There’s been a wave of new investors over the past few years, and some are now adrift. Commission-free brokerages like Robinhood and SoFi opened the door to new retail traders and investors. They were drawn in by meme-stock mania, pandemic boredom, and a record-setting bull market after the March 2020 crash.
Now things are different.
The Federal Reserve is clamping down on cheap debt. Now companies that were recording sky-high stock prices are coming back to earth as institutional investors flee into fixed-income and defensive stocks.
Unfortunately, retail is left holding the bag in many of these cases. The new class of investors may have grown up listening to Discord gurus, StockTwits midwits, and the few lucky now-millionaires on Reddit’s WallStreetBets (who were a decided minority).
If you were riding momentum or listening to someone else’s analysis, you might not know the best way to strike out 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 were into risky biotech stocks that had to be approved by the FDA any day now (they weren’t) and leveraged gold ETFs like JNUG and JDST. I lost my shirt – so I had to double down and learn how to choose stocks correctly.
I want you to learn from my mistakes, so let’s look at some fundamental principles of how to pick a stock to invest in.
We’d be remiss not to mention that, over the long term, broad-market index investing in ETFs or mutual funds like SPY or one of Vanguard’s many offerings. This isn’t too exciting, though, and I’ve always enjoyed the research journey and learning to pick stocks to buy. You can’t go wrong with, if nothing else, investing in that broad index but retaining some cash to play stock jockey. 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 most basic and foundational stock-picking advice. Think about the products and services you use every day. If you’re a fan of Netflix, Coca-Cola, or Target, chances are good there are many more customers just like you. This makes companies you understand and know an outstanding stock to pick because you understand their service (as opposed to investing in complex securities like obscure biotech firms), and it’s fun to literally own a piece of the company you’re a customer of.
And, as you learn how to pick 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 firm. This company was unknown but rolling out some fascinating equipment that had enormous implications for the industry, and I got to be one of the first users. Now, this wasn’t insider trading at all. The contract was publicly available, but since I had a foundation in picking stocks to invest in, I identified this opportunity and enjoyed significant returns as I bought in at $20, riding it all the way up to $100. This is an excellent example of buying what you know, and that lesson stuck with me, so I always look for opportunities to invest in the products I use.
If you do want to research independently, it’s essential to understand your risk profile. Are you young, with enough disposable income to take some risky gambles? Or are you closer to retirement and prefer stocks with consistent dividends and a low likelihood of going to $0?
Besides asking yourselves these questions, you also need to understand the types of risk.
Systematic risk is overall market risk. Think of any time the market went down– the Dot-Com Crash, 2008’s Housing Crisis, and COVID-19’s brief bear market. This risk is unavoidably damaging to your portfolio, aside 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 through downturns is an excellent way to bring your investment cost down.
Idiosyncratic risk is a type of risk specific to a company or type of company. This risk happens when products are recalled, bad news comes out, or other factors that tank stocks. This is a prime reason you diversify when choosing what stocks to pick. This means keep a balance in a market index fund or at least don’t go exclusively all-in on unprofitable tech stocks hoping for a moon mission – you saw what happened at the beginning 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 primary decision is whether you want to target growth or value stocks. There are other options, but this is the simplest, and these two categories comprise most stocks you’ll see.
- Growth: these stocks hinge on the promise of future potential or significant future growth, and that potential is priced into the stock price. Growth stocks can be “too expensive” for the underlying company’s financial status. This type of stock is better for risk-positive investors who can afford to lose some money while waiting for possibly huge returns down the road.
- Value: These stocks are the market mainstays and are better for risk-averse investors. They are proven companies with healthy financials and often return dividends to shareholders. They likely won’t see significant gains in stock price over time since, in many cases, the business is running at a steady state, and all future cash flows are priced into the stock.
Company and Stock Metrics
Now let’s look at some measures to look for when choosing stocks to buy. Using the growth/value model, we’ll define these quality metrics and see how they apply to stock in those sectors. We’ll choose a holding from Vanguard’s Value Index (Exxon, XOM) and Growth Index (Apple, AAPL).
Price-to-Earnings (P/E) Ratio
P/E ratio is a golden standard for quickly assessing whether a stock is good to buy. You get the P/E ratio by dividing the company’s earnings per share (EPS) by the current stock price. A higher P/E is a riskier investment that may be overpriced, while a low P/E ratio means the stock trades at a fair price. It’s also helpful to compare the P/E ratio of a stock against the market P/E ratio to see if the stock is overvalued compared to the overall market. Since growth stocks price in future potential, they usually have higher P/E ratios. As of August 2022:
- S&P500 (market) P/E ratio: 18.69
- XOM: 10.33
- AAPL: 28.79
This justifies our assumption – since Exxon’s future cash flows are predictable and value stock, the P/E ratio is low because future potential is priced in. Investors expect Apple, a growth stock, to continue to generate innovative products, so it trades at a relative premium because of that expectation.
Price-to-Sales (P/S) Ratio
The P/S ratio is an alternative to the P/E ratio when a stock is less profitable or unprofitable. It’s beneficial for valuing growth stocks for this reason. P/S ratio is found by dividing the company’s total market cap by the last year’s revenue. In general, like P/E ratios, higher means overvalued and lower means undervalued. There is an exception, though – you need to compare the stock’s P/S ratio to the same industry’s ratio instead of the market ratio. This is because you want to know if the stock is worth picking compared to its peers.
- Computer technology (Apple’s industry) P/S ratio: 6.71
- AAPL: 02
- Oil & gas P/S ratio: 5.6
- XOM: 1.08
From this, we see that (compared to industry peers) Apple is slightly overvalued, but Exxon is significantly undervalued.
If you’re risk-averse and want to generate income in addition to capital gains, you are likely looking for a value stock that issues dividends. When considering dividend stocks, there are three primary metrics to look for.
- Annual dividend yield: the percentage of the stock price per share that is returned to shareholders annually.
- XOM: 3.85%
- Dividend growth: since inflation eats away at the value of cash, and the dividend, you want to ensure the dividend shows growth potential. You can look at various time frames to determine growth, but three years is usually good to get an idea of the growth rate and avoid any idiosyncratic risk effects on the dividend.
- XOM: 2.61%
Unlike the other metrics we’re looking at when choosing a stock pick, beta is a derivative of the stock itself instead of the company. Beta measures volatility compared to the market and is vital for risk-averse investors to understand the stock beta when considering risk-adjusted return rates. With beta, the market is assigned a value of 1, which is the market’s overall volatility. Stocks then get a beta from historical returns compared to the market. A beta greater than 1 means it is more volatile than the market, and a beta less than 1 means it is less volatile. Betas can be negative, which means it moves opposite the market’s volatility (up when the market is down, and vice-versa). This can be good if you’re trying to diversify your portfolio against systematic risk. It can also be harmful because a stock with a negative beta during a bull market means that the stock is losing value as the market rises.
- AAPL: 1.1. This means that if the market goes up 1%, Apple will go up 1.1%.
- XOM: 1.2.
Since oil & gas is sensitive to external geopolitical events and politics, Exxon has been more volatile and has a higher beta, while Apple follows the market more closely.
Third-Party Stock Picks
Hopefully, this gave you a few 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 a stock is a good pick or not. Luckily, many great companies provide analysis for you and tell you whether a stock is good to pick or not.
Motley Fool is one of the longest-running and most reliable stock pickers available. Motley Fool’s research and recommendation service, Stock Advisor, provides specific stocks they assess as good to buy. If you want some help picking stocks, you can get exclusive new member pricing here.
Morningstar is an institutional favorite, and for a good reason. Now available to the average investor, Morningstar used an algorithm to gather over 150 analysts’ opinion and assigns it a star-based rank to tell you if it is an excellent stock to pick. They also provide the data behind the rating, so it is suitable for an investor who wants to learn but also be told what stocks look good. Click here to see if Morningstar is right for you.
An astute investor will notice that we didn’t touch technical stock analysis or how it plays out on a chart over time. This is a very complicated but successful way of picking stocks. TrendSpider does this for you and monitors stock chart patterns that day traders and other short-term traders use to predict price movement. It’s more advanced, and many fundamental investors (concerned with topics like those we discussed here) choose not to use technical analysis. You can get a seven-day trial here to see if charting is more up your alley.