How to Choose Winning Stocks
Finding the right stocks to invest in is no easy feat. While some may say that blue-chip stocks are your best bet, you can never be too sure. Even the strongest companies are still vulnerable to conditions that are beyond their control. Those conditions can include widespread corrections, economic recessions, or unexpected events, also known as black swan events.
Nevertheless, there are precautions that you can take to protect your capital. We will discuss those in this article along with the following topics:
- Metrics to consider when selecting stocks.
- Importance of fundamental analysis when buying a stock.
- Importance of technical analysis when buying a stock.
- Steps to consider before investing.
Continue reading to learn more about which stocks to invest in.
I. Metrics to Consider When Selecting Stocks
Metrics are criteria that can help you narrow down the list of stocks that are likely to be winners. If applied correctly and consistently, you’ll minimise your risks and boost your return on investment. You will not only protect your capital, you will also give yourself a good chance of growing it.
There are many metrics that you can use to put together a list of the best stocks to buy. Many investors prefer to look at fundamental factors such as annual income statements to understand the financial health of a company. On the other hand, there are those who look at technical factors such as the current trends to discover the best stocks to buy today.
For the sake of both types of investors, we’ll look at both fundamental and technical factors.
Fundamental factors are concerned with the stock’s intrinsic value. Fundamental analysts often look at these factors:
Price-to-Earnings Ratio (PE Ratio)
PE ratio is one of the most popular valuation metrics investors look at to determine the relative value of a stock. The metric indicates whether a stock is overvalued or undervalued. It determines the market value of a stock in relation to the company’s earnings.
To calculate the PE ratio, all you need to do is divide the market price of a stock (or its market cap) by its earnings per share (or total earnings). The earnings per share in the denominator can be the one posted in the most recent earnings report for calculating the current PE ratio. On the other hand, if you use the expected earnings per share in the next earnings report that’s estimated by analysts you can calculate the forward-looking PE ratio.
As a general rule, stocks that have PE ratios lower than 15 are considered undervalued stocks. On the other hand, equities that have PE ratios that are higher than 20 are considered overvalued, or growth stocks.
Another similar valuation metric is the price-to-sales ratio. The price-to-sales ratio is especially useful in determining the relative valuation of a stock in comparison to others in the same industry when a company has negative earnings. That’s because the PE ratio is inconclusive when earnings are negative. In this calculation, instead of dividing market cap by total earnings, it’s divided by total sales or revenue.
Debt can spur a company’s growth as it provides much-needed capital to boost expansion efforts. However, too much debt can also be the source of a company’s downfall. Therefore, be sure to look at this metric before you consider buying the stock of any company. This will help you get a glimpse of the overall health of the business.
The debt-to-equity ratio can be calculated using a company’s balance sheet. It’s simply debt divided by equity. A high number relative to other companies in the same industry can be considered a red flag. It often signifies the company’s reliance on debt to finance operations.
Sales Growth Rate
A company’s sales growth rate over a period of three to five years gives you a very good idea whether there’s a growing demand for the company’s product or service. You should be wary if the company’s growth rate is dwindling, especially when the economy is booming. This can be an indicator that helps make the case that the firm is stagnant and may go out of business if it doesn’t adapt properly. It could also mean that it’s a well-established business which captured most of its market share in its industry. These are often blue-chip companies.
On the other hand, you may want to consider stocks of firms that have a booming growth rate. They are often small-cap stocks that either offer a new product or introduce a technological innovation to an unserved market. For instance, pot stocks spent several years shooting higher. Many of those cannabis stocks showed impressive sales growth rates as they shot up toward their peak.
Very often, high sales growth rates translate into high PE ratios. This is because investors anticipate higher prices in the future due to high sales growth.
There are many more fundamental investment metrics investors should look at before buying a stock. These include return on equity (ROE), free cash flow (FCF), payout ratio, dividend yield, PEG ratio, etc. All of these fundamental metrics should not be looked at on a standalone basis. You need to review the overall health of a company by analysing many metrics as well as the company’s financial statements before determining whether it has solid fundamentals.
Technical factors reflect investor sentiment with respect to a given stock. The stock is considered bullish when the price is going up and sentiment is positive. On the other hand, the stock is bearish when the price is going down and investor sentiment is negative. Here are important metrics to consider when looking at a stock from the perspective of a technical analyst.
There are three trends in technical analysis:
- Uptrend – The stock is bullish and investors keep buying it because they expect the price to continue increasing.
- Downtrend – The stock is bearish and investors want to sell because they fear that the price will continue to fall.
- Sideways – The stock is neither in an uptrend or downtrend. It is trading within a clearly defined price range.
Before you buy a stock, you must first determine its current trend. Very often the trend dictates the price of an equity regardless of its intrinsic value. This is also true for the stock market index. Experts use the index as a measuring stick to determine the market’s overall trend.
Therefore, if you’re a beginner, buy stocks that are in an uptrend. If you have some experience, perhaps you can also bet on equities that are trading sideways.
Volume is the number of shares that have been bought and sold in a given time period. You often see volume bars at the bottom of a chart. Volume can be calculated using multiple timeframes, reflecting daily, weekly, and monthly volume.
You want to buy stocks that trade in heavy volume, because this determines their liquidity. This means that a lot of people are buying and selling that particular stock. In general, the higher the volume, the better. A high-volume stock suggests that people are interested in it. It would be very easy for you to find a willing buyer when you want to sell your holdings if you’ve invested in high-volume stocks.
More importantly, volume indicates demand. If volume is skyrocketing, it would be safe to assume that price will eventually follow.
Volatility is a measure of risk. It is often referred to as standard deviation or how much in percentage terms a stock’s price swings, whether up or down, within a given time period. For instance, a stock that usually moves less than 1 percent a day is considered a non-volatile stock. On the other hand, there are securities such as penny stocks that can move by 10 to 20 percent in either direction on a single day. They are considered to be very volatile.
It is recommended that new investors stay away from highly volatile stocks. The emotions brought about by big swings can be overwhelming. Stick to stocks that typically move between one to five percent per day. These securities are more stable and they will be less likely to trigger your emotions.
II. Importance of Fundamental Analysis When Buying a Stock
To help you find the best stocks to invest in, you should understand the relevance of fundamental analysis. When you make an equity investment based on fundamentals, you are doing so because you believe that the security or the common stock is trading below its fair value.
The metrics that we mentioned above, such as the PE ratio will help you determine whether a stock is trading below or above its intrinsic value. It is also important to consider whether the stock pays out a dividend. Dividend stocks are popular among value investors because they are able to grow their investments by receiving a certain percentage of the company’s profits.
There are two common ways of investing based on fundamental factors. One is value investing and the other is growth investing. Value investing focuses on picking value stocks that have low PE ratios, as well as stable earnings and dividend payouts. Whereas, growth investing focuses on picking growth stocks that have high PE ratios and are growing their revenues and income significantly every year. Growth companies do not usually pay out a dividend.
III. Importance of Technical Analysis When Buying a Stock
Technical analysis is a trading discipline that enables you to make reliable market forecasts based on historical price action. Technical analysts rely on many tools and techniques in stock trading such as stock charts, support, resistance, candlesticks, patterns, and trends.
This methodology is important in stock market trading because if you can predict the movement of the market, you’ll be able to grow your capital at will. Of course, technical analysts are not always accurate. Nevertheless, the goal is to minimise losses by selling losing stocks quickly and maximising gains by letting winners run.
If you want to learn how to trade stocks, consider learning more about technical analysis.
IV. Steps to Consider Before Investing
Many investors have a checklist that they go through before taking on a trade. We’ll give a general step-by-step guide to start with. Feel free to change them according to your investment style.
- Check the health of the overall economy – Unless you’re an expert bottom-picker, it’s never a good idea to buy stocks while the economy is in a recession.
- Check the pulse of the market – Are the major indexes in a bull market (uptrend) or a bear market (downtrend)? If you’re a new investor, buy stocks when the overall market is bullish.
- Identify your investment horizon – Will you be trading on a daily basis or are you a long-term investor? Define your timeline before buying equities.
- Define your risk appetite – What losses can you handle before selling your investments? This is often defined in percentage terms.
- Identify the type of stocks you’re ready to invest in – Are you investing in blue chips only or are you ready to play with smaller-cap stocks?
Consider going through these steps once you have a short-list of stocks that you want to invest in. These parameters are designed to make your investing experience easier.
V. Bottom Line
We’ve covered the basics to help you learn to trade stocks. We provided metrics that can help you identify winners. We also provided a step-by-step guide on what to consider before buying equities. We will end with a quote from legendary investor Warren Buffett: “The most important quality for an investor is temperament, not intellect.”