5 Steps to Picking Stocks

Put down that newspaper. Shut down the online feed reader. Heck, unplug the phone. None of those information sources will help you find great stocks that are ready to pop. They're too slow.

What do you mean, slow?
OK, let me give you a hands-on example. Let's say you were scanning the news on Thursday morning, and you saw that IT consulting firm Perficient had decided to start a $10 million buyback program. Management sounded confident, and all signs pointed to an undervalued stock. The opening bell hadn’t rung yet -- back up the truck!

If only investing were that easy. Within minutes of finding that press release in the wild, Mr. Market pumped up the lowest asking price on Perficient's stock by 5% -- too late to jump on that bandwagon for a quick profit, and it took all of four minutes in pre-market hours.

That's a lightly followed small cap, and it might take a few moments to evaluate the stock-price repercussions of something as mundane as a stock repurchase announcement. Imagine how lightning-quick the hair-triggers are around a closely watched heavyweight like Apple (Nasdaq: AAPL  ) or Pfizer (NYSE: PFE  ) . They could release the second coming of the iPod or Viagra, and you'd miss out on significant gains by the time you finished reading the headline.

Show me the way to real profits!
Making money in the market is easy, actually; it just takes a bit of due-diligence work. I prefer that over stress-induced ulcers, every time. This Fool follows a simple five-step process, and you can do the same:

  1. Come up with a list of potentially market-beating investments.
  2. Dig deeper on each list item and discard the chaff.
  3. Follow the short-short ticker list until you truly know the business.
  4. Invest real money.
  5. Check up on your holdings occasionally; buy more or close the position as appropriate.

Making a list
There are many ways to get started. You could seed your favorite stock screening tool with promising financial conditions, and see what comes out. For example, a quick screen for superb returns on equity and invested capital over the last three years comes up with some interesting tickers:

Company

TTM ROIC

TTM ROE

P/E Ratio

CAPS Rating (out of 5)

Hansen Natural (Nasdaq: HANS  )

44%

46%

22.9

****

Southern Copper (NYSE: PCU  )

42%

59%

13.8

*****

Crocs (Nasdaq: CROX  )

45%

52%

8.7

**

Amazon.com (Nasdaq: AMZN  )

19%

58%

62.7

**

MEMC Electronic Materials (NYSE: WFR  )

32%

52%

20.8

****

Data from Capital IQ, a division of Standard & Poor’s.

Other methods that spring to mind include sifting through the highest-rated stocks in Motley Fool CAPS, focusing on a favorite market sector like beer brewers or nuclear power contractors, or taking one of our newsletters for a free 30-day spin and picking some cherries from the scorecard. Any way you do it, you should end up with a manageable selection of research candidates.

Checking it twice
This is where you dive head-first into the stocks you found. Look at revenue and earnings growth trends. Examine the balance sheets. Weigh cash flows against debt loads, figure out why Amazon’s P/E ratio is so high and why Crocs’ is so low, and learn as much as you can about the products and services that make the whole thing tick. Without this step, you're not investing -- you're gambling, and you might as well go back to the news wire. Good luck with that.

If the information you find makes a stock look scary, you scratch it off the list. Can't quite wrap your head around the complexities of copper mining and global commodity prices? Bye-bye, Southern Copper. And so it goes.

Find out who's naughty and nice
By this point, you've boiled that list down to the cream of the crop. They're companies you would like to know better, and that you feel comfortable taking on. This is where you can turn your TV back on, and it's okay to open The Wall Street Journal again. Keep a close eye on your picks and see where they're going. Feel free to abandon the ones that disappoint you over time.

In the end, some companies might truly impress you, or a stock price might get severely and unfairly punished when you know the company is solid. Then it's time for the next step.

Guess who's coming to town?
Buy in. Take a position. Make yourself a shareholder. If you did your homework properly, you should get rich. Step five shouldn't take too much of your time. Just monitor your holdings at your convenience, to make sure you still believe in the reasons behind the buy. If not, you sell. Ideally, that won't happen for years -- maybe never.

Again, you can't pick winners when they've already won. It's too late. But an ounce of preparation makes for a pound (about $2 at today's rate) of profits.

Further Foolishness:

Apple and Amazon are Motley Fool Stock Advisor picks; Pfizer is both an Income Investor recommendation and an Inside Value bargain.

Fool contributor Anders Bylund is a Hansen Natural shareholder, but holds no other position in any of the companies discussed here. You can check out Anders' holdings if you like, and Foolish disclosure knows that haste makes waste.


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