How to Choose a Stock to Buy

by Contributor ; Updated July 27, 2017
Choosing a good stock takes time and dedication

Items you will need

  • A brokerage account
  • Some money
  • Time
  • Determination

This article is intended to help investors choose a stock to buy. Most people that invest on the stock market do so trough mutual funds. While this is a good choice for people who don't want to do the work that choosing a good stock requires, the results are often mediocre. By doing careful research on their stocks, individual investors can, in my opinion, achieve great results.

When I started investing I felt so confident in my abilities that I did so with all of my life savings (Thinking back I believe that this was probably a mistake). From my very first weeks and months I was impressed by my own results. I kept obliterating the market and most professional money managers! In 2008 the return in my portfolio was 35% (without shorting a single stock). Since the market dropped about 50%,I had effectively beaten the market by about 85%! It doesn't get much better than that. I am not mentioning this to brag, but to emphasize that an individual investor can make some of his own investment decisions even if he or she is not a professional (but I do plan on becoming one). While I don't expect to accomplish this again anytime soon, good opportunities are always there for the taking. I have to say that these are not the returns most people will get. I did not accomplish this because I was a "good' investor. It happened because of what I knew. Before I started investing I had read 9 books on investing. Many of them with drastically different styles. My strategy now is unique and it combines a little bit most of the books I have read. I have now read 14 books on investing and I have started to invest in currencies. I do not expect the average investor to read 9 books before investing, that is why I recommend starting with a virtual money account (one that does not risk any money whatsoever).

Now I'll list some of the criteria that will help you find good investment opportunities:

Step 1

Always ask yourself these two questions:

What am I buying?

AND

How much do I have to pay for it?

Never use only one of these questions, always ask both.

Step 2

WHAT AM I BUYING?

When you buy a stock you are effectively buying a piece of a business, therefore, you become one of the legal owners. Always be sure that you are buying something that you would like to own! I do not even make any trade (even if I just hold the stock for a few days) with a stock that I would not hold for the long term. If the market does not do what I expect it to do, I just hold on to my investment and make money on the long run. Heads I win, Tails I still win. While not common, this is the type of situation I seek.

Things to look for on business:

Above average(or at least VERY stable) profit margins.

Long term above average return on equity.

Easily payable debt.

No need to keep inventing or consistently changing products (This rules out most technology stocks).This makes the business much more predictable. I also try to avoid companies that are too dependant on management's decisions.

Management whose decisions you like or at least are comfortable with.

Increases its earnings in the long run.

Has some sort of durable competitive advantage.

Step 3

HOW MUCH DO I HAVE TO PAY FOR IT?

Never assume the market price of an asset (or stock) is a rational price. The current price may be way too expensive or dirty cheap. Its up to you to determine just that. I strongly believe stock markets are not efficient.

I recently bought the common stock of a Colombian Bank whose earnings have increased about 20 percent since I bought it a few months ago, yet the market values the company at a lower price than the price I paid for it (This is not a mystery, since investors are afraid of banks for the moment). Again, I strongly believe stock markets are not efficient.

Things to look for in price:

A low PEG ratio. The lower the better, but don't sacrifice business quality.

A decent dividend yield (not necessary, but a big plus)

The price must not be on free-fall! If it is dropping fast wait until it stops!

Relatively low P/E ratio (Don't pay more than about 18 times earnings unless the earnings are growing like crazy or the business is top notch).

Try to find stocks trading below net asset value (not necessary, but a plus).

You should pay waaay less for stocks on politically unstable regions of the world.

A price you are happy with even if the stock drops 99% the very next day. Remember that market prices can be volatile. A good deal is a good deal even if tomorrow brings an even better deal.

Step 4

Do not ignore secular or macroeconomic trends. Take advantage of them. Always take into account the global economic environment and outlook. I will be adding links to related articles on the resources section at the bottom of the pages, so consider adding this page to bookmarks. ( :

Tips

  • Always do everything for a reason. Preferably learn from other people's mistakes. Read, learn and be open to new ideas. Research is key. Be sure to always have really good and useful research available! If you don't understand your investment you wont have confidence in it. Research, research and research some more.

Warnings

  • Remember to be diversified! If something unexpected happens, such as your company's main plant being destroyed by an earthquake, reconsider your investment. If the facts change you should consider changing your mind. Why? Because the asset changes. Any investment you make is your decision alone.

Photo Credits

  • blog.wired.com, grants.nih.gov/grants/partners/0107Nexus.htm, glassian.org/.../Paper/stock_certificate.html, investing-school.com/.../, seekingalpha.com/article/29471-broadcom-shoul...,