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How To Pick Stocks
When it comes to life goals, financial security ranks near the top of the list for most people. There are many ways to achieve financial security. Some more effective than others, but investing in stocks has long been the most reliable path to success.
Of course, putting money into unfamiliar, untested companies is nearly always a losing proposition. The key to making money in the stock market is picking the right stocks. The world’s best investors know that picking profitable stocks requires careful consideration. Over the course of their careers, they have developed winning strategies for building wealth.
For example, Warren Buffett (net worth $108 billion) has been investing in stocks for more than 80 years. He chooses undervalued companies with wide moats, solid financials, and a history of growth over time.
On the other hand, Bill Ackman (net worth $3 billion) chooses companies that could be great, but aren’t. Once he owns stock, he uses his influence to make the changes necessary to increase the company's value.
Controversial hedge fund investor Steven Cohen (net worth $17 billion) is famous for his ability to pick stocks based on technical analysis. He examines trends in individual stocks and the market as a whole to predict short-term price movements.
Average investors might not have the resources of major players like Buffett, Ackman, and Cohen, but their investment strategies are transferable. Here’s how to pick stocks like a pro to increase the likelihood of achieving financial security.
What Is Stock Analysis?
The list of stock-picking strategies is virtually endless, but all of these strategies have something in common. They are based on some form of research and analysis that falls into one of two categories: fundamental analysis and technical analysis.
What Are The Three Layers Of Fundamental Analysis?
Fundamental analysis may involve multiple steps, but the underlying concept is simple. This method aims to determine the intrinsic value of a company and its stock, which consists of collecting and examining relevant information.
Some key points include the quality of a company’s management, the design and effectiveness of its business model, the stability of its financial position, and how efficiently it uses its assets to generate profits.
However, the company’s strengths and weaknesses are just one layer of the fundamental analysis process.
A comprehensive review includes two additional layers. The first involves moving beyond the individual company to analyze the broader industry. The second is a careful analysis of the economy as a whole. What economic events could impact the stock, and what do the economic indicators suggest will happen next?
Value investors like Warren Buffett rely on fundamental analysis almost exclusively. They are focused on long-term gains, and the best way to achieve that goal is to buy quality stocks at a fair price.
An even better option is to buy quality stocks when the price is lower than the company’s intrinsic value. These undervalued stocks get an extra boost in value when the market catches up to the business.
What Are The Four Basics Of Technical Analysis?
Technical analysis takes an entirely different approach to picking stocks. For the most part, the goal is short-term gains. Technical traders are less interested in a company’s fundamentals. Instead, they use historical price patterns to predict future price movements.
There are four basic principles on which technical analysis is based:
- Markets reliably behave in one of two ways. They either bounce between resistance and support prices, or there is a continuing trend. Identifying which environment is applicable is critical, as the strategies for picking stocks for one will not work with the other.
- All other things equal, trends are more likely to continue than reverse. That means the smartest technical investors pick stocks based on current trends.
- Though market trends are more likely to continue than reverse, they can’t last forever. The end comes in one of two ways. Either the market experiences a “rollover” in which it finds a resistance level it can’t overcome, or it trends upward until it becomes wildly overvalued. When this occurs, the most common outcome is a sudden, dramatic price collapse.
- Finally, markets can be counted upon to repeat one particular pattern again and again. They move in one direction, and then there is a short pause. They change direction for a brief period and then reverse again. That's when the true trend begins in earnest.
Technical analysis isn’t suitable for investors who wish to pick stocks for long-term financial security. These methods are intended to predict short-term price movements, requiring traders to get in and out of the market with precision.
How To Pick Stocks: A Three-Step Plan
True investors – those with a long-term plan – typically use fundamental analysis when picking stocks. Instead of looking at their stock purchase as a gamble, they pick which stocks to buy based on their intrinsic value and likelihood of increased value over time.
However, conducting a fundamental analysis of specific companies isn’t the first step in terms of how to pick a stock. The process begins with an evaluation of individual financial goals and personal characteristics.
Step 1: What Are Your Financial Goals?
There are all sorts of reasons to start a portfolio. Sometimes the purpose is to prepare for retirement, and other times, there could be large expenses like a home or education coming up.
In many cases, there is no specific purchase on the horizon – the goal is to build a financial cushion for peace of mind or generate some extra income. There are no wrong answers except to skip this step altogether. A clear goal offers guidance on how to pick the best stocks for your portfolio.
For example, if your goal is long-term growth, you have the time necessary for a promising start-up to get off the ground and begin turning a profit. Established companies are a better choice if you are planning for large expenses in the next five to ten years.
When your goal is to generate regular income immediately, stocks with big dividends are a must. Examples include oil and gas producer and dividend aristocrat Exxon Mobil, with a dividend yield north of 3 percent or healthcare firm AbbVie, which has a dividend yield of 5.2 percent.
What Kind Of Investor Are You?
Understanding your financial goals is just part of the prep work necessary to pick stocks successfully. The second big question is:
- What kind of investor are you?
- Can you stick with your investing plan through market fluctuations?
- Are you uncomfortable with risk and uncertainty?
Your personal characteristics matter because selling out of fear or buying popular meme stocks is the fastest way to incur large losses. Discipline is a common characteristic of the world’s best investors. They stay the course regardless of market ups and downs because they know this is a normal part of the economic cycle.
If you don’t think you can watch your balance drop without taking action, higher-risk growth stocks, like those in the ARK Invest portfolio, might not be right for you. These include companies with recent IPOs or those that aren’t yet profitable. Examples include ride-sharing giants Lyft and Uber, social media platform Pinterest, and the real estate service Zillow.
You will be more comfortable with stable companies that have a slow, steady rate of growth. For example, blue chips like Warren Buffett’s Berkshire Hathaway, established tech stocks like Apple, or successful financial services providers like American Express. They have ups and downs like any other company, but they typically avoid the sort of wild swings that spook shy investors.
If you don’t mind taking a gamble, you can include higher-risk growth companies on your list for consideration. But that doesn’t mean throwing money away on overvalued shares. Companies like cybersecurity provider CrowdStrike and crypto trading platform Coinbase might have bright futures, but at today’s prices, it could be a long time before investors realize any real returns.
Be aware of any tendencies towards excessive risk-taking so that you can remind yourself to follow all the steps, including a complete fundamental analysis, before buying stocks.
Gambling on meme stocks like distressed video game retailer GameStop or outdated software firm Blackberry might be a popular choice, but fundamental analysis demonstrates that these bets are unlikely to pay off.
Step 2: What Are Your Criteria For Picking Stocks?
Fundamental analysis of any company takes time, so the next step is to narrow down the options.
Make a short list of candidates based on your personal financial goals and your individual characteristics as an investor – that is, a list of companies that possess the features to fit your needs.
Factors to consider include the following:
Is it a business you understand?
This is key to making decisions when the company adjusts its business model, changes its strategy, or introduces new leadership.
If you understand the general industry and the particular company, you will be better able to predict how new developments could affect your investment.
Is it a business with significant competitive advantages?
Warren Buffett coined the term “moat” to describe competitive advantages that keep other companies from encroaching on market share. Like the moats around castles, competitive advantages protect revenue and profits. Stronger competitive advantages make a wider moat – one that is difficult for competitors to overcome.
Competitive advantages come in multiple forms, such as economies of scale. Large companies can buy in such bulk that their costs come down. That allows them to offer lower prices to consumers – prices small businesses simply can’t match.
Walmart is an example of a company with a wide moat due to the massive size of the business. Suppliers agree to lower per-unit prices in exchange for tremendous volume, which has made it possible for Walmart to attract and retain price-sensitive customers. That’s an enormous market. In 2021, Walmart averaged 240 million customers per week.
Unique, proprietary brands, patents, and licenses are also strong moat-builders. Being the only source for an in-demand product is a clear competitive advantage. For example, pharmaceutical companies rely on patents to protect sales of life-saving medications.
Abbvie’s Humira offered the most effective therapy for several life-altering medical conditions, and the company enjoyed oversized revenues for many years.
However, its patent is set to expire, making investors wonder whether Abbvie’s moat will be too narrow for comfort. Loss of exclusive brands, patents, and licenses changes a company’s value – an important consideration when picking stocks.
Other competitive advantages include high switching costs, such as the time and expense associated with moving to another provider or brand. Apple is a company with high switching costs – once you are immersed in the Apple ecosystem, moving to Android is an expensive, time-consuming project.
There is also the “network effect,” in which a product or service becomes more valuable as its user base grows. Delivery companies like DoorDash and Instacart use this effect to their advantage. More users attract more businesses to the app, and more businesses on the app attract more users.
The companies with the widest moats have cultivated several of these to make it virtually impossible for competitors to steal away business. That makes them strong candidates when it comes to picking stocks.
What other criteria are important to you?
Understanding the business and choosing companies with wide moats are universal to all investors regarding how to pick stocks. However, there may be additional criteria that you want stocks to meet before you can consider them for your portfolio.
For example, defense stocks like Lockheed Martin, General Dynamics, and Raytheon are doing well, but some investors prefer to stay away from the entire industry. The same goes for firearm manufacturers like Smith & Wesson and tobacco companies like Altria.
Conversely, some investors aren’t concerned with excluding specific industries or businesses, but they are passionate about socially responsible investing (SRI).
That could mean choosing companies with high environmental, social, and governance (ESG) scores, like Worthington Industries and Texas Instruments, or it could mean direct investment in businesses driving change, like sustainable energy company First Solar.
Understanding the criteria most critical to you makes it easier to build your short list of prospecting investments. Once you have the list, the real work begins.
Step 3: How To Pick Stocks With Fundamental Analysis
All the information you need to begin your analysis can be found on the company’s investor relations page. That includes current and historical financial statements, as well as company news, events, and leadership profiles.
The Three Most Important Financial Statements
Many companies issue a press release when they announce their quarterly and annual results. These memos highlight important numbers but don’t necessarily give you the whole story. For best results, have a look at the actual documents. Start with these three:
Balance Sheet
This is a snapshot of the company’s financial position at a given point in time – often the last day of the quarter. It lists assets, liabilities, and shareholders’ equity.
Among other critical details, this document gives insight into the company’s debt. That’s important to understanding whether and how growth will occur and the likelihood of profits that will benefit shareholders.
Income Statement
This is a view of the company’s income and expenses over the period being measured, e.g., the quarter or year. It lists revenue and sales, along with the direct, indirect, and capital expenses, then calculates net profit or loss.
Obviously, shareholders benefit when the company is profitable, but a loss isn’t always a deal-breaker. New companies might not be profitable yet, but if they are moving in the right direction, they could still be a smart buy.
Statement Of Cash Flows
The third financial statement illustrates how cash moved in and out of the company during the period being measured, as well as the total amount of available cash at the end of the period.
Such statements typically cover three categories – operating, investing, and financing – and they break down how cash increased and decreased during the period in each category.
Other Forms
Aside from the three most important financial statements, there are several other forms that publicly traded companies must file. Each offers insight into the company’s operations, condition, and prospects, which is valuable information for potential investors.
- Form 10-Q – An overview of performance, as well as how this period’s performance compares to previous periods.
- Form 10-K – A more detailed discussion of the company’s performance, including information on the organization’s management team, history, and organizational structure.
What Ratios Are Most Important In Fundamental Analysis?
Financial statements are full of numbers, but those numbers are meaningless without context.
How can investors determine whether a particular figure is good or bad in terms of how to pick stocks?
Fundamental analysis relies on ratios that use various measures to determine the health of an organization. The most important ratios in fundamental analysis include the following:
- Debt-to-Asset Ratio (D/A) – This shows the percentage of the organization’s total assets that were purchased by taking on debt.
- Debt-to-Equity Ratio (D/E) – This shows the percentage of the organization’s assets against total equity.
- Earnings-per-Share (EPS) – This is calculated by subtracting preferred stock payments, bond interest, and taxes from the organization’s profits, then dividing that result by the number of common shares that are outstanding.
- Price-to-Earnings Ratio (P/E) – This breaks down share prices to make comparisons easy. It shows how much $1 of an organization’s earnings would cost an investor. The trailing P/E uses the most recent earnings-per-share figure. The forward P/E uses the predicted earnings-per-share figure for an upcoming period. Higher P/E ratios aren’t necessarily bad, but it’s important to question why one company’s P/E ratio is substantially higher than others in the same sector.
- Price-to-Earnings Plus Growth Ratio (PEG) – While the P/E ratio shows the cost of $1 of an organization’s earnings at a single point in time, the PEG ratio adds in the anticipated earnings growth rate for a given period of time.
- Price-to-Book Ratio (P/B) – This shows an organization’s value as compared to its current assets. To put it another way, if the company was sold right now, what would each share be worth?
- Return on Equity (ROE) – This shows how well an organization invests its capital to generate earnings growth from an efficiency perspective.
- Dividend Yield – This shows how much the organization pays to shareholders in the form of dividends. However, it is essential to keep in mind that the current dividend yield does not guarantee future dividends. Evaluating the likelihood that the organization can continue to pay dividends is critical for income investors.
- Getting started with fundamental analysis can feel foreign if you haven’t spent much time with financial statements, but the good news is that tools and resources are available – often at no cost. The best online brokerage firms, including big names like Robinhood, E*Trade, and SoFi, offer access to educational materials for all of their members.
What Are The Benefits Of Undervalued Stocks?
There are two good reasons to focus on identifying and buying undervalued stocks. The first is simply this:
Even the most experienced analyst doesn’t calculate a stock’s intrinsic value correctly every time. Some factors that go into fundamental analysis are fluid, and unexpected or unknown challenges and obstacles can come up without warning.
When you pick undervalued stocks, you have a margin of safety – even if your evaluation of the company’s value is off, you have room to breathe.
The second reason is related to total returns. Undervalued stocks don’t stay that way forever. Eventually, others notice the gap in price versus value, and the stock price goes up.
If you buy undervalued stocks, you enjoy enhanced returns when that happens. Not only do you realize gains from the expected growth – you also get the bonus of an increased stock price that brings shares in line with the company’s true value.
The question of how to pick stocks can feel overwhelming for those who are just starting out in the market, but don’t worry. The process gets easier over time. The more you look at financial documents, the faster you will be able to identify quality stocks that will support your financial goals.
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