As I’ve said before, it is very difficult to predict the near-term future. It is much easier to predict the long-term future, at least in the investment world. This is not to say that it is difficult to predict if a given stock will go up or down the next day when some news is heard. If a scandal breaks out, obviously the stock will fall in price. Likewise, if a large drug company gets a new wonder drug approved, the stock will go up. Sometimes a stock will still trade in an unpredictable way, such as when the price of the stock has already gone up so much on the expectation that the drug would be approved that it falls a bit after the actual announcement comes. (This behavior is the reason for the old axiom, “buy on the rumor, sell on the news”.) But in general, the reaction of a stock’s price to news is fairly predictable.
The issue is that just as you can predict the direction of the stock due to the news, so can everyone else. You will therefore never be able to profit off of the news since you’ll be in a long line to buy or sell the shares, and the people on the other side of the trade will have heard the same news and adjusted their prices accordingly.
The long-term side, on the other hand, does not seem to suffer the same fate. While everyone has the same information and is able to do the same analyses, there still tend to be differences in price between what a company trades at and what it should be trading at given its future earnings. Probably the reasons for this are that 1)it is more difficult to predict with certainty future earnings, so there is a “risk premium” included in the price and 2)people tend to get bored and therefore don’t have the patience to wait long enough for the mispricing to be resolved. Whatever the cause, the behavior of the markets works in the favor of the long-term investor. It is normally fairly easy to pick stocks that will probably be worth more in the future (due to future earnings and dividends) and yet the price of the stock will not always fully take in these future earnings into account. Buy buying a set of good prospects, the chances are good that one will outperform the markets, which are made of both good and not-so-good prospects.
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So what are the traits for which to look? I always look for as many of the following traits as possible:
1)A steadily growing stock price (a nice, steady increase over several years),
2) Earnings that have been growing steadily (which tends to cause the steadily growing stock price),
3)A respectable Return on Equity (15% or more),
4)Room for the company to continue to grow — the market is not yet saturated,
5) Consistency in the management team (don’t buy a stock when the people who made the business successful are moving on).
6) A strong cash position (low or no debt and a low debt/equity ratio).
7) A P/E ratio that is not high compared to historic values for the company.
Basically the idea is to find stocks that have been growing, have a management team that knows what they are doing, are well-functioning businesses that invest capital well, and whose share prices have not gotten out of line with future prospects. In future posts, I’ll go into more detail on each of these traits.
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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.