How To Pick The Perfect Stocks For Your Portfolio

14 mins

How To Pick The Perfect Stocks For Your Portfolio

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What Are Stocks?

We’re not going to lie, stock picking can be one of the most exhilarating ways of putting your money to work. Seeing your carefully chosen shares rocket after the company reports great earnings might make your heart beat faster (and make you feel super smart), but don’t be fooled about the risks – stocks can just as easily go crashing down.

If you don’t want to hand over control of your investments to someone else (in a mutual fund or robo-advisor, for example) this pack will teach you tips to stop you from biting off more than you can handle.

Before we go too far, what actually is a stock? Stocks (a.k.a. shares or equities) are an ownership stake in a company that gives you a claim on a small portion of its earnings. In this Pack we’re going to focus on shares of public companies – which are generally very easy to buy or sell on public exchanges – rather than those of private companies (like your aunt’s home maintenance business).

Stocks can reward investors in two ways: by increasing in value as they attract more buyers and through paying a regular income stream from the company’s profits (known as a dividend).

For retail investors (like you and me!) stocks are one of the most popular forms of investment as they are relatively simple to get your hands on and your head around.

What affects a company’s stock price? It might be easier to count how many grains of sand there are on a beach… Stock prices are a fickle lover and ultimately reflect how much investors are willing to pay for a company’s projected cash flow. In layman terms, you’re taking a punt on a company’s future – which can be influenced in a myriad of ways.

Can you give me some examples? For a start, the economic or industry conditions in the markets in which the company operates are a huge factor. For example, Nike is massive in the US, but if fewer people play ‘ball or there’s a recession then Nike is likely to see slower sales growth and less future cash flow (let alone if Cristiano Ronaldo breaks his leg).

Secondly, you have market-share trends: if a company is gaining or losing lots of market share it’ll be earning more or less revenue respectively – which will feed through to its ability to make a profit. Ask yourself: are there any competitors on the horizon or has your chosen company got a firm grip on the market?

And then of course we have to mention costs. Is there anything that could hurt a company’s profit margin? A perhaps obvious example is if production costs suddenly rise, a company’s ability to generate cash will be negatively affected.

Ultimately, of course, shares are worth what the market of many thousands of buyers and sellers says they’re worth. And all these things – and many others – will be closely watched by all those people in the market.

Screening Out

Now we’ve briefly discussed the things that can move a stock price, we’re going to help you narrow the playing field somewhat.

As corny as it may sound, when picking stocks the world really is your oyster – pretty much any region or industry is fair game. Except maybe North Korea (for now). And because there’s so much choice, it’s probably easier to decide what you don’t want to invest in before you try to find out what you do want.

How do I even start? The best place is probably to understand how much risk you’re willing to take. Any investment pays you a relative return as compensation for risking your money. As with pretty much anything in life: more risk = a bigger potential return (and bigger potential losses).

You tend to find safer stocks in “necessity” industries – things that people pretty much have to buy, no matter how little cash they have in their pockets. Examples include water companies or producers of consumer staples like toilet roll and baby food. These sorts of companies exhibit slow and steady growth, and plenty of profit (sometimes called earnings) to distribute back to you through dividends.

If you want something a bit more high-octane, look out for younger, rapidly growing companies or those putting lots of their hard-earned cash back into the business to grow it further. However, it’s unlikely you’ll get regular dividends when investing in these high-growth stocks. Instead, you’re hoping for a big share-price increase that you can sell on for a profit – or holding out for an eventual dividend when the company’s growth starts to slow.

How do I distinguish between safe and risky stocks? We feel you. It’s not easy to sift out what is and isn’t right for you. To make life easier, screening tools exist to sort long lists of stocks according to various attributes – valuation or profit growth, for example. Professional investors tend to use expensive desktop terminals from the likes of Bloomberg or FactSet (which do 1,001 other things as well) but there are free online tools such as Wallmine or Finviz that the likes of you and me can use.

There are tons of factors to consider when weeding out the stock for you, but we’ve summarized a few key things to look out for:

🔷 Region: you can pretty much split this factor into two – developed countries and emerging markets. Basically, more economically developed regions tend to have more established businesses, governance, and laws to protect investors – making stocks safer on average.

🔷 Industry: Industries that everyone needs (like consumer staples) tend to be more reliable but experience slower growth. Meanwhile, companies on the cutting edge of a new technology might grow exponentially fast – but they could also crash and burn if they, say, run out of cash before becoming profitable.

🔷 Company size: Big companies tend to find it harder to grow because they’ve often already banked all the easy wins. On the other hand, smaller companies have higher profit growth potential but come with the risk that they may not survive long enough to become an industry stalwart.

🔷 Valuation: You may have heard of “value” or “yield” investors – they look at how cheap a stock is compared to its ability to generate cash (especially versus its industry peers). While on the face of it a cheap valuation seems like an obvious thing to look for in a stock, some say it’s a high-risk approach because there’s no guarantee cheap stocks will become less cheap over time.

Using a screener to apply a few of these rules to a long list of stocks can quickly leave you with maybe a few dozen options of interest. Now what? Stick around and we’ll show you.

How To Research Stocks

Once you’ve done your initial filtering to produce a shortlist of stocks of potential interest, it’s time for the hard work to start.

Before jumping into a stock because it hits all the metrics of your beautifully constructed filter – or because your cousin’s girlfriend told you it’s the hot new thing – take a breath. Making well-informed equity investments is about understanding the company’s “secret sauce.” In other words, ask yourself why this company will perform better than everyone else in the market.

What sort of things should I consider? For a start, does the company grow faster than others in the industry? If so, why? Perhaps its products are better or cheaper so it attracts more customers, or so much more expensive that only a few extra sales translate into faster growth. Or maybe it’s got exclusive deals that give it access to customers no one else can reach.

Next, consider the competition. If the company’s products are cheaper than others, are its profits suffering as a result? If they’re more expensive, what’s to stop rivals undercutting it and pinching its customers – as some Chinese smartphone makers have done to Apple?

Finally, is this company able to produce its products cheaper than anyone else? If so, why? Does it have a proprietary process others can’t replicate, or simply access to cheaper facilities or workers? If it’s the latter, how sustainable is that advantage likely to be over the long term?

It’s not always easy getting your hands on this information, but listed companies will have an “investor relations” section on their website where you’ll find presentations answering some of these questions. But don’t only focus on the positives – company reports include a detailed “risks” section, which’ll highlight major uncertainties on the horizon. Doing this can help you avoid any obvious risks.

Any other tips? One of the easiest ways to keep on track of your chosen company is to set up alerts on stock-price trackers or news websites. They allow you to keep abreast of any company press releases and price swings. Many investment apps also allow you to personalize your alerts, meaning that it only triggers a notification if certain conditions are met. It’s worth being selective with your alerts: if you receive non-stop notifications, you might miss the really important ones.

Where else can I find information? Don’t forget the humble newspaper. Both before handing over your hard-earned cash and after you’ve taken the plunge, it’s important to keep on top of any developments. For better or worse, the media can play a significant role in your investment. A spell of bad PR can lower share prices, potentially making it a great investment opportunity if the company’s business performance is unaffected.

Keep an eye out on what the Wall Street Journal, the Financial Times, or Bloomberg are writing about the companies you’ve picked (and Finimize, of course!). It can also be worth digging into more niche industry sources of news – like The Business of Fashion or Women’s Wear Daily in luxury goods, for example.

All the above will also feature opinion pieces on emerging industries and new areas of growth in the global economy. These can be a goldmine for finding out about interesting under-the-radar companies.

Once you’ve found a company that ticks all your boxes and you’re excited about investing in, it’s time to think about whether that company’s stock is a bargain or a rip-off. Next, we’ll dig deeper into how to think about a stock’s value for money...

Assessing Valuations

Sometimes a great company isn’t a great investment. Often this is down to the valuation of the company’s stock – basically how much you have to pay for it.

What do you mean by valuation? The price you have to pay for a share will be decided by the market (the balance of buyers and sellers at the exchange) and is out of your control. All you can consider is whether the current price represents value for money. Or whether you’d be better off waiting – or trying a different, less popular stock altogether.

In some ways, picking a stock can be like picking a restaurant for dinner. Yeah, you could try to squeeze in and get a table at the trendy place downtown that just got featured in that style magazine, but you might find yourself sat by the toilets and getting a nasty shock when the check arrives. You might have a better time overall if you head to that little local eatery your neighbour was recommending. It might not be as Instagramable but the food is probably as good and there isn’t a line out the door.

How do investors judge valuation? Here are a few trusty measures that are widely used by the pros:

🔷 Price-to-earnings (a.k.a. P/E) is a ratio measuring the price of a share relative to how much profit per share a company makes. You can compare the price with either the company’s most recently reported profits, or with analysts’ predictions for profit in coming years. Usually higher growth companies have higher P/Es as investors are willing to pay more upfront for a share of the earnings they hope will roll in over time.

🔷 Enterprise value-to-sales (a.k.a. EV/sales) compares the total value of a company (defined as the value of the company’s equity and net debt) to its sales. It’s typically used to evaluate earlier stage companies that have little or no profits.

🔷 Dividend yield compares a company’s dividend to its share price, presented as a percentage. For example, a stock costing $100 and paying $5 a share in dividend would have a yield of 5%. If a stock is described as “high-yield” it suggests it’s cheap as you don’t have to pay much relative to the dividend you’ll get over time.

You don’t have to calculate all these numbers by hand. The screening tools mentioned earlier can do the math for you.

Of course, only time will tell if that cheap stock you selected was a bargain or whether it was cheap for a reason. There’s no slam dunk way to know for sure, unfortunately (or stock picking would be easy!). Buyers of “cheap” stocks (a.k.a. value stocks) will argue that earnings growth will eventually return, creating demand for the shares from other investors and pushing their prices higher. Sellers will argue that the shares only appear cheap because earnings expectations are too high – they’ll eventually fall and make a stock look fairly priced, if not expensive.

When looking at valuations, don’t look at the company in isolation. Examine valuation over the company’s history and compare it to rivals in the same sector. This additional context for what’s high, low, and average will help you figure out whether its current valuation is legit. You can also do this through those handy stock screeners.

Next, we’ll show you how to take the plunge.

How To Buy Shares

So you’ve figured out how much risk you’re willing to take, done your research, and now you want to actually spend some money… Hoorah, let’s get spending.

To actually place an order to buy stocks, you’ll need a broker. You can go old school and find a traditional broker where you can place orders over the phone. They’ll charge you a fee for every transaction (and perhaps other fees, like an annual membership) but might offer other services like research on companies or tax planning. Or you can go direct via online brokerage platforms like IG and Hargreaves Lansdown in the UK, or TD Ameritrade and Fidelity in the US. You’ll still pay transaction fees, but they might be lower.

In either case, when you sign up you’ll have to tell the service provider who you are and what your level of investing expertise (or naivety) is. Depending on your answers, you may need to sign a waiver saying you understand and are comfortable with the risk you’re taking (you could lose everything, after all). And if you’re investing overseas, expect even more paperwork for tax reasons.

But are some brokers better than others? They’ll all have slightly different fees and levels of service – and some of their apps will be more to your liking than others. It’s ultimately a matter of personal taste.

“I use multiple brokers. By building a relationship with multiple brokers you get advice. They’re able to sell you a suite of products, which you get benefit from. And also there’s the advice side of it – so you’re getting advice from different companies. I rely on their advice, and then I will then make a decision from there on.”

- Finimizer

What will my returns be like? Equities are generally a very volatile asset class – prices can swing higher or lower very quickly. Never invest more than you’re prepared to lose. It’s a good practice to “diversify your portfolio” – basically spreading your bets so if one stock doesn’t work out, the blow can be softened elsewhere. Diversifying also allows you to be a bit more flexible with your investment strategy as you don’t have all your cash tied up in one big bet.

OK, so how do I diversify? Diversifying isn’t just about buying more than one stock, it’s about making sure those stocks don’t all move together. If you’ve picked shares that are all focussed on retail in the US, you can be fairly certain that a US economic downturn won’t be good for your investments. So you might want to consider some other industries which wouldn’t get hurt the same way, such as utilities – people pay for energy all year round, no matter the state of the economy.

If you’re worried that now might not be a good time to invest because a selloff is imminent, remember that you don’t have to use up all your money in one go. It’s always an option to drip feed in your cash over several months. This applies to whether you’re focusing on just one stock (but we’ve told you why that might not be a great idea) or are spreading your investments across several companies.

So that’s it. Easy, right?

In all seriousness, picking stocks is not an easy business and is generally riskier than a lot of other forms of investments (e.g. bonds). So if there’s only one piece of advice you take from this pack it would be to make sure you really understand what you want from your stock (or portfolio of stocks) and understand the risks you’re exposing yourself to. Good luck!

Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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