Picking stocks is an intimidating process. There are 11 different stock market sectors, 69 distinct industries and more than 8,400 stocks across three major U.S. exchanges. How on earth can anyone — let alone a beginner — go about intelligently choosing specific stocks that are primed to do well?
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Right off the bat, investors should know that there’s no foolproof algorithm or formula that will ensure success. As many stocks as there are, there are thousands more investing philosophies, schemes, strategies and mindsets that investors use to approach the market.
As a newer investor, or even as an experienced market participant re-examining your own approach, it’s helpful to understand the following principles. Here are seven things you should know before picking stocks:
— Know you’re betting on yourself.
— Know your goals.
— Don’t invest in businesses you don’t understand.
— Understand financial ratios.
— “If it’s too good to be true …”
— Assess the “moat.”
— Understand systematic risk.
Know You’re Betting on Yourself
Before you start devising your plan to become the next Warren Buffett, it’s absolutely vital that you understand the game you’re playing and what the odds are.
By opting to pick individual stocks, you’re betting on your ability to beat the market and exceed the return of the stock market at large. This is extremely difficult to do: 84% of professional fund managers, whose entire job is to beat the index, fail to outperform their benchmarks after a five-year period. After a 20-year period, 95% of managers fail at that task, according to the SPIVA U.S. Scorecard, a study by S&P Global.
Perhaps retail investors have better luck? They don’t, as it turns out. In the 20 full years between 2002 and 2021, the S&P 500 grew at a 9.5% annualized rate. The average investor earned just 3.6% annually, barely outpacing the 2.2% tax levied by inflation, according to J.P. Morgan Asset Management.
Psychological mishaps like buying when stocks are on a run and selling when they’re down, as well as overtrading, are largely to blame for the miserable actualized returns of everyday investors.
So, while this principle is arguably the least satisfying of the seven, it’s also the most fundamentally important. By choosing to pick stocks and not buying a low-cost index fund like the Vanguard 500 Index Fund (ticker: VOO) that automatically earns you market returns, you’re engaging in a bit of hubris and choosing to go against the odds.
Know Your Goals
If you still wish to pick your own stocks despite the odds, the next step is to outline your goals. Are you a young, swing-for-the-fences investor who wants to amass a multimillion-dollar stock portfolio by the time you’re 40? Congratulations, you’ve just narrowed your universe down to high-risk, high-reward names — likely out-and-out growth stocks or beaten-down contrarian names.
Do you have a shorter runway, and simply desire to play it safe and maybe earn a little income while you’re at it? You’ll likely only want to consider blue-chip companies and dividend stocks; you may find some ideal portfolio pieces among real estate investment trusts or dividend aristocrats.
And for those aiming to be short-term momentum investors or trade based on charts, your aims are beyond the purview of this piece.
The bottom line: Having even a loose idea of your investing goals will be a big help in culling down that list of 8,400 choices to the stocks that make sense for your portfolio.
Don’t Invest in Businesses You Don’t Understand
A stock is nothing more than an ownership stake in a business. If you were investing in a local small business, would you want to put your money behind it without looking at its books and understanding its revenue, costs, seasonality, opportunities, risks, competition and advantages?
Doubtful.
Good stock picking requires the same diligence and understanding — a concept oft-repeated by investing greats over time. Warren Buffett has shouted this from the proverbial rooftops for decades, while Peter Lynch, the famed former manager of the Fidelity Magellan Fund, cautioned to “never invest in any idea you can’t illustrate with a crayon.”
Understand Financial Ratios
Of course, once you know your goals and come across a good business that you understand, the search doesn’t end there. You need to have some idea about whether the stock itself is cheap or expensive.
This is where financial ratios — derived from the market value of the stock and various numbers from the balance sheet, income statement and cash flow statement — come in handy. Valuation metrics like price-earnings, price-sales and price-book are some well-known examples, but other metrics can help convey how well a company can pay its debts, how profitable operations are and how efficient it is.
While it’s not necessary to scrutinize every last financial ratio before investing in a company, you should know where the important ones stand in relation to peers — and know which way they’re trending.
“If It’s Too Good to Be True …”
If it’s too good to be true, it probably is. This ancient aphorism holds true in the stock market, where many deceptive temptations can await investors. One common mistake newer investors can make is to be drawn in by stocks with attractive-seeming valuation metrics, most commonly the price-earnings ratio, or P/E ratio.
Cyclical companies like homebuilders, automakers and banks may on occasion sport P/E ratios much lower than the rest of the market, making them appear cheap. But just because you see PulteGroup Inc. (PHM), Ford Motor Co. (F) or Citigroup Inc. (C) trading for single-digit P/E ratios doesn’t mean these stocks are oversold. In fact, the market may be signaling that the peak of the earnings cycle is in the rearview mirror, and trailing earnings are much higher than one can expect moving forward. These kinds of seemingly cheap stocks are known as “value traps.”
Another inclination many investors may face concerns the desire for high dividend yields. While a good blue-chip income stock may pay a 2% to 4% dividend, plenty of names in the market might yield 7% or higher.
Meteoric yields are typically a red flag: Often either the stock itself has fallen dramatically for good reason, or the past dividends are considered unsustainable and a trimming or cessation of the dividend is expected.
Assess the “Moat”
Especially if you want a set-it-and-forget-it portfolio, you’ll want to pick stocks of companies that have long-term competitive advantages distinguishing them from the broader market. Warren Buffett refers to these perks as “moats” that protect the corporate castle.
In essence, wide economic moats help ensure that companies continue to thrive and protect margins in the long term.
Moats for Coca-Cola Co. (KO) include its globally recognized brand and its distribution network, for instance. Apple Inc. (AAPL) also has an enviable global brand, network effects that make its products more useful as more people use them, and high switching costs because users would be forced to adapt new software and buy new compatible accessories if they switched to a competitor.
The extent of a company’s moat will affect the price investors are willing to pay for the company’s stock, as wider moats are more valuable.
Understand Systematic Risk
The last thing to know about how to pick stocks is that your portfolio will frequently rise and fall for reasons unrelated to the specific stocks you own. This year provided a great example of systematic risk in action, as all three major U.S. stock market indexes entered bear markets as inflation, war and soaring interest rates shellacked equities.
These external factors, which no single company or board of directors can control or avoid, can drag down even well-chosen, long-term stock picks. Eradication of this broader market risk is impossible, but investors can mitigate company-specific risks through diversification.
While systematic risk is a part of life, investors can confront it by buying stocks with lower correlation to the market, known as low-beta stocks, or embrace it by selecting high-beta stocks. Beta measures the volatility of the wider stock market, which is always 1.
While beta isn’t a perfect metric, generally speaking, stocks with betas below 1 will move in a less-pronounced way when markets rise or fall, while the opposite is true for high-beta stocks. In theory, this makes low-beta stocks more preferable in bear markets and high-beta stocks better picks for bull markets.
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How to Pick Stocks: 7 Things All Beginner Investors Should Know originally appeared on usnews.com
