How to pick winning stocks looks at a process for finding the winners. In this lesson and those that follow we’ll examine the individual components that make up stock selection. We’ll be thorough without going overboard. Let’s look at how to pick winning stocks…
What is a winning stock?
Let’s start by reinforcing the fact that earnings drive share prices. As investors, we are looking for good companies that have a history of making money.
We want companies that generate free cash flow. This is money that is left over after all the salaries, bills, running costs, taxes, and dividends are paid. This money can be used to:
- pay higher dividends
- reinvest in the business to fund growth
- pay down debt and in doing so improve future profits
- buy back shares – making existing shares more valuable
Superior company profits are linked to stock price performance.
Ideally, we also like to see that the stock price has spent a fair portion of the last 10 years trading at significantly higher prices. This gives us some upside potential from a charting perspective.
If a stock has traded at a higher price in the past, then given the right operating conditions it should be able to scale those heights again.
We want to buy at a low price, then sell at a higher price sometime in the future. That’s why it makes no sense buying stocks that are already expensive.
The price you pay for a stock is extremely important. Superior returns rely on purchasing a stock at the right price.
Stock market investing is based on probabilities. We can’t predict the future, but we can make sure that we only buy stocks that have the best chances for success.
If we look out for “booby traps”, we’ll increase the likelihood of success even further. These booby traps are more commonly called “red flags” in the investment world.
A red flag is an indicator that might suggest:
- that a company’s financial health might not be as good as it seems
- the future performance of the company might be under threat, or
- there could be some questionable accounting practices taking place in the financial statements
Spotting red flags allows us to avoid companies that might have hidden problems.
How to find the winners
Stock picking is matter of filtering and it follows a process. Let’s define one.
A stock selection and analysis process:
1. Use stock screening tools to find stocks that may have market beating potential. See Using a Stock Screener
2. Calculate Key Performance Indicators for each stock to determine whether the company’s financial performance is likely to be appreciated by the market.
We are just looking at some basic numbers to determine if this company is worthy of more analysis. If the stock doesn’t look promising then we’ll drop this stock and look at some of the more promising ones. See Key Performance Indicators
3. Examine a stock chart to determine whether the stock is worth buying from a technical analysis perspective. See Stock Chart Analysis
4. We need to understand the business if we are going to buy it. The father of security analysis – Benjamin Graham said that when we buy a stock we should act as if we are buying the whole business.
If you were buying a business, what things would you want to know? See Business Analysis
5. Profitability analysis. Does this company have a history of making money? How consistent are the profits? How easily can we predict profits? See Profitability Analysis
6. Financial health. Financially strong companies produce the best returns. We want to see manageable debt and strong cash flows. A substantial amount of cash in the bank would also be comforting. See Financial Health
7. Management assessment. Owning a great business isn’t going to be very rewarding if management aren’t doing a good job. We put the company’s management under the microscope and ascertain their effectiveness (or lack of). See Management Assessment
8. Industry analysis. The company you are considering buying operates in one, or possibly more industry sectors. It is useful to know what is currently happening in the sector. And what the prospects for the sector might be going forward.
Industry trends are usually more pronounced than the trends of individual companies within a sector. So by analyzing a sector we get a more reliable picture of what’s happening. See Industry Analysis
9. Company valuation. The worth of the company determines how much we should pay for the stock. Once we’ve valued the stock we determine how much money we’re prepared to pay for it. We want to pay significantly less than what it’s worth. That way we get both value and a margin of safety. See Company Valuation
10. The investment decision. This our final check. We’ve analyzed the stock thoroughly by this stage. Now we ensure that we’ve completed all of our due diligence. The stock looks good. It’s the right time to buy. See The Investment Decision
11. Portfolio management. This is all about maintaining a portfolio that is diversified to minimize risk. And optimized to provide superior returns. See Portfolio Management
A structured stock selection process gives you a framework to work within. It ensures that nothing gets missed. It also saves you time.
You check the most important things first. If a stock doesn’t pass your initial quality hurdles, then there’s no point in spending any more time on it. That’s why the KPI calculations and stock chart examination follow on directly from stock screening. We want to weed out the weakest contenders as soon as possible.
As you’ll see when you get to The Investment Decision lesson. I use a checklist to ensure that I’ve covered all the required aspects of the analysis and selection process.
- Behind every winning stock is a good company with a history of making money
- Stocks that have produced good returns in the past are good candidates
- A formal stock selection process ensures that you perform all the relevant checks
- Check the most important things first and leave nothing to chance
- Continue on to Lesson 2: Using a Stock Screener