How can you buy the right stocks? The answer is: it depends! You are about to discover a free, simple three-part stock-picking system that has made many an investor rich. You will receive for free all the knowledge and resources you need to go out and start making money in stocks right away! But, first you must know that this is only one of many strategies used by successful traders to make money in the stock market. The strategies you use depend on why you are investing in the first place. Ask yourself how big is the return you want to see on your money. How much money are you willing and able to put up? How fast do you want to see a return? Now that you have asked these questions you are ready to find the right strategy for you.
Here is a basic three-part stock-picking strategy that is essential to most investors whether you are trading stocks and options on a daily and weekly basis for short-term, highly leveraged returns (meaning, lots of profit fast!) or you are picking stocks to add to your retirement portfolio (meaning, secure long-term investments, often income producing). This strategy for finding quality stocks is useful for all investment horizons. Though there is a lot you can learn in addition to this, you will be able to start using this immediately to find great stocks to make money right away! Now, before revealing this essential strategy, take a quick moment to paint a picture in your mind that will help you to better understand and apply the strategy.
Imagine you are a hawk hunting for a tasty little mouse or a nice fat rabbit to eat. You are soaring over the land high up in the sky. You see the land stretch out around you like a patchwork quilt: forest, meadow, river, hill, farm. Where are you going to have the clearest shot at your prey? The meadow or the farm, right? It is early spring, so you know that the rabbits are more likely to be out than the mice. So, you head over to the meadow where the rabbits hang out, instead of the farm where more mice tend to be. Now, you do a general sweep over the meadow to identify some potential rabbit houses, and you start your stake out on a perch. You watch a minute and see some movement in the meadow. It’s a rabbit. You can’t just swoop in and take it without planning your approach. You have to fly over and grab it at the right time: fast enough to take your opportunity, but not so fast that you don’t get a good grip on it. You wait for the perfect time, you fly over, dive, and bam! It’s yours: a nice fat rabbit. Now, you have to take somewhere to eat it: it ain’t over ’til it’s over.
This strategy to buy the right stocks involves an approach similar to a hunting hawk’s. You have to: 1. Look High; 2. Look Low; 3. Buy Right. In other words, get a bird’s eye view so you know where the market is and where your opportunities are. This involves “macro-economics”. Also, you have to know how to ferret out and identify your best candidates. This involves “fundamental analysis”. Lastly, to BUY the right stocks you must buy the stocks RIGHT. Remember, you must be able to later sell right to realize your profit–which you can do if you buy right. This involves “technical analysis”. Luckily, there are a ton of free resources to help you do all of this!
1. Look High. Get a bird’s eye view so you know where the market is and where your opportunities are. This involves “macro-economics”. In today’s globalized economy you need to have a good sense of how the world market functions–its rhythms and dynamics, and how to track them. However, just focus on the US market for now. There are a few things to take into account here, but you don’t have to be an economist to do this. Don’t spend too much time and energy here. No one is ever going to be able to really comprehend everything that’s going on, and if they try they’ll probably end up with analysis paralysis. This doesn’t necessarily involve reading the headlines and speculating on what they might mean for the market–in fact, forget the news, it is a recipe for missing the forest for the trees and becoming a reactionary mess rather than a responsible investor.
In general, you are looking for two things in your bird’s eye view: market cycles, and market dynamics. What that means is the market goes in cycles of boom and bust, and at different times different industries do better than others. This is often called the “Business Cycle”. Also, within these overarching rhythms all parts of the market–every industry and every stock–tend to move together according to market dynamics of buying and selling. This second part about market dynamics will be dealt with in the third piece of the strategy involving the technical analysis of buying right, so the main thing to consider here is market cycles.
There are a number of theories about market cycles, and you will no doubt come across them if you are serious about investing, but the most basic cycle to consider is that of boom and bust. To maximize your returns you want to buy low and sell high, right? Well, fortunately while the market has risen in general over the last century or so, it has also gone through periods of recession and periods of growth. With those booms and busts the prices of stock go up and down, which is exactly what you want them to do if you want to be able to buy low and sell high. Go to www.freestockcharts.com and look at the Dow Jones Industrial Average for the longest period to see this pattern. Also, go to the National Bureau of Economic Research’s (NBER) website www.nber.org/cycles.html to see the periods of expansion and contraction (boom and bust) in the US economy since 1854.
The trouble with NBER is they don’t predict these cycles, they just call them after the fact. That makes them reliable, but almost useless. NBER declared in September of 2010 that the beginning of the last expansion period began in June 2009! That’s a year and a half after the fact. What it does tell you is that these periods do happen, frequently. And, looking at the stock market you can see that these periods of boom and bust happen alongside stock prices going up and down. Pretty basic, right?
So, one thing you can quickly figure out is that you want to buy stocks when the prices are going up during an economic expansion, once the recovery has started, but not at the end of the boom right before the bust begins. How do you figure out what stage the cycle’s in? It’s pretty intuitive, but there are a number of ways people try to measure it. One way to gauge the economic cycle is to understand that different industries do best at different points in the cycle. Although it isn’t in the exact same order for every cycle, here is a diagram that does a great job of showing this concept: http://tiny.ly/LYwR. You can use this diagram to find your bearings in the cycle to figure out if you even want to buy stocks right now or not.
2. Look Low. Know how to ferret out and identify your best candidates. This involves “fundamental analysis”. Fundamental analysis, also known as “bottom-up” analysis, focuses on each company individually. You’re looking for strong companies with a good outlook and stock at a price you’re willing to pay.
In simplified terms, there are two major camps, and you’ll discover here a way to get the best of both. There is “value investing” and “growth investing”. Visit www.morningstar.com for opinions and resources from the value side. Visit www.investors.com for Investors Business Daily’s opinions and resources from the growth side. Value investors look for companies with good outlooks and underpriced stocks, while growth investors look for companies that have been growing and are likely to continue to grow. Value investors tend to be more conservative and long-term oriented and are typically not afraid to invest in a company that hasn’t done so well if they think it might be undervalued and has a positive outlook. Value stocks tend to show steady returns and appreciation. Growth investors tend to be more willing to move in and out of stocks more frequently. Though they are most concerned with projected growth, they don’t tend to take risks on stocks that have not shown a good track record. Growth stocks tend to be more volatile, basically meaning they have a wider range between their highs and lows.
There are a few things to look for in any stock regardless of whether you are a growth or value investor. To search for stocks with these criteria, go to http://screener.finance.yahoo.com/newscreener.html and launch Yahoo’s free stock screener. You can select multiple criteria to filter stocks. Familiarize yourself with these criteria. Here are a few you can use right away to find good stocks now. Add on criteria as you feel comfortable in order to narrow your list and get a fuller view of each stock, but using them all would be redundant.
The first thing to heed is Warren Buffet’s alleged sage practice to never buy stock in a company that doesn’t make a profit. It’s kind of a no-brainer, but that’s exactly what investors didn’t do in the dotcom bubble. The first criteria to select is under “Profitability”. Select “Return on Equity” (ROE). This will tell you how much net income a company made over the last twelve months compared to what the company is worth: it’s profitability. You’ll want to screen for companies that have at least 20% ROE. There are other criteria that gauge a company’s profitability and financial strength, and ROE is a good one to start with.
Next, to get the best of both growth and value investment select “PEG ratio” under “Valuation”. This essentially tells you how the current price compares to projected growth of the company and the stock price. So, you can find stocks at a good price with a growth outlook. You’ll want stocks with a PEG ratio no larger than one.
Now, you might also want to include a screen for growth in the past and growth projected in the future. You might want to keep the bar low so as not to exclude too many good value stocks. Under “Growth” use “Est Earnings Growth Past 5 Years”. Under “Analysts Estimates” use “Earnings Growth Est Next 5 Years”.
Other areas to consider are net income, sales growth, how much of the stock is held by insiders and institutions, debt to equity ratios, and cash on hand. You might also want to include the industry the stock is in to see if it is in an industry that will do well this season or not. Rising tides raise all boats: stocks in an industry that does well as a whole tend to do well also.
Once you’ve finished your screen, you’ll need to create a systematic ranking based on the data you’ve gathered about your pool of candidates. Try exporting the data to spreadsheet. You can then assign points to each stock according to how strong it is in each criteria. For example, assign a point to the candidate if it is within a prime industry for the current stage of the economic cycle, subtract a point if its industry is cresting, and assign no points if its industry is somewhere in between or you aren’t sure. Those stocks with the most points are probably your best candidates.
Okay, you have your top picks, but wait! Don’t rush out and by all the stock you can in each just yet. Now that you have a sense of clarity, you need a sense of timing. You need to get tactical. Who cares if you bought stock in a great company if you paid too much for it? When is the perfect time and price to buy?
3. Buy Right. To BUY the right stocks you must buy the stocks RIGHT. Remember, you must be able to later sell right to realize your profit–which you can do if you buy right. Buying right means buying at a low enough price that you can reasonably expect to sell at a higher price than you bought at. This involves “technical analysis”. (It also involves fundamental analysis, especially if you are a value investor. Analysts make their living on setting buy, hold, and sell price ranges. To do that they rely on all three levels of analysis touched on in this article, and more. So, buying right really is everything, but for the purposes of this article, “buying right” is used for the tactical entries and exits of trading.) Technical analysis looks at the dynamics of the market itself, leaving out anything to do with company fundamentals, macro-economics, headlines, guru news-ertainers or their dogs’ predictions. A common assumption of technical analysts is that all the fundamental and macro-economic information gets “baked into” the actual market action, and even if it doesn’t get baked in the market is basically predictable. Technical analysis takes into account historical data of things like stock prices and trading volumes identifying patterns and attempting to capitalize on them.
Relax, you don’t have to be a math whiz to do this, but technical analysis is very important, as is each of the other two levels of analysis discussed so far. Technical analysis not only helps you find the right timing for your entry and exit points it also allows you to filter out the duds in your fundamental candidates list. You may have a 30 year investment horizon or a three day horizon, but once you decide you want to buy or sell a stock, you’ll want to find the best time to do it so you don’t miss any profits, or worse, take a loss. Waiting a week may make a difference of 5, 10, 20%!
To identify a good entry point and find a good exit point, you’re going to want to apply technical analysis both to the market in general, using an index like the SP-500, and to your individual candidate stock. You want to apply technical analysis to the market in general because, rising tides raise all boats. Even good stocks often take a hit in bad market conditions, and even bad stocks do okay in good market conditions. You’ll want to technically analyze each stock because not all stocks with good fundamentals do so well, and not all stocks correspond with market fluctuations as tightly as others. So, you can use technical analysis to weed out the weak stocks from your fundamental analysis.
Now, there are literally hundreds, maybe thousands, of technical indicators designed to give traders an edge. And, like fundamental analysis, a simplified view of technical analysis breaks it into two styles of technical trading. You can call them value trading and momentum trading. Value trading wants to buy low and sell high, while momentum trading wants to buy high and sell higher. Value trading looks to set up predictable trading ranges to assign a high and low value to buy and sell at, while momentum trading looks at other traders’ behavior to try to catch a wave before it really takes off. Investors Business Daily (www.investors.com) recommends and teaches a momentum trading strategy, while a more value oriented investor following Morningstar (www.morningstar.com) will probably use a value trading style.
Here are two commonly used and trustworthy indicators. It is a good idea to check out others, but don’t use too many indicators. First of all, your brain can’t handle it. You can only keep track of three to seven simple details at a time–nine if you’re real sharp and having a good day. You can create a tracking a ranking system on a spreadsheet like you used for your fundamental analysis, but you are still apt to come up with analysis paralysis if you try to use too many indicators. Plus, different indicators are best used with different trading styles. You are liable to end up with conflicting messages if you use too many indicators.
Www.freestockcharts.com has all the indicators you will ever need. To apply a value-based trading tactic use the MACD and the Bollinger Bands. Before using those, you’ll want to get a general sense of the direction the stock is moving. Set the chart to a daily period and look at the data for the past year. Now switch it to a weekly interval and look at a longer stretch of time. Where is the stock headed? Is it going up? down? sideways? back and forth? is it moving one direction now, but the longer trend is a different direction? As you study more charts for more stocks you will become comfortable recognizing different behavior patterns in stocks and the market in general, and you will come across many ideas and tactics from various sources. For now, if your candidate is in the middle of a down-turn, steer clear! However, maybe it’s at the bottom of a trough, or in the middle of what’s called a correction, a temporary pull-back in the middle of a larger trend.
Now, set up your MACD and look for patterns. Without going into the mathematics behind this indicator, the MACD is a set of two undulating lines, one undulating a little “faster” than the other so that they cross each other about where they change direction. Notice they also tend to cross each other about where the stock trend changes direction! This indicates your low and high points to buy and sell. Look back and notice what would have happened if you bought and sold every time the MACD crossed itself. Try adjusting the frequency of the MACD. Try 9-17. Using prior data and multiple stock charts to practice using the MACD, be discerning, not literal: you will start to notice which signals to heed and which to ignore.
Now, set up your Bollinger Bands and look for patterns. This will give you a range or field within which the stock price is most likely to fall during a given amount of time based on previous performance. Try adjusting the period to 20-2. Try overlaying another band with a shorter period. Go back and look for patterns. You’ll notice the stock making reversals at the edges and along the mid point, and you’ll notice it sometimes riding the edge up or down like an escalator. This indicator is best used in conjunction with the MACD to augment your sense of the trading range and discern the true signals from the few false signals.
That’s it! That’s all you need to go out and buy the right stocks, and start making money in the market. Whether you have a little money or a lot, whether you want a lot of money fast or you want secure long-term investments, or anything between, you’ll already see how you can start using the three-part strategy outlined above to meet your investment objectives. Remember to: 1. Look High; 2. Look Low, and; 3. Buy Right. Now, go out and give it a try! Get a handle on this system, and then continue your study here and elsewhere.
