How to Pick a Stock: Basic Best Practices for New Investors

So you finally decided to start investing. You know that a low P/E ratio is generally better than a high P/E ratio, your portfolio should be diversified across multiple sectors, a company with a lot of cash on its balance sheet is superior to one excessively burdened with debt and analysts' recommendations should always be taken with a grain of salt. Now that you have all the fundamentals of investing mastered, and perhaps even studied the more complicated concepts of technical analysis, you are ready to pick stocks. (For additional reading, refer to Investing 101.) For more info, check out this Stocks Basics Tutorial.

But wait! With tens of thousands of stocks to choose from, how do you go about actually selecting an equity investment? Going through every balance sheet and income statement out there to see which companies have a favorable net debt position and are improving their net margins is an impossible feat. Furthermore, choosing an investment based strictly on the criteria inputs of a stock screener is prone to error and does not produce a full representation of the company. Finally, simply coat-tailing institutional investors will usually not help you find any ten baggers as fund managers tend to focus primarily on safe blue chip stocks.

The first step to picking stocks is determining the purpose of your portfolio. Investors focused on income, capital preservation, or capital appreciation requirements will have different investment criteria. Income-oriented investors will usually focus on low-growth firms in industries and sectors such as the utilities, although other alternatives such as REITs and master limited partnerships are also readily available. Those who have a low risk tolerance and are primarily concerned with capital preservation tend to invest in stable blue chip corporations. And investors who are looking for capital appreciation should target companies of ranging market caps and life cycle stages. (To learn more, check out The Stock Cycle: What Goes Up Must Come Down.)

Keeping diversification in mind, any one of the aforementioned investor types could use a combination of the above strategies. However, deciding which category you fall under is the easy part; figuring out what stocks to actually pick is where the process becomes more complicated. Although there is no single correct method on how to go about picking stocks, a basic strategy should help investors narrow down their search before they start analyzing the financials of a firm.

In order to be an informed investor, it's important to stay current on market events and opinions. Reading blogs, magazines and online financial news is a simple form of passive research which can be done on a daily basis. Sometimes, a news article or blog post will form the foundation of an underlying investment thesis.

For example, reading a newspaper article about a major acquisition can spur further research into the fundamentals which drive that particular industry. The internet provides a tremendous level of convenience, whereby any major event will be analyzed through multiple perspectives by different investment professionals. Sometimes, the underlying argument can be as simple as "there is currently a movement away from poverty in the emerging markets which is causing an increased number of people to cross the border into middle class status. As a result, there will be a surge in demand for product/commodity X." Taking this argument one step further, the investor can deduce that with an increase in the demand for X, producers of X will likely prosper.

This type of basic analysis forms the basis of the overall "story" behind the investment, which justifies purchasing any stock in the specific industry of interest. An important research requirement is to scrutinize the assumptions and theories of the original argument: if the supply of X is infinite, an upward demand push will likely have minimal effects on companies in the business of selling/producing X. Once you are comfortable and convinced of the general argument after performing this form of qualitative research, corporate press releases and investor presentation reports are a good place for continued analysis.

The next stage in the stock picking process involves finding the companies in which you may be potentially interested. There are three simple ways to do it:

1. Find the ETFs which track the performance of the industry and check out their holdings. This can be as easy as just searching for "Industry X ETF"; the official ETF page will disclose either all or only the top holdings of the fund.

2. Use a screener to filter stocks based on specific criteria, such as sector and industry. Screeners offer users additional features such as sorting companies based on market cap, dividend yield, and other useful investment metrics.

3. Continue searching through the blogosphere, stock analysis articles, and financial news releases for ideas on companies in the chosen investment space. Remember, be critical of everything you read and analyze both sides of the argument.

The three aforementioned methods are by no means the only ways on how to pick a company, but they do offer an easy starting point. There are also clear advantages and disadvantages associated with each strategy that investors should note.

Searching for companies based on ETF holdings is probably the quickest way of narrowing down your search. However, ETFs typically hold only the largest companies in the space, often ignoring micro and small cap corporations. These types of funds also tend to focus on domestic markets. Stock screeners offer a very efficient alternative to narrow down the list of companies subject to desired inputs. Although screeners provide a more comprehensive list of securities which includes international firms, the investment metrics are often somewhat misleading. Seeking out expert opinions via news sources is the most time-consuming alternative, but it undoubtedly carries significant advantages. Firstly, reading stock analysis pieces will further your understanding on industry fundamentals. Secondly, investors will often come across junior companies, which can neither be found through screeners or within ETF holdings. Finally, research at this stage cuts down your subsequent research time later on in the stock-picking process.

Once you are convinced that "Industry X" is a solid investment and you are familiar with the major players, it is time to turn your attention to investor presentations. Although presentations are less comprehensive than financial statements, they provide a general overview of how firms make their money and are much easier to browse through than 10-Q and 10-K reports. Additionally, presentation reports will usually have forward-looking information on the expected direction of the company and its industry. While the previous tips of going through fund holdings or performing a screen will produce a large number of potential equity investment options, looking through company websites and presentations lets you further refine your search.

The information in an investor presentation report includes such material as balance sheet/income statement/cash flow statement performance, operational highlights, future growth opportunities and a general industry overview. Analyzing presentations involves more in-depth scrutiny of the actual company in order to decide why a particular stock is likely to outperform one of its competitors. Investors must now determine which companies are most attractive based on the presented information and narrow down their search once again. A key consideration is that the purpose of an investor presentation report is to give the company a chance to put its best foot forward.

At the end of your research process for picking stocks, you may be left with only a single investment prospect or a list of ten or more companies. You may decide, after all your research, that this industry is not right for you. That's OK! Your painstaking research may have just helped you prevent a potentially sour investment – knowing when to say no is an essential aspect of the art of picking stocks.

However, if you're still convinced of your original thesis, your research should focus on in-depth financial statement analysis. (Learn about the components of the statement of financial position and how they relate to each other. See Reading The Balance Sheet.)