A reader emailed us yesterday, asking what methods we use to pick stocks. So, We thought we’d share the steps we take to choose stocks. Here is a run down of how we do it:
First, we narrow it down a bit. We consider a sector that we are interested in, or amongst multiple sectors, and then look at a number of stocks and then narrow it down to five or so to look at in more depth. Then we look at a number of factors associated with the stock. These include:
1. Look at the price growth over the past two to five years. This makes sense because typically growth follows earnings; with increased earnings, the company often becomes more valuable. We often use yahoo finance to look at the charts, as a first run, to narrow down our options.
2. Upward mobility. In looking at the price history, we tend to favor those that have upward mobility and don’t have major drop-offs that might indicate something wrong with the stock.
3. Debt to Income Ratio. This is also an important factor to look at. Typically it should have less 50% ratio, or in other words, for every dollar of assets they should have less than fifty cents of debt. Basically you want them to solvent.
4. Splits. We also like to see stocks splitting, as least from time to time. While a split in a stock just means that the stock is then divided into more pieces to reduce the overall price, giving stockholders a greater number of stocks, this tends to mean that stocks are doing very well. Stocks don’t split without having seen a substantial amount of growth.
5. Dividends. We like dividends. In fact, we love them. We think they are not only great to receive, but they are also a measure about profitability of company. After all, CEOs can always fudge their numbers, but if you’ve got to write out a check to your stockholders you’ll have to put your money where your mouth is.
6. A Clear Business Model. We tend to also choose company’s that we understand the general business model. If we haven’t a clue, we tend to stay away from that. Warren Buffet also advocates for this approach.
Second, look further in the company. Once you’ve narrowed your list down, you’ll need to do due diligence. This means doing some close research. Look at reports issued by the company and then also pull the quarterly and annual financial reports from the SEC. Repeat: If there is one place to look at reports, the SEC is it. Google searches for recent news is also helpful. If questions come up, get on the phone and call or email the company’s investor relations department.
If the due diligence pans out, there are also a couple of other criteria we consider
1. Like what you buy. We are all consumers, so keep in mind your own impressions about the company. If you’ve had customer service issues with a particular company, then you might consider that others have as well. Similarly if you like and enjoy the product or service your company makes, others might have the same view.
2. Two Heads are better than One! We’ve found that our best stock picks are those that we choose together. With both of us bringing our arguments to the table it is easier to walk away with a sound judgment. After all, it’s pretty easy to convince yourself of a good deal, but harder to convince your spouse sometimes! If you aren’t in a relationship, then talk it over with a trusted friend.
Don’t listen to everyone! Don’t listen to loud mouths on message boards. Similarly, Guru’s like Jim Cramer often make too many stock picks so please take their recommendations with a grain of salt.
Lastly, if all else fails, rent a monkey and get it to choose your stocks for you!