How to choose stocks in 3 simple steps

Brian Barnes
Brian Barnes February 7, 2018
How to choose stocks in 3 simple steps

By now, you’re probably already familiar with M1’s pies, which make it easy to customize your portfolio to your unique investing needs. You can choose from our Model Portfolios, pick from more than 6,000 stocks and ETFs to build your own, or opt for a combination of the two. Now you need to know how to choose stocks to build your portfolio.

Selecting the right investments is crucial to your financial success. The securities you buy should align with your goals, reflect your expertise, and offer superior value to alternatives. So how do you make the right choice?

First, it’s important to remember that people spend lifetimes attempting to become great investors, and a few quick tips will certainly not transform you into Warren Buffet. Investing is a science, an art, and even includes a good bit of luck. At the same time, however, grasping the fundamentals and doing your research can go a long way. When it comes to making better investment decisions, all you really need is a good process. Here are my top tips for how to choose stocks:

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Start with what you know.

Let’s start by taking a page from Warren Buffet’s playbook because — let’s face it — guy is clearly doing something right.

Warren Buffet’s investing philosophy prescribes buying stocks in businesses you understand, such as those you encounter in your everyday life or within your industry of expertise. This stems from the idea that making investment decisions is much easier when you understand a company and are more apt to follow industry news and trends. The Berkshire Hathaway CEO refers to this familiarity as the “circle of competence,” where the area of the circle aligns with your skills and expertise. Buffet asserts, “The size of that circle is not very important; knowing its boundaries, however, is vital.”

In other words, you don’t have to know everything about everything to choose stocks. Just as professional athletes pursue success by focusing on the one sport at which they excel (rather than every single sport), Buffet contends investors wondering how to choose stocks can benefit from identifying and playing to their biggest strengths while avoiding potentially sticky unknown territory. The Oracle of Omaha used the principle to dodge the internet investment frenzy of the late 1990s and early 2000s, insisting he knew too little about these new businesses to invest. This ultimately allowed him to avoid the adverse consequences of the dot-com bubble, as he continued to invest in market stalwarts like Coca-Cola.

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Assess price and valuation.

At the end of the day, earnings act as predominant driver of stock prices. After all, a company with solid or expanding revenue streams is more likely to provide returns for shareholders and invest in future growth. At this phase, you’ll need to choose one or several financial ratios to weigh earnings and price to determine the best investment.

To start, consider the price-to-earnings (P/E) ratio — arguably the simplest means by which to gauge stock value. The P/E ratio essentially boils down to how much investors are paying for a dollar of profits, meaning you would likely seek a lower P/E to potentially earn more money at a lower cost. With that said, it’s also important to realize stock prices aren’t always a result of current performance. Rising stock prices often reflect investor hopes that a company will increase earnings in the future. So when choosing a stock, be sure to consider a company’s vision for the future and how it plans to grow business; a higher P/E could indicate greater growth potential.

P/E should only be used to compare stocks within an industry, however, and may not provide a the full picture. Measures like EBITDA (earnings before interest, taxes, depreciation and amortization) make it easier to compare profits and value between industries by removing operating expenses that may distort net income. Other methods, such as the comparables method or the DCF model, may also be used to examine stock value across companies or industries.

The truth is, analysts employ variety of strategies for stock valuation, and arguments can be made for or against the use of nearly any approach. Your best bet will ultimately be choosing a method you understand and with which you feel comfortable.

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What’s your story?

Why do you own or want to own this particular stock? What is it about this company and its future that compelled you to buy? This is your narrative for stock ownership, and your story should consist of three basic parts.

First, you’ll want to evaluate your own investing goals to determine which types of stock you may want to seek out. Start by assessing your timeline. Will you need the money within three to five years? Or do you plan to invest for another 30+ years as you prepare for retirement? For a longer holding period, it may make more sense to target higher risk stocks with greater growth potential. If you’re looking to supplement your income, on the other hand, a blue chip or reliable dividend stock may better suit your needs.

Next you’ll need to begin constructing your story for ownership of specific stocks. From a high-level perspective, you can essentially take one of two routes at this juncture. First, you can choose to invest because you believe the stock is currently undervalued. For example, you may look for a company that recently fell short of analyst expectations, resulting in a knee-jerk reaction that caused stock price to slip (often indicated by a lower-than-average P/E). If the company appears otherwise strong, this could signal an opportunity to buy. On the other hand, you may decide that while a stock is fairly priced, it has outsized opportunity for growth. These are the companies that you expect to experience exponential growth over the course of, say, 5-10 years. With either approach, you’ll need to do a bit of research to back up your buy.

The final piece of your story requires outlining an exit plan. While it may seem odd to consider selling so early in a buy-and-hold strategy, it’s important to make upfront decisions about the circumstances that will prompt you to sell. For example, you may designate a price target upfront, opting to sell when the stock price reaches your predetermined range. You may also choose to prioritize the underlying business fundamentals, opting to sell if sales deteriorate or profit margins drop. Deciding ahead of time how your story for a particular stock will end is just as important as choosing where it starts, and prevents you from holding too long or selling too early.

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Of course, knowing what not to do plays an equally important role when choosing stocks for your portfolio. For more information on how to choose stocks, check out my top five common investing mistakes to avoid.