You have probably heard stories of how people who bought stocks like Amazon, Coca-Cola, and Apple (to name a few) made lots of money. Of course, for some of these people, it was just pure luck – they were just guessing or doing what some friends or family members were doing. However, for others, the choice of these companies was deliberate. They knew how to pick a stock to invest in.
Warren Buffett is one such person who knows how to pick stocks. The billionaire investor has become a household name in the investing world and his insights continue to be fundamental to the success stories of many.
In this article, we will consider insights from Buffett and other top investors on how to pick stocks to buy. We’ll cover:
- Fundamental analysis: Buying wonderful companies
- Valuation: Buying wonderful companies at a wonderful price
- What makes a stock good for trading?
- Technical analysis: When to buy a stock
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1. Fundamental analysis: Buying “wonderful companies”
In one of Warren Buffett’s quotes, he insisted that: “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
Many people worry so much about stock prices that they forget to think about the company that they are buying. For them, a stock is a good buy as long as it is undervalued (worth more than its market price).
However, for Buffett, since a stock represents ownership in a company, the soundness of the company must be more fundamental than its price.
“Know what you own, and know why you own it,” said Peter Lynch, former manager of Magellan Fund at Fidelity Investments, in one of the popular investment quotes.
So, what makes a company wonderful in Buffett’s eyes? There are two main sources we have to answer this question: Warren Buffett’s stock holdings (investment portfolio) and statements on various occasions.
Below are some of the most important things to look out for based on these sources:
- Economic moat (protective moat): Buffett does not want to invest in companies that are indistinguishable from their competitors. A wonderful company must have competitive advantages (economic moat) that others cannot replicate.
It is the presence of an economic moat that guarantees that the company will sustain or grow its market share going forward.
Relatedly, Buffett avoids companies that depend too much on the prices of commodities like oil or gas. The volatility of these commodities can make these companies’ financial performance unpredictable.
Instead, he wants companies that can raise prices without losing market share. “If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. If you have to have a prayer session before raising the price by 10%, then you’ve got a bad business,” he said.
- Return on equity: The return on equity is the ratio of a company’s net profit to its equity. In essence, it is how much a company earns for each dollar of shareholders’ equity. It is a good approximation of the company’s ability to turn investors’ funds into profit.
Buffett wants a company to have a growing (over the years) and competitive (when compared to similar companies in the same industry) return on equity.
Warren Buffett’s concern about consistent performance over the years is the reason he generally avoids initial public offerings (IPOs). He is not in a rush to buy just as he is not in a rush to sell.
- Debt: Too much debt can threaten the survival of a company. Also, the company may have to use money that it could pay as dividends to shareholders to service debt.
Buffett does not avoid companies with debt but he wants the debt-to-equity ratio (total debt divided by total equity) to be low. In other words, he wants the company to generate its profit not from excessive debt but by good use of investors’ funds.
The current ratio, which is current assets divided by current liabilities, is also important. It shows how well the company can use its liquid assets (easily converted to cash) to meet its short-term liabilities. If the current ratio is poor, then the company can experience short-term illiquidity.
- Profit margins: Earnings are the main engine that drives a company’s stock. Therefore, Buffett wants a company with high (relative to competitors) earnings and consistent earnings growth.
A good measure of earnings is the net profit margin, which is the net profit divided by the net sales (revenue).
The net profit margin tells us how well a company is turning its revenue into profit.
Some companies have high revenue but their expenses (operating expenses and interest expenses) can be so high that their net profit becomes low. In the same way, revenue growth can be positive while net profit stalls because of growing operating expenses.
Buffett wants those that can minimise the cost of operation to turn high revenue into high (and growing) net profit.
- Management: Though Buffett’s quantitative analysis (using the company’s financials) is well known, his qualitative analysis is equally important.
A crucial part is considering if the management team is experienced, honest, forward-looking, and committed to shareholders’ interests.
Two things are especially important: how well they run the business and how they treat shareholders compared to themselves. “The poor managers also turn out to be the ones that really don’t think that much about the shareholders, too. The two often go hand in hand,” he said.
Note: If you are an investor who cares about receiving regular income, then you have to include dividends as one of the criteria to identify wonderful companies. You can choose companies with a growing dividend payout ratio (dividend paid divided by net income) or a high dividend yield (dividend per share divided by market price per share).
Irrespective, the five criteria highlighted above are key if you want to know how to pick a stock to invest in.
They are especially crucial if you are a long-term investor looking for the best long-term stocks to invest in. This is because the kinds of factors Buffet is concerned with are the ones that drive the long-term price of stocks, unlike short-term market volatility which is often driven by investors’ fear and greed.
How to pick a stock to invest in: The benefits of stock screeners
With thousands of stocks available on different stock exchanges, it is practically impossible to conduct a fundamental analysis of all of them. So, how can you narrow down the list?
Buffett advises that you focus on your “circle of competence;” that is, an area where you have a considerable amount of knowledge. This ties into Buffett’s advice that you should only invest in companies that you can understand.
If you have experience in the retail sector, for example, you will be in a good position to evaluate companies in that sector – especially the qualitative aspects of fundamental analysis.
However, there might still be a handful of companies in your circle of competence and who says you can’t have many circles of competence?
One way to quickly narrow your options and make the stock selection process simpler is to use a stock screener. A stock screener allows you to set certain criteria and it will select only those stocks that meet them.
Below is a list of just some of the income statement and balance sheet filters you can use to screen stocks on Yahoo Finance:
Source: Yahoo Finance
For example, you can filter for stocks with at least 20% return on equity, maximum debt to equity of 1.5 (or 150%), minimum current ratio of 1.5 (150%), and profit margin of at least 20%, among others. These four filters bring us down to 102 stocks in the US.
If we assume that your circle of competence is utilities and consumer defensive sectors, that narrows down the list to just six stocks.
Of course, the task does not end here. There is no comprehensive quantitative measurement of economic moat and management. Thus, you will still need to use these factors to evaluate the list the screener returns.
2. Valuation: Buying wonderful companies at a wonderful price
Though our focus is on how to pick a stock to invest in rather than at what price to buy those stocks, we won’t do justice to Buffett’s thoughts without a brief detour on price and value.
“The stock market is filled with individuals who know the price of everything, but the value of nothing,” according to Phillip Fisher, another renowned investment manager.
What’s the difference between price and value? Let Warren Buffett answer: “Price is what you pay, value is what you get.”
Once you have identified wonderful companies you must ask if their current market price is low or high relative to their intrinsic value.
The intrinsic value of a stock is derived from analysing its financial statement.
However, it is not an objective figure that everyone can agree on. Rather, it is a subjective evaluation based on different choices made by the value. Intrinsic value can be calculated based on:
- Dividend: You can derive the intrinsic value as the present value of the future dividends you will receive from the company.
- Earnings: Alternatively, you can estimate the future earnings of the company and derive the intrinsic value as the present value of future earnings.
- Cash flow: Instead of dividends and earnings, you can focus on the present value of the company’s projected future cash flow.
- Multiples: This is one of the most popular valuation methods. It involves comparing the company with other similar companies in their industry (called comparables) based on multiples like:
- Price-to-earnings ratio (P/E ratio): This is measured as the price per share divided by the earnings per share (EPS). It is the amount of money investors pay for $1 of the company’s earnings.
- Price-to-book ratio (P/B ratio): This is calculated by dividing the price per share by the book value per share (total equity divided by the number of outstanding shares). It is the amount of money investors pay for $1 of the company’s book value.
- Price-to-sales ratio (P/S ratio): This is measured as the price per share divided by the sales per share. It is the amount of money investors pay for $1 of the company’s earnings.
- Price-to-cash ratio (P/C ratio): This is calculated by dividing the price per share by the operating cash flow per share. It is the amount of money investors pay for every $1 cash generated by the company.
Whichever valuation method is used, the key insight here is to ensure that the stock is undervalued (intrinsic value higher than the current market price) before making a purchase.
To cater to the subjectivity of valuation, Buffett will not buy until the margin of safety (the gap between market price and intrinsic value) is at least 20%. In other words, the stock must be undervalued by at least 20% for him to feel safe.
Warren Buffett in this regard belongs to the value investing school. However, not all investors are too concerned about intrinsic value.
Growth investors, who are often contrasted with value investors, only care about buying wonderful companies that are growing profits, revenue, and cash flow at an above-average rate (growth stocks), irrespective of the current price.
How do the two approaches compare?
“Historically, value investing has outperformed growth investing over the long term,” said Rob Berger, a financial expert and contributing editor for Forbes advisor. “Growth investing, however, has been shown to outperform value investing more recently. One recent article noted that growth investing had outperformed value investing over the last 25 years. Since 1995, value mutual funds have returned 624%, while growth mutual funds have returned 1,072%.”
Some investors also combine both approaches in an investment strategy called growth-at-a-reasonable price (GARP) investing.
3. What makes a stock good for trading?
Warren Buffett tends to focus exclusively on long-term investors. As he said, “Our favorite holding period is forever.” That is, he prefers to hold a company for as long as the fundamentals are sound.
But what if you are a stock trader who prefers to take profits daily, weekly, or monthly?
In addition to selecting wonderful stocks, you want to ensure those stocks are appropriate for trading.
So, what makes a stock good for trading?
Let’s consider some factors to consider:
- Liquidity: Liquid stocks are those you can buy and sell quickly without significant changes in their prices. If you have to wait for hours and days before your buy or sell order is filled, then the stock is illiquid.
If you are a stock trader who wants to buy and sell stocks regularly, then liquidity is key.
Liquidity is measured by both the daily trading volume and the average trading volume (usually a 30-day average).
The more liquid the stock, the better.
- Volatility: Volatility measures how fast a stock moves, either upwards or downwards. Market volatility is traditionally considered a measure of market risk.
However, for traders, stock volatility is a good thing. This is because volatile stocks provide more opportunities to make a profit.
For example, a stock that does not move beyond 1% a week (upward or downward) will not have the same profit opportunities as one that moves about 10% in any given week.
Volatility is measured by the average true range (ATR) of a stock. The bollinger band provides a visual description of volatility.
Below is an example:
The gap between the upper band and the lower band (and between both and the middle band) shows how volatile the stock is within a defined period.
A simpler approach is to consider the percentage by which the stock moves up or down within a given period.
- Response to events: If you trade based on news and announcements (earnings reports, change of CEO, mergers and acquisitions, interest rates changes, among others) then you want to select stocks that respond to them.
- Diversification: If all your stocks are in the same industry, any unfortunate event affecting that industry can cripple your portfolio. Diversifying your stock portfolio can help to reduce risk especially if you trade based on events.
We have already introduced stock screeners in a previous section. Just as you can screen for stocks based on fundamentals, you can also screen them based on liquidity and volatility.
For liquidity, daily and average trading volume are good metrics.
What about volatility?
You can screen based on percentage change in price within a defined timeframe (within a day for day trading and days and weeks for swing trading).
Usually, only large-cap stocks (stocks with market capitalization exceeding $10 billion) meet the liquidity and volatility criteria. Thus, a shortcut is to filter for only large-cap stocks.
4. Technical analysis: When to buy a stock
While price is an optional consideration for investors, it is the lifeblood of traders. For them, selecting stocks to buy and deciding when to buy them cannot be differentiated.
Technical analysis is the name of the process traders use to predict the movement of prices and make buy and sell decisions.
Learning how to start trading stocks requires a good grasp of technical analysis.
Interestingly, some investors also use technical analysis to decide when to purchase a stock. The lower the price you invest, the higher your rate of return on that investment. These investors wait for the most opportune time when they can maximize ROI.
Understanding and predicting price movements
There are three key components of technical analysis: chart patterns, moving averages, and technical indicators.
Chart patterns
Different charts show past movements of share prices including line charts and bar charts. However, the most useful is the candlestick, shown below.
Candlesticks can be used to identify support and resistance levels. You can also identify certain candlestick patterns and use them to predict price movements.
The most popular include bullish engulfing, bearish engulfing, morning star, evening star, hammer, and hanging hammer, among others.
Moving averages
A moving average is the mean movement of prices over a given period. There are two main types of moving averages: simple moving averages (SMA) where every price point carries equal weight and exponential moving averages (EMA) where the most recent price points have greater weight.
The most common moving averages are the 20 SMA, 50 SMA, 100 SMA, 200 SMA, 9 EMA, 12 EMA, and 26 EMA with the numbers representing the periods covered by the moving average.
Below is an example of moving averages laid atop a candlestick chart:
Though past performance does not guarantee future performance, they show patterns that are instructive when predicting it.
Technical indicators
These are mathematical calculations based on price and volume data that are converted into charts that can be overlaid on chart patterns or included below them.
Some of the top technical trading indicators include:
- Bollinger bands: As we have seen, it is a common measure of volatility. They can also be used to identify when a stock has been overbought or oversold.
What does overbought stock mean? It means that there has been too much buying activity and a correction (decline) is near. Similarly, oversold means that selling activity is too much and a correction (rise) is near.
- Relevant strength index (RSI): It measures the size and speed of recent price changes (usually the past 14 days) and also compares the strength of downward movements with upward movements. The RSI ranges from 0-100.
Many traders consider a stock overbought when the RSI exceeds 70 and oversold when it falls below 30.
Some also see a divergence between the RSI and the price chart (one going up and the other going down) as evidence of a potential reversal in prices.
Below is an example of an RSI:
- Moving average convergence divergence: Traders use MACD to indicate the direction and momentum of a market trend.
As seen below, there are three key components of MACD:
Source: Fidelity Investments
The first is the MACD line which is the difference between two EMAs and shows how both converge and diverge.
The signal line shows the movement of the EMA of the MACD line and the histogram shows the relationship between both lines.
When the MACD line crosses above or below 0, some traders see it as evidence of an upward or downward trend, respectively. For others, an uptrend is when the MACD line crosses the signal line from below and a downtrend is when it crosses it from above.
Buy and sell decisions
The whole essence of chart patterns, moving averages, and technical indicators is to help traders choose when to buy and sell stocks.
However, since there are many candlestick patterns, moving averages, and indicators, each trader must decide on a trading strategy that works for them.
If you want to go the trading path, you must be ready to test different strategies and select the one with the better track record (more profits than losses) that also fits with your risk tolerance and time horizon (whether you are a day, swing, or position trader).
Setting stop losses is part of buy and sell decisions. When entering a trade, you must set a stop loss which indicates the maximum amount of losses you are willing to bear when the trade goes against you.
How to start trading select stocks in the UAE
So far we have seen how to select stocks for investing and trading and we have made two quick detours on how to buy these stocks at the right price.
While these two are the most important, the platform you use to buy and sell stocks is also crucial.
If you are in the UAE, you can buy and sell US stocks in a cost-effective, secure, accessible, and convenient way through Sarwa Trade:
- Cost-effective: Transfers from your local bank account to Sarwa and from Sarwa back to your local bank account are free. Our commission of $1 or 0.25% of the traded value is lower than the brokerage industry average.
- Secure: We are regulated by the ADGM Financial Service Regulatory Authority and our website and app are protected by bank-level 256-bit encryption. Your money and data are safe.
- Accessible: You can start trading with as low as $1 and you can buy fractions of a share if you can’t afford a single share.
- Convenient: Our website and app are easy to use and we also provide market news and other reports that will make your investing and trading seamless.
Those who prefer index funds and exchange-traded funds (ETFs) to individual stocks, can also invest in and trade them on the Sarwa Trade platform.
[What are you waiting for? Sign up for Sarwa Trade today to kickstart your stock investing or trading journey]
Takeaways
- Selecting good stock market investments does not have to be a matter of luck. You can make sound investment decisions by learning from the strategies of successful investors.
- As an investor, you want to select stocks with economic moat, great and consistent financial performance, and low debt levels.
- As a trader, you want to also select stocks that are liquid, volatile, and respond to market events.
- In addition to knowing how to pick a good stock to buy, you must also know the right price to buy them.