There has been a wave of new investors over the past few years, and some of them are now adrift. Commission-free brokerages like Robinhood and SoFi have opened the door to new retailers and investors. They were drawn to meme stock mania, pandemic boredom, and a record-breaking bull market after the March 2020 crash.
Now things are different.
The Federal Reserve is cracking down on cheap debt. Now companies that were posting extremely high stock prices are back on Earth as institutional investors flee to fixed income and defensive stocks.
Unfortunately, retail is left with the bag in many of these cases. The new class of investors may have grown up listening to the experts of Discord, StockTwits and a few lucky millionaires now on WallStreetBets (who were a definite minority).
If you’ve been practicing momentum or listening to someone else’s analysis, you may not know the best way to launch on your own now that the game has changed. Believe me – I know.
My introduction to the stock market was very similar, and my first forays into risky biotech stocks were It was To be approved by the FDA any day now (it wasn’t) and leveraged ETFs like JNUG and JDST. I lost my shirt – so I had to double it up and learn how to choose stocks correctly.
I want you to learn from my mistakes, so let’s take a look at some basic principles of how to choose a stock to invest in.
We would be remiss not to mention that in the long run, a broad market index invests in ETFs or mutual funds like SPY or one of the Vanguard Many offers. This is not very exciting, and I have always enjoyed the journey of researching and learning to choose stocks to buy. You can’t go wrong with investing in this broad index, if nothing else, but still keep some cash to play the title role. It’s fun and teaches a lot about how finance and companies work.
Buy what you know
“Never invest in a business you cannot understand.” Warren Buffett
This is the basic and basic advice for choosing stocks. Think about the products and services you use every day. If you’re a fan of Netflix, Coca-Cola, or Target, there are likely to be many customers just like you. This makes the companies you understand and know the outstanding stocks to pick because you understand their service (as opposed to investing in complex securities like obscure biotech companies), and it’s fun to literally own a piece of the company you’re a client of.
And as you learn how to choose stocks to invest in, you’ll better identify opportunities. Before I became financially independent but still actively invested, I worked for a company that signed a contract with a technology company. This was a little known company but they came up with some great equipment that had huge implications for the industry, and I have to be one of the first users. Now, this was not an insider trade at all. The contract was publicly available, but since I basically had a choice of stocks to invest in, I selected this opportunity and enjoyed great returns as I bought for $20, riding all the way up to $100. This is an excellent example of Buying What You Know, and this lesson stuck with me, so I am always looking for opportunities to invest in the products I use.
If you want to research independently, it is essential that you understand your own risk profile. Are you young and have enough income to do some risky gambling? Or are you closer to retirement and prefer stocks with fixed dividends and a low probability of hitting $0?
Besides asking these questions to yourselves, you also need to understand the types of risks.
Systematic risk is systemic market risk. Think about any time the market goes down – the Dot-Com crash, the 2008 housing crisis, the brief COVID-19 bear market. This risk inevitably harms your portfolio, apart from some alternative investment options, and is inevitable if you invest long enough. But time is on your side and keeping your money in the market during recessions is an excellent way to bring in your money Low investment cost.
Personal risk is a type of risk that is specific to the company or type of company. This risk occurs when products are recalled, bad news emerges, or other factors stockpile stocks. This is the main reason for your diversification when choosing the stocks of your choice. That means keeping a stock in a market index fund or at least not participating exclusively in unprofitable tech stocks in the hope of a moon mission — I saw what happened at the start of 2022 as the Fed raised rates and last year’s winners quickly became immediate losers.
growth and value
Once you know your risk profile, the next key decision is whether you want to target growth or value stocks. There are other options, but this is the simplest, and these two categories have the most stocks you’ll see.
- Growth: These stocks are contingent on the promise of potential or significant future growth in the future, and this potential is priced in the stock price. Growth stocks can be “expensive” for the underlying company’s financial position. This type of stock is best for risk taking investors who can afford to lose some money while waiting for huge potential returns in the future.
- Value: These stocks are the mainstays of the market and are best for risk-averse investors. They are proven companies with good financial statements and often return dividends to shareholders. They likely won’t see significant gains in the stock price over time, because in many cases, the business is operating in a steady state, and all future cash flows are priced into the stock.
Company and stock metrics
Now let’s look at some of the actions to look for when choosing a stock to buy. Using a growth/value model, we will identify these quality metrics and see how they apply to inventory in those segments. We will choose possession of Vanguard Value Index (Exxon, XOM) and Growth Index (Apple, AAPL).
Price to Earnings Ratio (P/E)
The price-to-earnings ratio is a gold standard for quick assessment of whether a stock is a good buy. You can get the P/E ratio by dividing the company’s earnings per share (EPS) by the current stock price. A high P/E is a riskier investment and may be overrated, while a low P/E ratio means the shares are trading at a fair price. It’s also helpful to compare the market’s P/E ratio against the market’s P/E ratio to see if the stock is overvalued compared to the market as a whole. As growth potential stocks price in, they usually have higher P/E ratios. As of August 2022:
- S&P500 (Market) P/E Ratio: 18.69
- XOM: 10.33.0
- AAPL: 28,79.009
This justifies our assumption – because Exxon’s future cash flows are predictable and the value of the inventory, the P/E ratio is low given the pricing of future potential. Investors expect Apple, the growth stock, to continue to produce innovative products, so it is trading at a relative premium because of this expectation.
Price to Sales Ratio (P/S)
The P/S ratio is an alternative to the P/E ratio when the stock is less profitable or unprofitable. It is useful for evaluating growth stocks for this reason. The P/S ratio is found by dividing the company’s total market capitalization by last year’s revenue. In general, like P/E ratios, higher means it is overvalued and lower means it is undervalued. There is an exception, though – you need to compare the P/E ratio per share to the same industry ratio rather than the market ratio. This is because you want to know if the stock is worth picking up against its peers.
- Computer technology (Apple industry) price / price ratio: 6.71
- AAPL: 02
- Oil and Gas Ratio P/S: 5.6
- XOM: 1.08
From this, we see that (compared to industry peers) Apple is slightly overvalued, but Exxon is undervalued.
If you are risk averse and want to generate income as well as capital gains, you are likely looking for a valuable stock that will yield dividends. When considering dividends, there are three primary metrics to look for.
- Annual Dividend: The percentage of the stock price that is returned to shareholders annually.
- XOM: 3.85%
- Dividend growth: Because inflation eliminates the value of cash, and dividend growth, you want to make sure that dividends show growth potential. You can look at different time frames to determine growth, but three years is usually good to get an idea of the growth rate and to avoid any particular risk effects on earnings.
- XOM: 2.61%
Unlike other metrics we look at when choosing a stock pick, the beta is a derivative of the stock itself rather than the company. Beta measures volatility compared to the market and is vital for risk-averse investors to understand stock beta when thinking Risk-adjusted return rates. With the trial version, the market value is set to 1, which is the total volatility of the market. The shares then get a demo of historical returns compared to the market. A beta greater than 1 means it is more volatile than the market, while a beta less than 1 means it is less volatile. Betas can be negative, which means that they move opposite to market volatility (up when the market is low, and vice versa). This can be good if you are trying to diversify your portfolio against systemic risks. It can also be harmful because a stock with a negative beta during a bull market means that the stock loses value as the market goes up.
- AAPL: 1.1. This means that if the market rises by 1%, Apple will rise by 1.1%.
- XOM: 1.2.
Since oil and gas are sensitive to external geopolitical events and politics, Exxon has been more volatile and has a higher beta release, while Apple follows the market closely.
Third-party stock picks
Hopefully this has given you some ideas of what to look for when choosing a stock to invest in. If you’re confused, don’t worry – like anything, it takes research and practice to get a feel for whether or not a stock is a good choice. Fortunately, many major companies provide analysis for you and tell you whether it is a good idea to pick a stock or not.
Motley Fool is one of the longest-running and most reliable stock pickers available. The research and recommendation service from Motley Fool, a stock advisor, provides specific stocks they rate as good to buy. If you want some help choosing stocks, you can get exclusive pricing for new members here.
Morningstar is an institutional favorite, and for good reason. Morningstar is now available to the average investor, and has used an algorithm to collect the opinions of over 150 analysts and assign them based on stars to tell you if it’s an excellent stock to pick. It also provides the data behind the rating, so it’s suitable for the investor who wants to learn but also be told what stocks look good. Click here to see if Morningstar is right for you.
An experienced investor will note that we haven’t touched on technical analysis of stocks or how it plays out on the chart over time. This is a very complicated, but successful method of selecting stocks. TrendSpider does it for you and monitors the stock chart patterns that day traders and other short-term traders use to predict price movement. It’s more advanced, and many fundamental investors (interested in topics like the ones we’ve discussed here) choose not to use technical analysis. You can get a seven-day trial here to see if the chart is more relevant.