Sunday, February 26, 2012

How to Pick Winning Stocks in Five Easy Steps

How to Pick Winning Stocks in Five Easy Steps

You can see just how important politicians are.

While Julia Gillard and the Fairy Ruddfather try their best to win the prize, how has Australia coped?

The shelves were still full at the supermarket.

The traffic lights still worked at intersections.

The electricity companies kept the power on.

And we're sure even the Telstra BigPond outage wasn't directly anything to do with the Labor Party leadership spat.

That's because it's just noise. It isn't worth listening to. And once you filter out the rubbish, you figure out things are still working OK.

You see the same effect in the markets. In a moment, we'll show how you can filter out this noise and pick up bargain stocks others have discarded.

First, let's get something off our chest...


A Lot of Noise

Aside from creating a few basic laws for property rights and individual freedom, everything else politicians do just isn't needed.

In fact, their meddling is more of a business inhibitor than a business creator. Businesses the width and length of Australia must be relieved that at least for the next week or so, the pollies won't try to "fix" something in the economy.

Even so, you'll often hear people say that a particular politician is a "visionary". That they've helped create prosperity.

Wrong. We say politicians are sick in the head.

What else can explain the fact that their only purpose is to sit in an office and come up with new ways to tax successful ideas?


No. The real visionaries are the people who take risks... the folks who invest their own hard-earned money in a project or idea. They know if they get it wrong, they could lose everything.

But if they get it right, they could make a fortune.

If a pollie gets it wrong, they just raise taxes and say it was a good idea, it's just they didn't spend enough money on it.

A bit like the home insulation bungle. Or the Vietnam War.

The point is politicians make a lot of noise. And it's the noise that gets all the attention.

This brings us back to the financial markets. Where the same thing can happen:
  • Greece will default.
  • The U.S. government owes USD$16 trillion.
  • The European Central Bank is thinking up another bailout plan.
  • The Reserve Bank of Australia will/won't raise interest rates.
Don't get us wrong. You should know this stuff. And you should consider it when you make your investment decisions.

And heck, we've spent half the past three-and-a-half years bringing it to your attention.

But it's also important to remember that when the noise is at its loudest, that's often when you can make your best investment decisions...


Opportunities in the Din

Don't forget, despite the noise, businesses still carry on doing business. The tills still ring (or beep). Miners still mine. And explorers still find big new resources.

And as we look at the market today, we can see market "noise" has beaten down many stocks. That goes for some blue-chip stocks as well as the small-cap tiddlers we look at.

Until recently, we were struggling to come up with stocks worthy of making it into our monthly investment advisory, Australian Small-Cap Investigator.

But today, we're struggling to come up with a reason for keeping stocks out. We won't deny it. It's good to be in that position.


The only thing is, which stocks should you go for?

In the world of small-caps, that's not hard. You look for stocks trading for pennies. And there are plenty of them. Stocks that were more than a dollar a couple of years ago are now only five, 10 or 15 cents.

Of course, there's usually a reason why the stocks have fallen so much. That's where you have to put in the extra work to find out why.

That means ignoring the big picture noise (Greece, U.S. debt, the RBA, etc.) and instead focus on the company specifics.


Five Steps to Picking Winning Stocks

To do this we look at five things:
  1. How much cash the company has and how fast it's likely to spend it (this is important for small-cap stocks because they typically don't make a profit. Their only way of getting cash is to sell more shares or borrow money.)
  2. What's the outlook for the company and its industry? In other words, are they claiming typewriters are about to make a comeback... or are they in a leading-edge industry, or developing a product in high demand?
  3. Next, we look at price action (actually, we usually look at this first). What has the share price done? Right now, we're looking for beaten-down stocks. Companies that for some reason are trading near their lows. If we can find a stock that's been unfairly hit by investors, it can mean there's a lot of upside to come.
  4. Then there's risk. Here you need to know the potential downside. For small-cap stocks, it's usually no more than a few cents... because they're trading for no more than a few cents! If we see a stock at five cents, we know the maximum downside. But what we also need to work out is the upside. If it can only go up to six cents, we're not interested. But if it can go to 20 or 30 cents, we're all ears...
  5. That brings us to the reward. As we say, if the reward for a five-cent stock is a gain of 20 or 30 cents, it's worth taking the risk. Here we're after 200%, 300% or 500% gainers. But you can apply the same strategy to blue-chip investing. If you think a stock will only gain 5% a year, why would you buy it? You're better off sticking the cash in the bank. At least you'll compound your returns.
In short, it's important to make note of the big picture stories. Because that's how to frame your portfolio and asset allocation.

But when it comes down to picking individual stocks, you're often best off leaving the big picture at the door.

The big picture helped you get there, but from that point on you should focus on what the company does, how it plans to make money... and most important: how much money you'll make if it all goes to plan.

Cheers.
Kris.

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