How to Pick Stocks

Investing and succeeding in the stock market means, at the end of the day, picking the right stocks. You can be a technical wiz, or an economic genius, but unless you can pick the right stocks and turn a profit, you’ll lose money.

That sounds like common sense, but you’d be surprised how many investors think picking stocks is an irrelevant part of succeeding as an investor. Some turn to index funds or mutual funds to take the decision-making out of their hands, trusting in professional managers or the market itself to turn a profit.

It’s no coincidence, though, that the most successful traders in the market’s history came up with their own strategies and tactics for picking stocks. If you want maximum return, learning to pick stocks is highly recommended.

I can’t guarantee that you’ll become an expert stock-picker; those individuals are not as common as you’d think. But, by learning all you can about stocks, the market, and fundamental and technical analysis, you’ll be able to navigate the market, find the stocks that are best for you, and trade with confidence.

Learning About Strategy

The first step is to learn about trading strategy.

A strategy is a plan. It’s a roadmap that describes the principles you want to trade by, what you’ll look for, and what kinds of stocks you’ll select. Part of strategy means knowing your risk profile – which is how much risk you’ll want to take on. Some people are risk-acceptant. They are more willing to pursue an aggressive trading strategy for greater return. Some people are risk-adverse. They prefer conservative strategies that conserve wealth and steadily grow income.

You need to determine how much money you want to make, how quickly you want to make it, and how you want to make it.

For investors who are more conservative, there is an income trading strategy. This approach focuses on finding stocks that pay strong dividends. Dividend-paying stocks tend to be established companies that distribute profit to their shareholders. Income trading is conservative because you are not trying to grow your wealth by finding stocks that grow rapidly; instead, you are trying to create a stream of income.

Another strategy that is a bit riskier is a value trading strategy. Value stocks are stocks that are undervalued and oversold. These stocks tend to have low P/E ratios, which means they are cheaper than stocks with higher P/E ratios. They also tend to have strong financials, such as more assets than liabilities, and depressed stock values that are lower than what the company’s worth would otherwise indicate. Value trading can be described as finding good companies for reasonable prices.

Finally, for more aggressive traders, there is a growth trading strategy. Growth trading focuses on stocks that are high performers. These stocks have high growth rates, high P/E ratios, and high growth prospects and forecasts. They are commonly found in the tech sector, but also include healthcare stocks and really any stock that represents a new company in a rapidly-growing industry.

The reason risk is higher for these is because growth stocks can be overbought and overvalued. They also represent downside potential because no stock climbs in value forever. Thus, growth trading, while more profitable in some years, is riskier.

Choosing Stocks

Once you have identified a strategy (or combination of strategies) for your portfolio that fits your risk profile and financial goals, you can start picking stocks.

Before you do, though, try to learn as much as you can about the market, the economy, and fundamentals of how stocks are valued and traded. You have two general approaches:

• Fundamental Analysis: This approach takes a look at the fundamentals of the stock – its debt, financing structure, products or services, income, revenue, profit, return on equity, earnings per share, growth prospects, and every other bit of info that involves the company’s financial strength and performance.
• Technical Analysis: This approach focuses on the fluctuations of price and volume in a market and identifying patterns and trends in both. Technical analysis doesn’t pay nearly as much attention to a company’s financial profile as fundamental analysis does.

Some swear by one or the other, but I recommend using both. Fundamental analysis is especially important to avoid buying in a stock that has an unstable situation and bleak future. You can’t ignore everything outside of price, volume, and patterns; by the same token, you can seriously augment your trading by learning about price patterns, reversals, range and momentum trading, and indicators that help you determine when a stock is undervalued or overvalued.

The best way to narrow down the 5,000+ stocks that are in a given market to a few for your portfolio is to use a stock screener. You simply input the criteria you want in your stocks and the stock screener does the rest – giving you a short list of stocks that match what you are looking for.

If you are a growth investor, you’re looking for stocks with high growth rates, rising current earnings per share and annual earnings, and better-than-average cash flows.

If you’re a value investor, you’re looking for stocks with low debt-to-equity ratios, low P/E ratios, depressed prices, and positive future earnings forecasts and prospects.

If you’re an income investor, you’re looking for stocks that have higher-than-average dividends and dividend yields, a steady track record of paying out dividends, stable performance, solid reputations, and rising dividends year over year.

At all stages of the process, tie the stocks you select into your overall trading strategy. If you need to change your strategy to find one that works, go for it – just make sure you have a strategy and use it.

Tips for Selecting Stocks

Here are some tips for better stock-picking in any market:

• Stocks that have been on a long winning streak may be overbought – which means they are overvalued and due for a fall.
• Stocks that have been battered and eventually level out could be due for a gain, especially if they’re established companies with good future prospects.
• Stocks with a beta greater than one tend to be more volatile than the market. Stocks with beta smaller than one tend to be less volatile than the market (which has a beta of one). Stocks with negative beta gain when the market loses, and vice-versa.
• Use as many valuation methods as you can to determine a stock’s value. This doesn’t mean that the market views a stock’s value in a realistic way, but it helps.
• When the market tanks, the impulse is to sell. This represents opportunities to buy good companies for bargain-level prices.
• Find stocks that create in-demand services and products with strong business models and a common-sense approach to doing business. Fads are fads; stick with companies that have a history of sustained leadership in a field.
• Avoid IPOs. While IPOs give you a chance to make a lot of money quickly, most of this money is made by institutional investors and insiders – not the average, outsider investor. IPOs can rise quickly and crash just as fast – or just crash from the beginning.
• Diversify. Buy stocks in different industries and sectors. This provides you with protection from all but severe market downturns that negatively impact everyone.
• Don’t try to “time” the market. It’s impossible to do so on a consistent basis. Instead, look for stocks that have real, tangible strengths; these companies tend to do better than most in virtually any kind of market.

One way to get better at picking stocks is to practice, practice, and practice some more. You can trade with practice accounts for free without putting any of your money at risk; I recommend finding a strategy and trying it out for months before you jump in.