For many investors, picking stocks seems like gambling in a casino. No matter what they do, they tend to choose wrong. Yet, you can avoid this bewilderment and improve results by using a sensible stock-selection method.
What method is best for you depends on who you are. Warren Buffett advises investing only in companies that you understand. But if you're like me, your familiarity with individual companies is too narrow to have enough stocks to choose from.
What if there were a way to pick stocks without knowing much about the companies? There is. Instead of requiring you to pore over reams of performance data, a fairly simple method focuses on three basic concepts:
Earnings growth. Earnings are company profits, and earnings per share (EPS) are the portion of these profits allocated to each share of stock outstanding. Rising EPS usually means a rising share price. Trailing earnings usually refers to the EPS figure reported for the last four quarters. Just as significant are forward earnings — analysts' estimates of future EPS.
Good earnings and forward earnings can support a broader decision to buy a stock — instead of, say, a certificate of deposit (CD), which carries far lower risk than stocks but far less upside.
Price/earnings ratio. The top number of the P/E ratio is the current price of a stock and the bottom is its current earnings-per-share figure. So if you pay $20 for a share of stock and each share earns $2, the stock has a P/E ratio of 10. The goal is to get the lowest possible P/E because this means you're paying a low price for relatively high earnings.
The historical average for P/Es is in the neighborhood of 15 or 16. For some stocks, it has run as low as 4.8 and as high as 44. Though a low or moderate P/E is generally desirable, too low a number might be a sign that a stock's price is being depressed by negative factors. Again, you need to see enough upside to compensate for the risk of buying a stock instead of a lower-risk investment like a CD.
Dividends. This is a check in the mail from the company whose stock you own. Consistent quarterly payments to shareholders out of company profits are a classic sign of a company's long-term financial health. And after all, eventually getting money back on your investment is the reason you buy stocks in the first place.
Dividends typically come from mature companies that don't need to put profits back into the business. Though younger, faster-growing companies tend to have better share-price growth than older, mature companies, they often don't pay dividends because they need all of their profits to fund growth opportunities. (If you can find a company with good share-price growth as well as dividends, buy the shares.)
Although looking for consistent dividends is a tried-and-true investing strategy, you shouldn't limit your portfolio to these companies. If you do, you'll probably miss out on some great stocks. Yet, according to a recent study of the S&P 500, 44 percent of the index's total return over the past 80 years has come from dividends. So, disregard dividends at your peril.
Investors who focus on these three criteria together, tend to do a better job of picking stocks. Though this method carries no guarantee, it's as good a way as any to judge the financial health of companies and make judgments about expected returns over the long haul. Analysts put out estimates of expected returns, but ultimately, you must come up with your own figures. Focusing on these three economic concepts can help you do this.
For this method to work, you must apply it consistently, using discipline and avoiding the pitfall of letting fear or greed cloud decisions. Individual investors who stick to a well-reasoned, well-defined process — running their portfolios like a business — tend to do much better.
Many investors end up buying stocks in un-businesslike ways. For example, if you hear about a great stock at a party, odds are that you're late for the party of share-price growth. You may find that such stocks have good earnings but, because the prices have been pushed up by their current popularity, they have astronomical P/E ratios. So their earnings are probably too expensive to justify a buy. Commonly, people buy these "hot," priced-up stocks, only to sell them later when the air comes out; they buy high and sell low. One of the toughest things for most individual investors to understand is that you can't accurately predict future performance based on the present or recent past. A company's future performance is more likely to resemble its long-term past average. Investors who focus on the recent high performance can easily overpay.
Stock returns tend to be associated with dozens of financial, competitive and market factors. Instead of worrying about all these complexities, you can assess a company's potential returns by assessing its financial genetic code. This code is reflected by its earnings growth, P/E ratio and dividend record.
Ted Schwartz, a Certified Financial Planner®, is president and chief investment officer of Capstone Investment Financial Group (http://capstoneinvest.net). He advises individual investors and endowments, and serves as the advisor to CIFG Funds. Because Schwartz has a background in psychology and counseling, he brings insights into personal motivation when advising clients on achieving their wealth management goals. Schwartz holds a B.A. from Duke University and an M.A. from Oregon State University. He can be reached at firstname.lastname@example.org.