How to pick a winning stock.
The financial industry would have you believe that you need to pay considerable fees to financial advisors and wall street professionals to gain an advantage in the stock market and have them guide you on how to pick a winning stock.
The whole marketing system for investing is geared towards making you, as a retail investor, think you don’t have what it takes to successfully pick a winning stock in the stock market to make reasonable gains.
In this blog, I will show you how to go about picking a winning stock. And how don’t you need to have vast amounts of capital to invest in making any gains in the financial markets.
Financial success in retirement.
What if I told you that just investing $2000 a year the right way could pave the way to financial success in retirement?
Let’s look at some of the methods which you can use to pick a winning stock.
I need to preface this article because I am not a qualified financial advisor, and if you are looking to invest, you should consult a financial professional, all of the knowledge in my articles comes from a place of experience rather than qualification.
Find a great company.
To invest in an outstanding stock, you first need to first find a great company; in a previous article, we said you are buying a small portion of that business when you are investing in their stock.
As the company grows, so does your portion or “share” of this business. Your stock value will be based on how that business performs over the long term.
Look at some of the most successful businesses today, if you had invested in them for the long term, you would be sitting pretty well right now.
Look at successful companies.
Let’s look at a successful company such as Apple, for example, and see where you would be today had you invested in their IPO (initial public offering)
Apple first sold its’ shares to the public on December 12th, 1980, at a price of $22 per share.
Apple stock has split five times since then, three times at 2-for-1, once at 4-for-1, and once at 7-for-1.
This means that you would have received two shares for every share you owned on the 2-for-1 splits.
Four shares for every one share you owned on the 4-for-1 split and seven shares for every one share you held on the 7-for-1 split.
If you bought only one share.
If you had bought only one share for $22, you would now have 224 shares today after the stock splits; The most recent split was in August 2020.
So without any growth on the one $22 share you bought in the IPO, it would be worth $4,928 just in stock splits, which isn’t a bad investment even if the share or stock prices stayed the same!
That one investment of $22 would now be worth $32,032 at the current stock price of $143
If you invested $2200 at the IPO for easy figures, you would now be sitting on $3.2 Million over the past 42 years.
This is without investing another cent in Apple stock, just buying the IPO and leaving it to grow for 40 years.
You need to find a good company with good fundamentals, good management, and a healthy-looking future, put a relatively small amount into it, and then forget about it for the long term.
Pick out a company with a solid future.
Try and pick out companies with a solid future and invest early; take your time to really investigate the company and fully understand the business, how it makes money and how it will benefit people in the future.
Invest a modest amount of money.
Invest modest amounts of money into fewer businesses which you have done a lot of research into, rather than investing lots of money into stocks and shares here and everywhere and constantly trying to buy and sell and beat the market because you won’t be able to time and beat the market.
Pick a business, invest a modest amount early, then hold on for the long term; think of investing in 10-year increments as a minimum.
How long do businesses take to start making gains?
Don’t ever invest thinking of holding a business for a year or 2; most companies can take 6,7,8 years, or even longer to start making gains, and if you are a short-term institutional investor, this is where you are going to lose many of the enormous profits which come from holding the stocks for the long term.
Make sure you have the patience to ride out the markets, for the long-term, stocks will go up and down. This is just the natural rhythm of the market; sit back and accept it.
Only invest money with your disposable income.
On another note, you should only invest money that you have as disposable income.
This way, if something happens in your life, you won’t have to sell your shares when the market has just dropped to pay for your rent or a car repair in an emergency.
Five things we can look at to determine if a business is a good.
1. Look at the company’s sales.
We first need to look at the companies’ sales and future earnings growth.
Is the company developing new products, or is the company selling more and more products?
Try to understand the company’s story and its goals for the future.
- Which direction are they heading with the business?
- Does the business have multiple income streams, or are all its eggs in one basket?
- Is the sales revenue growth gradually increasing year on year?
- Are they in a pioneering industry that will be huge in the future? Or could some new revolutionary future product make their product obsolete?
Consider all of these points above when looking for your next stock pick.
If you manage to find a growth stock that increases its value by 25% a year profits will double in 3 years, quadruple in 6 years, and increase 8-fold in 9 years!
These are what we call growth stocks; the great thing with stocks that answer all the previous questions positively is that you don’t have to jump into them immediately because you know they will be around for the long term.
2. Look at competitive advantages.
Secondly, you need to look at competitive advantages.
What advantage does this business have over another? You need to research and investigate why you would buy the products from this company over a competitor.
Talk to people and look at product reviews, and look at YouTube video reviews of the products. Are they positive, or are they harmful?
How does the company handle customer service? Do they have a good reputation or a poor one?
It would help to establish where the company is positioned within the industry and where it sits amongst its competitors.
- Does this company offer a better product experience, or is customer support better than the competition?
- Are the products of superior quality, or are they just a trend that may die out?
- Can the product be developed further to improve and adapt to the future market, or will it be obsolete when a competitor designs a new product?
All of these things need to be considered when looking at a company’s competitive advantages to ensure that you pick a winning stock.
3. Look at return on capital
Thirdly you need to look at the return on capital. This measures the return an investment generates for capital contributed.
If you invest in companies stock, you are a capital contributor; you are giving this business money in the hope that they will turn it into more money for you, in the rise of the stock price or in dividends.
So, you need to look at what return on capital management was able to generate with previously invested sums to see if they are losing money on it or are making a healthy return.
If they are making good returns, this usually means that they can continue to do so if they have had a great track record of being able to do so previously.
As a rule, you are looking for a company that can produce a 15-20% return on capital; if you find a company in this range or above, you need to consider investing in this company.
Put a tick in the box and do some more research against the other 4 points in this list to evaluate the stock properly.
4. Look at the valuation of business.
Fourthly it would help if you looked at the valuation of the business.
The valuation of the business is determined by the price-to-earnings ratio, which I am sure you have heard of when looking at stocks.
Let’s say you own a coffee shop downtown, it costs you $100k to buy it, and it generates earnings of $10,000. The price-to-earnings ratio would be 10.
How do you know if this is good or bad? Well, it depends on the industry.
P/E ratios need to be taken with a grain of salt because there are other factors that need to be considered, including growth potential.
P/E ratios are only useful when you are comparing companies that are in the same industry.
The P/E ratio is a good metric to look at to see if a company is under or overpriced in the market.
For example, a good PE ratio to look for before you start to look a bit further into the business is 20-25%
A stock with a P/E ratio of around ten would indicate that the stock is underpriced.
A stock with a P/E ratio of around 50 or greater would indicate that it is over-priced relative to its steady profits.
So aiming to find stock picking with a P/E ratio of around 20-25% is a good starting point for further research into a stock.
5. Look at free cash flow.
And last but not least, you need to look at free cash flow.
Free cash flow of a business is:
Cash generated by the business minus Cash used to invest in the industry, otherwise known as capital expenditure.
This determines the free cash flow of the business.
A company that generates a free cash flow of 10% or more is considered good, and you should look for businesses that create this level of free cash flow as a starting metric.
An example of a company with a lot of free cash flow is Apple; they have hundreds of billions of dollars in free cash flow; in fact, they have so much that they don’t know what to spend it on, which is a good position to be in.
Other companies with a large free cash flow are companies such as Mircosoft, Exxon Mobil, and Amazon.
While many of these businesses have already risen to meteoric heights, we need to be finding emerging companies that also have an excellent free cash flow as early as possible in the life of the business.
While many start-ups won’t show a substantial free cash flow early on, keep an eye out for the ones you think may have in the future, and as that free cash flow starts to increase, then this could be the time to invest in these value stocks after doing further research on the points previously of course.
Recap.
So, to recap this list of what you need to pick a winning stock, you need to look at the following:
Sales and earnings growth: Find a business that can increase its growth by around 25% a year.
Competitive Advantage: Look for ways that the business is better than the competition and can continue to be better in the future.
Return on Capital – Look for a 15%-20% return on capital
Valuation of the Business: Look for a 20-25% PE ratio as a start to look further into the company and do some more research into how the business can increase sales in the future.
Free cash flow – Look for a business that has at least 10% free cash flow
Final thoughts.
Buying stocks is a much more challenging investment vehicle than it used to be just a decade ago. There are many areas to consider when thinking about where to invest your money, but there are ways to greatly minimize the risk of buying a stock that does poorly.
The best way is to invest for the long term and not be concerned with small or even large fluctuations in stock prices on any given day.
This is a complex philosophy for many people to adopt. If you can keep this attitude, you are far more likely to succeed as an intelligent investor.
Using the tips I have set out above will put you on the right path and help you pick a winning stock good luck.
