How to Pick a Stocks

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Picking stocks is the main capability related to investing. 

Any investor or trader takes this as the first step. Even if no one can know for sure if the choice is the right one, there are some tools and information that can help you make the right choice. 

In this sense, investors and traders can choose without relying only on the hope that their choices are in line with their financial goals, but they can take different measures to increase the probabilities that the stocks they pick can give the desired results. 

Knowing your goals is another fundamental part of investing: having a deep understanding of your personal finances, in order to set realistic goals, budget, and risk you’re able to afford, is the most powerful risk management tool. 

In this article, we will talk about the basics of stocks and stock markets, as well as the different techniques and types of analyses to make informed decisions.

Understanding the Basics of Stocks

A stock is a security that represents a portion of the capital involved in the management of the company that issues the stock. 

In simple terms, stocks represent the ownership of the part of the company. When an investor decides to buy a stock, he will gain rights over the earnings (and losses) of the company — in proportion to the amount he invested. 

Different types of stocks grant different rights. The main distinction is made between common and preferred stocks. 

The difference between common and preferred stocks lies in the rights they grant: 

• Common stocks usually grant voting rights to their shareholders; 
• Preferred stocks don’t give voting rights, but give shareholders the priority when it comes to paying dividends. 

Dividends consist of compensations given to shareholders, usually on a regular basis: they can come in different forms, like sums of money. Dividends represent portions of the profits of earnings or reserves of the company, and are paid to shareholders in proportion to their investments. So, dividends play a pivotal role, both for the company and the investor — who can earn steady returns. Despite this, it’s important to know that a company is not obliged to pay dividends to their shareholders: some companies decide to reinvest those earnings, instead of distributing them, in order to make the company grow. In this case, shareholders can earn in terms of capital and the evaluation of the stocks they invested in — one of the top companies by market capitalization that use this strategy is Amazon. 

We mentioned capitals, stocks, and market capitalization: this is another key term to understand. Market capitalization — or market cap — is the market value of the company, obtained by multiplying the number of outstanding shares by the price of the share. 

When companies are defined as “large”, usually this definition is given according to their market capitalization. 

Getting Familiar with the Stock Market

The companies that issue stocks that can be publicly traded are listed on stock exchanges: here is where the stocks can be sold and bought, and every exchange has its own rules a company needs to follow to be listed. 

The top exchanges by market cap are the New York Stock Exchange (NYSE), and the Nasdaq. On these exchanges, there are not only stocks, but also other financial instruments that can be publicly traded. An example of these financial instruments are indices. 

Stock indices are one of the favorite tools of traders and investors interested in stock markets and diversification: indices are baskets of stocks that derive their prices from the assets they include. In simple terms, they track markets and allow investors to get exposure to several assets in a single transaction. 

Indices can group specific stocks for different reasons — for example, the Nasdaq100 is mainly composed of stocks of companies in the tech and telecommunications industry, while the S&P 500 tracks the largest companies by market cap listed in the US. 

Navigating all the financial instruments currently available can be overwhelming, and that’s why brokers play a pivotal role in simplifying the access to stocks and derivatives — especially today, with online brokers, traders and investors can find intuitive interfaces and invest with a few clicks. 

All this simplicity is a double-edged sword: it’s true that more people can pursue financial goals as they wish, but this doesn’t mean that the required knowledge to navigate financial markets can’t be overlooked. If you want to pick a stock by making informed decisions, analysis becomes your best friend. 

Diving into Fundamental Analysis

Fundamental analysis is one of the types of analysis used by investors and traders to pick a stock. This analysis takes into account the position of a company within its industry of reference, its features, and financial health. 

To assess the financial health of a company — which can tell you how valuable is the stock it issues — there are some key points to consider: 

1. Revenue and Profit — both these indicators have to do with the income of the company, but while revenue refers to the gross income, profit considers income after  taxes and expenses. 
2. Debt levels — a fair amount of debt is considered good for a company, since it lowers the costs of the company, but a high level of debt is considered dangerous for the financial stability of a company. 
3. Cash flow — this indicator records the cash that flows in and out of a company. This can help investors understand if the company is stable enough to pay for its expenses and reinvest — in a nutshell, if it has sufficient liquidity. 

Investors can get all this info from the financial statements of the companies they invest or are interested in, and they can get additional information by merging key parameters and understanding the most important financial ratios:

1. P/E Ratio — the Price-to-Earnings ratio allows investors to understand if the stock issued by the company is overvalued or undervalued by comparing the price of the stock to the earnings of the company. 
2. D/E Ratio — the Debt-to-Equity ratio helps investors understand whether a company has a ‘good’ amount of debt — a high D/E is not positive for the financial health of a company, since it means that the company doesn’t have enough assets to pay for its liabilities. 
3. ROE — the Return on Equity measures the efficiency of a company in producing profits, and it’s obtained by dividing the net income of the company by shareholders’ equity. 

All these elements can help investors understand what is the value of a company and what are the risks associated with it, so helping them pick a stock in line with their goals. 

But, as mentioned, fundamental analysis is only one of the analyses used to pick a good stock.

Embracing Technical Analysis

Technical analysis takes into account past performance of a stock to find possible patterns that could repeat in the future. 

This analysis uses price charts and technical indicators, and it’s particularly useful when investors and traders look for the entry or exit point for the stock they’re interested in. 

This type of analysis requires a good understanding of technical indicators and their meaning, as well as trading psychology: 

1. Technical indicators: to mention they most common, RSI (Relative Strength Index) measures the intensity of price movements, and is used to understand if a stock is overbought or sold; MACD (Moving Average Convergence Divergence), is used to identify the beginning of new trends. 
2. Trading psychology is used to understand the sentiment of other traders and investors, since they’re the main drivers of prices.

Sector and Industry Analysis

Every company that issues a stock pertains to a specific sector or industry: understanding these elements can help investors pick a stock by analyzing the overall growth or risks related to a specific industry. 

While some may show consistent growth and low volatility, some others might be more prone to external factors — like geopolitical changes and interest rates, and to mention one important example, the tech industry, which was particularly affected (both positive and negative) by the pandemic. 

The analysis of industries and sectors might lead different investors, who look for different levels of risk and volatility, to pick stocks in line with their preferences.

Evaluating Company Leadership and Governance

Leadership and governance have often been mentioned by Warren Buffett as some of the key elements he analyzes before picking a company for investment purposes. 

Strong leadership often leads to stable performance and growth over time, positively influencing the price of a stock issued by a publicly traded company. 

The same applies to governance, which can be defined as the set of rules put in place to manage a company: different skills, cooperation, stable leadership, are some of the elements that often lead to successful performances. On the contrary, poor management may result in frequent CEO turnovers, issues and controversies related to management and the relationships with workers, might be red flags that could lead to more serious troubles for the company in the long term.

The Role of Economic Indicators

As mentioned, external and macroeconomic factors influence the market, and investors’ sentiment and overall performance of the economy fuel each other: if the global performance of the economy positively affects market sentiment, which leads to an increase in stock prices. 

On the other hand, when there are conditions like high interest rates and inflation, and a poor global economy, investors’ sentiment is negatively affected. 

Sentiments mostly affect the market in the short run, but they have a pivotal role in understanding market cycles, which usually repeat themselves over time. 

This also mean that timing the market and understanding what is the current market cycle phase of a stock requires deep knowledge of technical analysis and market psychology; on the other hand, long-term investments are less prone to the effect of different phases — since they usually have the time to go through complete market cycles and grow (as long as the company that issues the stock is valuable under a fundamental perspective).

Risk Management in Stock Investing

Managing risk is as important as stock picking. This happens because, despite analysis and knowledge, no one knows how markets will develop. 

Of course, analysis and knowledge limit the risks related to investing, but there are also other tools. 

1. Planning: traders and investors should always have a plan before starting. This involves an accurate analysis of your own financial goals and what’s a level of risk you can afford. This has a huge impact on stock picking, especially because different stocks and stock categories can show different levels of volatility — hence, different levels of risk. 
2. Diversification: this helps investors to choose different assets, which show different levels of volatility and react differently to external factors, to limit risks and balance portfolios.

Formulating Your Own Stock Picking Strategy

Any plan — or strategy — should be designed according to your own goals, the reasons why you’re investing, and the level of risk you want to deal with. 

Investors who want to invest because of specific reasons like paying for their children’s college might tend to choose investments perceived as more secure, while those who have stable income and just want another stream of income might tend to risk more. Every investor is different, and chooses different strategies — like growth investing (investing in stocks that, according to fundamental analysis, might grow at an above average rate), or value investing (investing in stocks that are considered undervalued).

Tools and Resources for Stock Picking

Investors have additional tools to directly analyze the stocks they might be interested in: for instance, stock screeners can allow you to get only the stocks that meet your criteria, while reliable financial news sources can help you understand the general sentiment, as well as the macroeconomic factors that might influence markets. 

But the most important element is always knowledge: using reliable sources to understand markets and investing will help you to pick the stock that can fit your needs, and speed up your analysis.

Summary

Picking stocks needs you to understand markets and how investing works — as well as the different elements that influence stocks, tools to manage your investing activity and smooth risks. 

Knowledge is always the first step — and the most valuable investment.

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