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Buying stocks is easy especially when completely guided through the steps. But choosing what stocks to invest in and which companies to buy from requires preliminary decisions, self-assessment, analysis of different factors, and more! It is probably the most critical point in the process. Investing has absolutely no such thing as a money-back guarantee, so it must be given a lot of thought.
Just the Nuggets
- Before anything else, decisions like investment goals, risk tolerance profile, plans for diversification, and amount of investment must have already been made by the investor.
- Picking stocks is a research process that makes use of fundamental analysis and technical analysis.
- Understand the business models of prospective stock companies and their financial ratios as a measure of their financial health.
- Interpret basic technical analysis tools like candlestick charts and moving averages to capture a snapshot of how your prospective companies have previously behaved in the market.
The Starting Line
Good investors know that when they enter the stock market, they’ll be in it for the long haul. There is no minimum as to how long you should invest in the stock market. But normally, you should be in it for at least 10 years. So, you must align your goals with a longer time horizon.
Every investor has their own purpose for investing. You absolutely can do it for education, retirement, passive income, business, etc. As soon as you get married or have a baby, you can start investing so that 10 or more years later, you’ll have funds for your child’s education instead of getting a student loan. You can also do it in your 20s or 30s so you can still spoil yourself even when you’re already retired.
However, if you are motivated by the following reasons, take your time to reassess your financial plan:
- emergency fund
- steady income stream
- stock investing craze
- debt payments
Risk Tolerance Profile
Generally, the higher the risk, the higher the return (which means risk and return are directly related). However, do not forget that in hindsight, higher risks could also mean greater losses. That is why there are different types of investors according to their risk tolerance profile, and you must identify where you belong among these types.
If you’d rather earn a little than lose money, then you are a conservative investor. You just want to play it safe so you make sure you have your life vest on before jumping into the sea.
If you want to earn more but still not too keen on losing a lot, then you are a moderate investor. You position yourself somewhere between the safe and the risky zone. You can jump into the sea without a life vest as long as there’s a floating ring nearby.
If you value the returns more than the fear of the looming possibility of loss, then you are an aggressive investor. You are the type to jump into the sea and even go free diving. However, do not misinterpret this to be a reckless mindset. Being aggressive is good as long as you know what you’re doing and you’re able to manage the risks well.
If you are not sure what type of investor you are, there are several available risk tolerance quizzes online that you can take.
Plans for Diversification
Your risk tolerance profile will determine how you’ll diversify your portfolio—a summary of your owned investments and their day-to-day standing, particularly on the gains and losses.
The portfolio contains bonds. Bonds are money loans you allow the government or corporation to borrow as long as they return to you the agreed face amount plus interest.
The portfolio is a mix of bonds and equities. The easiest way to do this is to invest in mutual funds (a pool of investors’ money held by a fund manager) and index funds (a diversified group of stocks that usually follows the market’s general trend).
The portfolio has fully controlled investments. Aggressive investors are flexible to choose what and how much investments to buy, what strategies to apply, and many more.
How Much to Invest
When you invest money, think of it as part of your expenses in the present. After a decade or more, you’ll reap the returns. So never borrow money just to invest in the stock market. Use extra cash you don’t immediately need.
Usually, stockbrokers have a required minimum amount of investment for account opening.Technically, that’s the money you’ll have to initially prepare. However, there’s a trend recently where online stockbrokers do not require any amount for account opening, plus they waive off commission fees. There are more ways now to invest in stocks with little money!
Most importantly, make it a habit to regularly set aside a percentage of your income (e.g. every month) for investments. Build and stack your assets over time, little by little.
How to Pick Stocks
Picking stocks is a research process that requires you to look at different perspectives. There are two techniques in stock investing: fundamental analysis and technical analysis.
You may see many articles wherein both techniques are compared against one another. While it’s true that technical analysis is more complicated and advanced, it mainly depends on how you use both techniques.
For beginners, it’s preferred to start with fundamental analysis because it mainly answers the question of what stocks to buy. Technical analysis, on the other hand, is more focused on answering the question of when to buy the stocks.
This allows you to assess the financial health of the stock companies you are eyeing on. Much like how you choose which fruits to pick, see to it that they must be in good condition.
Qualitative Fundamental Analysis
In this approach, you’ll size up your stock picks using intangible measures. Get a feel whether the company or corporation would give you returns after your time horizon.
1. Know how the company makes profit
Warren Buffett, probably the most influential guru in the world of investing, advises not to invest in a business you don’t understand. The first step is always to know the business model of a company. In other words, know how they earn revenues.
Take Netflix, Inc. for example. Netflix earns money from monthly subscribers by offering on-demand movies, TV shows, etc. Aside from partnering with film production companies, they also produce original series. They offer entertainment value to possibly anyone with a mobile device. Ask the right questions like—will Netflix continue to earn money in the next 10 years with this kind of business?
2. Check out the company’s competition
As part of diversification, do not invest your money in same-industry companies or those with the same products/services. Invest also in other sectors like utilities, healthcare, financials, consumer, etc.
Following the same example, you can compare and contrast Netflix, Amazon (Prime Video), and Walt Disney (Disney+). If you can’t decide which of the competing companies to choose, compare their initiatives, gimmicks, and most important of all—customer relations.
3. Follow company-related news
Assess the reputation of the company both in the business and consumer world. Keep yourself updated on their business model. An ideal company continues to innovate so they can offer something new to their customers.
Aside from that, be updated with corporate governance news. Did the company acquire more shares by buying someone else’s company? Was there a change of leadership in the major stockholders? All these things will affect the stock price fluctuations.
Quantitative Fundamental Analysis
This technique makes use of the company’s financial statements. When the company goes public and sells their shares in the stock market, they are obliged by the Securities and Exchange Commission (or the equivalent bureau in your country) to issue financial reports regularly (e.g. annual or quarterly) for their investors’ benefit.
These reports are looming and could easily intimidate beginner investors. But don’t worry, you can learn the basic indicators. Use these ratios to quantify your prospect company’s standing.
1. Earnings per Share (EPS)
Significance: EPS is a gauge of the company’s profitability. It determines the relative portion of the profit allocated to each outstanding share.
Rule of Comparison: The higher the EPS, the better.
2. Price-to-Earnings Ratio (P/E)
Significance: It is used to standardize if the stock is overvalued or undervalued. When a stock is overvalued, it’s like you’re buying during a price surge—the price is higher than its intrinsic value. On the other hand, buying an undervalued stock is like buying at a discounted price.
Rule of Comparison: The lower the P/E, the better.
3. Dividend Payout Ratio (DPR)
Significance: It is used as a gauge of how much of the company’s net income will be given as dividends.
Rule of Comparison: The higher the DPS, the better.
4. Debt-to-Equity Ratio (D/E)
Significance: This tells you where the company gets the majority of its funds for its operations. Is it from debt or its equities (i.e. net worth)? In personal finance, debt has an ugly impression. But in business, it’s often preferable when companies use good debt as leverage.
Rule of Comparison: The higher the D/E, the riskier.
To manage the risks, you’ll have to compare the D/E to the rules of thumb that differ among industries. These are some examples according to an article in Harvard Business Review:
- Tech companies (or those needing a lot of R&D): ≤ 2
- Manufacturing companies: 2-5
- Financials: 10-20
If math is not your strong suit, don’t worry. The formulas are shown to give you an idea of what the ratios are comparing. You don’t have to compute because tools such as stock screeners will do it for you. All you have to do is compare values within the same industry or sector.
Basic Technical Analysis
Relying heavily on market price history to speculate on the future movement of the trend, this analysis is for the firm believers of the saying, “history repeats itself.” So, they use patterns to anticipate the next movement. Take note that these techniques are suitable for experienced day traders who buy and sell stocks multiple times a day.
But that’s not to say that technical analysis is not for long-term investors. You can still use basic charting concepts to assess if the company has been doing well in the past decade or so. For example, you can compare how the competitors Netflix and Amazon have been doing in the stock market for the past decade.
This type of chart is called a candlestick chart. The blue trendline represents the moving averages. Both of these indicators are useful in the research process of picking stocks for a long-term investment.
This is the most common type of chart in the stock market. Market prices are represented in green and red vertical bars with extended wicks at both ends. If you know how to interpret candlesticks, you’ll see different price data (open, close, high, and low) for a given period. You’ll also gain knowledge about the market behavior just by looking at the lengths of the candlesticks and the wicks.
What must a candlestick chart look like for your top stock pick? There must be more green bars than red ones, with the trend generally going up. That means—throughout their company history, they continue to increase their market value. But take note that downtrend red bars are also an indication that the company has the financial resilience to bounce back from their lows to a general upward trend.
This tool is preferable if you want to smoothen the price fluctuations. It’s like looking at a zoomed out market trend, although it has a lagging effect. It’s calculated by taking the average of the closing prices—the last price recorded when the market closes on a trading day—in a given period.
Fortunately, there is no need to apply manual math. Free charting tools like TradingView already have all the fundamental and technical analysis indicators and strategies at your disposal.
When the candlesticks are above the moving average line, the trend is going upwards. An ideal company must have candlesticks above the moving averages.
Invest With The House: Hacking The Top Hedge Funds by Meb Faber (Cambria Investment Management)
Now that you have your stocks list, continue to follow up on them closely. It’s like checking up on the seedlings you’ve planted. The research process moves along with time. When your company grows, so do your investments. Take inspiration from Warren Buffett’s words:
Our References and Further Readings