How To Choose Profitable Stocks? Are You Doing It Right?

Financial market players perceive stocks as a real path to financial independence. The vast majority of retail investors invest their funds in stocks, playing an important role in institutional portfolios as well. However, do all market newcomers know how to choose profitable stocks? Are you doing it right?

Where to Start

So, you’ve entered the stock market with a sum of money and, naturally, want to invest it profitably. Of course, you’re confident that buying stocks is the best decision for this. However, there are hundreds of issuers in the market, and not all of their securities will bring the expected profit. Where to start stock selection, and which companies should you pay attention to?

Let’s be clear, the process should not start with studying the business, financial indicators of issuers, and the size of dividends that various securities bring. First and foremost, you need to determine what you personally want.

In the terminology of market professionals, the first step is called determining the client profile. To understand what type of investor you are, you can turn to a broker, financial consultant, or investment company. But no one prevents you from taking all the necessary steps yourself.

To solve the problem, you need to honestly answer several questions:

1. What is your financial goal? You need to formulate it as precisely as possible. An answer like “I want to get $10,000,000” is not suitable. You should not only specify the amount you want to receive as a result of investing but also determine the time frame for receiving this money. It’s equally important to know why you need it. For example, if you want to live comfortably after retirement, the declared $10,000,000 might be too much (recent surveys show that in the USA, most working people consider having a capital of 1.4-1.5 million sufficient for retirement). However, if buying a luxury yacht is in your plans, this may not be enough.
2. How much do you plan to invest at once? Do you plan to regularly replenish your account from incoming income? What are the amounts of these investments? The answers to these questions are called financial planning. It is extremely important because it allows you to calculate what level of return will suit you. For example, for a return of 15-20%, it is sufficient to buy reliable stocks that pay dividends and steadily increase in price. For an annual financial result of 40-50%, you will need to pay attention to high-yield stocks.
3. What level of risk are you willing to accept? Risk assessment assumes that you will honestly answer the question of how much of your capital loss you will accept calmly. For example, if you can tolerate losing no more than 10-15% of your capital without regret, you can be called a conservative investor; 15-30% — moderate, from 30% to 100% — aggressive.

Attention! On any financial market, the acceptable level of risks and potential returns are directly dependent on each other. It’s not possible to earn a 100% return on investments with a 10% risk. However, with risks of 50% or more, achieving a more impressive financial result is feasible.

Another point that a novice should know is that buying 1-2 types of stocks can hardly be considered investing. An investor forms a whole portfolio of securities, where losses from some assets are offset by income from others. This approach is called diversification. Proper portfolio management allows for a high probability of achieving the desired return and reaching financial goals within the planned time frame.

So, your investment profile is determined. Depending on it, the stock portfolio should include:

• Conservative: highly reliable securities that consistently bring profit in any economic situation. The return on them is low, but the risks are minimal.
• Moderate: In addition to stocks with increased stability, the portfolio can include securities that can quickly increase in price under favorable circumstances. On average, such a portfolio will have a higher return than the previous one. However, the risk level also increases, but the main part of it can be compensated by reliable stocks.
• Aggressive: It includes profitable stocks that determine the main part of the profitability. In addition to them, it is necessary to use conservative securities to protect against excessive risks.

However, such general recommendations can only limit the list of stocks to choose from. The discussion about the selection of securities issued by specific companies will continue further.

Choosing Stocks Wisely: A Few Tips

Now it’s time to figure out which specific stocks you should include in your portfolio. Experienced investors use several effective strategies for this.

Choose Between Dividend or Speculative Income

All stocks can bring:

• Dividend income due to the distribution of part of the company’s profits among shareholders.
• Speculative income, which is determined by the difference between the purchase and sale price of securities.

When choosing between dividend stocks or securities of issuers that do not pay dividends (or pay irregularly), consider the investment horizon. For long-term investments, it is recommended to at least partially invest in stocks with dividend payments. They are received relatively regularly and can be reinvested (these amounts can be used to buy more securities). This will significantly increase returns through the power of compound interest.

Non-dividend stocks, which generate income solely through price growth, are better suited for short-term investments. The thing is, the cycle of rapid growth can quickly be followed by a decline in prices. To avoid missing out on profits, they will need to be sold in a timely manner. Working with such securities is more challenging because it requires constant monitoring of the market situation.

Attention! Dividend payment is the right of the issuing company, not its obligation. Therefore, at any time, a decision may be made to cancel dividend payments (at least for a certain period). To avoid ending up in such a situation, those who rely on a stable percentage income from stocks should focus on securities of “dividend aristocrats”. These are issuers that have not missed payments for a long time and have not even significantly reduced them.

Identify Common or Preferred Stocks

Some companies issue two types of stocks: common and preferred. The former provides voting rights in all decisions. Owners of the latter can expect priority dividend payments.

If investment strategies are based on receiving dividend income, it is better to choose preferred stocks. It is worth noting that in this case, the investor typically receives a more stable income.

For flexibility and profit through price appreciation, common stocks are more suitable. It’s important to know that their liquidity is higher than preferred stocks, so selling such securities quickly without profit loss is significantly easier.

Conduct Comprehensive Business Analysis

All public companies whose stocks are traded on the exchange must publish financial statements. Many investors choose securities based solely on this data. Don’t repeat their mistakes!

1. First of all, it is necessary to understand the overall economic situation. If there is a crisis in the country, stable growth from most stocks cannot be expected. You will have to choose only companies that demonstrate stability in such times, for example, from the essential goods sector.
2. Next, it’s worth understanding what is happening in the selected industry and sector. Many stocks are subject to seasonal fluctuations. Examples include companies in the agricultural sector. Similar properties may be exhibited by issuers from the oil industry, mining, and others. It is advisable to choose only those stocks that have growth potential in the near future.
3. Only after that should you proceed to analyze the financial statements. They will indicate how the issuer conducts its activities. Attention should be paid to such indicators as revenue, company profitability, net and operating income (EBITDA), etc.

When studying financial results, it is important not so much to be absolute indicators as to their changes. For example, it is necessary to pay attention to how the price of securities has changed over the past years. If this price does not show stability and is invariably followed by a decline, then betting on assets is not worth it. If, however, the price shows a gradual increase, it can be assumed that it will continue in the future.

Relative indicators or multiples are also important. For example, a good idea of the value of stocks is provided by comparing them with the company’s earnings. The price-to-earnings ratio (P/E) shows how many years it will take for the investment to pay off if the stock price and the company’s earnings remain at the same level. This is one of the basic indicators. A low value indicates that the issuer’s stocks are undervalued and should be bought.

Note! There are quite a few multiples, but all their calculations provide only theoretical forecasts. In such a model, it is assumed that stock prices depend only on earnings and does not take into account the influence of external economic factors, news background, and public opinion.

Fundamental analysis (that’s what the sequential steps described above are called) usually provides accurate results. However, it is not always necessary to buy undervalued stocks. Analyze the company’s business to understand if its stocks can grow. Do not refuse overvalued stocks either. For example, if Netflix continues to show results as it has in recent years, even with its high P/E, it is profitable to buy its stocks.

Read Economic News

News agenda also influences stock quotes. For example, during the coronavirus pandemic in 2020, healthcare sector stocks rose after publications about vaccine development or new drugs. However, today AstraZeneca is withdrawing licenses for the distribution for its vaccine, which has already led to a decline in the quotes of its securities.

Buy Promising Stocks

Stock market analysis includes not only fundamental but also technical analysis. The results of the latter should be used as often as the former. For example, a company’s stocks may remain undervalued for years. As a result, the funds invested in them will not bring a profit.

However, if an upward trend is visible in the price chart, it is worth considering purchasing such securities. There are many technical indicators developed for the stock market. You don’t need all of them — choose the ones whose operation you understand and whose readings you can easily interpret.

Overall, forming a profitable stock portfolio is a fairly complex task. It is not suitable for all beginners. We would advise starting your activity in the stock market by investing in more understandable instruments, such as ETFs. As long as they continue to generate profit, you will have time to learn and make informed choices about other assets, including stocks.