One of the most common questions new investors ask is “How do I pick stocks,” or “How do I know what stocks to buy?” Probably the only more common question is “What stocks should I buy now?” I’ll probably never answer the third question because stock picking is never a sure thing and I wouldn’t want anyone buying something I recommend and then being unhappy with the results. I am willing, however, to talk about the process I use when selecting stocks.
The first thing to remember is that I am not looking to trade stocks. I’m looking to own a piece of a company and then give the company a chance to grow. At times, when I wish to hedge against the market sitting there for the next decade, I may purchase a stock for income and buy shares of an established stock that pays a good dividend. Most of the time, however, I’m looking for growth stocks that will grow ten times of more over the next decade or two. Here are the basic stocks I follow when looking for a stock to buy:
1) Timeliness and Safety: I generally use Valueline Investment Survey for stock screening. The company follows about 1200 stocks and provides data on each of them, including a full-page report. They also have a proprietary indicator called Timeliness and another called safety. Timeliness is a measure of price momentum – basically how well Valueline thinks the stock will do over the next year when compared to the other stocks they follow. Safety is a measure of how stable they feel the company’s finances are – basically how well they could sustain a downturn. I use these factors to narrow down my search from the whole market to maybe 50 stocks.
I usually start by looking at stocks that have a 1 for timeliness (the highest rating), and then maybe a few with a 2 or a 3. I rarely buy a stock with a timeliness below a 3. With safety, I like a 1 or a 2, but will settle for a 3, or maybe even a 4 if I’m not investing a lot of money.
2) Price: The next thing I look at is price. I generally want to be able to buy at least 100 shares, and maybe 500 or 1000 shares. I therefore tend to look at stocks trading below $50 per share, and sometimes below $20 per share. I generally stay away from stocks with prices below $10 per share since there is generally a reason they are priced so low, but there are exceptions.
3) Price Trend: Stocks that are well-managed and have a good business will generally have done well in the past. Stocks that do well have rising prices. I therefore look for stocks that have increased in price steadily int he past. “Steadily” is an important term because I want consistency in growth. I’m not looking for something that shoots way up just to fall just as fast.
4) Appreciation Potential: I next look at how much room it has to grow in the next several years. ValueLine does projections for the next 3-5 years. One could also do the same thing by looking at the earnings growth rate and the historical PE and projecting forward. I try to avoid stocks that have run up significantly recently, such that there is little room for growth within the next few years. I may watch these stocks, however, and wait for a drop in price to provide a better entry point.
5) Expansion Potential: I want a stock with a lot of room to grow. I would therefore shy away from stocks like Coca-Cola or Wal-mart that are everywhere and would require a huge expansion to double their earnings. Ideally I’ll find a company that is not national yet and can still move into many markets. Another possibility si a stock that is adding product lines.
6) Earnings Growth: I also look at the rate of earnings growth, both over the last several years and projections into the future. I like something in the 10-20% range. Too high a growth rate is not sustainable and the price is likely overpriced.
7) Return on Equity: I like to find stocks that have a return on equity of 15% or more.
8) Debt: I really like to find a company that is debt free because it shows they handle their expenses and growth well.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.