact profits and the stock price adversely. The bottom line is that higher EPS growth has to be accompanied by higher sales growth. In general, you would like an increasing trend in sales growth culminated by at least 20% increase for the latest quarter(s). It is also helpful to compare sales growth to that of the industry or competitors if possible.

III.4 - Dividend Growth

Some investors prefer to use dividend growth, rather than the dividend yield, when selecting stocks. Their argument is that it is a better indicator of how strong a stock is, and an increasing dividend growth allows for an increasing stream of income. We will explain this point with an example. Suppose you have paid $90 for a stock that pays a $3 (annual) dividend and held on to it for 5 years. The dividend yield at that stage is 3.33%. Assume that, after 5 years, the stock price appreciates to $120 and the annual dividends stand at $5 per share so the dividend yield at that point is still 3.33%. However, for you, it is at 5.55% ($5/$90). 

Of course, it is also possible that the company does not do well at all, stops paying dividends and the stock price may even crash. This is why it is important not to consider dividend growth on its own when screening stocks. You need to start of course with a strong dividend yield (at least 3%); other relevant ratios you may also like to consider are (high) ROE, (low) PE and (low) dividend payout ratio (ideally under 60%). The choice of a dividend growth rate when picking stocks depends on the interplay between the rate and the aforementioned quantities but, in general, a rate of 5%-8% is favourable. The dividend yield and the dividend growth rate need to balance each other out such that a lower yield is compensated for by a higher growth rate and vice versa.  

Of course, you can always go for a consensus between analyst ratings or follow one particular analyst’s recommendation; there are firms/analysts who specialise in rating stocks using different methodologies, some of them have a good track record. However, in this case, you need to understand that you are following someone else’s judgement and people do make mistakes irrespective of how good their track record is. If you decide to go down that route, at least analyse the corresponding stocks further before you hastily jump and buy them.

These are the elements that can sometimes make or break a company, but you cannot quite put your finger on them or attach numbers to them. This latter fact is what can make this analysis subjective and, possibly, frustrating.

V.1 - Industry

We have looked extensively at industry analysis and how a company’s operations and profits can be influenced by the industry or sector it is in. But how does this analysis materialise when we are about to pick stocks? It is important to keep in mind that the industry performance has, in most cases, a direct impact on the performance of a company: a company with poor fundamentals overall may still fare well in a strong industry, especially during a bull market, and a company with solid fundamentals can still fare poorly in a weak industry. So always start with an analysis of the industry, making sure the offered products or services and the prospects of the industry align well with your investment philosophy. 

There are general industry characteristics that are common to all companies in the industry. There are also changes that can occur during the lifetime of an industry: new technologies can be invented in the respective industry that propel it or in another industry that weaken it, new ways of doing business can increase or decrease efficiency or productivity and new conditions implied by internal or external factors (such as waning or strengthening demand, shortage in supply, increase in costs, etc) can have a direct impact on profits. These changes will affect players in an industry irrespective of how strong or weak their performance has been. 

Some characteristics of an industry are particularly notable. The stage in the life cycle, at which the industry is in, has implications for the expected risks and returns of a company operating in that industry. The competitive nature of an industry, including its barriers to entry and exit, can decide how much a firm has the potential to succeed or fail. For example, it is much easier to start a restaurant than a car manufacturing company. A company’s market share in an industry can signal how strong a company’s position in the industry is and how likely it is to succeed and fare well or not.

V.2 - Business Model

V.2.1 - What is a business model?

A business model is one of the most important concepts in fundamental analysis, yet it is one of the most overlooked. Have you ever tried asking friends who trade about the business model behind the stocks they have invested in? Well, try to but do not be surprised if they are unable to produce a coherent clear story about the business. The stock market is a very strange place: what you think is obvious may not necessarily be so! What is a business model to start with?

A business model is the company’s way of generating profits. A business model includes the products or services a company offers, its client base (because this is its selling point and its revenue generator) and its costs. A business model is a vague concept; what differentiates it from strategy is the fact that it does not account for competition like the latter does.

A successful business model means that the company is able to offer a differentiated product or service at competitive prices while controlling its costs. All three elements determine how successful a company is and shed a light on its future prospects. One of the ways to judge a business model is by analysing its total profit vis-à-vis its expenses. If the business model is not working well, then there is something wrong with the product or service or the numbers (pricing or costs). A business model needs to be flexible enough to allow the company to adapt to a changing environment if required.

A business model is unique. There are general categories of different types of business models that have been widespread to a certain extent but eventually each company will eventually have one specific business model exclusive to it. In fact, a business model has to be unique; otherwise, it will be hard for the company to differentiate itself. 

Why should you care so much about a business model? You should care because when there is an unreasonable euphoria in the market whereby herd mentality has kicked in, it will be very hard to stay level headed and this is why you need reasonable criteria that you can fall on. The business model is one of them. Why? Because it implies that the bottom line is that a company HAS to make money before you even consider investing in it. If it seems ridiculous to you stating the obvious, remember the dot-com bubble! 

A lot of stocks were going up even though their underlying companies were not making a penny. An unproven web-based business model (at least on a large scale) was enough for everyone to jump into the market hoping for future expected profits that never materialised. Eventually, the whole market came down crashing from levels that were not seen again for some stocks. However, do not conclude that it is enough for a company to have a good business model: It is not enough for a business model to only be good. As an investor, you have to aim for companies that have an exceptional business model because these are the companies that eventually generate stellar returns. 

V.3 - Management

As a shareholder, you implicitly rely on management to determine how richer or poorer you are going to be down the line. How is this even possible? Simple, the management team takes the decisions that ultimately determine the success or failure of a company and, hence, how much money you will make or lose on your stocks. So instead of hoping that management makes wise decisions, why don’t you analyse how qualified this team is and take this analysis into account before you decide to buy or sell a stock?

There is actually a systematic way of doing this.

• Find out whom the management team is made of (e.g., CEO, CIO, CTO, etc) and explore their track records, which will depend to a large extent on their experience (and perhaps education, to a certain extent). Do these track records blend well with the industry and the type of business the company operates in? Try also to find out more about the management style of decision makers right at the top: is the overall management style at the firm serious and disciplined or is it more relaxed and casual? How does this fit with the product or service the company is offering? How does this affect the company’s adaptability to its environment?
• Find out about the tenure of the management team. Has it been in power for a long time and is it still producing the required results? Alternatively, is the team performing poorly and will it be taking the company down with it? If so, you really do not want to be onboard a sinking ship irrespective of how the numbers look good now. Has the company recently gone through a management restructuring process? If so, try to find out what the reasons behind this decision has been and what the new management team will bring on. It is not unusual for a new management team to revamp the whole operation and take the company to new heights. It can be helpful if you can find out what the underlying reasons for shuffling the management team are: are there any major issues and how critical are they? How easy will it be for the new team to overcome them?
• Always keep a close watch on management pay. Is the management team, particularly the CEO, receiving inflated compensation packages that are hardly justified by the company returns and/or industry standards? Even if the team is doing an excellent job that is reflected in stellar company performance, there is a limit on how much they should be receiving in compensation because, otherwise, this money is being taken from your pocket or away from productive operations.
• Do not be overwhelmed by the amount of information you need to retrieve as the above points may hint. There are some reliable resources that you can use which can make your life much easier (if you are willing to put in the hard work of sifting through documents that is. A lot of information can be concluded from the company’s statements and annual reports; of particular help are the proxy statement and MD&A.
• Proxy Statement: the SEC requires companies to submit a proxy statement prior to a shareholder’s meeting, with the aim of providing more information on items or matters that shareholders are expected to vote on. These items actually reveal interesting details about the company which you may not be able to find elsewhere. For example, in here you can find information on management background, executives’ pay packages, executive ownership in the company, changes to the board of directors, any potential conflicts of interest and the company’s accounting or audit firm costs, besides other outstanding items. Analysing these items in detail allows you to gain valuable qualitative knowledge of the company and to add some textual information to the numbers that you see in financial statements in order to form a better picture of where the company may be heading in the future.
• MD&A: the MD&A stands for management discussion and analysis, and it is an important section in the 10-K report. In layman terms, this section provides updates on how business is currently going and what its future prospects are from the company management’s point of view. More specifically, management needs to explain financial statements, to provide more insight into the firm’s financial positions that helps better analyse financial information and, finally, to explain earnings and cashflow such that the investor can use this information to make future projections.

However, even though the MD&A is an SEC requirement and should be based on facts, it is important to note that it is not audited and that it represents management’s thoughts and views. Therefore, always approach your analysis of this section with scrutiny, paying particular attention to the language management uses. For example, terms such as “challenges” should raise an alarm that warns you about possible problems within business operations.

V.4 - Product and Brand Name 

We have briefly touched on this in our discussion about value propositions above in the business model section. However, a company’s product and brand name are such essential concepts that it is important to dedicate one whole section on them. When you are investing in a company, you are investing in its product and brand amongst other things. A company’s product differentiates it from competition and attracts the necessary customer base that will generate its revenue steam.

It is not actually very difficult to spot a good product. Keep an eye on new products that are revolutionary. If you notice demand for a particular product is surging even if just locally, this should entice you to look further. In fact, new successful products are always glaring, making them easy to spot. However, do not fall into the trap of thinking a product is great just because you have been waiting for something like it. You need to be in tune with what demand, that ultimately drives sales, is like.

Not every company has to be offering a brand to be successful, but a strong brand definitely helps. Brands serve as a proof that a company has done things right for a long time; it takes years of development, marketing and delivery to build a brand name. Moreover, brand diversity is a very good thing; it acts as a reassurance that if one brand goes haywire, other brands will be able to make up for it.

Fundamental analysis is arguably a great tool for spotting good stocks. However, it may not be quite as helpful for timing an entry: investors do repeatedly pick a great stock only to enter the market at the “wrong” time and end up losing money nevertheless. This is where technical analysis steps in. However, although it can be more promising at timing the market, it is not 100% guaranteed to spare you from getting in at the wrong time. Obviously, this is not so much of an issue if you are a long-term investor because eventually a good stock will always bounce back in the long-term (provided of course that the business the company is operating in does not go haywire). 

Technical analysis is perceived to be better at capturing market psychology, which is partly why it is used by a lot of traders to time their entry and exit into a particular stock. In fact, some traders (more so speculators) do not even worry about fundamental analysis: they base all their trading strategy on technical analysis and quite a number of them end up making a decent amount of money.

Another reason why you may like to consider technical analysis in tandem with fundamental analysis is that the latter relies on your assumptions as you have seen in our discussion of fundamental analysis tools. It does frequently happen that a fundamental analyst makes the wrong assumptions or the market shifts for one reason or the other, making the model as good as obsolete. Technical analysis studies the market and so it is more likely than not for it to help you spot problems in stocks or to give you hints of what the majority of traders think of a particular stock.

To understand technical analysis, you need to first and foremost understand charts. In fact, technical analysts are sometimes called chartists. Charts are graphs, plotted on paper or on computer screens, that represent different types of information. There are various types of charts: line, high-low-close, point and figure charts, candlestick charts, etc. Technical analysts analyse charts in order to spot patterns. Charts can help in several ways.

• Trend: They help you in visualising the trend of the stock. To draw a trendline, you need to ideally connect three retracements with a line (even though two would do). Is the line slanting upwards, in which case the trend is an uptrend or downward, in which case it is downward? Each new high a price makes in an uptrend represents a good buying opportunity (during a pullback), that is buy into a retracement that is close to or above the trendline avoiding to buy below the trendline as this can be signalling a trend reversal. On the other hand, a new low in a downtrend represents a good shorting opportunity (during a pullback), in which case you sell at a retracement that’s at or below the trend line. 
• Market timing: They also help you timing your entry and exit points. Moreover, some argue that it provides you with clues as to where the stock price is headed: technical analyst relies on the premise that “history repeats itself”; there are predictable fear and greed cycles that repeat themselves, providing insights into the direction of the stock.
• Support and resistance levels: this concept sometimes serves the same purpose as the previous concept (market timing). Determining support and resistance levels is more of an art than a science. There are times when the stock price seems to be bouncing off a particular level as if it is unable to go any lower; this is known as a support level (some traders like to place trades around this level, for example, they may choose to buy at or around this level, or short if the stock price breaks below it). On the other hand, the stock price may seem to be hitting a ceiling above which it is unable to break; this is known as a resistance level (some traders like to short at this level, or buy if the price manages to break above it).
• Trade confirmation: No matter how much research you have done using fundamental analysis, you could still be wrong and end up losing money after all your hard work. Technical analysts read charts to confirm their opinion about a stock or reject it because they believe that charts discount information about the stock price, which is not available in the market yet.

II.1 - Traded Volume

Traded volume gives a lot of insight into a stock price movement. Usually, traders look at daily traded volume (even though some may prefer to examine volume over alternative time periods, e.g. a week, a month, etc) because volume mainly validates the price either as a confirmation or an anomaly. So it is used more for market timing or as a supplementary tool in stock selection rather than as a primary tool.

We have previously discussed volume extensively so you can always refer to the Volume page to find out more about volume and its implications for trading. Your key takeaways in this section are:

Volume helps you to choose a liquid stock: the last thing you want is to get stuck with a “great” stock that you cannot sell. For example, you can look at volume as the number of shares traded, in which case you require a stock to be trading at a volume greater than a specific number (e.g., 50,000 or higher). Alternatively, you may decide to work with dollar volume (Price x Shares Traded) and set a criteria whereby the dollar volume is greater than a specific amount (e.g. $500,000 or more).

• You may alternatively decide to include criteria that incorporate changes in volume over a period of time, rather than restrict it to a number. For example, you may only like to consider stocks that show heavier trading day to day or week on week: one such criterion can be selecting stocks that show an increase in volume between last week and this week (or any time period that works better with your trading or investment strategy). 
• One such quantity that can help you with this approach is On-Balance Volume (OBV). This is another concept that we have discussed at length in the Volume page. We will not dwell again over it. However, it lends a helping hand when trying to understand volume changes, so you may wish to screen for stocks with an OBV that trends higher (if you’re buying) or lower (if you’re shorting).
• Volume also helps you identify market tops and bottoms, as we have seen previously, so that you do not end up buying at the wrong time. In general, there are three stages in a trend (as stipulated by Dow): an accumulation phase where smart money is buying, a public participation phase where retail investors jump in and a distribution phase where smart money is selling (this can take few weeks). You do not want to buy when smart money is selling because you’re at a market top and you should expect the market to go down soon (of course, there are always exceptions).
• Likewise, volume helps you spot trend reversals and continuation. In this case, placing one number on the volume is not enough. You need to monitor volume changes and price changes in tandem on daily basis. When the volume and the price do not tell the same story, this is where you need to hold off your horses.

Moving averages indicate the direction of the trend. They can also act as support and resistance for the price level. In fact, this is a concept that we have also discussed in boring details. We will not go into the nitty gritty features of moving averages but we will only discuss how moving averages can be used in stock selection. The choice of moving average type (SMA, EMA) and the corresponding time frame depends on your investment horizon. In general, there are two main ways in which we can use moving averages to screen for stocks.

• Crossover: this point refers to two moving averages, of different periods, crossing each other. When the shorter moving average crosses the longer moving average on the upside (i.e., moves above), it gives a buy signal. When it crosses it on the downside (i.e., moves below), it gives a sell signal. For example, some traders may include one or more of the following criteria in their stock screeners (to go long): 10D SMA moves above 20D SMA, 20D SMA moves above 50D SMA or 50D SMA moves above 200D SMA.
• Price distance from moving average (above, below): How far a price is from its moving average is important. For example, some traders like to short stocks whose prices have considerably stretched away from their moving average lines. If you plan on including this criterion in your stock screener, you need to decide on the time period for calculating the moving average (e.g., 10D, 20D, 50D and 200D) and the distance between the price and this line (close, “moderately” far, very far). For example, your screener may look for stocks whose prices are 20% above their 50D EMA. 

The Relative Strength Index (RSI) is a momentum (leading) indicator that compares price performance to itself over a period of time (most commonly, 14 days). It computes the ratio of the periods, when the price closed up, to the periods when it closed down. Its value is always between 0 and 100, and it is used to indicate if a stock is overbought (RSI > 70) or oversold (RSI < 30). You may decide not to stick to 30 and 70 in your stock screener; however, you want to be sensible so you do not select a stock to buy if the stock is overbought or to short if it is oversold. Some traders buy stocks that have an RSI close to 50 and increasing, others prefer buying stocks that have an RSI that is below 30. You may like to include in your stock screener a criterion where a shorter length RSI is compared to a longer length one, for example, 10D RSI > 30D RSI; however, this requires a more careful and sophisticated analysis with thorough backtesting at your end.

The Moving Average Convergence Divergence is an indicator that looks at the difference between the fast exponential moving average (shorter time frame, e.g., 12D) and the slow exponential moving average (longer time frame; e.g., 26D). There are three parts in a MACD:

• MACD = 12D EMA – 26D EMA
• MACD Signal Line = 9D EMA of MACD
• MACD Histogram = MACD – MACD Signal Line

In your stock screener, you may look for stocks with MACD that has recently crossed above (bullish/buy) or below the signal line (bearish/sell). In other words, you may screen for stocks whose 12D EMA (fast line) has crossed its 26D EMA (slow line). 

So probably you are now thinking: right, so I have a wealth of information on how to pick stocks (maybe more than I need) but it is impossible to find a stock that satisfies every single criterion that has been mentioned above! If you understand your investment philosophy well and know exactly how to tie it up with various selection criteria that go well together, then good for you… go ahead. However, if you are a beginner and you are all muddled up as where to start, there are plenty of approaches out there (such as, value investing, growth investing, income strategy, etc) that, alongside the above information, can help you get started. However, as usual, study them well and analyse them historically before you decide on whether you would like to follow one of them or not; better yet, you may prefer to incorporate few of their elements into your own stock picking methodology. Alternatively, you may like to start with a couple of criteria that make sense to you.

Stock picking is an alternative term to stock selection. They both mean choosing the stocks you would like to trade.

You may not need to understand them but you need a method to rely on; otherwise, you will just end up guessing and we all know that is not going to end up well at least in the long run! It does not harm to have a brief overview of these approaches before you start selecting stocks and trading them.