Stock picking is definitely an art and not a science. Just as you can’t become a violin virtuoso by studying violin playing in a book, you can’t become an expert stock picker by reading financial books or developing a set of screens. It is part natural ability and part experience. Still, there are certain traits that I look for when picking stocks.
I only look for long-term buys because it is easier to predict which companies will do best over long periods of time. Your guess is as good as mine when it comes to picking a stock for the next week or the next month. There are a lot of random factors that influence stock prices in the near-term. There is also probably some manipulation involved. You can push stock prices one way or another for a short period of time, but not for months or years. Only great, well-run companies will increase in price over years or decades.
When buying a stock I approach it as I would if I were buying a business with a set of managers in place. I want to find a company that is profitable and well-run. I want the company to have a good product that people need and that is unlikely to be replaced in the near-term. I also want there to be room for growth since most of my profit will come from stock appreciation. The stock price may not reflect the fundamentals of the company immediately – I’ve seen stocks fall ten or fifteen percent despite the earnings hitting record highs. Over long periods of time, however, companies that are growing and making more money will see their stock prices rise.
Here are specific factors I consider:
1. The price history: One of the best indicators of a well run, profitable company is a steady increase in price. I love stock charts where you can lay a ruler across the price history and the price follows the ruler upwards at a steady rate. See, for example, the chart for Church and Dwight. Obviously if the price has been increasing for a long time, the company must have been doing well. I try to avoid stocks that are increasing in price extremely rapidly since these are normally fads and bubble stocks that crash down just as fast.
2. Earnings growth rate: A company that is increasing earnings quarter after quarter will increase in value over time. I like to see companies that increase earnings for several years at a healthy but sustainable rate. This is somewhere between 10 and 20% per year. Note that some companies increase earnings by expanding their business, others increase them by repurchasing shares, and some increase the amount they make at all locations or per employee. Of the three, increasing earnings at all locations is the best, increasing them through expansion is good, and buybacks of shares is the least exciting.
3. Little of no debt: Just as people who manage their finances well have little or no debt, a company that manages its finances well will have little debt. The best companies are those that can grow organically, meaning that they make enough from operations to pay for development and expansion; however, some businesses, such as the banking industry, inherently use more debt than others.
Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. 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. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.