Trading Stocks: How Do I Find Good Stocks?

This is a guest post from John Forman from The Essentials of Trading. Forman is the author of a book by the same name. He has been a trader of the stock and other markets for over 20 years, and is a professional stock market analyst for Thomson Reuters.

The wealth building potential of the stock market is enormous. I think we all realize that. The long-running debate, though, is whether one is better off investing in individual stocks (or funds that do just that), or whether it's best to just put your money in an index fund. Most funds fail to beat the market, so it would seem index funds are the better choice.

While it is certainly true that index investing has some advantages, and some mutual funds do perform better than the indices, no index or fund will ever offer the upside potential of investing in individual stocks. It's a matter of math.

Indices and funds include many stocks which move in all different directions. One of those stocks could double in price for the year, but because most others in the collection will do much less well, the index's or fund's performance will be much lower than that one stock's gain. An investor who held that stock by itself, though, would have done quite well.

Of course you need to be able to find the stocks that will beat the indices and funds.

How Do I Find Good Stocks?
The requirements for success in the stock market are much like the requirements for success in any other undertaking. Proper preparation is one of them — potentially the biggest — and a major part of preparation is having a firm objective in mind. As an investor, that normally means either seeking capital appreciation or pursuing income, or some combination. For the purposes of the discussion here, I will focus on the capital appreciation.

Another part of the equation is timeframe. I'm not talking about how long you have to retirement. There's plenty of literature in financial planning circles about how you should structure your investments from that perspective. What I'm referring to here is how long you will expect to hold any given stock position in your portfolio.

Are you a patient long-term buy-and-hold investor who will have no problem sitting through the inevitable ups and downs of the market? Or are you someone who wants more action, doesn't have the patience to hold stocks for years at a time, and/or cannot stomach the idea that at points your positions could go well against you for long periods of time?

You may not always be one or the other. It is, however, important to know which mode you are in when you are looking to pick good stocks. A lot of stock market players get themselves in trouble because they go into a position thinking they are one type of player only to change their minds once prices start moving.

Fundamental Analysis
If you are in the first category, then your focus in trying to find good investment stocks is to look at the big picture. You are Warren Buffett. You look at the company and its management team. You look at its business and, in many cases, the broader economy. What you are trying to identify is a company which will steadily increase in value over time.

How do you do that? By thinking about what it takes for a company to grow and profit in a sustained fashion.

What do companies like that have? They have strong management teams who know what they are doing, who have a long term view and who aren't worried about the quarter-to-quarter results or stock price fluctuations. They are in growing business sectors (or niches) where the competition isn't so intense that no one can really make any money.

This sort of approach to looking at companies is generally referred to as fundamental analysis. Fundamentals are the underlying elements that determine the long-term growth and profitability of a company.

The idea is that you are giving your money to some really capable people and having them put it to good use in their business. Then you let them do their thing in the way they best see fit. So long as they continue to do good things and keep the business on track for positive growth in value, you stay invested. Maybe somewhere down the line you will cash out your investment. Maybe you'll leave it to your kids or donate it to charity. Whatever the case may be, you would expect the value of your stake in the company to have grown nicely in value by that time.

Security Analysis by Benjamin Graham and David L. Dodd is the classic text for stock market fundamental analysis. You can also find a brief overview at StockCharts.com.

Technical Analysis
Now, if you are in the second category where you're not just going to buy a stock and lock it away, you need to think more specifically about your holding period. By this I don't mean to imply that you will hold a stock for an exact period of time and that's it. I just mean you should have an idea of how long you would expect to be in the position. That could still be years, or it could be months or weeks.

The advantage of the long-term investor is that they need not worry about the fluctuations in the price of the stock. They are investing on the basis of the long-term growth of the company with the assumption that the stock price will generally follow along at about the same pace.

Less long-term players (often referred to as traders) have to be cognizant of the intermediate and shorter-term price action. Generally speaking, the shorter your expected holding time horizon, the more you will have to focus on the price action. This is because the fundamentals mentioned above are usually slow moving elements which play out over the longer timeframes. They don't change quickly, so they can't really influence short-term price movements much.

What I mean by that is stock prices can move in the short-term on a great many factors. It could be news, economic data, changes in interest rates, the general market environment, and lots of other things. Just because a company is making money hand over fist doesn't mean the stock price will be rising. If the company continues to do that, the stock will probably move higher eventually, but in the meantime other factors could cause it to go sideways or to even fall. This is something that baffles a lot of new investors.

Focusing mostly on price moves you into the realm of technical analysis. This approach seeks to identify patterns of price movement in the market for the purposes of determining likely future direction. This is also referred to as market timing, which basically means seeking to define good points at which to buy and sell. A lot of stock investors use fundamental analysis to find good companies, then use technical analysis to try to pick the best time to buy the stock.

Technical Analysis of the Financial Markets is widely considered the ultimate source on the subject. StockCharts.com offers an introduction to technical analysis.

Value Investing
To this point you'll notice that I haven't used the term value investing yet. Many people would refer to Warren Buffett as a value investor, and as such would put value investing in the long-term investing category.

Value investing need not be a “buy it and bury it” type of approach, however. In fact, I'd guess that most people consider it the process of identifying stocks trading out of line with the value of the company in question. They use any number of metrics to determine what a company's stock should be worth. If the stock isn't close to that value, they will either buy it or sell it in expectation that it will eventually get back in line. In most cases, once that happens, the stock position will be exited.

This probably all sounds very familiar. You've no doubt heard of Wall Street analysts putting out price targets and ratings and such. They generally use fundamental analysis to come up with what they think is the value of the company right now (adjusting it for new information, of course). Then they look at current price to see how it matches up with what their valuation calculations tell them.

If you'd like to learn more about value investing, consider Benjamin Graham's classic, The Intelligent Investor. The Motley Fool has an interview with Bruce Greenwald about the three steps of value investing.

It Takes Work
Regardless which type of stock market player you are, there are no approaches which don't require effort on your part to pick the good stocks. Even if you have someone giving you recommendations, you should still be doing your own due diligence to see if they really fit in with what you are trying to do in the market.

Also keep in mind that no matter what timeframe investing/trading you do, you should always take the longer-term view. It's extremely unlikely that any one stock position is going to make you rich in a short period of time. If you try to score it big on any one trade you're probably going to end up losing a lot of money. Wealth accumulation in the markets is best sought by steady growth, putting the power of compounding to work in your favor.

This article is part of Financial Literacy Month.

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JerichoHill
JerichoHill
12 years ago

I think one thing you don’t mention strong enough is that the different investment strategies carry differing risks. For example, while technical analysis is believed to offer the highest potential returns, it also offers the highest potential losses. Someone who views trading with an economist’s mindset is going to look at a basket of options and weight that risk appropriately. We’re going to want to minimize our risk while maximizing our investments. As a primary vehicle of saving, individual stock purchases do not make much prudent sense, because of their risk potential. As a strategy of diversification (ie, different investment… Read more »

Dylan
Dylan
12 years ago

“No index or fund will ever offer the upside potential of investing in individual stocks. It’s a matter of math.”

It is also a matter of math that the probability of achieving that “potential upside” is less than 50% (worse than coin flip odds). Most of the people that try to pick stocks believing they posses the necessary knowledge and skills and think they will be the exception to the rule will have been better off buying the market than trying to beat it. It’s a matter of math.

Andy
Andy
12 years ago

I am an index fund guy and probably won’t try my hand at individual stocks. Although most people (and professionals) can’t beat the market, I think the argument for doing it is if you are a risk taker and want to add potentially greater returns with greater risk. Of course it is probably not a good idea to do this with a significant percentage of your portfolio.

John Forman
John Forman
12 years ago

JerichoHill: I was asked by J.D. to write about stocks, so that’s what I did. Naturally, one must consider stock market investing in terms of an overall financial plan. In terms of your comment “..while technical analysis is believed to offer the highest potential returns, it also offers the highest potential losses..”, I completely disagree. Technical analysis is not necessarily seen as the highest return strategy. Certainly not by me, anyway. Also, fundamental or value investors are perfectly capable of losing at least as much as technical traders. It all comes down to the risks the individual takes, not the… Read more »

John Forman
John Forman
12 years ago

Dylan: “It is also a matter of math that the probability of achieving that “potential upside” is less than 50% (worse than coin flip odds). ” Certainly so, but odds don’t matter. Expectancy is what matters. I will agree with you 100% on folks thinking they’ve got what it takes. And you’re right, many of them should stick to index funds. By far the biggest problem I see with individual traders/investors is that they don’t take playing the market the same way they would other other things like learning a language or playing guitar. Doing well in the markets requires… Read more »

John Forman
John Forman
12 years ago

Andy:

I honestly believe that individuals have a better shot of beating the market than the pros for the simple reason they don’t have the overhead costs or the constraints of the funds. Of course they have a learning curve to overcome first.

Schizohedron
Schizohedron
12 years ago

Interesting post for those with the time to research individual securities in the depth they need to be scrutinized, and cites some excellent books on the topic, but– “Indices and funds include many stocks which move in all different directions. One of those stocks could double in price for the year, but because most others in the collection will do much less well, the index’s or fund’s performance will be much lower than that one stock’s gain. An investor who held that stock by itself, though, would have done quite well.” because I turn this statement around like this– “Index… Read more »

gousalya
gousalya
12 years ago

I have been investing for awhile now and all I know that helps is to buy and hold. It is a long term investment and by watching the market on a weekly basis, you will get yourself educated sufficiently by learning what are good stocks to invest in. Time is the one element that is crucial in investing. I use the money I don’t need immediately so as I would not be pressured to sell them when market is down.

J.D.
J.D.
12 years ago

I think that many readers know the arguments for index funds, but still want to pick the occasional stock or two. I’ve certainly been that way in the past. (Though I seem to be cured for the moment.) I’d rather that these folks had an idea of where to turn for actual stock-picking methods instead of doing what I’ve done in the past: pick by gut. I was happy to see this post from John — I think it’s a fine overview. I still need to share the story of our ill-fated investment club: we started at the height of… Read more »

John Forman
John Forman
12 years ago

Schizohedron:

CANSLIM is the basis for my own personal stock trading, though I have made a number of adjustments along the way to suit my own situation. The core of the approach, though, made immediate sense to me all those years ago when I first read the book. I give it credit for putting me on the path to where I am today as a trader/investor and market analyst.

Scott
Scott
12 years ago

Another thing to keep in mind with index funds is the expense of the fund versus being more active trading. An index fund from Vanguard can have an expense as low as .15%. If your expense for a stock or fund is closer to 2%, you’ll have to bet that your individual stocks can not only BEAT the index, but beat it by 2%. That said, I know this article isn’t about funds, it’s about individual stocks, and I really appreciated the talks about different types of trading. I would like to invest a small portion of my portfolio into… Read more »

Dylan
Dylan
12 years ago

“Certainly so, but odds don’t matter. Expectancy is what matters.”

John, I really have to disagree with this. Try cashing a check in the future for what you expected to have.

John Egan
John Egan
12 years ago

There is no “one size fits all” investment philosophy. I’ve made and lost money on a variety of market programs. I do believe that one sure-fire way of losing money is ‘buy and hold'(whether or not you buy stocks or funds). There are many articles regarding ‘buy and hold’ indeces -vs- ‘buy and homework’ (to borrow a phrase from Cramer) and it is clear to me that you stand to gain little if you do not closely follow and sell whatever you have at intervals. Clearly not all investments do well in all phases of the market. You only have… Read more »

John Forman
John Forman
12 years ago

jegan: I think Buffett would disagree with you about the value of buy and hold investing. It can work, if you truly have a long term timeframe and pick good companies. His advantage is that he’ll never need to sell to fund his retirement spending. He can literally sit in a stock forever. For the rest of us things are a bit less straightforward. I agree with your last statement. Look for good stocks using the fundamentals and time your trades with the technicals. It’s worked well for me over the years, so I’m not going to change the course… Read more »

John Forman
John Forman
12 years ago

Dylan: I’m not sure I’m following. Are you trying to make a statement about present value?

Katharine
Katharine
12 years ago

What is CANSLIM?

John Forman
John Forman
12 years ago

Katharine:

CANSLIM is a stock trading methodology outlined by William O’Neill (founder of Investor’s Business Daily) in his book ‘How to Make Money in Stocks’. There’s no space to go into the details here, but I’m sure if you Googled it you could find a breakdown of what the accronym stands for and the basic rules.

Paethon
Paethon
12 years ago

In my optinion: Forget stockpicking. If not even the experts who do it the whole day can pick the right stocks (and they cant, otherwise most of the funds would perform better than the index) why should I as a hobbystockpicker be better? Especially when you consider that in the time I am researching stocks I could also educate myself in a way to maybe just get a better job or just work more to get more money. In my opinion stockpicking just isn’t worth the trouble. Of course: If you like doing it, than do it. But see it… Read more »

Adam
Adam
12 years ago

The person that gets their stock investment advice from a one page article is exactly the type of person who needs to stay the hell away from individual stocks.

This might as well be an article on how to play blackjack.

Nancy
Nancy
12 years ago

Back in ’95 when I went from saver to investor, I also made my stock choices on something I heard an Uncle say once – If the economy ever went really bad, you should be in something that people would still need (he owned a pet shop!).

If/when the economy tanks, will people stop going to MacDonalds? I think not. Will they still use electricity? Definitely. Will leisure/hobbie activities suffer? Probably.

Not too scientific, I grant you. But look around today at what sectors are suffering.

John Forman
John Forman
12 years ago

Adam:

Did you actually read the article? At any point was specific advice as to the best way to pick stocks (or anything else, for that matter) ever provided?

The answer is no. This article is a discussion of the primary methods (broadly speaking) employed by stock pickers. That’s it. Nothing more.

You’re right, though. No one is going to master stock selection by reading an article or even a book. It takes education and experience – and a bit of guidance along the way never hurts either.

John Forman
John Forman
12 years ago

Nancy: While there’s certainly value in your uncle’s advice, it’s more of a long-term sort of view when you know you’re likely to be riding through economic downturns. You can flip it around when things are going well, though.

jtimberman
jtimberman
12 years ago

Gentle readers, remember this: The average amatuer day trader is losing money hand over fist trying to beat the market. Every day people are going broke doing this as a hobby!

This guest poster’s summary states he is a *professional* stock analyst. While I’m sure his methods are great for his job, they’re not going to translate well to the average person who doesn’t do stock trading for a living.

The Financial Philosopher
The Financial Philosopher
12 years ago

Before an individual decides to trade stocks for themselves, they must know themselves intimately. If this self-awareness exists, then the individual can proceed to determine if there is a “non-financial” return in trading stocks…

In other words, if you do not think you will truly enjoy trading stocks, then it won’t be worth all of the extra hours and effort to have a 20% chance of out-performing the market over the long-term.

Dylan
Dylan
12 years ago

@ John – My comment is not a statement about present value. It is about the likelihood of stock picking resulting in a favorable outcome. Regardless of how devoted one is to learning the methods, the odds are against you. Stock picking will not work for more dollars than it possibly can work for. So, why should anyone give any weight to the expectation that it will beat the market when it’s more likely it won’t? My point was that you can only spend the money you actually have in the future, not the amount you had hoped for by… Read more »

JerichoHill
JerichoHill
12 years ago

I believe Dylan is referring to the efficient market hypothesis.

John Forman
John Forman
12 years ago

jtimberman: Point of note. I am a profession analyst, not a professional trader. I don’t trade for a living. I am a part-time trader myself, and quite happy to be.

As for my methods and their applicability, I haven’t actually presented my methods, so I’m not sure how you can make that kind of statement.

John Forman
John Forman
12 years ago

The Financial Philosopher: I definitely agree. While long-term wealth building is the main practical focus of investing (in any form), to achieve that objective takes a deeper involvement than something casual.

John Forman
John Forman
12 years ago

Dylan: No matter how you invest – even if it’s just bank CDs – there is an expectation of future value. That expectation is based on the probabilities of various potential outcomes. Obviously, in the case of CDs the expecation is based on a very high probability that the quoted rate will be achieved and the near zero chance that something else will happen. As for the odds being against an individual trader, that’s likely true, though people toss that out all the time with no stats to back it up. Either way, in my experience it has less to… Read more »

miracletech
miracletech
12 years ago

Re the section on Fundamental Analyses – you are NOT Warren Buffet.

The idea of the small investor using Fundamental Analyses to choose a stock is absolute Bird Poop. The information necessary to really analyze a company is just not available. What you can find are a few facts and a lot of “spin”.

Suppose you had used fundamental analyses a couple of years back on Countywide Financial? Would you have seen the subprime mortgages, then present, that eventually brought the company down?

Chris
Chris
12 years ago

Humans are fallible. Is it reasonable to believe that a market that moves at the will of the masses will accurately value every stock on the market on a per second basis? I don’t believe it is. The crowd is not right simply because they’ve all decided to travel the same path. Benjamin Graham said it best, “the stock market in the short run is a voting machine, in the long run it is a weighing machine.” Yes the day traders can influence the day to day value of any given share, but ultimately the company itself drives long-term value.

John Forman
John Forman
12 years ago

For the record, I’m not a believer in the Efficient Market Hypothesis. This probably won’t surprise most of you. I have very specific experience based reasons for it. The EMH is founded upon the rational behavior of market participants and upon the near instantaneous distribution of new information. Neither of those assumptions has any basis at all in the reality of the markets. People trade and invest emotionally. Information gets to people and incorporated into their decision-making process in a more gradual fashion is assumed. Are high volume, high participant markets mostly efficient? Sure. Most of the time they are.… Read more »

John Egan
John Egan
12 years ago

Mr. Forman, I don’t think anyone can argue with Warren Buffet, (and who doesn’t like his little earthy asides…) In fact I have posted here generally about his philosophy and recommended a book based on his basics. Also, principally, I agree with his method of valuing companies. However, I am not Warren Buffet. I did not show any extraordinary abilities to add large columns of numbers in my head at an early age. Nor did I grow with a stockbroker as a father and I do not have his present wealth. And, of course, Warren buys companies. Something I can’t… Read more »

Dylan
Dylan
12 years ago

John, The stock market is not a zero sum game, but trading is. For every dollar won one over the market, one must be lost. There cannot be more capital outperforming the market than underperforming the market. Because trading intermediaries get paid, regardless of whether you win or lose on a trade, trading is actually a negative sum game. This is why odds are against stock picking. The question is whether you can do better investing in part of the market (stock picking) versus investing in the whole market (indexing). This is the negative sum game, not whether you can… Read more »

brooklynchick
brooklynchick
12 years ago

NO NO NO! Read John Bogle or David Swenson or any other giant in the field, and they will say -choose an INDEX FUND! Keep your fees low (use Vanguard) and just buy an index. I know lots of Wharton grads who’ve lost their entire retirements making stock pics.

DC Economist
DC Economist
12 years ago

I completely agree with the notion that the market isn’t efficient, but that it follows an imperfect approximation of efficiency.

I think one of the problems here is that a short summary of trading strategies can’t fully express the risks and benefits of each, or to present case studies.

jamenjaw
jamenjaw
12 years ago

Well speaking from someone who grabbed a stock because Jim Cramer said it was great because it’s a REIT I’m a bit said about now but then I looked back over the past 1.5 years (wow long time) of owning that stock I have gained about 4-6 shares of that stock just by reinvesting the dividends. Now I know most of you will be going “you should not have done that, you should have sold a while ago” Myself I’m thinking on long term with this stock and since it is growing at a good clip I’m going to stick… Read more »

Writer's Coin
Writer's Coin
12 years ago

I am a huge fan of index funds. For people starting out, I recommend index funds and tons of research. Paper trade individual stocks and read the financial page EVERY DAY. Make this a habit and after a while you’ll start to get to a point where you’ll “know” a little bit of what you’re talking about. Then start researching individual stocks. Paper trade them, take your time, no rush. It takes years to “get” this stuff at the most basic level. Once you’re ready, pick out the one or two individual stocks you really think are good choices and… Read more »

John Forman
John Forman
12 years ago

miracletech: My, that’s a negative attitude! Keep in mind that not everything in fundamental analysis comes from the company. More macro elements come into play. You can absolutely get a great deal of it from them – with low hype from the required filings, at that. Plus, you can get on conference calls and all that stuff that used to be only open to analysts. What you do with that information, of course, is what determines whether fundamentals are of any use to you. As for Countrywide, given the number of people who saw problems coming in housing well ahead… Read more »

John Forman
John Forman
12 years ago

Chris: Well said – the very point of long-term fundamental trading.

John Forman
John Forman
12 years ago

jegan: Spoken like a very reasonable and ration individual. 🙂

John Forman
John Forman
12 years ago

Dylan: I totally agree that one must weigh the opportunity cost of investing in individual stocks against index returns (or any other vehicle). If you can’t do better, then stick to index investing.

As for trading in stocks being zero sum (really negative sum), please lay it out for us. I want to hear how you are defining things, especially when investing is considered.

John Forman
John Forman
12 years ago

DC Economist: Exactly!

John Forman
John Forman
12 years ago

brooklynchick: I’m not disagreeing at all with the value of index investing. J.D. asked me to write something about stock picking, which I did.

That said, the concept of index only investing has a foundation in classic financial theory. I’m well versed in that (for better or worse) having that as my educational focus at both the undergrad and grad level. That foundation, however, is very shaky. Read Mandelbrot’s The MisBehavior of Markets sometime. Very interesting stuff.

John Forman
John Forman
12 years ago

Writer’s Coin: Very good points. The big problem most investors have is that they dump a big portion of their money into the markets and starting trading/investing it with no education and no experience. Paper trading is readily available these days. Use it. Developing your understanding and analytic skills. Then slowly start moving into live trading.

PBJ
PBJ
12 years ago

Seems more like a topic for GetRichOrPoorQuickly.com.

Dylan
Dylan
12 years ago

John, There is not much more to it for me to lay out. Every trade has two sides (buyer and seller). The result of the trade will at any future point be better than the market for one side and worse than the market for the other by equal amounts, not counting transaction costs which includes spreads. As for investment growth, you can participate whether or not you trade along the way. Whether you buy and hold a slice of the entire market through an index fund or trade parts of it by picking companies, you still get to participate… Read more »

jtimberman
jtimberman
12 years ago

@John ESI Money, Oops, I misunderstood the summary then.

John Forman
John Forman
12 years ago

Dylan – I absolutely agree that trading identifies value. The movement of prices is essentially a value discovery process. Saying each transaction has a buyer and a seller, though, is not the same as saying that there is a long and a short for each trade. Big difference. A long benefits from price appreciation, and a short benefits from price depreciation. The same cannot be directly inferred for buyers and sellers. In the futures market, where traders are either long or short (or flat, obviously), but no actual purchase or sale is made until delivery (if they stay in that… Read more »

Brigid
Brigid
12 years ago

OK – may as well jump into the fray… I doubt anyone’s going to take me seriously, but how I pick stocks is a lot like how I used to pick antique/collectable type items. I didn’t buy things based on how much they could possibly go up in value – I made sure first that I actually liked the item. Was it attractive, in nice shape, when with the decor in my house, etc. If the answer was yes, there was a good chance that I’d buy it. If the item didn’t hold or increase it’s value I still liked… Read more »

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