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by Aleksandre Natchkebia on July 25, 2018

How to carefully pick stocks to invest in

Stocks are one of the most popular investment asset classes in the world. Billions of shares change hands daily and there are huge exchanges all around the world meeting the demands of traders of all types. Although there are several types of stocks, at its core a stock represents a share of ownership in a company. This does not always translate to a control over the company’s actions, but it does mean that the holder is entitled to a portion of the profits made by the company. Shares are appealing to many customers because of their high potential for gains. In fact, stocks have historically been found to show the highest return among all asset types in portfolios. Furthermore, they are very liquid and can be sold easily, unless there are special financial circumstances. All of this leads to many investors seeking new stocks to invest in. Obviously, not every stock offers the same benefits to the holders, therefore there is a process of deciding which ones to include in one’s portfolio and which ones to avoid. Here we list some of the factors that can be considered when making that decision.

Asses your risk and know what you’re looking for

Before starting the search, it is important to know exactly what your preferences are. It will largely depend on the investor’s risk aversion what kind of stocks he/she will pick. If you have holdings comprised of various assets, check how the added stocks will affect its riskiness and the return of the overall portfolio. In addition to this, an investor has to have an idea on how long he/she will hold on to these stocks. Depending on whether they will be sold in a few months or kept for years, different stocks might be more attractive to the investor. One way to think about this is by looking at what your goals are. If you want to invest in stocks in order to keep your capital safe, then you might be less focused on growth and more on stability. On the other hand, if you want to rely on the capital gains you will likely look for stocks with a better growth potential. It is also important to know how diversified you want your portfolio to be. Many stocks experience growth cycles, and if your tolerance for risk is not very high, you will want to offset the changes in the prices of one stock by the changes in the other.

Look at the history and track record

Many investors look at investing in stocks as a guessing game and try to find companies that haven’t been ‘discovered’ yet. Unfortunately, this doesn’t always end well. First of all, if a company has already had a public offering of its stock, it is unlikely that it is a small start-up that no one yet pays attention to. Secondly, there are large venture capitalists who are looking for such companies specifically and have a lot more resources to find them than small investors do. It is also very difficult for small investors to wait for news and press releases in order to forestall the market. According to the Efficient Market Hypothesis, all the information that is available on the market is already reflected in the prices. While this might be difficult to comprehend and there are some people who actively disagree with it, it is almost certainly true for small individual investors.

So how can one assess the future prospects of a stock? One way to do this is by looking at its past performance. If a stock has shown stability over a period of time, it is likely that the risks associated with it are less. On the other hand, if a share price exhibits large volatility, it might be less safe to invest in. There is an indicator called ‘beta’ which shows the stock’s volatility compared to the general market. If the stock’s beta is less than one, it is less volatile than the market and if it’s more than 1, the percentage changes in its prices, on average, have been bigger than the changes in the whole market. Looking at the track record is less reliable when growth is concerned. If a stock exhibits continuous growth over a period of time it will surely attract investors attention and if it is undervalued the prices will be swiftly corrected. There is a highly debatable Random Walk Theory as well, which needs to be mentioned. It says that it is futile to look at the past performance of a stock as the changes in price are independent of each other and have the same distribution. This means that if a stock falls today, it does not mean anything for how it will behave tomorrow.

Look at what others are investing in

If your goal is to find a safe investment that will allow you to hedge from inflation and accrue smaller but more stable gains, it might be a better option to make less risky decisions. One way this could be done is by looking at what other investors are choosing. You can look up some of the most popular and best-performing Exchange Traded Funds and see what stocks are included in the indices they track. This information should be available for the public so you will not have any trouble finding it. On the other hand, some of the privately managed funds might not disclose this information to anyone. It is also possible to filter the stocks by sectors. Some sectors have been known to provide stability and safety. Blue-chip stocks, which are shares of larger and well-established companies are always a safe choice and can be very appealing to the less risky investors.

Research the financial statements of the company

Companies that are publicly traded are obliged to disclose their financial statements to everyone. If you have narrowed down your search to a few companies and want to choose among them, one way is to look at these documents. Less sophisticated investors might not be able to use this information, but if you have some financial knowledge and the ability to understand these reports, they can be very helpful. It is also possible to find out from these statements how the company pays dividends to its shareholders. Some companies focus more on growth than on paying out dividends and if you think that this stream of income is important for you, you should definitely research the behavior of the company in this aspect beforehand.

Avoid companies with smaller market capitalizations

If you are a smaller investor that does not have the resources to create a portfolio from multiple asset classes, you might want to be more careful with the stocks you pick. If your tolerance for risk is not very high choose mid-cap and large-cap companies as it is less likely that they will experience any serious problems in the future. The smaller companies, which could be relatively new, might go out of business or be forced to liquidate so the stocks could lose their value. In most cases, it is safer to invest in the larger companies. This also means that it is better to look for companies that have a big market presence and established brands. Companies like Walmart and McDonalds, which have been in business for a long period of time are not likely to go anywhere anytime soon. Consequently, they are a good choice to include in your portfolio.

Look at the price compared to the value

It’s not wise to judge stocks just based on price. Price on its own doesn’t say anything. A stock of $100 is not more valuable than the one that costs $50. Instead, there is a measure called the Price-to-Earnings or P/E, which can help investors identify the value compared to the price. When choosing a stock, the important thing is to find the one that is undervalued i.e. the price of which is lower than the true value of the stock. In this case, it is considered that the price will ultimately increase to reach the true value. The P/E measures the price of a share compared to the earnings per share. A P/E of 20 would roughly mean that an investor has to invest $20 in the company in order to get earnings of $1 a year. Generally, the rule of thumb in finance is that a P/E of 15 and under means that the share is undervalued and is therefore cheap and a P/E of 20 and over is overvalued and expensive. This is not the case across all sectors and all kinds of companies. For example., if a company is generally believed to have a big potential for growth it’s likely that its shares will be overvalued. So, expensive shares shouldn’t be discarded altogether as they are expensive for a reason.

 

 

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