How to pick stocks wisely?

Stock picking is the process of analyzing and picking a specific stock that helps in making a good investment.  It is one of the most difficult thing that most investor struggle with. But stock picking can be successful only when it is combined with strategic planning and a deep understanding of the company you are planning on investing in.  Let’s look at how you can pick stocks efficiently.

When you think of investing, you might think of buying and selling individual stocks and trying to pick the next big winner. And it’s easy to see why people tend to think about investing this way. The financial media always seems to be talking about which individual stocks are doing well (and which aren’t). Stock picking conversations have become even more common thanks to social media and online forums.

You may be surprised to learn that stock picking is not the primary strategy that experts recommend to most investors. Sure, it has its benefits. But it also comes with some big risks that shouldn’t be the approach you take for most of your investment portfolio. Stock picking gives you control over your investments in a way that investing in funds doesn’t, but it also requires a deep understanding of the stock market – and even then, it only sometimes leads to positive returns. Following are the seven principles while selecting the “right” stock.

1. Quality assessment

When picking stocks, it is not necessary to find the best companies. Even average or better ones can have a high value. Use a simple trick to assess quality: look at a company’s S&P Earnings and Dividend Rating. Benjamin Graham suggests that any company with a “B” rating or better is a safe bet.

In other words, a company does not necessarily make waves in the market or catch the attention of investors with a high-quality rating. However, it is important that the company has good results (history) and shows signs of growth (future). Companies rated “B” or higher are likely to be worth more than companies below.

2. Financial leverage

Avoid companies that have debt much higher than their current assets. A company with a low debt load is more likely to be sustainable and not have to give away its fixed assets to pay off debt, especially in turbulent times. It has been advised to choose companies with debt that do not exceed 110% of net current assets (for industrial companies). The formula for value investing is a ratio of total debt to current assets of less than 1.10. This data can be found on multiple pages.

3. Liquidity of the company

In accordance with the previous point, the company’s solvency is indicated by the current ratio: the ratio of current assets to liabilities. Value investing recommends you pick a company with current assets of at least 1 ½ (or 1.50) times its current liabilities. The indicator expresses the company’s ability to repay short-term obligations.

4. Positive earnings growth

Select companies that have positive earnings per share growth. Use the last 5 years of company profit as a record. Companies that have increased profits year after year without deficits are a safer bet. Using this principle, you minimise your risk by investing in the safest companies in a certain industry or sector.

5. Price-earnings ratio

The cumulative growth over the past few years should be considered when investing in a company. Earnings per share (EPS) expresses the profitability of a company. Price to Earnings Ratio (P/E) is the ratio of EPS to the company’s share price.
The trick is to invest in companies with a P/E ratio of 9.0 or less. Companies that sell at low prices relative to EPS are often undervalued, meaning the value should increase.

Note: This criterion does not consider fast-growing companies and that P/E ratios vary by industry/sector. Therefore, always look at the P/E ratios of the company’s competitors before making a decision.

6. Ratio of price to reservation

Find companies with a price to book value (P/BV) ratio of less than 1.20. P/BV ratios are calculated by dividing the current share price by the most recent book value per share for the company. Book value provides a good indicator of a company’s underlying value. Investing in stocks that sell near or below book value makes sense from a value investing perspective.

7. Dividends

Another simple and self-evident principle courtesy of an investment guru. Invest in companies that give back, which is also a principle that Warren Buffet carefully adheres to. Companies that pay dividends help you create passive income. Many retail investors have made irreparable mistakes by jumping on the hype train and following other investors without doing their due diligence. The risk is lower by default with value investing because it is a more informed way of investing.