How to Pick Stocks to Invest in
By Dale Gillham |
Everyone knows that investing in the stock market is about building wealth, but how do you pick the best stocks to invest in?
Each of us have our own method for selecting stocks with some relying on hot tips, while others use professionals or stock tipping reports, and some people just like the company because they use their products. There are also those who apply time consuming analysis, while for others it is like throwing a dart at the a board and hoping for the best.
Most people seek out recommendations from others because they lack the required knowledge, skill and confidence to do it themselves. But this needn’t be the case.
How do you pick stocks to invest in?
When picking the best stocks to invest in, you need to ensure they align with the goal of your portfolio, whether that be growth or income or a combination of both.
A common question asked by beginners starting out is whether they should buy a particular stock or continue holding a stock they had recently bought. When asked this question, I would always respond by asking why they were looking at that stock in the first place.
Unfortunately, I would receive a myriad of answers, but none of them mentioned that the stock aligned with their investment goals rather it appeared that most took a scatter gun approach as to how to pick stocks to invest in.
If you have ever visited a financial adviser, you will know that they usually select a fund based on your investment goals and the risk you are willing to take. And this process is no different when identifying stocks to include in your portfolio.
Your goals will be influenced by many things including your income, the size of your family and your current wealth. But irrespective, the questions you should be asking to determine which stocks are suitable for you include:
- How long do I want to invest for?
- How much money do I require to achieve my goals?
- What returns do I expect?
- What level of risk will I feel comfortable with?
- How much capital am I willing to risk for the opportunity to make higher returns.
And most importantly, is what I decide to invest in going to allow me to sleep at night because it is far better to manage your investment risk rather than worrying about how your investments are performing. Particularly, if you choose to invest in stocks outside the top 150 by market capitalisation.
Fundamental factors to consider when picking stocks to invest in
So how do you select the best stocks to place in your portfolio. Here are four factors I use to narrow down my selection.
Firstly, if you are trading over the medium to long term and your investment goal is for growth and income, then look for stocks that pay a dividend yield of 3 percent or higher. The dividend yield is simply the income you receive from holding the stock expressed as a percentage of the stock’s current market price.
Typically when looking for stocks, I don’t recommend you invest on dividends alone. This is because the stock must represent good value, first and foremost, in terms of capital gains. In other words, you should look for undervalued stocks that are likely to achieve good solid growth in terms of capital gains and a good income from dividends.
Secondly, the stock should have a low price earnings or PE ratio.
The potential for a company’s share price to rise and fall depends on the how fast its earnings are expected to grow. Therefore, the PE ratio provides investors with an indication of the prospects of the company.
A low PE ratio compared to other stocks in the sector or index suggests that the stock is undervalued and a good buy. Inversely, a high PE ratio indicates that the stock is overvalued and should be sold.
That said, this method does have its limitations because the published PE is based on the previous year’s earnings, which is an historical measure rather than a projected measure of the performance of the company.
Therefore, while the PE is important, I believe the Earnings per Share or EPS is more important.
The third factor to consider is stocks with double digit EPS growth.
In simple terms, the EPS indicates the profitability of the company. Obviously, you want to see a company deliver results, as this leads to the stock’s price rising.
If the EPS is consistently increasing, it suggests that the company is well managed. You also want to look at the projected EPS to see whether the growth of the company, and therefore, the growth of the share price, is expected to continue. In this instance, you would be comparing the current EPS against the 1 and 2 year forecasted EPS.
Do not get bogged down in detail. If you find a stock has a good dividend yield and a history of delivering good EPS growth but it does not have a low PE, I would still place this on your watch list. Similarly, if a stock has a high PE, pays little or no dividend but the stock price is rising, I would still place this on your watch list as this could indicate a good growth stock.
The forth factor to consider is that you want to see the stock trending up for at least 3 months.
An uptrend is not confirmed until a stock has been rising with consistently higher highs and lows for 3 or more months, which represents 12 or more bars on a weekly chart. While this statement is not flawless, it does provide you with a starting point from which you can analyse the strength of a stock.
You may even look for stocks that have surpassed their all-time high price, as these are likely to exhibit less resistance and, therefore, more likely to continue to rise. In saying that, the stock does not have to be above its all-time high to be considered a good stock to buy, but this is valuable to know.
So there you have it, my four steps for how to pick the best stocks to invest in. Now that you understand this, I encourage you to spend time identifying stocks to suit the goal of your portfolio so that you develop a well diversified portfolio.
In my latest book, Accelerate Your Wealth – It’s Your Money, Your Choice I outline these strategies in more detail as well as a whole lot more so that you can be armed with the right strategies to select the best stocks to invest in.
Now let’s get into this week’s stocks. Watch the video to learn more.
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