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How to Pick the Best Stocks to Invest In

Young investors often seek how to choose stocks. Believe it or not, any halfway intelligent individual has just as much of a chance to be successful in the stock market as a Harvard grad with a MBA in economics. The key to picking the best stocks to invest in is to not follow the crowd and let emotions remain on the sidelines. There are tens of thousands of publicly traded companies that are traded within the US alone; So how does one go about picking a stock? The following is a list of tests to carry out within the first 5-10 minutes of analysis which will assist in eliminating 95% of potential stocks:

Qualitative Analysis on How to Pick the Best Stocks to Invest In:

1. The first and most important aspect of how to pick the best stocks to invest in is analyzing potential industry growth and sector sustainability. Is the industry growing (etc. e-commerce) and is there a potential for technology or new innovations to make this industry obsolete (etc. blockbuster).
2. The second thing to consider while searching for the best stocks to invest in is to look for is an obvious competitive advantage: examples would include Google’s control over online advertisements or Starbucks brand loyalty advantage.
3. Management’s track record. Some questions one might ask: What has the CEO accomplished? Has he/she ever turned a struggling company into a thriving one? Does management own and retain shares of the company? Has upper management ever founded companies of their own (better yet have they taken their companies public)? 
4. Only invest in companies you understand. One might not understand utility or tech companies; therefore, one should not buy them because this is not how to pick the best stocks to invest in. If an investor has no idea what makes them money, their regulations, and new advances that could potentially make them obsolete, then the investor should not even consider investing.
5. Focus on mid-cap to large-cap stocks. First rule in investing, do not lose your investment.

*Yahoo Finance, Motley Fool, and Google Finance are all excellent free sources for qualitative information

Quantitative Analysis on How to Pick the Best Stocks to Invest In:

1. Want a Price over Earnings (P/E) x Price over Book (P/B) =  < 22.5.
2. Consistent dividend growth, solid dividend yield, and EPS growth. If a high percent of EPS is not paid out in dividends, then the investor would need to seek a ROE >25%. Take into consideration growing companies usually reinvest profits immediately back into the company in order to sustain growth and maintain their competitive advantage.
3. Business must have a positive free cash flow
4. Appropriate margin of safety. This can be calculated by finding the intrinsic value of the stock utilizing Graham’s formula and dividing the difference between the intrinsic value and the stock price by the stock price. Graham’s formula is as follows: v = (EPS x (8.5+2g) x 4.4)/Y where g = average annual growth rate over a period between 5-10 years and Y = the present AAA Corporate Bond Rate
5. PE Ratio  <15 and PEG Ratio <1
6. Quick Ratio of >1.5. This shows the company’s ability to pay its short term debt
7. Debt/Equity Ratio <0.4 – When companies fall on hard times, they tend to borrow. Before the crash in 2008, Lehman Brothers had a debt to equity ratio of 30:1. This means for every $30 of debt there was only $1 of equity. Thinking rationally, would one pay $1 to incur $30 in debt and honestly think the company will be able to pay that back?
8. Healthy profit margins in comparison to the two industry leaders and/or closest competitors
9. A Return On Invested Capital (ROIC) above Weighted Average Cost of Capital (WACC). ROIC is the percentage amount a company is making over the cost of capital (WACC). WACC is typically 8-12% therefore an investor would need at least a ROIC >12%.
10. Focus on stocks with Betas <1. Stocks with large betas tend to have greater risk. Tread carefully though because some betas may be misleading. For instance, take a stock that has dropped 50% in price. This stock’s beta could be greater than a overvalued stock trading at the same price even though the one that has dropped by 50% could be a much better buy.

* A couple free online tools that will assist in searching for the best stocks to invest in and perform these quantitative tests are google finance’s stock screener, gurufocus, and finviz. Refer to the following article for more free online finance tools.

If after these tests have been performed and the stock still looks promising, then one should search through news articles, 10Ks, and financial statements for a more in depth analysis as to why this stock appears to be trading cheap in comparison to its value.