My five criteria for how to pick the best stocks to buy and how to avoid the big stock market mistakes
I don’t usually write about how to pick stocks on the blog or that investing is about finding the best stocks to buy. Over more than a decade as an investment analyst, I’ve learned that the long-term themes are more important to good stock returns than picking the best stocks at exactly the right time.
But the investing media is all about hot stock tips and what you have to buy NOW. It’s tempting to jump at the market’s favorite stocks and every piece of advice you see on TV.
How do you ignore all the hype to really find the best stocks to buy?
I thought I would take you through my process of selecting the best investments when I hear a ‘hot’ stock tip from other analysts.
Building your own process will help resist the urge to trade stocks constantly, spending a fortune on investing fees, and will keep you from jumping into the many over-hyped losers. It also means you don’t have to waste your time with stock market anomalies or give your portfolio over to robo-investing platforms.
How to Pick the Best Stocks to Buy
My own process for picking the best stocks is surprisingly short. I have five factors I look at first before digging deeper into a company’s annual reports and relevant news.
My first criteria for a stock is the longer-term catalysts that can make it a good investment even if my timing isn’t perfect.
There may be a lot of good reasons to invest in a beverage company but are there really any big drivers in the future that will take the sector higher?
Agricultural companies have been hit hard lately with the drop in crop prices but global population growth will make for an entirely different story over the next few decades. We just are not going to be able to produce enough food to feed nine billion+ people. The theme is so strong that I put it in my American Future Fund, one of the four funds I created on Motif Investing. With strong forces behind a general theme, you don’t have to pick the best stocks because all the companies in the sector will benefit.
Using Stock Fundamentals to Find Good Stocks to Buy
My second criteria is a look at the company’s cash flows.
Most investors fixate on earnings but profits can be easily manipulated by management through deferring expenses or booking sales before they actually happen. It’s much harder to manipulate actual cash coming into the business.
A stock I have followed for several years but just recently bought is Lending Club Corporation (LC). Investing in peer loans is one of the biggest assets in my portfolio, providing the safety of bonds and the upside return of stocks, but I had never bought shares in the company itself.
Start with Cash Flow from Operations when looking at a company’s cash generating power. This is the actual cash the company makes from its business. A company may report a great profit every quarter but if it’s not generating cash from business then something is wrong. I also look at Free Cash Flow (FCF) which is just the cash flow from operations minus the amount the company spends investing in future growth. For Lending Club, both these accounts have been increasing steadily over the last few years and the future of p2p lending should mean lots of cash for investors.
A lot of hot stock picks on TV will come after a big drop in the stock price of a company.
My third criteria for picking stocks is the larger economic picture and how it affects the company.
This works into the idea of themes even if the time frame is much shorter. If the economy is favorable for a specific sector then you don’t necessarily need to find the best stocks to make money.
Shares of The Gap (GPS) tumbled 18% after the company disappointed investors with its March sales announcement. Weather during the winter months led to weak sales on traditional cold-weather clothes and unsold inventory may need to be heavily discounted to get it out the door. It didn’t help that overall retail sales for the month of March fell unexpectedly across the U.S. and investors are selling out of retail stocks.
But I looked closer at the March retail sales number and found something that points to a positive outlook for retailers. Spending on Building Materials, Home & Garden Supplies was up 11% in March against the same month last year even as overall retail sales climbed just 3.8% over the year.
People don’t buy patio furniture if they’re worried about the economy or how much they might be able to spend. Strong retail sales for the discretionary businesses bode well for other retailers like The Gap. The company has a strong brand name and owns several stores with strong brands including Banana Republic, Old Navy and Athleta. I bought shares after the drop and am confident the company can turn itself around.
Using Price-to-Earnings to Find Good Stocks to Buy
The stock price relative to earnings or sales is my fourth criteria for picking stocks.
Investors have a nasty habit of getting overly excited about a company and paying way too much for its stock. Investors have piled into shares of Tesla (TSLA) after its pre-launch of the Model 3 and the stock has soared 76% in two months.
While Tesla may someday be just as big as GM or Ford, it has yet to make a profit. The company is hoping to earn $1.28 per share this year but that still means the stock is priced at 199 times earnings. That means Tesla shares are 12-times more expensive than the general stock market!
Never mind that the company will need billions to build the factories to produce the Model 3 or that the average price of the car will be well out of reach for most consumers. Everything has to go perfect for the company for shares to keep moving higher.
You might point to shares of Amazon (AMZN) which has traded for more than 500 times its earnings for years while the stock has jumped 238% over the last five years. There are exceptions to the rule but I would rather miss out on one hot stock that defies rational value if it means I don’t lose money on the many stocks that fail to meet expectations and tumble. Tesla itself has seen shares fall by more than 35% over two separate periods just in the last two years.
Investing is just as much about not losing money as it is about making money. In fact, playing the amateur’s game and not losing money is one of the eight Stock Market Basics that will make you a better investor.
Stock Market Themes to Find the Best Investments
My final criteria for picking the best stocks to buy is whether there is a better way to profit from a larger theme.
Many of the hot stock picks you hear on TV have all the potential of catching a falling knife. A stock may be falling and might have some good upside going forward but do you really want to bet that the pain is over for the price? Try to buy falling stocks at just the right time and you’re just as likely to get cut or worse if the company never recovers.
Case in point, oil stocks have been hammered on the 70% drop in the price of oil. There are some good opportunities in individual stocks but many have more debt than they can handle and might not survive to benefit from the long-term upside. Why not hedge the risk and invest in a fund that holds many individual companies?
The SPDR S&P Oil & Gas Explorers and Production ETF (XOP) gives me instant diversification across 57 companies without the risk of investing in any one name. A few companies may go under but none account for more than 3% of the fund and the investment means I can benefit from the value play across the sector. You don’t have to pick the best stocks to profit from the stock market.
If there isn’t a better way to profit from a larger theme and an individual company fulfills most of the other criteria then I’ll put it on my list for further analysis.
If I decide that a stock meets the majority of these criteria then I progress to a little deeper analysis of the business model and cash flows. For the non-professional investor, this is why Peter Lynch’s advice of buying what you know is so important.
Working in a specific industry or sector, you’re going to understand the business around that industry much better and be able to analyze different companies. As a professional analyst, I can look at several industries and analyze stocks across sectors.
You might not have as much time to devote to picking the best stocks and you really shouldn’t need to do it. Focus on investing on broader themes like these three themes that will provide the best investments over the next 30 years and then pick a few individual stocks from the industry in which you work.
Having a process for picking the best stocks to buy is critical to saving money and not making the big mistakes in investing. Focus on the larger, long-term themes for the majority of your investments and pick a few stocks that you really like for a little extra return. Most importantly, resist the urge to jump at every hot stock recommendation you see on TV or read on the net.