Are you new to stock trading or investing? If so, you might have felt bewildered among a wide range of stocks with constant ups and downs. It is the reason why many predecessors advise novice ones to have a solid foundation which includes the stock selection methods.
This article unfolds fundamental aspects such as the role of the stock selection process, common stock selection techniques, noticeable elements of stock picking, and a detailed guide on the process.
Why is the Stock Selection Process Crucial?
Before doing something, we should start with why we should do it instead of following the guide as a robot. Stock selection is no exception.
Simply put, you spend your money buying or investing in stocks with the anticipation of getting profits. Instead of pouring blood money into stocks that you are not sure of generating profits, it is better to have techniques or methods that support you to spot highly-potential stocks.
It saves stock investors from throwing their money through windows. Also, they have higher chances of obtaining high profits and low risks amid the tumultuous market trends. Rather than investing money into saturated or decreasing stocks, mastering stock selection enables beginners to expect profits from day one.
Which Stock Selection Methods Do Investors Use?
There is a wide range of stock selection approaches that new investors should know. Common methods mainly are
- Analytic Hierarchy Process (AHP) is a structured method to organize and analyze complex decisions through insights into mathematics and psychology.
- Fuzzy Analysis helps investors spot vagueness and imprecise information in the stock selection process.
- Data Envelopment Analysis (DEA) is a nonparametric approach applied to operations research and economics to estimate production frontiers.
- Genetic Algorithm is a technique solving both constrained and unconstrained optimization problems with the base of natural selection.
- Clustering, also known as cluster analysis, groups a set of similar objects. It is widely used in exploratory data analysis, pattern recognition, machine learning, etc.
- Support Vector Machine (SVM) is a model analyzing data for classification and regression analysis.
- Neural Network (NN) is a computing system inspired, usually for machine learning, with the aid of insights from data analysis.
- Random Forest is a learning algorithm for classification, regression, and other tasks by the construction of multiple decision trees at training time.
- Convolutional Neural Network (CNN) is a common approach to analyzing visual imagery based on the shared-weight architecture of convolutional neural networks.
- Recurrent Neural Network (RNN) includes connections between nodes for the creation of a cycle, enabling output from some nodes to affect subsequent input to the same nodes.
- Long Short-Term Memory (LSTM), in the field of Deep Learning, is a varied version of recurrent neural networks to study long-term dependencies, especially in sequence forecasting problems.
- Reinforcement Learning (RL) indicates an area of machine learning related to how intelligent agents should take actions in an environment for the maximization of the cumulative reward notion.
4 Steps to Picking a Stock
Novice investors might encounter difficulties and confusion in the beginning period, especially choosing profitable stocks among various ones in the market. The following guide walks you through a step-by-step process to choose a profitable stock for your watchlist or portfolio.
Choose an Investing Theme
A theme is simply an industry of stocks that investors choose. They typically pick industries that have compelling drivers for growth but are out of favor. For instance, the anticipation of growing household formation drove some investors to prefer building stocks in response to the real estate crash in the early 1990s.
Another approach is to find industries having a strong base and a lot of room to grow through insights into positive long-term fundamentals. For example, the aging baby boomer population leads to the development of healthcare in the past decade or so.
If you do not pick a potential theme, you might end up throwing money through windows. Thus, choosing an investing industry is the first and foremost step toward the creation of a universe of stocks.
Use Statistics to Analyze Potential Investments
After picking one or some themes, analyzing potential investments is the next step. Investors are prone to focusing on big corporations with huge market capitalization such as Amazon (AMZN), Apple (AAPL), and ExxonMobil (XOM). Yet, things under the spotlight are the things everyone can see, hence the values are universally shared. Standing out with the influx of profits requires a hawk’s eyes to see the not-yet-to-come profits in much more obscure segments!
After whittling down the list by market capitalization, investors should consider some elements like growth prospects. For example, a company that is a newbie in the industry, indicating to be in the early stages of the business or product life cycle, is expected to aggressively grow in sales. In a scenario of more mature companies, they might step into the saturation stage.
There is a tendency of a younger company that free cash flows will be back into the company. Meanwhile, big corporations with years in business tend to use cash flow for the payment of above-average dividends.
Some important parameters for stock selection are what we share in this section, hence it can smooth the trading process. There are some components in a screen, including a company’s financial position, through financial ratios, liquidity ratios, debt ratios, and profitability ratios. Liquidity ratios include a company’s cash and short-term asset position related to its short-term liabilities. It indicates the possibility to reach its short-term obligations, especially working capital.
Meanwhile, debt ratios measure a company’s ability to fulfill its debt obligations and the size of a company’s debts related to its equity or assets. Profitability ratios provide insights into the return on assets employed, dollars invested, or equity held.
Besides, investors can also use some valuation parameters that ease the process of making decisions based on attractive stock prices to the company’s earnings, assets, book value, and other characteristics
Another screen includes stock valuation parameters that help investors determine whether a stock price is attractive relative to the company’s earnings, assets, book value, and other characteristics. Common valuation multiples include price-to-earnings (P/E), price-to-sales (P/S), price-to-book (P/B), and enterprise value to earnings before interest, taxes, depreciation, and amortization (EV/EBITDA).
Build a Stock Screen
Investors can build a professional stock screen with the aid of several superior software packages, brokerage firms, and financial media websites. It is crucial to identify investment goals before constructing a screen. Some components should be under consideration including time horizon, tax implications, and risk tolerance. The criteria parameters used on the screen will follow investors’ goals.
For example, an investor that is a 22-year-old college graduate wants to invest his graduation gift money into some stocks. His goal is to minimize taxes while having a long time horizon and a high-risk tolerance. Thus, he is comfortable investing in an early-stage company with high growth potential rather than the long-term but higher risk than a more mature company.
As a result, the criteria in his screening should include
- Young industries.
- High revenue growth.
- Lower market capitalization.
- Companies with unattractive ratios as young companies look for capital and spend more for business launching.
Narrow the Output of Analysis for Stock Picking
Screens might whittle down the list of companies for investors’ stock selection. Narrowing down the list requires further scrutiny of the particular companies, including one’s comfort level with the industry, or personal or social concerns.
The deep analysis will step in as the field is sufficiently narrowed. The analysis will help investors draw insights from available information such as Securities and Exchange Commission filings and company or investor websites.
5 Key Criteria of Choosing Stocks
Among many factors boosting novice investors’ confusion, they should learn which ones have crucial roles in-stock selection. The five criteria below are the keys to the whole process. In other words, they can guide investors through the confusing process and pick profitable ones for both short and long-term profits.
First and foremost, stock investors should consider the profitability of stocks, not only at the present but also in the future. Thus, considering a company’s financial fundamentals such as earnings, operating margins, and cash flows is crucial. Insights from such factors could paint a reasonable picture of a company’s current financial health and profitability in the short and long term.
It is the ratio of revenue obtained for each dollar of assets. For instance, a company has an asset utilization ratio of 40%. It indicates that the earning is 40 cents for each dollar of assets the company owns. Every industry might have different favorable asset utilization ratios. Yet, it is a common ratio to measure efficiency over time.
Capital structure indicates the funding of a company for its business operations, using both debt and equity. When a company characteristically musters capital to create sufficient short-term liquidity to cover operating costs, while also saving enough for finance expansion, it follows a conservative capital structure.
Investors will be thrilled to find a company with favorable earnings momentum. As it illuminates the speed of a company’s growth in the future. Investors seek the patterns through earnings reports over the previous eight quarters and analysts’ projections.
Evaluating the intrinsic value of a company involves the analysis of complex absolute and relative valuation models. It helps stock investors to determine whether a stock can grow in the future no matter how its performance is at the present. In other words, it is a way to cut through the market buzz to determine a stock’s real value.
The stock selection process is not that difficult or challenging, isn’t it? Hopefully, the information in this article enhances your knowledge about stock-picking techniques and the key parameters. It relates to insights into a company’s performance and potential growth in the future. Stock selection is among the top crucial first and foremost steps for stock investors. As a result, they can anticipate high profits amid the tumultuous market trends.