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Your stock universe - A guide to selecting investment stocks
When investing (or trading) in shares in any share market, there
are many to choose from. In the Australian share market
alone, there are more than 2000 equities to choose from -
including both companies and ETFs. So how can you decide
which of these to invest in? Across all of the available
equities, there are a number of different characteristics which
might help you to make your decisions.
Many investors and traders will firstly compile a list of
equities which they will call their own "stock universe". Then
they will make a selection from that list based on a variety of
other criteria. The important point here is that having compiled
a "stock universe" list, they will tend to ignore any equities
that are not on the list.
By compiling such a list, it will simplify the investment
decision process, and help to reduce some of the distractions
that can cause confusion.
Stock selection - two step process
Many investors and traders will do two things:
- One or more "stock
universe" lists - Prepare a list of their own
"stock universe". But they might have more than one list, in
which case there would be a strategy that describes how to
use each list. For example, one list of speculative stocks
might be traded with just a small portion of the investment
capital, while another list of large-cap blue chip stocks
might be used for longer term and more stable investment
returns.
- Separate strategies
- Have a strategy that describes exactly how an investment
would be made in a stock within the stock universe. Each
stock universe would potentially have a separate strategy to
guide the investment.
WHY bother to prepare a "stock universe" list?
Many investors and traders don't prepare a stock universe list.
They simply look across all stocks in the market, and apply a
filter (one or more filters) to produce a list of investment
candidates. If you do work through the process of preparing a
list, then you will probably find the following advantages:
- It will help you to stay focused on the investing/trading
activities.
- It will be easier to prepare a trading/investing plan to
is suitable for a specific stock universe, because the
strategy might be a little different for a different stock
universe.
- It will help to avoid distractions. Many investors/traders
are happy to read the latest news and announcements about
their "favourite" stocks. But if we invest in potentially
any stock in the market, then there is too much news to
read. By having a stock universe, it will help us to decide
which news to read, and which news to skip over.
What if I don't prepare a "stock universe" list?
It's quite okay if you don't prepare a "stock universe" list.
You can still search through the whole market for
investing/trading candidates. And you might be distracted by
stocks that don't really fit your stock criteria. That's okay.
Some people would say that this is not the smartest way to
operate. But you will probably end up at about the same
end-point.
HOW to compile your own "stock universe" list:
So, how do we compile our own "stock universe" list? Here are
some considerations for investing in equity markets around the
world. The "stock universe" might simply be any one of the
following:
- Large-caps - The
stocks in a particular large-cap index (eg. in the US
market, perhaps the S&P500 index).
- Mid-caps -
A selection of mid-cap stocks.
- Small cap stocks -
Smaller cap stocks (eg. in the US market, the stocks in the
Russell 2000 index).
- Sector specific -
The stocks in a particular market sector (eg. Health Care,
or Technology), or make a conscious decision to ignore the
stocks in a particular market sector (eg. Materials, or
Energy sectors).
- A manual selection of
stocks based on market cap - This can be done using
appropriate stock
selection tools (more notes below).
- Stock liquidity -
You might choose to invest (or trade) only in liquid stocks.
That is, the stocks that have enough turn over on the market
each day so as to increase your chances of getting into a
position, or exiting one, quickly and without moving the
market. See a discussion
about Stock Liquidity. This topic is also to with Risk and Money
Management.
If focusing only on the Australian market, then the following
considerations might be useful:
- The so-called "top 200" stocks - the XJO index
(S&P/ASX 200).
- The so-called "top 500" stocks - the XAO index.
- The stocks in the mid-cap 50 index (XMD).
- The stocks in the Small Ordinaries index (S&P/ASX
XSO).
Some considerations to help you decide
When giving some thought to this topic, the following
considerations might help:
- Blue chip stocks:
- Many investors think that they would like to invest in
blue chips stocks. That is a good aspiration.
- However, there is no clear definition of the term blue
chip, and therefore there is no list of blue chip stocks
to work from.
- See the latest definition of the term
blue chip at the ASX website, and note that this
definition wording has changed a couple of times since the
GFC in 2008.
- Any broker or financial advisor that has a list of blue
chip stocks is using their own criteria to compile the
list.
- In truth, at various stages of the economic cycle, blue chips can
disappoint.
- If you are looking for a definitive list of blue chip
stocks, then good luck.
- Large cap stocks:
- These tend to have a market capitalisation in the order
of $10 billion or more (subject to change).
- These are analysed by the research analysts, and
recommended by the brokers.
- There tend to be many buy/hold/sell recommendations for
these stocks
- Of the 2000+ stocks on the Australian market, only a
small number of them are large cap stocks and watched by
the research analysts. The conclusions and recommendations
of the research analysts do influence the opinions and
purchase decisions of many investors. You might choose to
consciously follow the crowd and consider their views, or
you might decide to avoid these stocks.
- The Australian XTL index (S&P/ASX 20) comprises just
20 large cap stocks.
- Small cap stocks:
- These tend to have a market capitalisation in the order
between about $300 million and about $2
billion (subject to change).
- The companies that are considered to be small cap
stocks, tend not to be watched by research analysts, nor
recommended by lots of brokers. You might decide to ignore
these, or to follow these stocks.
- Small cap stocks tend to be less liquid than the larger
cap stocks. So be careful about the stock liquidity.
- Mid-cap stocks:
- These tend to have a market capitalisation in the order
between about $1 billion and $5 billion (subject to
change).
- This category comprises stocks that have a market
capitalisation in between the large cap category and the
small cap category.
- These stocks tend to be less well followed by analysts
and brokers. You might like this idea, or not like it.
- Micro cap stocks:
- These tend to have a market capitalisation in the order
between about $50 million and about $300
million (subject to change).
- Micro cap stocks have an even smaller market
capitalisation than the small cap stocks, and are often
even less liquid than the small cap stocks.
- These stocks tend to have even smaller share price
values, which can be volatile.
- Low share prices ("penny
dreadfuls")
- The share prices of companies (on the Australian market)
can vary from as high as $100+ all the way down to less
than 1 cent (ie. to fractions of a cent). The stocks with
a share price of just a few cents or less are often
referred to as the "penny dreadfuls" of the market. The
penny dreadfuls do not usually include any blue
chip stocks, so some people avoid them.
- It is true to say that share prices above about $10 are
unlikely to double or triple in price, whereas share
prices of less than a dollar or so can double in price.
You might decide to have one strategy that focuses on low
share prices (these stocks can be riskier), as opposed to
focusing on the higher priced shares.
- Fundamental metrics
- Debt to equity ratio - Companies with a debt to equity
ratio of about 50 percent or more are more likely to be
stressed when the economic cycle turns and it is harder to
borrow funds to finance company operations. So choosing
companies with a low debt to equity ratio can mitigate
this risk.
- Liquidity
- The notion of stock
liquidity is important for a couple of reasons.
- Hundreds of stocks on the Australian market have very
low daily trades,
and/or low daily volume
or turn-over.
- Without realising it, many investors eventually exclude
illiquid stocks from their stock universe at some stage
during the daily or weekly search for stocks.
- Many investors and traders will filter their list
of investment candidates to exclude the stocks with a very
low level of liquidity.
- See more
information about stock liquidity.
- Sectors:
- You might have a view that info-tech stocks are likely
to have the best candidates at the current point in time.
So you might choose to focus on the stocks within the
info-tech sector. Likewise, for the healthcare sector, or
one of the other sectors.
- Some investors consider some types of sectors to be "old
world" as opposed to "new world". For instance, the
technology sector stocks are considered to be companies
that are more likely to be more valuable in the long term.
This notion is discussed in Nicholas Darvas's book "How I
Made $2,000,000 in the Stock Market".
- Here is one key point to bear in mind about sectors. The
sector indexes (eg. XIJ, XHJ, etc.) are only comprised of
stocks from the XJO (S&P/ASX 200) index. If you want
to know what other stocks across the market are considered
to be in the same GICS sector, then you will need to look
at a list of stocks grouped by GICS industry group code. See more
about the GICS coding system.
- See
more information about the Australian market
sectors, including downloadable
information sheets.
How do the above market indexes relate to each other? Is any one
of them included within another? See
Robert's Index Composition handout.
Stock selection tools
So how do you actually go about compiling a useful stock
universe list? Many investors/traders will maintain a list of
their favourite stocks (their stock universe) as one or more
watch lists in their computer software - either with their
online broker, or in their chosen software package. It is quite
alright to have more than one stock universe, depending on your
investing strategy.
The range of available tools includes:
- Search tools available with your online broker.
- Free web-based search tools at various websites.
- Charting and technical analysis software tools - such as BullCharts.
Some more tips
Here are a few tips about how to find stocks in a particular
category like those described above:
 For
stocks of a particular range in market cap, use your
charting software to do a search* (in BullCharts, one of the
140 supplied scans is in the "Fundamental" category, to scan
by Market Cap).- For the stocks in a particular sector, view
the "Index Composition" section in Security Manager in
BullCharts*. (See the screen shot at right)
- For the stocks in a particular GICS industry group, view
the "Industry Groups" section in Security Manager in
BullCharts*. (See the screen shot at right)
- To find out the liquidity level of various stocks, firstly
understand more about the issues to do
with liquidity, and then use a tool* to identify
the liquid stocks for inclusion in your universe, or
the illiquid stocks to exclude.
* - The Australian
BullCharts charting software is this author's preferred
tool, and can perform these searches.
More information?
See the links above right for more details.
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