How to Know Which Stocks To Buy (and When)
So you got a hot stock tip from your brother-in-law. The story sounds compelling and you’d really like to make some money in the market. But how do you know if this is really a worthwhile investment? And if you’ve got multiple stock tips, how do you know which stocks to buy?
If you’re feeling lost when it comes to choosing the right stocks for your account, you’re not alone. My unscientific opinion (based on talking with hundreds of investors) is that more than 90% of stock buyers don’t really have a process for selecting which stocks to invest in.
They just pick the stories that sound best, and hope things turn out alright.
But that’s not you. (Or at least it won’t be after today). Instead, you’ve got a process for researching your investments, and picking out which stocks match your objectives.
So let’s get started on researching which stocks to buy
Editor’s Note: This is part III in our multi-part series on fundamental investment principles. See also:
- Part I – What is a Fair Price to Pay For My Stock?
- Part II – Are you a Growth Investor or a Value Investor?
Stay tuned for our next installments. You can also email me (Zach@ZachScheidt.com) to let me know what fundamental questions you have about investing.
Two Perspectives For Researching Investments
When you’re researching an individual stock to invest in, there are countless pieces of information that you could review.
But the majority of investment research falls into one of two categories: Top-down research, and bottom-up research
Top-down Research Focuses on “Big Picture” Macro Trends
A top-down researcher starts by looking at a 40,000 feet high view of the economy. This investor might look at economic growth in an individual country. Then he would determine what area of the economy is driving that strength. (Is it healthcare? manufacturing? retail or technology?)
As the top-down researcher narrows his focus, he will eventually settle on an attractive sector, and then a specific industry. Eventually, the top-down investor will identify a handful of stocks (or even just one company) that will benefit from this trend.
Resources for top-down researchers typically include government economic reports, along with key industry data.
For instance, a top-down researcher would pay close attention to economic reports like unemployment statistics, monthly auto sales, consumer confidence reports, interest rates, and currency fluctuations.
You could think of a top-down investor as someone who starts with a funnel of many stocks to choose from. This funnel slowly narrows those stocks down to a few key opportunities that make it all the way through the research process.
Bottom-Up Research Focuses on Individual Company Data
If top-down research is akin to seeing the world from 40,000 feet, bottom-up research is more of a “boots on the ground” perspective.
Bottom up researchers are skilled at looking deep into a company’s operations too determine if the stock is a good investment or not. Typically, a bottom-up researcher will have a few specific areas of expertise such as automotive firms, consumer technology stocks, or medical device companies. This way, a researcher can focus on developing a deep knowledge of a few key stocks.
Resources for bottom-up researchers typically include a company’s balance sheet, income statement, along with company-specific reports and presentations. Often, bottom-up investors will do fact checking with a companies customers and vendors to make sure that the company records are accurate.
When I think of bottom-up researchers, I compare them to detectives who are always looking for clues. The best bottom-up researchers often know more about the companies they are investing in than the company executives themselves!
Taking Advantage of Both Research Perspectives
There is no rule that says you have to decide between top-down and bottom-up research. Both of these perspectives can be incredibly helpful in researching stocks you are interested in.
In fact, I typically spend some time on both top-down research and bottom-up research for every recommendation I make or stock that I invest in.
There are many great resources you can tap into for both top-down and bottom-up research. Here are a few that I pay special attention to.
- The Wall Street Journal / Barron’s
- Grant’s Interest Rate Observer
- Bespoke Investment Group
- Seeking Alpha
- Brokerage Reports (Morgan Stanley, Goldman Sachs etc.)
- The SEC’s EDGAR site (Electronic Data Gathering and Retrieval)
- Bloomberg Terminal
There are countless other resources you can use to gather information on your investments. These are just some of the tools that I use on a daily basis.
Creating a Checklist For New Investment Positions
If you learn to pilot a plane, one of the first things that you’ll be introduced to is a pre-flight checklist. This is perhaps the most important item for any flight, because it helps the pilot review all the important issues before ever leaving the ground.
Investors can also benefit from a pre-flight checklist. This list will likely be different for each investor (depending on what items are most important to each individual). But a basic checklist would likely include the following items:
Macro Economy: Are we in a period of expansion or contraction? Or is this a stagnant economy?
Sector Trends: Is this an area that is experiencing growth? Is that growth likely to continue?
Industry Information: What important issues are affecting this industry? Demographic trends? New technologies?
Specific Company Issues: What are the strengths, weaknesses, opportunities and threats (SWOT) in play?
Stock Valuation: How much am I paying compared to earnings? Is this the best metric to use, or should I look at book value (or another metric)?
Growth Prospects: Will the company grow profits over the next few years? Does the company’s growth prospects justify the price?
Income Analysis: Does this stock pay a dividend? How much of a company’s earnings are paid to investors? How is this likely to change in the future?
Once you’ve developed a checklist for evaluating a stock, you’ll be ahead of 90% of investors. You’ll then be able to take your brother-in-law’s stock tip and carefully evaluate it to determine whether this is a stock you want to invest in or not.
Having a system not only helps you pick out the best stocks to invest in, it also helps you know what stocks you should keep in your portfolio.
In the next installment, we’ll discuss how to know when to sell your investments. After all, that’s every bit as important as knowing which stocks to buy.
As always, let me know what you think about this, and what additional questions you have. You can email me any time at Zach@ZachScheidt.com. I look forward to hearing from you!