So you decided to step away from low-cost ETFs and want to jump into investing in individual stocks? This might seem like a black hole where your money goes in and nothing comes out, but with the proper research and knowledge, you can go from this mindset to one where you can make confident decisions for long-term investing.
If you are just starting, here are some tips to point you in the right direction.
1. Know the Difference Between Investing and Trading
There is nothing wrong with either path, but know what you are getting yourself into. Investors buy and hold companies (stocks) where traders look to profit from the price movement of a security over a particular period of time. If you consider yourself an investor and end up buying and selling the same stock within a week or even a month, you will likely lose A LOT of money very quickly.
Being an investor, you have to be disciplined and make very calculated choices that you can afford to hold for years. You are picking your own stocks now. It’s not about how many stocks you pick, it’s about making the right choices about each stock you own. This brings us to the second tip.
2. Invest in Stocks as if You Were Purchasing a Small Company
Purchasing a stock is purchasing a stake in a company. It may not seem like it, but you are a part-owner of that company when you purchase the stock. If that company does well, it will eventually translate to your stake in that company increasing in value.
I like to look at stocks as if I were purchasing a small company. If you were to purchase a local shop in your town what questions would you ask? You might start with some of these:
- How much is the listing price vs. what the owner earned over the past year? (P/E Ratio)
- Are there any large debts that would be difficult to pay off? (Current Assets vs. Current Liabilities)
- Are they selling the right things? (Is there a growing market demand for their product/service?)
- How did the shop perform compared to others in the area? (Performance vs. Peers)
This list could be longer than Santa’s. The point is that instead of buying a ticker symbol, think of stocks as an ownership stake in a company (which they are). Do your homework and ask the right questions that may seem like common sense. You may find many companies that you initially investigate and want to invest in do not pass the criteria you would hold for purchasing a small business outright. In these instances, you want to trust your gut and pass even if everyone is yelling BUY BUY on Twitter and Reddit.
3. Don’t Overpay
Finding true bargains in the stock market takes a little bit of digging and number crunching. The general advice here of not overpaying should only take a few minutes. For the company you are looking at, go to a site like Yahoo! Finance and pull up the last year’s financial information and look at some of the following:
- P/E Ratio (Price of the stock over past year’s earnings) – Imagine buying a pizza shop for $200,000 and the total earnings you would take home as an owner ended up being $4,000 (P/E Ratio of 50)? It would take a long time to just break even. This is what the P/E ratio displays. The higher this is, the larger the growth prospects should be. In general, if you see this P/E ratio higher than 30 the stock is likely overvalued unless there is significant growth planned for the future.
- PEG Ratio (PE Ratio over Company’s expected Growth Rate) – On the topic of growth, this ratio factor’s in a company’s expected growth into the P/E ratio. If the PEG ratio is over 3 the stock is considered expensive. A PEG ratio of less than one is considered a good deal.
- P/B Ratio (Price over Book Value) – Think of a company’s “book” value as what the company would be worth if it didn’t have an income. Or if you had to dissolve the company and sell all its assets and pay off all its debt. If the company you are looking at has an extremely high P/B ratio (10 or more) it’s best to steer clear. Value investors tend to look for P/B ratios under 3, and a bargain is usually a P/B ratio of less than 1.
- Company Market Cap vs. Target Market Size – 2021 has brought along some crazy valuations. Look at what the market cap is for the company you are investigating and the total market opportunity the company is going after. You may see that the current value exceeds the total potential. Do not even bother investigating further if this is the case.
You may find many well-known companies that end up being overvalued. It should not be surprising as these companies are in high demand. If you are set on investing in that company, be patient as there may be a market sell-off or dip that brings along a good buying opportunity.
4. History Tends to Repeat Itself
A generalized statement, but if the company has performed well in the past and has consistently increased its earnings/dividends it is most likely to continue this behavior moving forward. On the flip side, if the company has performed poorly consistently it is most likely to do the same moving forward.
It is easy to let one “good” quarterly statement fool many people but look into this more before putting your money at risk. Investigate if there were any fundamental changes in the company. This could include a new management team, decreased debt load, or an innovation. Unless you are convinced there is a bigger change at hand look elsewhere.
Remember you are putting your hard-earned money at risk, let the company prove to you why you should be an investor instead of taking a “leap of faith”.
5. Develop Your Own Strategy and Build Your Portfolio Around It
There are hundreds of ways to approach the market, the trick is finding what is best for you. Before you begin buying your own stocks you need to figure this out. This will develop the type of companies you want to own, how many, and for how long you would like to own them.
A good example may be that you want to invest in companies that can provide you additional income. If this were your strategy you may want to focus on value stocks that have a history of increasing dividends.
A great company that fits into this investing strategy may not fit well if you would prefer to grow your principle rapidly. There are different strategies for every style, you must see which one fits you best and stick with it.
Even the experts frequently underperform the market with their choices on individual stocks. Keep that in mind when you decide to start buying stocks. The advice in this article is not the “stock picking commandments”, rather a few tips to point you in the right direction. Have any other tips? Feel free to leave them in the comment section!
