The 10 key steps to stock picking

Laura Miller

 · July 20, 2020  · 07/20/2020

Stock-picking is simply choosing companies to invest in. The hard bit is knowing which ones. The fun bit, we think, is working that out. This is your crash course in navigating stock markets.


Firstly, why invest in company shares?

Warren Buffett, generally seen as one of the planet’s most successful investors, (worth close to $90bn), explains investing like this: “If you don't find a way to make money while you sleep, you will work until you die.” Here’s why.

  • Beat inflation

You’re probably getting 1% or less a year in interest on savings in a bank. Prices from food to fuel are rising at 2.5% a year, average inflation for the last decade. So your money is really worth less now than 10 years ago. Investing is a way to beat inflation, by making money work and grow.

  • Magic growth

You invest some money, it earns interest, you have more money, which stays invested. Now you make more interest, because it’s earned a bigger pot. And this repeats. That’s the power of compounding. The longer you do that, the more your pot grows.

The risks

Investing comes with warnings. Before we get to stock picking, read this part really well.

  • Volatility

Your shares may fall in value at some point. Share prices are affected by global events and business threats as well as other factors. Volatility – fluctuations in share prices – is normal, usually temporary, but scary. Buying individual shares is typically riskier than buying a fund that tracks a large group of companies, so expect big swings in the value of your investment.

  • Capital loss

Sometimes your shares will fall in value and not bounce back, or not quickly enough, and you’ll sell them for less than you paid. Investing means there is a real risk you may lose money. How would you feel if you lost 10% of your original investment? Or 50%. Or 100%. Only invest what you can afford to comfortably lose.

  • Beware the hype

Excited by a new technology or cryptocurrency? Be careful. Just because some companies in an industry are doing well does not mean they all will. Over-hyped companies collapse, taking a lot of investor money with them.

  • Exchange rate risk

Backing companies based outside the UK, like the US? Currency changes mean you could lose money even if their share price rises. If you buy shares with British pounds in a company that trades in US dollars, for example, and the dollar falls in value, you could find your shares are worth less than you thought. (Of course, if the dollar rises you’ll be better off!)

The 10 Key Steps to Stock Picking:

Now you know the main risks and rewards, here’s how to learn some stock picking strategies.

1. Standing out from the crowd

Don’t just pick a random stock, first choose a sector or industry. Read about it. Will it benefit from some future revolution like renewable energy or artificial intelligence? Does it have growth potential? Then find companies in it doing something innovative, or better than rivals. Firms with a unique selling point are often good investments.

2. ‘Cheap’ stocks

Back companies that will be worth more in future. One way is to use the price-to-earnings ratio (P/E) to find shares that may be being sold for less than they are really worth (‘undervalued’). Calculate P/E by dividing a company’s share price by its net income (easy to find in accounts). Or just Google the company name and ‘P/E’. This feature is actually coming soon in the Revolut Trading app, so watch this space.

As a general rule of thumb, a P/E below 15 is cheap and above 20 is expensive in our view. Cheap is not always best – companies expected to grow fast will be more expensive but could make you more money. Compare P/Es for firms selling or making the same thing.

3. Dividends

Dividends are a percentage of the company’s profits you get as a reward for investing in it. Companies that pay regular dividends, over decades, are usually (but not always) in good financial health.

But beware. High dividends could mean the company isn’t investing in itself, so won’t grow in future. Look for companies that pay out little but often, and increasing.

4. Earnings growth

Did the company you plan to invest in earn more last year than the year before? What about over the last five years? If it shows steady growth in the amount of money it makes each year, that’s a positive sign it’s a healthy investment choice.

5. How much debt?

You would think twice about lending money to a friend already in a lot of debt – do the same with potential investments. Companies often have some debt. To judge if it’s worrying, work out its debt-to-equity ratio.

To do this, divide the company’s total debt by the total shareholder equity (company assets minus its liabilities). Lower numbers generally mean less risky –  we take the view that you don’t really want higher than 2. Except this depends on the industry. Big established firms can be at 5. Banks, because of how they work, can be at 10. Compare a company with its peers. If it is widely different, find out why.

6. Navigating choppy waters

Do shares in your company only fall when others do, and bounce back just as quickly? That’s a good indicator it knows what it’s doing. If it’s share price is erratic when rivals are stable, that’s a warning sign.

7. Who’s in charge?

Look at the company’s share price during the CEO’s time at the helm – it should be higher than when they started. Alternatively changes at the top, especially after problems, can sometimes be a good time to buy a company cheaply while other investors fear uncertainty about its future.

8. Don’t put all your eggs in one basket!

Investing is all about making calculated risks. Don’t bet 100% on any one company or industry or asset class. Smart investors often invest widely, spreading their cash across multiple investments (around 15 - 30 is the norm.) and asset types.

Investing in a few unrelated (‘uncorrelated’) sectors, companies, and geographical regions, also creates a better chance that if you lose money while one has a bad patch, you’ll make money elsewhere (but this of course, is not always guaranteed).

9. Buy and hold

Choose carefully the companies you want to invest in and try to keep them for a couple of years. You’ll generally have a better chance of making a profit, plus trading more tends to cost more, so that will eat into your returns. Unless that is, you’re with Revolut Metal – because then you can enjoy unlimited commission-free trades each month.

10. Invest ethically

The final reason you may pick a stock is because you want to choose companies with an ethical conscience. This is known as Environmental, Social and Governance investing (ESG). With even Larry Fink, CEO of Blackrock – (the world’s biggest asset manager) – now saying he is going to pivot investors’ money towards companies fighting climate change, making a similar move could be smart.

However, don’t let your heart completely rule your head when investing. You should still apply the same rigorous research techniques from above as to all your stock picking. Not all ethical investments are made equal.

Remember!

1. Do your research
2. Be smart, avoid the hype
3. Diversify your investments
4. Don’t invest more than you can afford to lose
5. Keep enough cash to cover basic needs and emergencies


Note: You can follow the author Laura Miller on Twitter.
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