How to Pick Stocks: 7 Things All Beginner Investors Should Know

These tips will help you get the most out of your investments.

History is filled with stories of great stock pickers like Warren Buffett, who made his fortune as a value investor buying the stocks of downtrodden large-cap U.S. companies and reaping massive returns. While most retail investors would be best served by a low-cost passive index fund, trying to pick a few stocks can be a great hobby and way to potentially increase your returns. However, keep in mind that it’s not as easy as simply buying and holding blindly. The market is rather efficient, and the opportunities for average investors to truly find a golden buying opportunity are limited. Nonetheless, there are a variety of ways investors can ensure success and manage risk when it comes to stock picking. Here are seven things you should know before picking your first stock.

Never invest in a business you don’t understand.

This quote comes from Buffett himself. One of the most common ways investors get burned by a stock pick is when they don’t understand how the company works, or blindly invest in it based on hype and fear of missing out. A great example is the recent meme stock craze. Investors can avoid this by picking companies with solid, easy-to-understand business models that produce everyday services and products they personally experience. Think of companies like McDonald’s Corp. (ticker: MCD), Costco Wholesale Corp. (COST) and Coca-Cola Co. (KO). If you find yourself struggling to explain what the strategy of your company is, what its core value proposition is and how exactly it makes money, it might not be a good pick.

Understand financial ratios.

A company’s public financial disclosures consist of three main documents — the balance sheet, profit-and loss-statement, and the cash flow statement. From these documents, investors can calculate a variety of financial ratios that give them insight into how well the company is managed, its historical growth, whether or not it’s profitable, and if it’s financially stable or not. Investors should compare these ratios between different years and also between peers of a similar market capitalization in the same stock market sector or industry. The five general categories of ratios to know are liquidity (current, quick and cash ratios), leverage (debt-to-equity and interest coverage ratios), efficiency (inventory and asset turnover ratios), profitability (gross margin, operating margin, return-on-assets and return-on-equity ratios) and market value (price-earnings, earnings per share, book value per share, and price-book ratios).

Watch out for value traps.

Value stocks are those that appear to be cheaply priced relative to their fundamentals. New investors often get caught up in assessing a company’s price-earnings, price-cash flow, price-book, and price-sales ratios, and may make decisions solely based on those figures looking low relative to sector peers. However there’s always the risk that the company looks undervalued because it is in fact doing poorly. This is called a value trap — where the company isn’t actually undervalued but is rather suffering financial distress and low future growth potential. To avoid value traps, always consider a company’s qualitative factors, such as its competitive advantage, management effectiveness and whether or not it has potential catalysts on the horizon.

Avoid chasing high yields.

New dividend investors often screen for stocks with high dividend yields, but this approach can lead to holding potentially unprofitable and stagnant companies. Because dividend yields are calculated by the annual dividend per share divided by the stock’s price per share, a plummeting share price can make the yield appear very high for the time being, potentially tricking unsuspecting investors. A good way to screen for a yield trap is by checking the company’s payout ratio, calculated as a company’s annual dividend payout rate divided by its earnings. If it’s over 100%, this might not be sustainable, as it means the company isn’t profitable enough to pay its dividend solely using retained earnings and may be taking on debt elsewhere.

Check insider activity.

Insiders are always more likely to know what the best valuation for their company truly is. Generally, investors should pick stocks where the management team has a strong stake in its future performance. A good way to screen for this is by checking for insider transactions, including buys, sells and options exercises. These filings are delayed but can still act as either an early warning signal to sell or bullish indicator to buy. For example, a substantial amount of insider selling could be a warning signal that management feels the stock will likely drop due to some negative development and are cashing out their stake ahead of time. Strong insider buying could indicate a vote of confidence by management in the company. As a rule of thumb, insider buying activity is more predictive than selling, as insiders can need a cash influx for all sorts of personal reasons, while buying is a fairly objective endorsement.

Assess the economic moat.

Warren Buffett popularized the term “economic moat,” referring to a company’s ability to maintain a competitive advantage. Companies with a “wide” economic moat are those that can maintain their dominant industry position for decades while fending off competitors. This translates into more ample margins and consistent cash flow, with all other factors being equal, increasing company values over time. There are quantitative ways to assess a company’s moat provided by numerous organizations, but often a qualitative method is suitable. Generally, investors can assess a company’s advantage in terms of size (economies of scale), intangibles (patents, licenses and brand recognition) and costs (cost leadership and switching costs). Examples of companies with wide economic moats include Alphabet Inc. (GOOGL, GOOG), Coca-Cola and Apple Inc. (AAPL).

Understand market risk.

No matter how solid a stock pick is, it’s subject to market risk. This is the risk of your investment losing value when the broad market takes a downturn, even if the fundamentals of the company have not changed in the slightest. Market risk can be measured by beta, which calculates how sensitive a stock is to market movements and the direction it tends to go. The market always has a beta of 1. Stocks with a beta higher than 1 move in the same direction as the market with higher sensitivity. For example, a beta of 2 means the stock will usually move twice as much in the same direction as the market does. A beta of less than 1 but greater than zero implies lower sensitivity. Finally, a negative beta implies a stock is likely to move inversely to the market.

How to pick stocks: 7 things all beginner investors should know:

— Never invest in a business you don’t understand.

— Understand financial ratios.

— Watch out for value traps.

— Avoid chasing high yields.

— Check insider activity.

— Assess the economic moat.

— Understand market risk.

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How to Pick Stocks: 7 Things All Beginner Investors Should Know originally appeared on usnews.com

Update 08/09/22: This story was published at an earlier date and has been updated with new information.

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