5 steps to start researching and buying stocks like the Wall Street pros
- Your budget, investment style, and risk tolerance should guide your
- Understanding a company's fundamentals is key to finding quality
- Certain documents, such as a company's annual report, reveal key financial information and risks.
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For individual investors, choosing the right stocks can feel like a daunting task. But if you want to manage your own portfolio, you can apply the same kind of techniques that the pros on Wall Street use in their research and analysis.
Not sure how to begin? Use these 5 steps to help guide your approach.
Step 1: Understand the types of stock analysis
The first step to researching stocks is to understand the different types of stock analysis. When researching stocks, the three main types of analyses are:
- Fundamental analysis: Examines fundamentals such as earnings, cash flow, and financial position to forecast performance.
- Technical analysis: Uses past prices and trading patterns to forecast future price changes.
- Quantitative analysis: Uses mathematical and statistical modeling to assess the value of a stock.
Each approach has its merits. However, in most cases, fundamental analysis should be your primary tool to assess the value of a given stock, according to Robert Johnson, chairman and CEO at index provider Economic Index Associates. "Investors should concern themselves primarily with a company or asset's fundamentals (earnings, cash flow, financial position, products, and the like)," he says.
The reason for this is that fundamental analysis breaks down the real-world performance of a company. Technical analysis, on the other hand, may reveal anomalies in an asset's price. But those can occur for many reasons, such as negative news coverage.
"Technical analysis is an assessment of statistics generated by market activity, such as past prices and volume," says Melanie Mortimer, president at SIFMA Foundation, which provides financial literacy programs. "Technical analysts use charts and other tools to project a security's potential future activity, taking cues from patterns in the data."
Quantitative analysis may use some of the same metrics as technical analysis but can incorporate statistical modeling in an attempt to determine whether a stock is a good investment opportunity. "Quantitative funds tend to rely more heavily on valuation metrics and market technicals such as price momentum," says Carl Ludwigson, director of manager research at Bel Air Investment Advisors.
Quick tip: Start your analysis by checking a company's fundamentals, such as earnings, profit margin, and revenue growth. You can then use technical and quantitative analysis to supplement your fundamental analysis to gain deeper insight.
Step 2: Establish your risk tolerance and budget
It's important to establish both your risk tolerance and budget before you research stocks. After all, there are many types of stocks and theoretically no limit to how much you can invest.
For instance, blue-chip stocks such as those included in the Dow Jones Industrial Average may provide a consistent return but not have quite the potential for gains as a startup company. However, there is naturally a greater chance of a startup performing poorly, or even going out of business. Therefore, you must determine the balance between how much risk you are willing to take and what kind of return you expect.
"With a longer time to retire and fewer financial obligations, an individual has the ability to absorb some volatility in their investment portfolio, knowing that time can help balance any short-term losses with longer-term gains, or the ups and downs of economic cycles," says Mortimer.
Willingness to bear risk, on the other hand, is more subjective. "One way to gauge a person's willingness to bear risk is to simply ask the question: If your portfolio suddenly declined in value by X percent, would you lose sleep over it and suffer substantial regret?" Johnson says. "If the answer switches from yes to no when X is 10 percent, then the person has very little willingness to bear risk, and quite frankly, has limited investment options."
Your budget also plays a role. There is a large difference between a 10% return on a $1,000 investment and a 10% return on a $100,000 investment. In other words, if your budget is relatively small, you may have to take bigger risks to see the return you want. That is not unusual, though, as those who are early in their careers tend to have less to invest — but also more time to take risks. Understanding where you are on this spectrum is key to forming your investment strategy.
Step 3: Know which investing metrics to pay attention to
There's no shortage of investing metrics available, especially for larger, well-established companies. Some are more critical than others. Key metrics to consider include:
- Price/earnings ratio
- Price/book ratio
- Net profit margin
- Free cash flow
- Return on equity
- Return on assets
Which metrics are most important depends in large part on the style of investing you prefer. For instance, two common forms of investing are value and growth investing. Value investing involves buying stock in companies that are undervalued, therefore selling at a discounted rate. Growth investing, on the other hand, means buying stocks of companies that are expected to grow at a rate faster than the market.
"Value-oriented managers tend to focus on price-to-book, price-to-cash flow, and other measures that indicate a depressed price compared to the normalized earnings or intrinsic value of a business which creates a margin of safety," says Ludwigson. In other words, for value investors, the key metrics are those that indicate the price is lower than competitors' stocks, such as on a price-to-earnings or price-to-book basis. The lower these ratios are, the better.
One thing to watch out for with value investing is the tendency toward mean reversion, according to Johnson. "Historically, asset prices and historical returns gradually move toward the long-term mean. So, if a particular stock is selling at a low P/E or price-to-sales multiple, all else equal, the P/E or price-to-sales ratio will likely revert to the mean at some point," he says.
Growth investors take an entirely different approach, says Ludwigson. "Growth managers tend to focus on revenue and earnings growth with less focus on metrics like price-to-earnings as they expect the earnings to expand over time to justify the price," he says. Oftentimes, growth stocks are companies that have not fully matured, so revenue and earnings growth is more important than price.
Quick tip: Certain metrics are more important than others to pay attention to, depending on the style of investing. For instance, price-based metrics lend themselves to value investing, while growth investors focus more on growth of earnings and revenue.
Step 4: Find the data you need to start your research
Now that you have an idea of which companies you want to analyze, it's time to dive deeper. Here are some of the documents, reports, and tools you may want to check:
- SEC reports
- The company's revenue and income
- Online brokerage research platforms
- Company press releases
- Stock screeners
- Industry trends
When first starting your research, you can check each company on an online brokerage's research platform as well as in stock screeners. These are a good way to check some of those metrics, like profit margin and price-to-earnings. Then, you can take a deeper dive into reports on the companies that look good.
There is no shortage of reports to detail the companies you are considering for investment. However, there are certain places you should direct your focus first, says Kevin L. Matthews II, founder of investment education company BuildingBread. "Any company that you're looking into usually has an investor relations section on the website. If you go there you can find any important press releases, financial documents, and documents filed with the SEC like the 10-K and 10-Q," he says.
Matthews notes that the 10-K (the annual report) is his favorite document to help with company research as it outlines performance as well as potential risks and other strategic and financial details.
In addition to reports found on a company's investor relations page, there are some databases you should know about, says Johnson. "The SEC's role of running the EDGAR database is of utmost importance to investors. The key types of documents on EDGAR include Annual reports (10-Ks), Quarterly Reports (10-Qs), Proxy Statements (DEF 14As), Prospectuses (S-1s), and Interim Reports of Material Events (8-Ks)," he says.
Step 5: Narrow your focus and pick stocks that fit your portfolio
As you have probably already discovered, there aren't any magic bullets that fit perfectly into your portfolio. Instead, you should look for the investments that best align with your investing goals. For example, do you prefer value or growth investing? What is your budget and what is your risk tolerance?
Once you answer these questions, you can start to formulate your investing strategy. Certain metrics, such as price-to-earnings, lend themselves more to value investing, while metrics like profit margin are more important for growth investing. You can then hone in on a company's fundamentals using an online broker and company reports to identify the right stocks for you.
Depending on how risky a given stock is, you can weigh it against your risk tolerance and budget to determine whether to invest — and if so, how much. Then, you can continue to evaluate using future quarterly and annual reports to ensure the company still fits within your strategy.
The financial takeaway
Researching stocks can seem overwhelming, but it doesn't have to be. First, determine your preferred investment style, budget, and risk tolerance. Then, you can use an online broker as well as internal and external company filings to find out more about each stock you are considering.
Once you have done that, you're ready to start investing. Be sure to continue to evaluate each of your investments, either quarterly or annually. You may want to make changes if a company no longer aligns with your strategy — just be aware of potential capital gains taxes if you decide to sell.
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