The stock picker’s guide to the market
There are thousands of options when it comes to investing in stocks. But knowing where to start can be daunting. We’ve put together a guide that should be able to help.
This is by no means an exhaustive list of everything investors should consider before buying stocks. But it should help create a shortlist for further consideration.
This article is not personal advice, if you are unsure whether an investment is right for you, seek advice. All investments and any income from them may fall or rise in value so that you could suffer a loss.
Investing in individual companies is not good for everyone – it is a higher risk because your investment depends on the fate of that company. If a company goes bankrupt, you risk losing your entire investment. You should make sure you understand the companies you are investing in, their specific risks and ensure that any stocks you own are held as part of a diversified portfolio.
The global economy goes through periods of growth and stagnation. An important but often overlooked part of the stock picking process is taking the time to think about the big picture. Getting an idea of the general direction of travel can help highlight promising industries.
When the economy is in recovery, cyclical industries tend to do well. These are sectors whose fortunes are linked to the health of the economy – they benefit from increased spending. Construction is a good example. When the economy is booming, governments have more money to spend on infrastructure. Companies are building new factories. But if times are tough, these projects are often put on hold.
In contrast, defensive industries outperform when the economy is weak. They understand the goods and services that people buy no matter what. Healthcare is a good example of a defensive sector. Come rain or shine, medical expenses will always be at the top of the priority list.
Below are some examples to get you started.
|Cyclical sectors||Defensive Sectors|
|Travel & Leisure||Health care|
Diversification is essential for long-term investors. This means that a strong portfolio will have a mix of cyclical and defensive industries. It’s very difficult to anticipate changes over time in the economy, so it’s a good idea to own plenty of investments across different investment styles, geographies, and industries.
The trends that matter
Apart from the general economic direction, it is also important to determine if there are any trends to watch. Remember, it’s best to take a long-term view, so these things should develop over the next five to ten years.
Inflation, for example, is something everyone talks about. The rapid inflation we’ve seen so far is probably short-term. Most expect it to slow down over time. But it might not fall below the bank’s 2% target for some time.
UK consumer price inflation
Source: ONS, February 2022.
Inflation makes everything more expensive, no business is completely immune. But there are some who benefit more than others.
Miners, for example, have appreciated price increases because it makes their products more valuable. The cost of everything from iron ore to diamonds is rising faster than the cost to extract it from the ground, bringing a windfall of cash for those in the industry.
Other industries that have tended to perform well when inflation is high are energy, consumer staples and financial services.
Inflation may be in the headlines, but it’s not the only trend to watch. Regulatory changes, consumer preferences and the impact of the aging of the population deserve consideration.
Our equity research team explores trends like these and the companies that could benefit from them, offering updates and information on a wide variety of the most popular stocks. More recently, we looked at what’s happening with technology and growth stocks.
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Once you’re comfortable with the big picture, it’s time to start narrowing the field. Reviewing valuations is one way to do this. It is best to compare stocks by sector. Look for stocks with reasonable valuations relative to their peers.
The most common way to assess valuation is to look at a price/benefit ratio (PE) report. This tells you how much investors are willing to pay for each pound of profit. The higher the PE, the more valuable investors think the company is. A low PE suggests that investors do not place as much importance on the company’s future prospects.
But when it comes to evaluating PE, it’s rarely that simple. A PE that has exploded suggests that future profits have already been priced in. These stocks tend to be more volatile due to high market expectations.
On the other hand, an ultra-low PE suggests there might be a problem on the horizon. The market can sometimes be irrational, but it is rarely completely wrong. Look for stocks that you believe have fair value. Whether it’s sharing or pizza, you often get what you pay for.
Looking at the PE ratio of two companies in the same industry also does not guarantee an apples-to-apples comparison. Other factors, such as their expected growth rate and dividend payouts should also be part of the equation. And the numbers are only part of the story – it’s important to look at the bigger picture.
Learn more about stock valuation
If you’ve found a share you like, it’s time to take a deep look. Part of this is to assess the financial health of the business. A high dividend payout can be a big draw if income is what you’re after. But dividends are not guaranteed and yields are not a reliable indicator of future earnings. It is important to look under the hood of the company to decide if it will be able to continue to pay and be happy with the risk that it cannot.
The simplest starting point is free cash flow. This tells you how much money flows through a business each year. It can be calculated using the cash flow statement.
Free Cash Flow = cash generated by operations – investments in the company.
If the free cash flow is positive at the end of the year, it means that there is money left over after paying the expenses of the business. If it is negative, it means that the company is spending more than it earns. The important thing to watch is the direction in which cash flow is moving. A lot of very young companies have negative free cash for years, and that’s not necessarily a problem as long as there’s a path to positive.
Companies that pay a dividend must have cash on hand, ideally with enough cash on hand to cover dividend payments. Looking at the dividend coverage ratio is another way to assess if a dividend is sustainable.
Dividend coverage = earnings per share/dividend per share.
This tells you how many times the group can pay its dividend using profits. Anything over two is generally considered “well covered.” Anything less than one suggests the dividend may not be sustainable. And remember that no dividend is ever guaranteed.
Speaking of loans, debt is another important factor to consider. Some degree of debt isn’t a bad thing, but too much can be crippling. This is especially true when interest rates are rising – borrowing becomes more expensive. A quick way to assess debt is to look at a company’s debt-to-equity ratio, which can be calculated using the balance sheet.
Debt/equity = total liabilities / total equity.
This tells you how much of the business is financed by loans. In general, the higher the number, the riskier the business. This ratio can vary wildly from industry to industry, so it’s important to compare two companies within the same industry.
Before choosing an investment, you should also read the annual report. This will give you an idea of the company’s strategy and priorities for the future. It will also flag potential risks to the business. Even the most financially secure business is sure to have a few bumps along the way. It is important to understand the business strategy and focus on the long term.
The annual report is also where you will find environmental, social and governance (ESG) data. As we move towards a more responsible and sustainable future, ESG performance becomes just as important as financial health.
Not only is it important to make sure you are comfortable with the company’s philosophy. It is crucial to examine the impact of these measures on the future of the company. Regulations are changing to hold companies accountable for their social and environmental impact, so ESG considerations are becoming an important part of the overall strategy.
The equity research team does much of this work for you. From comprehensive updates on the stocks you own to market insights, we give investors the tools they need to make more informed investment decisions for themselves.
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