How To Pick Stocks: 5 Essential Tips For A Successful Investment Strategy

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I have recently started my investment journey, by opening my first online brokerage account and by crafting my investment strategy. I’m personally not a huge fan of mutual funds, because of high management fees and because I want more control on what’s in my portfolio. So, since I’m not into day trading either, I naturally developed a high interest in stock picking. In my particular case, I prefer doing a lot of work to identify the right stocks, buy them, then hold them for a long time, instead of following the stock market on a daily basis. This is because I am more likely to make fewer mistakes by focusing on a long term approach to investing, rather than immediate reactions to short-term market movements, that do not necessarily reflect the value of companies. So today I will share 5 tips I have learned during my journey so far, in order to help you in your own investment strategy.

1. Set up your investment goals

What kind of investor are you? Do you prefer focusing on growth or income? In other words, do you want to buy undervalued stocks whose value will appreciate with time or are you looking for stable companies that provide sustainable dividends? Keep in mind that your portfolio can include both types.

2. Invest in companies you understand

The most stable companies are the ones that have been in business for decades. What are the brands you grew up with, and that are still part of your life today? Take a look all over your house and identify the brands you and your parents used to buy. For example: Colgate, Maytag, Kraft, Coca-Cola, etc. Those companies have had a strong position on the market for several decades and produce goods that most households buy in their everyday life, and that are likely to be bought in the next 50 years. Their revenue model is simple and clear. More sales = more revenue = more stability. So it would make total sense to own some of those stocks in your portfolio.

3. Understand Management

Invest in companies with trustworthy management. If a company is frequently changing executives, or constantly restructuring, maybe it means it has a hard time adapting to market conditions. Read the companies’ annual and quarterly reports, to ensure that management’s decisions have been consistent with the goals that have been set (e.g.: reducing costs, expanding in new markets, increasing EPS, etc). Tracking management is also a way to ensure that they are not taking risks hidden from their shareholders. Is the company’s board composed of experienced members and  industry experts? Does the CEO’s compensation encourage good business practices?

4. Review the financial statements

What do the income statement and balance sheet say about the company you want to invest in? In other words, how has the company performed these last years?

  • Income statement: Have revenues grown compared to expenses? What are the factors causing income to rise or fall (market share, pricing, margins, etc)? Are those revenues likely to grow or reduce in the future?
  • Balance sheet: How much debt does the company owe compared to its earnings? A common metric, Debt-To-EBITDA, gives an idea of how long it can take to pay back debt, before accounting for interest, taxes, depreciation and amortization.

5. Check valuation metrics

Picking stocks is very different than investing in mutual funds that are already diversified without you having to do anything. Alternatively, don’t just buy stocks because they are listed in popular magazines and TV shows. You have to take the time to identify the right stocks for you, by tracking key metrics such as:

  • Earnings per share (EPS): EPS is a company’s profit divided by its outstanding shares of common stock. It is often used as a benchmark to evaluate a stock’s value.
  • Price/Earnings ratio (P/E): This is the ratio of a company’s share price over its EPS. A low P/E ratio may mean that the stock is undervalued (good for a buy-low-sell-high strategy).
  • Price-to-Book ratio (P/B): Similarly to P/E, a low P/B ratio suggests that you are paying less for the value of the company’s assets.
  • Return on Equity (ROE): ROE is used to measure a company’s profitability. A high ROE means the company is profitable.
  • Enterprise value (market capitalization & debt) over the Net operating profit after tax (NOPAT) is another good metric that takes into account the debt of a company over its earnings. It is sometimes preferred to the P/E ratio because of that.
  • Payout ratio: It is the amount of earnings paid out in dividends. When a company pays dividends, it means it is willing to maximize returns for shareholders.

Conclusion: How To Pick Stocks

At the end of the day, stock picking is about finding the right investment opportunity for you. As very well put in the 2014 Canadian Business’ Investors Guide, “you want to know what the company has done in the past to increase its sales and earnings, what it plans to do to keep growing, and how much you’re paying for it”.

If you are new to stock picking, a good place to start is to open a brokerage account and use the educational resources and analyst reports provided by the brokerage firm. You can also go to the corporate website of the companies you are interested in, to download their financial reports. Also, business magazines and TV channels are also a great source of information to stay aware of current market conditions. Finally, you can set a virtual portfolio to practice your investment moves before investing your own money.

Did this help? Your opinion matters. You can rate this article, leave a comment below or share it on social media. Follow Bobbyfinance for more financial tips.

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