How to Pick Stocks for Long-Term Investors
If you’re wondering how to pick stocks, chances are, you probably already know. The question is not how to pick stocks. The question is where to look for stocks. At times, the market can be confusing. You can make it simple by sticking to the stocks of companies with which you’re familiar.
For instance, if you’re a doctor or pharmacist, you might know the best new pharmaceuticals. If you’re a real estate agent, you might be very familiar with Zillow (Nasdaq: Z) or RE/MAX Holdings (NYSE: RMAX). If you work at a bank, you might know more than you think about all the bank stocks.
Your Eyes Can Tell You How to Pick Stocks to Invest In
The good news is, you don’t have to have a particular profession to know to pick stocks. Get this; the popular iPhone originally came out in 2007. Apple quickly sold 6.1 million iPhones. Anyone who bought the phone or even just noticed its popularity could have bought Apple (Nasdaq: AAPL) stock at $3-$7 per share that year. Today, Apple stock is around $170 per share.
Famous investor Peter Lynch got one of his best stock ideas from his wife. She introduced him to L’Eggs pantyhose in the early seventies. Mr. Lynch bought stock in the company for his mutual fund. Later, his position in L’Eggs increased about 10x its original price before being bought out.
Recently, a friend of mine started investing in stocks with some other friends. The group was enamored by some high-flying stocks of companies that they had never heard of before. My friend decided to give his son a small amount of money to participate. When my friend asked his son which company he wanted to invest in, he said Home Depot (NYSE: HD). “Why?” my friend asked. His son replied, “Because you always go there.” Of course, the son’s stock was the best performer!
What is a Good Price For a Stock?
Believe it or not, the stock owner is the company’s owner. So, it is crucial to ensure that you don’t overpay for your investment. Think about it this way: if you could buy the entire company and pocket the earnings, how much would you be willing to pay for it? In other words, what will be the rate of return on your investment?
Typically, investors use standard tools to determine the right price to pay for a share of stock. The process of selecting a reasonable price range to pay for a stock is called valuation. One of the most popular valuation tools is the price-to-earnings ratio (or P/E ratio).
The P/E ratio of a stock can be compared to its average P/E ratio from past years. Also, the P/E ratio can be compared to similar companies. Simply put, the numerator is the price per share, and the denominator is the company’s earnings per share.
These numbers should look familiar. They are the price of the stock and the profits made by the company. Alternatively, If you flip the formula (E/P), it might make more sense. When you divide the earnings by the price, you get the potential rate of return on your stock.
A lower P/E ratio could indicate that the shares are a good investment. On the other hand, the higher the E/P, the more attractive the share price is.
How to Pick Stocks for Long-Term Investors
Many successful investors look at stocks as long-term investments. Not surprisingly, one of those successful investors is Warren Buffett. Mr. Buffett is famously quoted as saying, “Our favorite holding period is forever.”
Now, you may not hold a stock forever. When you find a company you like and buy for a reasonable price, you should be prepared to hold it for several years.
While you’re invested in a company, you should watch it closely. Keep up to date on press releases, news and quarterly earnings reports. Often, you can subscribe to alerts right on the company’s website.
Things will change. When things do change, remember why you like the company in the first place. Ask yourself if the change makes you like the company more or less.
In addition, keep an eye on valuation. If the P/E ratio gets significantly higher than average or much higher than similar companies, that is good news! It could also indicate that it is time to sell.
Keep in mind that companies that rapidly grow their earnings might have a higher P/E ratio. If you think the earnings will continue to grow, you might want to hold on. The P/E ratio can also change over the years.
The Psychology of Investing
Stock prices can rise and fall quickly in the short term. In addition, your friends might think your stock is a bum. Even worse, the stock market could come crashing down. These things can cause you to second guess yourself.
For instance, during the Financial Crisis in 2008-2009, many investors panicked and sold heavily. It was a scary time to be in the stock market for sure. Also, it presented investors with plenty of opportunities to invest in great companies at low valuations.
Take Nike (NYSE: NKE), for example. Many readers are familiar with the Nike brand. You’ve probably owned Nike shoes. Nike’s NBA endorsements are well-known. Yet, in 2009 the shares sold down to under $10 per share at one point. According to Value Line, the average P/E ratio for the year was 15.3. The long-term average P/E is around 20. That was an excellent value for the stock!
Today, the stock is about $145 per share, a handsome reward for investors for almost eleven years. You don’t have to be a genius to know how to pick stocks. In fact, it’s best to keep it simple!
About BJ Cook
BJ Cook is a long-time stock nerd. He has held several roles in the equity research world and earned the right to use the CFA designation in 2014. When he’s not writing for Investment U, you can find him searching for new investment ideas. Outside the investment community, BJ is a die-hard Cubs fan.