Q: I am now ready to invest in the stock market. I have already opened an account with a brokerage firm but I don’t know which stocks to buy? How do I choose the right stocks? Are there guidelines to follow? — A.K. Apostol, by e-mail
Every investor has a different investment objective. Some people like to invest in blue chip stocks for stability. Some like to buy riskier stocks for higher returns. Some just want to have fun trading in and out of the market for quick profits while others prefer to buy and hold forever.
Regardless of how you want to invest in stocks, the common investment goal is to make money. You make money when you cash in on your stock that has appreciated in value over a certain period. The key to successful stock-picking is finding stocks that can potentially increase its market value in the future.
With over 270 stocks currently listed at the Philippine Stock Exchange, selecting the right stock can be challenging. Having clear criteria to follow can help you lower your risks of choosing the wrong stock. Here are the five ways to select the best stocks to invest:
1. Choose stocks that are easy-to-understand
The first step in buying stocks, as a beginner, is to select those that are already familiar to you. Because a stock price appreciates based on earnings growth prospects of a company, it is important that you understand how the company that you intend to invest in operates and makes money.
For example, you may already be familiar with how Jollibee, SM or Meralco derives its revenues but you are not sure how Alsons Consolidated or Cosco Capital operates. While companies with an unfamiliar brand or those with complicated operations may not necessarily be a risky investment, always start with brands that you already know. When you have gained the confidence of investing, you can always expand your options by learning other companies.
2. Choose stocks with solid financial health
Once you have selected the stocks that you wish to invest, you must know how their financials are doing. You can go to their company websites and download their financial reports under the investor relations section.
When you review the financial reports, do not just focus on the recent reports like quarterly earnings report but also review their annual financial statements at least for the last three years to see if the company has been growing and earning consistently.
You will find earnings data of the company in the income statement report. Along with earnings, you can also check revenue growth as well as margins, which can be found in the same financial statement.
The other report you need to check is the amount of borrowing the company has, which you can find in the Balance Sheet report. You want to know if the company is borrowing too much at the expense of risking its profitability.
Since the potential appreciation of a stock’s value depends on its earnings outlook, it is important that you learn how to read basic financial statements.
3. Choose stocks with strong cash flows
While the growth in earnings is what you are after when evaluating a stock, sometimes reported earnings of a company can be manipulated by use of creative accounting.
In order to make sure that you pick the stock with high quality of earnings, you must validate its earnings with corresponding positive operating cash flows, which you can find in the Cash Flow Statement of the company.
The lifeblood of every business is the cash flow. It is easier to tell if a company is performing well or not by looking at its cash flow performance.
4. Choose stocks with sustainable competitive advantage
There is no guarantee that companies that perform financially well today will continue to do so in the future. There will always be new competitors that will enter the game and attempt to seize a share in the market.
Choose companies that can sustain above-average profits for the longest possible time due to its strong barriers to competition. These can come in the form of having a strong brand, huge economies of scale or being a market leader. Examples are Ayala Land, Jollibee, SM Prime and BDO.
5. Choose stocks that are undervalued by the market
Just because a stock is trading at Php1.00 per share, it doesn’t mean that it is cheap. In the same way, a stock that is trading at Php1,000 per share doesn’t mean that it is expensive. When you buy stocks, make sure that you are buying for its value and not for its price.
There are many ways to value a stock that are used by professional financial analysts, but one easy way to know whether a stock may be expensive or not is by the use of relative valuation. Because stocks differ in share prices and earnings, one way to bring these stocks in proper perspective is by the use of Price-to-Earnings (P/E) ratio.
Price-to-Earnings (P/E) ratio is computed by dividing the share price of the stock with the earnings per share. For example, the stock of Metrobank may be cheaper than Bank of Philippine Islands (BPI) because Metrobank has lower P/E ratio of 15x as compared to BPI’s P/E ratio of 18x.
While the use of P/E ratios may seem simple and pretty straightforward, bear in mind that this is just a convenient way of pre-screening stocks. You may need to research more to validate your investment assumptions because some stocks with very low P/E ratio may not necessarily be really cheap. For example, the company may have an earnings problem or some stocks deserve to trade at a premium with high P/E ratios.
Henry Ong, RFP, is president of Business Sense Financial Advisors. Email Henry for business advice email@example.com or follow him on Twitter @henryong888