You have finally decided to start investing. You already know that a low P/E ratio is generally better than a high P/E ratio, that a company with lots of cash on its balance sheet is superior to a company with heavy debt, and that analyst recommendations should always be followed with a grain of salt. And you know the cardinal rule of the wise investor: a portfolio must be diversified in several sectors.
This pretty much covers the basics, whether or not you’ve gone through the more complicated concepts of technical analysis. You are ready to choose actions.
But wait! With tens of thousands of stocks to choose from, how do you select a few worth buying? Whatever some experts suggest, it’s simply not possible to comb through every balance sheet to identify companies with favorable net debt and improving net margins.
Key points to remember
- Decide what you want your portfolio to achieve and stick to it.
- Choose an industry that interests you and explore the news and trends that drive it day-to-day.
- Identify the company or companies that dominate the industry and focus on the numbers.
- Note that stock picking as a strategy often underperforms passive indexing, especially over longer time horizons.
How to choose a stock
Smart stock pickers have three things in common:
- They have decided in advance what they want their portfolios to achieve and they are determined to stick to it.
- They keep up to date with daily news, trends and events driving the economy and every business in it.
- They use these goals and insights to inform the decisions they make to buy or sell stocks.
Determine your goals
The first step in choosing investments is to determine the objective of your portfolio. Everyone’s goal in investing is to make money, but investors can focus on generating extra income in retirement, preserving wealth, or capital appreciation.
Each of these goals requires a very different strategy.
3 types of investors
Income-oriented investors focus on buying (and owning) stocks of companies that consistently pay good dividends. These tend to be strong but low-growth companies in sectors such as utilities. Other options include highly rated bonds, real estate investment trusts (REITs), and master limited partnerships.
Investors who seek wealth preservation have a low tolerance for risk, either by nature or because of their circumstances. They prefer to invest in stable, blue-chip companies. They could focus on basic consumer goods, companies that succeed in good times and bad. They don’t chase initial public offerings (IPOs).
Investors looking for capital appreciation look for stocks of companies that are experiencing their best early years of growth. They are willing to take on a higher degree of risk for the chance to make big gains.
The diversified portfolio
Each of these types of investors can use a combination of the above strategies. In fact, this is one of the main reasons for diversification. A prudent investor may devote a small portion of a portfolio to growth stocks. A more aggressive investor should reserve a percentage for solid blue chip stocks to offset any losses.
Deciding which category you belong to is the easy part. Determining which stocks to choose becomes complicated.
A stock screener, if you use one, is error prone. Riding in the wake of institutional investors is an option, but you should be aware that they tend to rely on safe blue chip stocks that may or may not offer the best returns.
keep your eyes open
It is essential to keep up to date with market news and opinions. Reading financial news and following industry blogs written by writers whose opinions interest you is a form of passive research. A news article or blog post can form the basis of an investment thesis.
The underlying argument may be a common sense observation. For example, you may notice that emerging countries are producing new middle classes made up of people who demand a greater variety of consumer goods. As a result, there will be an increase in demand for certain products and raw materials.
The “story” behind a selection of stocks
The thoughtful investor has a “story” that explains every decision to buy a stock
Taking the argument one step further, the investor can infer that with an increase in demand for a product, some producers of that product will prosper.
This type of basic analysis forms the “story” behind the investment, which justifies buying a stock.
At the same time, it is important to critique your own assumptions and theories. You might like donuts and fast cars, but that doesn’t mean Southeast Asia’s new rich want them too.
Once you are comfortable and convinced of the general argument after doing this form of qualitative research, company press releases and investor presentation reports are a good place for ongoing analysis.
Find your businesses
The next step in the stock selection process is to identify the companies. There are three easy ways to do this:
- Find exchange-traded funds (ETFs) that track the performance of the industry you’re interested in and learn about the stocks they invest in. It’s as simple as searching for “Industry X ETF”. The ETF’s official page will disclose the fund’s top holdings.
- Use a filter to filter stocks based on specific criteria, such as sector and industry. Filters provide users with additional features such as the ability to sort companies by market capitalization, dividend yield, and other useful investment metrics.
- Search the blogosphere, stock analysis articles, and financial press releases for news and commentary on companies in the investment space you’ve targeted. Remember, be critical of everything you read and analyze both sides of the argument.
These three methods are by no means the only ways to choose a company, but they provide an easy starting point. There are also obvious pros and cons associated with each strategy that investors should consider.
Seeking expert opinions through news sources takes time, but it can yield results. It will deepen your understanding of industry fundamentals. It can also alert you to interesting small companies that don’t show up on screens or in ETF holdings.
Connect to business presentations
Once you’re convinced that the industry you’re interested in is a solid investment and you know the key players, it’s time to turn to investor pitches. They’re less comprehensive than financial statements, but they give a general overview of how companies make their money and are easier to digest than 10-Q and 10-K reports.
These reports will also contain forward-looking information about the expected direction of the company and its industry. Browsing through company websites and presentations helps you narrow down your search.
The process involves a closer examination of a specific company to see if it could outperform its competitors in the industry.
The next step
At the end of your research process, you may end up with just one investment prospect or a list of ten or more companies.
Or you may decide that this industry is not for you. It is very good. All that research may have saved you from making a bad investment.
Knowing when to say no is an essential aspect of the art of choosing stocks. You may be ready to pull the trigger, or you may act like a financial industry professional and perform an in-depth financial statement analysis.
Is stock picking an effective strategy?
Stock picking, also known as active investment management, tends to consistently underperform a passive strategy that tracks broader equity indices. In fact, research shows that over 90% of stock pickers underperform over a 15-year period.
Who is the most famous stock picker?
Although there are multiple contenders for the best stock pick of the modern era, Warren Buffett is often touted as the most high-profile.
Why is stock picking so difficult?
Trying to pick stocks is often quite difficult as the markets tend to be quite efficient, especially over long periods of time. The Efficient Market Hypothesis (EMH) states that market prices reflect all available information, and therefore there is no way to earn excess returns.