As investors, it's important to know how to go about finding the best stocks to buy. Before it's possible to successfully choose these stocks; however, it's essential to understand some of the fundamentals of evaluating securities.
The answer to the above question is straightforward: We're trying to figure out which stock to buy, before the rest of society wants to buy that same stock. It's called the stock market for good reason. It's a very efficient market, one that follows the law of supply and demand. As investors, we want to buy a stock just before demand increases; this means buying into a company that is "undervalued."
Now that we know what kind of stock we want to buy (undervalued ones), we must be able to identify the specific companies in which we'd like to invest our hard-earned money. There are roughly 3,000 companies listed on the New York Stock Exchange alone, so unless we have a lot of time, the list needs to be narrowed quickly.
The entire approach outlined below is based on a series of articles we've written addressing the topic of stock research. In this article, we're going to discuss the mindset investors should have when they're trying to decide if buying a particular stock is a good deal.
Many people like to play the market on gut, but serious investors aren't comfortable buying shares of a company that is in a business they don't understand. They'd rather spend their time focusing on sectors they know, instead of learning about topics such as nuclear physics.
For the average investor, this means focusing on business sectors they interact with daily: car manufacturing, toothpaste, or lawnmowers.
The best stocks to buy will be those that demonstrate good fundamentals.
Now some readers might be thinking: this magazine is old school; they aren't even going to mention technical analysis. That's correct. Technical analysis is the study of trading patterns and historical prices of a stock. Individuals lucky enough to be a day trader in a bull market might be forever sold on technical analysis. The techniques described in this publication rely more on in-depth stock research.
Fundamental analysis means looking at, and comparing, price / earnings ratios, book value, cash flow, and return on assets. Individuals not familiar with these terms should take the time to read our article: Understanding Financial Ratios.
Basically, investors are looking for stocks with real intrinsic value. That's discussed at length in the third article in our stock research series.
There are many stocks to choose from, so it's a good idea to stay away from stocks that are in the news because of large and looming lawsuits. Legal problems can drag on for years and lower a company's stock price, so it's better to steer clear of companies that have these problems.
Although past performance might be a good indication of future returns, the reverse can also be true. When evaluating a stock that demonstrates good fundamentals make sure to look at the predictions of the analysts tracking the company or industry. At the very least, make sure they are predicting stable or growth in earnings per share.
If there is one lesson everyone has learned from the dot-com bust of the 1990s, it's that companies need to be profitable to remain in business. Don't be confused when people start talking about revenues. A company can have a huge revenue stream, but earnings are the measure of a company's profitability. Serious investors in the stock market will have a deep understanding of fundamental research topics such as earnings per share estimates.
This is probably one of the most difficult things to do. We want to pick a stock that is not popular today, yet could be popular tomorrow. The forces of supply and demand are at work in the market. If a stock is popular, then demand has already pushed the price higher. Ideally, we want to find a "sleeper" company. This is one that is currently being ignored by the market, but has the future potential to rise in price.
Following these guidelines will allow new investors to stay one step ahead of the crowd. If we find a fundamentally strong stock in a sector that we understand, then we can rest comfortably knowing we picked a stock with the potential to provide for rewarding returns.
About the Author - Finding the Best Stocks to Buy