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There are literally thousands of stocks trading on the stock exchange. So, what stocks should you buy? How do you pick the right stocks? Because having a sound stock-picking strategy is key to your investment success.
High-Risk High Return
Most of us think that if we want a high return, we have to be willing to take high risks.
For example, penny stocks are a typical high-risk high reward investment. Its daily price fluctuation is much higher than other stocks.
So, it’s possible for you to turn your $10,000 investment into $15,000 in one single day.
But, it’s equally possible for you to lose and be down to $5,000 from your original $10,000 investment just as fast.
To me, this is no different from gambling.
And it’s probably the fastest way for you to lose ALL your money.
Penny stocks are dying companies.
So, the chances for price appreciation over time are close to zero.
Next, you are playing against professional traders who make a living manipulating these penny stocks.
For them to make money, they’ll trick you into buying high and selling low.
They have more capital. More experience. More information.
Almost all the odds are against you.
So, it’s best for you to stay away from penny stocks.
Low Risk High Return
But, wouldn’t it be ideal if you can get high return but with a low risk?
You can buy undervalued stocks using value investing strategy.
Why is this low risk and high return?
Because value investing is all about minimizing risk and maximizing return.
As value investors, they only buy good businesses at a significant discount to their intrinsic value.
This is what they call Margin of Safety.
Margin of Safety = Intrinsic Value – Market Price
Investing with a margin of safety lowers the downside risk and also boosts the potential return.
Generally, the higher the margin of safety, the better the investment is.
For example, if you estimate that the true value of Business XYZ is $10 per share. Now, the market price is $10 per share.
If you are a value investor, you might want to wait for the share price to drop to $8 per share or even $6 per share before you click “buy”.
The person who bought it at $6 would definitely have a lower risk and higher return than the person who bought it at $8.
However, there are two things that you will never know for sure:
- You cannot predict the future (e.g. the future stock price movement)
The stock price could go up or down. Also, it could stay at an elevated level or at a depressed level for prolonged period of time.
With that being said, the stock price of business XYZ could go even lower than $6 or it could bounce back and continue to go up and above $10.
- You cannot determine the intrinsic value of any business with 100% accuracy
There is no valuation method that can give you an accurate valuation of any business. Your valuation is only as good as your assumptions made.
That means your estimated valuation could be too high or too low.
If it is too high, you are running the risk of buying the stock at a worse price.
Because of this, the best you can do is to lower your risk when it comes to investing your money in the stock market.
How do you do that?
- Be conservative with our valuation for any business
- Adopt a higher margin of safety
- Invest with appropriate position sizing
- Diversify your portfolio
Now, you have a much better idea about how to invest in the stock market for high return at a low risk.
How To Pick Good Stocks
Next, we will look at how to pick individual stocks.
For value investors, they only buy good businesses at a sensible price.
So, what constitutes a good business in the value investor’s eyes?
To determine whether or not it’s a good business, we ask ourselves these three questions:
- What is its past performance like?
- How is the business doing currently?
- How will the business be doing in the next 5 years or 10 years?
To assess whether or not a business is doing well, the first thing you should look at is their financial numbers.
So, what are the financial numbers we should care about?
If you have started business before, you will know that these three basic formulas are the most important ones to any business.
- Profit = Revenue – Cost
- Net Cash Flow = Cash Inflows – Cash Outflows
- Equity = Assets – Liabilities
For a business to survive, it has to earn a net profit and generate a net positive cash flow.
If not, it will have problems paying its employees and other expenses and continue its business operations.
So, to tell whether a business is doing well, we first look at the following:
- Net Profit
- Net cash flow
Generally, you will need to examine these numbers for the past five years at least.
Has there been consistent growth in its revenue and net profit?
Was it able to produce positive cash flow year after year?
Next, you need to assess its financial position.
Does it have an above industry average debt to equity ratio?
If yes, it means it’s taking too much loan.
Businesses that are highly leveraged are exposed to more risks.
For example, if the interest rate keeps going up, it’ll incur increasing interest expenses and might lead to cash flow problems if its business performance deteriorates.
As value investors, we like to see
- Stable earnings and net profits that are growing steadily over the years
- Strong positive cash flow from operations
- A healthy financial position
It tells us that it has done well in the past and it’s doing well currently.
Next, we need to find out whether it will continue to do well over the long run.
For a business to sustain and grow for the next 10, 20 years, it needs to have its competitive advantage.
Warren Buffett coined the term “Economic Moats” to refer to a business’ ability to maintain competitive advantages over its competitors in order to protect its long-term profits from competing firms.
According to Morningstar, there are 5 types of economic moats:
- Intangible Asset
- Cost Advantage
- Network Effect
- High Switching Cost
- Efficient Scale
So, does the company have an economic moat?
If yes, then it’s worth a closer look and could be a potential candidate for our stock shopping list.
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So, one of the best ways to pick stocks that give you high returns with low risk is to buy good businesses at a significant discount to its true value. When you do that, you significantly limit your downside risk because the price you bought your stocks gives you a margin of safety.