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How to pick stocks, well

Much ado is made about the skill and training of professional stock pickers: the fund managers that run actively managed funds. So, can we – as humble private investors – realistically wander into this quagmire and achieve success? 

In truth, yes – we can achieve success, and the first foray can be taken gingerly without having to plunge into the deep-end of risk and increase the chance of losing all of our money. 

Start from the top

Broadly, investing in a stock involves knowing as much as you possibly can about the things that affect its value, which could mean big broad factors such as economic growth or changing interest rates, all the way down to much more granular company specific ones such as levels of debt or profitability. 

To begin with, think about the markets in which you would like to go hunting for your stock picks. The health and state of the economy that a market is nestled within is important, as changes to big macroeconomic factors such as economic growth, interest rates, and unemployment will flow through to businesses and affect your investments. Developed markets such as the US and UK tend to be quite stable for these factors, but the growth potential is also likely to be much lower when compared to emerging markets, such as India and China. Stock picking in the UK also comes with the home advantage of brands and businesses you are more likely to know.

Second, you need to consider the business sector you want to be in. Some sectors, for example utilities and healthcare, are more resilient to the cycles that economies go through – expanding and contracting – whereas others, such as financials and industrials, are more exposed.

Finally, consider the size of company you want to invest in. Smaller businesses, such as those listed on the UK’s Alternative Investment Market (AIM), tend to be more exposed to what’s going on domestically within an economy, whereas larger ones, such as those listed on the UK’s main market of the London Stock Exchange (LSE), tend to have a more global reach and are therefore less vulnerable to downturns in a single economy. In addition, smaller businesses tend to have share prices that bounce around a lot (known as volatility), as their operations are deemed to be riskier. 

Getting down to the picking

Marketplace identified, now you need to thoroughly research the companies. Plenty of information can be found in the places you buy stocks, such as share dealing services and trading platforms; but there’s loads of other websites too, such as Yahoo Finance, MarketWatch, and Morningstar for free access, and Stockopedia, Motley Fool and ShareScope for more in-depth paid-for analysis.

Laith Khalaf, head of investment analysis at AJ Bell, the third largest UK investment platform, also thinks the London Stock Exchange website is extremely useful for locating a company’s regular reports and accounts – which he describes as a “treasure trove of information”. These are formal documents distributed through the stock exchange for investors to understand how the business has been performing over the previous year. They will include broad descriptions of a company’s industry and its competitors, as well as audited financial statements that help you understand how it makes money. Khalaf describes some of the key things to look out for.

1. Profits

“One of the most important figures in a company’s results is the Earnings Per Share (EPS) figure. This tells investors what profits the company is making for each share they hold. There are two main ways to look at this figure.

“First, consider how it compares with prior periods to see if earnings are heading in the right direction, taking into account any one-off boosts or dents in profits that aren’t repeatable. Second, divide the share price by the EPS figure to derive the Price Earnings (PE) ratio, which is a measure of how expensive the shares are compared to the profits the company generates. You might be willing to invest in companies with higher PE ratios if you think there are good prospects for those earnings to grow quickly.”

2. Profit margins

“It’s also worth looking at a firm’s profit margin. A low profit margin means a company has little room for error or misfortune before slipping into the red, whereas a larger margin means the company is better placed to weather any storms while still turning a profit. Bear in mind some industries simply have low margins, for instance supermarkets and construction.

“While it may be less of an issue for the former as consumer demand for groceries is relatively stable, construction projects can often run late or over budget, wiping out profits and leading to losses – precisely what happened to Carillion before it collapsed.”

3. Dividends

“The dividend is another key figure in the reports and accounts for investors to mull, especially income seekers. Again, it’s a good idea to compare it with previous periods to see if the income payment to shareholders is growing. It’s also worth comparing the dividend per share to the earnings per share and considering how big a proportion of profits are being paid out as dividends. If it’s a high percentage, it may be a sign that dividend growth is limited, or in extreme cases that the dividend is unsustainable.”

4. Debt

“Investors should also pay heed to how much debt a company is carrying. In its annual results, net debt is the key figure here. Again, you can compare with previous periods to see if it’s heading in the wrong direction, which could be a warning sign. You can also divide net debt by EBITDA (Earnings Before Interest, Tax, Depreciation and Amortisation), which gives an indication of how many years it would take a company to pay off all its debt at current levels of profitability. Generally, a Net Debt to EBITDA ratio of less than 2 is considered healthy, and a ratio above 3 starts to raise eyebrows.”

A great strategy for getting going

The risks involved in holding just a few stocks can be exorbitant – you’re exposed to the fate of a tiny number of companies. That said, they can be reduced easily through diversification. Mixing up the markets, company sizes, and sectors aforementioned is the classic way to do this. But it can take time to properly diversify a portfolio and invest in a wide range of companies – on average, professional funds hold anything from 30 to 100 stocks.

A good starting point is to hold a ‘core’ of diversified funds that will get you to your financial goals – be it cheap trackers or slightly more expensive actively managed funds and investment trusts – to which you can then add ‘satellite’ holdings in individual stocks. Over time, as you master the art of stock picking and become more confident (and hopefully wealthier), you can add more stocks to your portfolio and dial-up the risk you’re taking if you want to bat for bigger returns. 

Profile: Warren Buffett

Reputation: the world’s greatest investor

Firm: Berkshire Hathaway

Investing ‘style’: value investing

Investment performance: averaged 20% per annum for over 50 years

Top investing tips:

  • Invest in simple businesses and get to know them well
  • Look for those with an ‘economic moat’ – advantages that are hard to replicate
  • Invest for the long term

Favoured financial metrics:

  • Low or reasonable valuations 
  • High and rising profit margins
  • Low or reasonable debt levels 
  • Strong returns on projects 

Famous quotes:

“It’s far better to buy a wonderful company at a fair price, than a fair company at a wonderful price”.

“Our favourite holding period is forever”.

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Author:
Marcus De Silva
Date published:
30 / 09 / 2022
Reading Time:
5 minutes