According to the Organisation for Economic Co-operation and Development (OECD), there were approximately 41,000 publicly listed companies in the world in 2019 with a combined market value of more than $80 trillion. From the Apple (AAPL) device in your pocket and the Nvidia (NVDA) chip in your laptop to the can of Coca-Cola (KO) in your hand and the Netflix (NFLX) movie you’ll be watching later on in the evening, the choice of stocks appears to be limitless.
But how do you go about selecting the right ones and how can you comb through every balance sheet to identify companies that have a favourable net debt position and are improving their net margins?
Keep on reading to discover the key steps to take when it comes to picking stocks for your portfolio.
Why should you invest in stocks?
Wondering why you should even consider investing in stocks? Here are some advantages:
Stay ahead of inflation
Inflation is the decline of purchasing power of a given currency over time on the back of strong economic demand. For instance, the S&P 500, which represents the returns of the largest U.S. companies, returned approximately 14% on an annualised basis during the last 10 years, which is far better than the average annualised inflation rate. This means that your money is worth less now than it did 10 years ago, so investing is a way to beat inflation by making money work for you and grow.
Achieve capital appreciation
Stocks offer investors great potential for growth over the long haul, otherwise known as capital appreciation. In fact, those who have stuck to their stocks for long periods of time, say 10 years or more, have generally been rewarded with strong, positive returns.
Receive a regular income
Dividends are regular payments of profit made to investors who own a company’s stock, distributed based on each shareholder’s stake in the company. Many stocks come with the added bonus of paying out dividends. If for instance, the company you have invested in pays a dividend of $0.90 and you own 100 shares, that’s $360 in dividends in a year.
Find out more about what stocks are and how they work in our detailed guide.
What should you do before you pick stocks?
Determine your investing goals
Before you nosedive into selecting the stocks you would like to invest in, you must establish what you would like to accomplish. Some investors are interested in capital preservation particularly as they get closer to retirement. Others are looking to increase their portfolio as much as possible over a long timeframe or are interested in generating additional income. Once you have established your goals, these should dictate the companies you’ll eventually add to your portfolio. For example, investors interested in income can buy stocks with good dividend yields. Those looking for capital preservation may want to choose well-established businesses that have been around for decades, producing steady and predictable profits year in, year out.
Decide how much money you are willing to invest
Remember that although the stock market will almost certainly rise over the long run and offer you good returns, some element of uncertainty in stock prices is expected over the short-term. For instance, in 2020, the market plunged by more than 40% due to the onset of the COVID-19 pandemic, only to rebound big time and reach an all-time high within a few months. The trajectory for risk assets is mainly affected by actions taken by policy makers, yet this differs from region to region, so the political and economic backdrop of a country is another key factor.
Establish your investing approach
Investing in stocks requires a fair amount of research and looking into things like quarterly and yearly earnings reports, amongst other things. If you’re lacking the time to research and evaluate individual stocks on an ongoing basis or if crunching numbers doesn't sound appealing, then consider taking a more passive approach, like investing in index ETF funds, which track a stock index like the S&P 500. Other alternatives are semi-passive ETFs and collective investment schemes, which take a more active approach.
What are the key steps to stock picking?
Stock picking is not a matter of simply selecting the companies you like and admire, but it involves doing your homework, including conducting thorough research, reviewing a stock’s fundamentals to monitor its viability and once you’ve accomplished all of the above, you can then decide whether it should form part of your portfolio.
Here are some things to consider.
Choose a theme and determine whether a company has a competitive advantage
Your stock picking can begin by selecting a particular sector or industry, after which you should read as much as you can about it. Focus on things like whether it has growth potential or whether it will benefit from some sweeping revolution like artificial intelligence (AI). Next, choose companies which are a cut above the rest and which ideally have a unique selling point. Warren Buffett calls this a moat. According to the business magnet and prolific investor, the key to investing is to determine the competitive advantage of any given company and to establish the durability of this advantage, since products or services that have a wide and sustainable moat around them are the ones that deliver rewards to investors. Investors need to be aware that emerging technology will not have immediate leaders, however, identifying future leaders is what will generate significant returns over a period of time.
Conduct fundamental analysis
Fundamental analysis is a method of determining a stock’s real or fair market value by looking at various economic and financial factors which can eventually affect the security’s value. These range from macroeconomic factors like the state of the general economy or that of the industry the company operates in to microeconomic factors, such as the management’s effectiveness in stirring the firm towards the path to profitability. Here are some basic metrics to keep in mind:
Earnings per share (EPS): this is a company’s net profit divided by the number of common shares it has outstanding. The EPS indicates the amount of money a company makes for each share of its stock and it is a commonly used metric for estimating the value of a corporation.
Price-to-earnings ratio (P/E): this evaluates a company’s share price in relation to its earnings per share. Companies with a high P/E ratio could mean that the stock is overvalued or that investors are anticipating high growth in the near future. In contrast, companies with a low or no P/E ratio could mean that they don’t have enough earnings.
Projected/earnings to growth (PEG): this anticipates the one-year earnings growth rate of the stock and it serves as an indicator of a stock’s true value. Similar to the P/E ratio, a lower PEG may indicate that the stock is undervalued.
Dividend payout ratio: this metric is the proportion of earnings paid out as dividends to shareholders, usually showcased in the form of a percentage. The dividend payout ratio will depend on a number of factors. For instance, a growth-oriented company that aims to expand or develop new products will probably reinvest most or all of its earnings and so it is expected to have a low or non-existent dividend payout ratio.
Dividend yield: typically displayed as a percentage, the dividend yield is the amount of money a company pays shareholders for owning a share of its stock divided by its current stock price.
Return on equity (ROE): this measures the company’s profitability in relation to shareholders’ equity. A good or bad ROE will depend on what is normal for the industry or company peers.
Trends in earnings growth
If, over time, a company’s earnings increase, then this is a positive sign, which could indicate that the company’s stock is a good investment choice. Having said that, you don’t necessarily have to look for large, sweeping growth. Even small and regular improvements over a long period can serve as a positive indicator. However, earnings growth and value must go hand-in-hand in order for the stock to be worth the investment, which means that you must evaluate its products or services, together with its target market and cost structure, which in turn, will help you determine not only the company’s competitive advantages, but also, its market opportunity and the sustainability of its cash flows. You also need to be aware of how future earnings growth is priced-in the valuation for a company. The rule is simple, if the investor’s valuation shows that earnings growth is not fully priced-in for a particular company, then there are opportunities for capital appreciation and vice-versa.
Take a look at the dividends
Typically, a company that pays constant dividends reflects an element of stability and good financial health, most especially if it has increased its dividend payout over a number of years or decades. On occasions, such as during challenging economic times for example, a company may decide to temporarily or even permanently cut its dividend in order to secure more liquidity. This could be an indication of worse to come, but it could also mean that it is in difficulty only temporarily. This is why it is important to evaluate the long-term merits of the company and that of the industry it operates in. As a rule of thumb, look for companies that pay out little but often and ideally, increasing. There are also other forms of redistributing capital other than dividends. Indeed, companies in the U.S. that are cash-rich tend to prefer buying their own shares rather than distributing dividends. A key reason for this, is to support their own share price. This is mostly relevant to U.S. technology and financial companies.
Interested in stocks that are known for paying steady dividends? Check out these dividend kings, aristocrats and zombies.
Evaluate the effectiveness of executive leadership
Looking at quantitative factors like profitability, revenue growth or debt levels alone is not enough. After all, a company is only as good as its leaders and their ability to plot a strategic course and steer the business in the right direction. As a result, examining a company’s effective leadership is just as important, including other qualitative factors like employee and customer satisfaction, brand recognition and company culture. Good leadership can help promote a stable and long-lasting company culture where innovation and flexibility are at the forefront, while generally speaking, a well-managed company usually enjoys stock prices that tend to trend higher.
Keep abreast of the latest market news by reading the financial news section or industry blogs so that you’ll know exactly what is happening.
Remember - don’t put all your eggs in one basket. Avoid betting on any one company, industry or asset class. Ideally, invest in a few unrelated sectors, companies and geographical regions, which will help diversify your portfolio. Find out more about how to create a diversified portfolio.
With endless metrics and rations to use in order to assess a company’s general financial health, these should help you build a well-informed narrative about the company you would like to invest in and determine the factors that make it a likely long-term investment.
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The contents of this article are not intended to be taken as a personal recommendation to invest but strictly based on research and for information purposes only. Retail investors should contact their financial adviser for a suitability assessment prior to taking any investment decisions.