The Motley Fool

How to Pick Stocks: Your 10-Point Guide

It’s easy to buy and sell stocks – your online stock broker provides easy-to-follow instructions on how to use their trading platform. The tough part is learning how to invest – how to actually pick stocks that can help you make money in the stock market. Here’s a simple ten-step list to picking great investments.

1: Understand how stocks make you money

When you buy a company’s stock, what you’re doing is purchasing an ownership share in that company. There are two ways to make money from stock investments.

The first is to hold onto your shares and collect dividends, which are a portion of a company’s earnings that it distributes to shareholders. Dividends are typically disbursed quarterly or semi-annually in Hong Kong, and they’re a good way to generate a steady stream of income.

The other way to make money from stocks is to sell your shares for a price that’s higher than what you paid for them. Let’s say you buy 100 shares of a company’s stock at $10 a share, and that the price climbs to $15 a share several months later. If you sell your 1000 shares at a higher price, you’ll make $5000 on the sale. (There are other opportunities to make money from stocks too, such as shorting stocks, but for now, let’s keep things simple.)

2: Commit to long-term thinking

The stock market can be pretty volatile, but the good news for investors is that in the long run, those who buy stocks tend to come out ahead. That’s why it’s important to come with a strategy for investing. The one we like to recommend is super simple: Find great companies to invest in, and hold onto those stocks for the long term. Despite its many downturns, the stock market has a strong history of rebounding, so if you’re willing to ride out the upheaval that inevitably comes with investing, you stand a strong chance of making money.

3: Look at businesses you understand

You’re going to have a harder time determining whether a company’s stock is a good buy if you don’t actually understand what that business does or how it makes money. On the other hand, if there are businesses out there that you already understand, you can use that preexisting knowledge to your advantage. If you’re into gadgets and technology, for example, and you read about them constantly for fun, you’re probably in a good position to compare two companies that make smartphones. Of course, you’ll still need to do some research before jumping in and buying up shares, but a basic knowledge of the company or industry you’re looking at is definitely a good starting point.

4: Identify companies with a competitive advantage

Buying individual stocks can be a riskier prospect than buying mutual funds or index funds, but doing so can also yield higher rewards. If you’re going to buy individual stocks, the key is to find the right companies. While the ones you choose might reflect your personal objectives, interests, or appetite for risk, generally speaking, there are certain key components that make companies successful. One such characteristic is having a competitive advantage. A competitive advantage is essentially a leg up over similar businesses, and the more sustainable a company’s competitive advantage, the more likely it is to remain profitable in the long run.

5: Find companies with strong management

Management teams are responsible for making strategic decisions that impact the value of their companies over time. That’s why it’s important to find companies with strong leadership teams. As you do your research into who’s running the companies you’re looking at, see if those managers have a solid track record, ample experience, and specific talents. You might also find yourself drawn to managers with certain characteristics.

For instance, Apple’s late CEO Steve Jobs was often touted as a great leader, a smart risk-taker, and an innovator.

6: Recognize growth avenues

If your strategy is to find stocks you can hold for a long time, you’ll need to identify companies that offer the best growth opportunities. Growth investors like to focus on companies that are expected to accelerate at a faster rate than their competitors, and that generate, or have the ability to generate, above-average earnings. Growth avenues, however, can take many shapes and forms, so when you look at different companies, take the time to understand not just how they’re doing today, but where they’re going.

7: Tune in to the most recent conference call

Earnings conference calls are a good way for investors to learn more about the companies they’re interested in. Companies listed in Hong Kong typically conduct conference calls on a semi-annual basis, usually following the release of financial information. During these conference calls, management will discuss the latest financials, major factors that impacted performance, and projections for the upcoming quarter or year. Tuning in to a conference call can give you a good sense not just of how a company is doing financially, but how management responds to changes in performance, for better or worse. This is important, because it’s possible for a company to have strong earnings one quarter and poor earnings the next — but the way management addresses hiccups can have a huge impact on a company’s long-term value and viability. Most companies post their conference call schedules on their websites and allow investors to listen online.

8: Determine a stock’s value

A big part of stock investing involves trying to figure out how much stocks are worth, and whether the price they’re trading at is fair. While there are numerous tools and formulas you can use to value a stock, we’re going to keep things (relatively) simple.

Companies are typically valued based on their earnings as well as their earnings per share. Earnings per share is the portion of a company’s earnings allotted to each outstanding share of its common stock.

Another measure of a company’s value is its price-earnings ratio, or P/E ratio. The P/E ratio measures a company’s current share price relative to its earnings per share, and it’s calculated by dividing a company’s stock price per share by its earnings per share. A high P/E ratio generally indicates that investors anticipate strong future growth for a company, and as such might be willing to pay a premium for its stock. However, a high P/E ratio doesn’t always mean that a company is overvalued, nor does a low P/E ratio automatically mean that it’s undervalued. Furthermore, the P/E ratio is only one measure of a stock’s value; it can help you figure out what constitutes a good price to pay, but it shouldn’t be the only thing you look at. Finally, you’ll probably find that a company’s P/E ratio is more helpful when taken in the context of other companies’ P/E ratios within the same industry.

9: Start small and diversify

Identifying great stocks can be very rewarding, but it can also be pretty risky. If you put all of your money into an individual company’s stock and its price falls, you run the risk of losing your entire investment. Even once you’ve identified a strong company to invest in, it’s a good idea to start out by buying a relatively small position of its stock. Furthermore, you’ll want to build a diverse portfolio to increase your opportunities for growth while minimizing your investment risk. If you buy stocks across a range of sectors, you lower your chances of having your portfolio take a major hit if a specific industry tanks.

10: Follow up on your investments

Once you buy stocks, it’s natural to want to know how your investments are doing. But checking up on your investments daily is a good way to drive yourself crazy. If your strategy is to hold your investments long-term, then there’s no sense in getting hung up on daily or even weekly price fluctuations. That said, you should still check on your investments once a month to see how they’re doing. And don’t just glance at your portfolio for its current value; check up on the individual companies whose stocks you own and look out for potential red flags. If, for example, there’s talk of new management down the line, and that makes you uneasy, you might want to pull out of that position rather than take your chances.

While buying stocks may seem like a daunting prospect, once you get over that initial hump, you’ll probably find that it’s much easier than you thought. Remember, there’s no perfect strategy or one-size-fits-all formula for buying stocks. A lot of it really does boil down to educated guesswork. But if you’re willing to do your research, sit back, and be patient, you stand a strong chance of coming out ahead.