Anyone can pick a stock. A monkey with a newspaper and a dartboard can pick a stock, or so I’ve been told. The goal is to buy stocks that will go UP in price. Easier said than done or everyone would do it.
There are a million or so reasons that influence a stock’s price over the short and long-term. On a day-to -day basis, the biggest influence on a stock’s price movement is generally the overall market of ALL stocks. In the short-term — most stocks move together.
Over days, weeks, months and years you see these returns develop their own independent patterns — some winners, some losers.
How do you decide if an individual stock might be a good or bad pick?
First off, at this point, I assume you have decided to buy individual stocks instead of a diversified fund, you understand the risks, and you have saved adequate cash reserves. Buying individual stocks are MUCH RISKIER than buying a diversified fund. Investing without adequate cash reserves is a recipe for failure. My article Financial Planning: The Thing You do Before You Buy Stocks discusses both of these issues and more.
When considering stocks to purchase, it is important to know and understand that stocks represent real businesses with real people behind them. Therefore, it is important to think like a prospective business owner when analyzing a stock, because that’s exactly what you are!
With a goal of simplifying the thought-process for those new to the idea of picking individual stocks, I came up with a three-word system to follow.
I’ll dig deeper into each of these as we progress, but these three words summarize the stock picking process: Story, Numbers, Expectations.
Story. Numbers. Expectations.
The stock picking process includes evaluating the story, numbers, and expectations for the business you are potentially purchasing.
- What’s the story? What makes you want to own this business?
- What are the numbers? How much money are they making?
- What should our expectations be for the company and stock?
It is also a good time to point out, these aren’t three individual steps we move through like we’re following Lego instructions. Stock picking is not a simple math equation.
These three steps represent themes that are woven together to help answer the first question: What’s the story?
What’s the story?
It can be overwhelming to think about narrowing the universe of stocks from over 10,000 to one. Let’s keep it really simple.
Start by doing nothing but watching.
“You can observe a lot by just watching.” –Yogi Berra
Watch for good business. Watch for a good story.
What makes a good business? Look for companies you think are probably making money — selling lots of whatever it is they provide. The more the better. Is there a line out the door of people waiting to buy? PERFECT!
It should be simple. You don’t have to know that XYZ Company just made a new organic, solar-powered, Bluetooth-enabled, titanium, artificial heart valve. You just need to notice what YOU know and YOU understand in YOUR everyday life.
Look Around the Corner
Good stocks start with a good story, but always be aware of “the next chapter” and any potential plot twists that could occur.
One of my key reminders to myself in investing is to “always be looking around the corner.”
You want to ask yourself questions about the future prospects for the company, “What do I think will happen next?”
The point in asking these questions is to think about where you see this business in three, five, or ten-plus years.
Questions to consider:
- What do you know about the company?
- How do they make their money? (Do they make money?)
- Will they be making more or less in a few years?
- Are they part of a new trend that will continue or a fad that will last only a few years?
- Will other companies try to copy them and if so, can your company withstand the competition?
- Will the story last long enough for you to be a long-term stock investor?
- What could go wrong or right?
Don’t try to talk yourself in or out of the investment. Do your best to take an objective view. You may find the process reinforces your position that you are onto something good with your idea.
You just want to keep in mind that history is littered with companies that go from boom to bust because markets change every day just as tastes change. You want to make sure you aren’t buying a fad right at the height of its popularity.
You’ve started on your stock’s story, now let’s continue and dig into the numbers. Numbers keep you grounded. It can be easy to get caught up in the hype associated with a company, and the hype associated with investing, in general.
Many companies are good at not only promoting their business, but also promoting their stock through carefully worded press releases and buzz words. All of these things can impact your decision-making and make you forget that you’re buying a business that you need to understand on a basic level.
The numbers can keep you grounded and focused on the fundamentals of long-term, buy and hold investing.
There are no shortage of numbers and ratios and other things we could cover, but I don’t want to cover more than we need. It really can and should be simple to pick good companies for investment.
The most important numbers to investigate in stock picking: earnings, dividends, the PE ratio, and debt, in that order (arguably).
Earnings represent company profits — and they are the heartbeat of good stock picking. Stock prices tend to follow the same path as company earnings. Learn more in our article titled Stocks Follow Earnings. Dividends represent the portion of earnings paid to shareholders in cash.
The PE ratio (calculated as Stock Price ÷ Earnings Per Share) represents how cheap or expensive a stock is relative to its earnings. Generally speaking, a higher PE ratio reflects market expectations for a higher rate of growth than a lower PE.
Debt is not a bad thing for a company. Too much debt is a bad thing. That’s reasonable. Most companies have debt, and it is way above the paygrade of this article to get in their face about it, but be aware.
Rarely is debt alone the reason a company goes bankrupt or gets in trouble. Bad businesses get into debt problems. Good businesses rarely get into debt problems. Good businesses attract additional investment money before debt becomes a problem, in my experience.
Don’t get me wrong, too much debt can slow growth and slow stock price growth. However, if the stock’s story is legit enough for you to notice it, and they have earnings to back it up, they can usually deal with debt.
Originally published at https://www.teachingkidstobuystocks.com/ on February 4, 2020.