Level: Beginner
Reading time: 5 min
Picking a stock is an intrinsic process of diving deep into the sea of investment opportunities. Analysts and statisticians are working round the clock to bring forward stocks with growth and expansion potential. In this article, we’ll look at 4 time-tested steps to help you select potentially profitable stocks.
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#1. Find an investing theme
The first investment process starts with identifying and selecting a theme. Thematic investing is researching and identifying companies with a particular theme. Once the theme has been selected, the requirement is to group them into investment lists, baskets, or funds incorporating several industries under one theme. Opposite to this is sector investing, where a particular industry is targeted.
These investment themes could be explored through mutual funds, exchange-traded funds (ETFs), stock lists, or assets waiting for investment opportunities worth billions of dollars. For example, television technology. This idea is not new, as a thematic investment in television technology has been studied for 70 years. This industry is still blooming and offers a broad array of investment strategies.
Thematic investing explores identifying trends that are reshaping our world and investing in stocks that stand to benefit from its growth. The latest trends include creative new uses of drone technology, the shift towards cloud computing, and the growing adoption of solar power and other renewable energy sources. The list is endless and is awaiting exploration and deep analysis, which brings us to the next step of this article, analyzing the potential.
Note! Remember, the more profit it offers, the more risk it involves, so choose wisely and make a diligent decision before venturing into a particular theme.
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#2. Analyze potential investments with statistics
The first step seems easy, but the next is to work out the worth of the theme and its future for investments in the long run. Peeling the stocks is the next essential step.
Today’s investors have their fundamental comfort zone of investing based on market capitalization. So they are trying to measure the size of a company in terms of the price of the shares, i.e., its shareholdings. It is one’s personal choice to invest in a large-cap, a small, or a mid-cap company. An investor might like to invest in a renowned company like Walmart (WMT), Apple (AAPL), or Tesla (TSLA) or a company that invests in sectors that are sustainable in the long run but holds a small market space in terms of its size or the product it deals with like gold or electronics.
Once the company has been decided, then comes the analysis of the company in terms of its growth potential and its characteristics. The product’s market potential is significant, especially in the nascent stage. The evaluation of an investment prospect itself is covered under varied strategies focused on economic trends, charting past prices and returns, speculating how the future performance of an investment will be, etc. The list is huge, but as an individual, ultimately, what matters is the return. The returns for old and huge companies could be giving out significant dividends; for small companies, they could be in terms of the increased price of their shares.
The next step in the process is statistical analysis. To understand finance, knowledge of statistics is a must. In addition, statistical concepts help investors monitor their investment portfolio performance, understand market trends and make better decisions. Financial ratios like liquidity, debt, and profitability ratios are other essential components that help in financial analysis. They help us measure the cash flow, debt repaying capacity, and the company’s profit or returns.
The last on the list is the stock valuation parameters which harness the potential of stocks compared to the company’s holdings in terms of assets, liabilities, profits, etc. There are a lot of parameters and guidelines to study and compare the price of stocks with the earnings, sales, or even the enterprise value before interest, taxes, depreciation, and amortization (EBITDA), earnings per share, operating cash flow, return on investments, dividend yield, moving averages, RSI, ADX and many more.
Note! Financial and statistical assessment of the company is mandatory for all investors before making investment decisions to reduce risks.
#3. Construct a stock screen
So, your choice of the theme has led you to promising companies to invest in. The next step is to create your stock screen.
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This task is simple today, thanks to the predesigned stock screen templates available online. Professionals have designed and fabricated these, making them worth exploring. Even some brokerage firms and financial websites provide these on their sites or once you take their services.
Then you need to define your investment goals in terms of the capital you want to earn, time horizon, and risk tolerance. After that, you must select the criteria parameters used on the screen. You can use stock screeners to separate stocks based on price, market capitalization, dividend ratio, P/E ratio, and debt-to-equity ratio. There are a lot of companies like Yahoo, Finance, FinViz, and Chart Mill which offer some free screeners and are available on the web.
Note! Stock screens are based on various computer languages and formats like Python and Excel. Choose what you are comfortable with, or use a predesigned and easy-to-use template.
Example screen #1
A 30-year-old man was recently blessed with a child and wants to invest in his child’s education. His goals are long-term, and seeing the increase in the cost of education, he wishes to minimize his present taxes and is capable of taking higher risks. To achieve his goals, he looks for smaller companies with more significant potential for an increase in the stock price in the long run.
He should base the investments on the following parameters:
- Companies in niche technology or products.
- Potential to generate a higher rate of revenue.
- Small or mid-size market capitalization (less than $1/2 billion).
- Liquidity, debt, and profitability: The ratios should be insignificant as an early-entry company generally has more debts and fewer initial profits. One should not expect much dividends as they want to reinvest maximum earnings.
- Valuation: Price-to-sales ratio would give an insight into the company’s potential.
Example screen #2
A retired man with cash received as retirement benefits would look for sturdy and safe investments. He aims to earn a regular income to pay off his daily household expenses, visits to his family, foreign trips with his spouse, etc. He is cautious about losing his hard-earned money and thus is ready to earn less but not take risks for extra income.
His stock screen criteria will be based on the following parameters:
- Old-fashioned industries.
- Companies with less growth potential.
- Large-cap companies (beyond 5 billion).
- Ratios: Strong liquidity and low debt ratio, high return ratio.
- Valuation: Higher dividend generation.
#4. Narrow the output and perform deep analysis
Today’s market is huge, especially with global partners and international growth potential. Hence, selecting and framing a stock screen could be a difficult task. Choosing a company is still left to the individual, and one has to decide based on choice in terms of industry, the country of operation, and social concerns.
After the entire process, once the final selection is made, the last step is to analyze various companies operating in the industry or the chosen product. Today, this is a difficult task since the data available in the public domain is vast, and their correctness sometimes needs to be improved. Also, this analysis should only use actual data from the Securities and Exchange Commission and the data available on the company’s website.
The bottom line
Stock picking is challenging, but if all the steps above are followed, it will likely reap the desired results. The effort involved is directly proportional to the returns. The selection process is to narrow down the beam and then carry out a deep analysis of each stock to unearth its potential for earning the desired returns. Remember, investment decisions are risk-prone and must be taken with due diligence and knowledge.
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