How Investors Can Screen for Stock Ideas

There are a lot of investors out there who go it alone. They do their own research and make trades through a low-cost broker. These investors are to be congratulated for their entrepreneurial spirit, but the problem is that sometimes these brave folks don't know where to begin or, more specifically, how to screen for stocks.

In order to select an individual stock, investors first need a good source of prospective buys. This is where up-to-date stock screeners and market data can prove quite useful to the individual investor.

In this article, we'll show you how this key research and information can be used.

Investors need as much information as possible about what's going on in the market. This means tapping into a variety of sources for economic, industry and company-specific information. To be clear, investors don't need to delve into statistics and the intricacies of every industry the same way Wall Street analysts do, but they do need to have a good grasp of what is driving the market.

Therefore, watching business reports via all kinds of media channels, reading news on financial websites and tracking investor sentiment on social media is highly recommended. Savvy investors should be on the lookout for data and events that will drive the economy going forward. Obtaining information from a wide cross-section of sources will ensure that an investor isn't receiving a biased or incomplete news flow.

In terms of news, these are some examples of the types of information investors should tap into on a regular basis:

Interest Rates

Information on interest rate trends, or the likelihood of a future rate hike or cut is extremely valuable. Remember, if an investor can properly predict or anticipate the likelihood of future rate cuts and increase his or her exposure to domestic equities, that investor stands to make a lot of money.

Again, this is why timely, thoughtful analysis of economic news is important. Business television channels like CNBC, Bloomberg or Fox Business usually do a good job at not only reporting interest rate news, but also helping the public gauge the potential for a change in future Fed policy. 

Oil & Energy 

Information on OPEC oil production and domestic inventory stockpiles is equally important. Why? The simplest answer is because our economy and future growth prospects depends on the ability to source oil at a reasonable price. This makes the supply/demand equation extremely important.

Again, financial media, including The Wall Street Journal and Reuters, do a great job at not just reporting this news, but also helping investors forecast possible changes in supply. 

Economic Indicators

Next, consider consumer sentiment numbers, housing starts and employment figures. These data sets, while primarily lagging indicators of the economy, give investors the sense of what the broader public is thinking and how they are spending their money. This is important data to have because it allows the savvy investor to see a trend and gauge the consumer's willingness to spend money on certain items in the near future.

As an example of using this data, if consumer sentiment is high, housing starts are steadily increasing and unemployment is down, one might properly assume that higher-end retailers will fare better. Conversely, when all of those indicators are flipped, a proper assumption would be that lower-end retailers would fare better. 

The trick to proper stock selection is being able to winnow down a number of potential investments to a few viable candidates. This can best be accomplished by knowing which types of companies to avoid.

Except in unusual circumstances, investors should generally steer clear of:

Distributors or Commodity-Type Businesses

Since these companies aren't manufacturers, they are merely middlemen that rarely have any unique qualities that would draw large numbers of investors. Plus, in general, there is often less of a barrier to competition when it comes to becoming a distributor.

Examples of such businesses would be makers of children's stuffed animals (non-specialized toys are a well-known commodity) and consumer electronics distributors that simply ship goods to retailers. These businesses could easily see their profits shrink if they lose even one sizable retail account, or if the manufacturer finds a different distributor to ship the goods for less.

Companies With Gross Margins Below 20 Percent

The most basic reason is that there is almost no margin for error. In fact, even the slightest downtick in business could send profits plunging. Typically, commodity-type businesses and distributors carry low margins. But so do certain start-ups that need to offer their goods and/or services at a lower cost in order to gain market share. Again, all of these companies are inherently "more risky."

(To continue reading on margins, see The Bottom Line on Margins and How Does Your Margin Grow?)

Companies That Are Not Considered "Best in Class"

Like your parents always said, "you get what you pay for." In other words, second-tier companies often remain second-tier companies unless they have the potential to one day become an industry top dog. How can an investor tell whether a company is "best in class?" Odds are it will have the largest market capitalization in the business, the largest presence in terms of geographic footprint and will tend to be a "trend setter" in the industry (in terms of price, technology and product offerings) in which it operates. Walmart, Apple and Amazon are good examples of such companies. 

Companies That Are Thinly Traded

Thinly traded means that these companies generally only trade fewer than 100,000 shares per day. The market or "spread" for these types of stocks is often extremely volatile. In fact, investors have enough to deal with when it comes to analyzing the fundamentals. Sharp swings in supply and demand and the potential impact on the share price is just too hard to gauge, even for a seasoned investor.

Companies That Have Recently Announced a Significant Acquisition

Companies that take on big acquisitions often end up reporting large, unforeseen expenses that can put a big damper on near-term earnings. Again, while such a deal could present an enormous opportunity, the downside potential is far too often overlooked.

Manhattan Bagels is a terrific example of this. In the late nineties, the nationally known bagel chain bought one of its biggest rivals on the West Coast. But it turns out there were accounting problems and the stores that the company bought didn't turn out to be nearly as profitable as it (or investors) had initially hoped. Because the acquisition was so huge, Manhattan Bagels couldn't weather the problems, and was eventually forced to file for bankruptcy protection.

(Discover the world of mergers and acquisitions in The Basics of Mergers and Acquisitions.)

There are a number of characteristics that successful companies tend to have:

Accelerated Sales and Earnings Growth

Look for companies that are growing their top and bottom lines in excess of 15 percent. Why this threshold? It's because this is the benchmark that many institutions look for prior to getting into a stock.

Of course, keep in mind that companies that grow at a faster pace often have trouble maintaining their growth after a few years, and are more likely to disappoint investors. Ideally, a range between 15 and 25 percent is the most desirable.

(To find out more about this subject, see Great Expectations: Forecasting Sales Growth.)

High Levels of Insider Buying

Insider buying is a great indicator that a company may be undervalued. Why? Because while some senior executives may buy shares simply to demonstrate their faith in the company, the lion's share buy company stock for just one reason — to make money.

Look specifically for companies where several insiders are buying at or near the current market price. A terrific source for insider data is the SEC. However, other non-governmental sources also offer good data on this subject, including Finviz and Morningstar. 

Companies Showing a Solid Chart

While technical analysis shouldn't be a major factor in the stock selection process, it does have its role. Ideally, investors should be on the lookout for a company that is steadily advancing in price on higher volume. Why? Because stocks that advance on increasing volume are under accumulation. In other words, there is a broad-based momentum in the stock that is likely to continue to bring it to new levels. Picture the trajectory of an airplane taking off — that's what you are looking for!

Also, you may want to look for stocks that are making new highs. Often companies that are breaking through (or have already broken through) technical resistance levels have recently experienced some positive fundamental improvement that is drawing attention to the stock.

Legendary investor Peter Lynch was famous for saying that all investors should either use or be very familiar with the products/companies they invest in. While this may sound like common sense, many investors tend to ignore this timeless advice. 

What's the advantage of buying what you know?

Investors with intimate knowledge of the products and the companies they buy can better understand their growth potential. Incidentally, it also makes it easier for them to predict future sales and earnings growth, and/or to compare their product offerings with those of other industry participants.

Investors should always review the major financial statements (income statement, cash flow statement and balance sheet) of the companies they invest in.

Specifically, investors should be on the lookout for:

Companies With Inventory Growth in Proximity to Revenue Growth

Companies whose inventories grow at a faster rate than their sales are more likely to be caught with obsolete inventory at a later date if sales growth suddenly slows.

Companies With Accounts Receivable Growth in Proximity to Sales Growth

Companies whose receivables are growing at a faster clip than sales may be having trouble collecting debts.

Tangible Liquid Assets

Companies with a large amount of cash and other tangible (hard, liquid) assets tend to be more solid than those that do not. A large amount of cash and other liquid assets will provide the company with the means to pay its short-term debts and service its longer-term notes even in difficult times.

Knowing how to screen for stocks and specifically what to look for is a major battle for most investors that go it alone. The above commentary should serve as a starting point for entrepreneurial investors. If you take the initiative, you will gain insight and sharpen your skills as you go along.

(To find out more about screening stocks, see Getting to Know Stock Screeners.)