5 Essential Individual Stock Picking Rules

5 Essential Individual Stock Picking Rules

A rules based strategy when picking individual stocks is a great way to avoid critical mistakes.  By focusing on quality fundamentals, investors can pick up the best businesses trading at fair or attractive valuations.  Sticking to these basic rules will keep your portfolio consistent to individual stocks that are profitable, fairly priced, pay a dividend and have demonstrated superior growth.

5 Essential Individual Stock Picking Rules

 

1.     Buy companies trading at reasonable valuation multiples.

Quick valuation ratio multiples (ratios) can give investors a quick indication of how expensive the stock is.  Remember that the share price of a stock is not indictive of its relative value when compared to the company’s profits, revenue and equity among other things.

We can easily assess the price per share against the profit, revenue and book value of a company per share with the Price to Earnings (P/E) ratio, Price to Sales (P/S) (sometimes called Price to Revenue), and Price to Book (P/B).  Stock Picking Metrics 101 is a good rule-of-thumb guide on what numbers to look for with these valuation multiples.

The price to earnings ratio, or PE, is a calculated by dividing the share price by earnings per share over the last 12 months.  This will give you a very quick idea of how expensive the stock is compared to how much profit the company is generating every year.

We want this metric to be low.

High: Over 30

Medium: 15-30

Low: Less than 15

Similarly, to price to earnings, P/S simply divides the current share price by total revenue.  Some studies indicate that buying companies trading at low multiples compared to sales outperform the broader market.  It does not tell the whole story with profit margins and that is why you should combine many metrics in your analysis to avoid mistakes.

We want this metric to be low.

High: Over 4

Medium: 2-4

Low: 1-2

Very low and ideal: Less than 1

The price to book ratio indicates how much you are paying for each dollar of the total equity.  For example, a PB ratio of 0.8 means that you are getting a 20 cent discount on every dollar you spend on the net worth of the company.

We want this metric to be low.

High: Over 3.5

Medium: 1.5-3.5

Low: less than 1.5

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2.     Buy companies with a history of profitability and high return on equity.

It is not uncommon for new individual investors to jump on the latest hyped up stock in the market.  It is also not uncommon that these hyped up stocks (despite explosive growth) are unprofitable every quarter.

Screening for companies with consistent profitability and a high return on equity is a good way to eliminate massive mistakes in a stock portfolio.  At the end of the day, a company cannot be unprofitable forever.  Investors will give pre-earnings companies high valuations with the hope that they will continue to grow and become profit earning machines.  Although that has some merit, they are usually already priced as if they have successfully executed their growth and profitability strategy.

An analogy I like to use is Joe’s Hotdog Stand.  Hypothetical Joe’s Hot Dog Stand has just introduced the best hot dog the world has ever seen and sales and market share are growing at an incredible pace.  But, Joe’s Hot Dog Stand is not profitable and loses millions of dollars every single quarter. 

Would you invest in Joe’s fast growing but highly unprofitable new hot dog business?  Probably not.  So why would anyone on the stock market?  Picking stocks is not like buying lottery tickets.  Stocks are an offering of part ownership of a company to the public.

After a long enough time frame, a stock will perform proportionally to earnings (net income) growth.

3.     Buy companies that have demonstrated recurring top line revenue growth.

A business’ sales/revenue is the beginning of all cash flows that come into the company.  Profits can fluctuate for a variety of reasons and is not always a huge concern depending on the business. 

However, if top line revenues into the company are shrinking, this is definitely a concern for the business.

4.     Buy companies that pay a growing dividend.

Stocks that pay dividend income and shown consistent growth in the dividend distribution are my favorite companies.  Companies that have been capable of growing the dividend for over 25 years are called Dividend Aristocrats and have shown outperformance in the market.

It brings me back to the question – if it does not provide income, is it truly an investment by definition or purely speculation?

Companies that grow their dividend with their earnings are fantastic for long term holdings.  A growing company that currently yields 2% annually with their dividend grows their earnings 5x and thus, the dividend distribution’s also grow 5x your yield on cost for what you paid for the stock will 10% a year.  Not too shabby.

5.     Buy companies with an obviously recognizable qualitative moat (competitive advantage).

All of the rules so far have been quantifiable with numbers.  However, rule number 5 on this list is the exception.  Recognizing competitive advantages and qualitative moats is where the art of investing comes into play.

A moat, derived from the wide ditch used to protect a medieval castle, describes how a company can keep its position as a leader in the market it operates in. 

Before going long on any position, I find a one minute pitch to yourself on the stock is a good exercise to be able to recognize a moat very easily.  If the moat(s) is very easy to recognize immediately and easy to sell, then you are probably off to a good start.

Bottom Line

When it comes to picking individual stocks, a set of rules to manage your portfolio is a great way to avoid mistakes.   These 5 rules are a guide for a place to start crafting a set of rules to manage a disciplined portfolio of undervalued or fair valued dividend growth stocks.  

This management style will be very profitable for long term investors when picking individual stocks and is the basis of buy rules for Stratosphere Premium, my real money portfolio that Canadians can follow along with every single month.

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