The good folks at Legg Mason (NYSE:LM) occasionally hold investment conferences. At a recent one, business professor Terence Odean gave an interesting speech, in which he explained why we investors buy the investments we buy. The secret he revealed was interesting, and upon a little reflection, it was not so surprising: We buy what we see.
He said: ". investors buy the stocks that catch their attention. The reason this happens is that there is a huge search problem when you want to buy an individual stock. There are between 5,000 and 7,000 stocks out there to choose from. . Hundreds of options or even dozens of options are still too many for us to have to search through. . We believe that many individual investors solve this search problem informally and perhaps unconsciously by only considering the stocks that catch their attention."
There you have it. It certainly rings true for me. I think it's true even for romantic pairings. Those who have found spouses have selected them from among the people they've met and who caught their attention, even though there may have been other good pairings for them somewhere out there. But let's get back to investing. Imagine that you're in the market for some promising stocks in which to invest. How do you go about locating them? Well, you could sift through the entire universe of stocks. Doing so carefully, one by one, checking out each company's financial reports and competitive position, would take so long that by the time you finished, your conclusions about the first stock might already be out of date.
Another approach would be to use a stock screener. You could set various parameters and then let it cull through the massive stock universe and present you with a more manageable subset. You could, for example, look for stocks trading with price-to-earnings (P/E) ratios of less than 20, net profit margins of about 10%, dividend yields of about 2%, and market caps of between $1 billion and $5 billion. That's effective, but if there's a really wonderful stock out there with net margins of 9.5% or a dividend yield of 1%, you'll miss it. Wal-Mart (NYSE:WMT), for example, appears to be a bargain to many people right now, with a stock price about 15% below its 52-week high. But its dividend yield is less than 1.5%. Walgreen (NYSE:WAG) would be excluded because of its $40 billion-plus market cap, yet it's an interesting possibility because of its strong and continuing growth, not to mention the boost it hopes to get from the new Medicare drug plan and new generic drugs coming on to the market. Some investors might be lured by General Dynamics (NYSE:GD), considering our nation's ongoing military involvements, but its 7% net profit margin would prevent it from appearing on your screen. Screening is powerful and useful, but not perfect.
The alternative that many of us opt for is to simply scan our usual sources of ideas, such as magazines, and perhaps discussion boards like those at The Motley Fool. This isn't a bad way to go. You end up presented with profiles of compelling companies, or lists of stocks that are deemed attractive for various reasons. Then it's up to you to follow up with as much additional research as you like, before deciding whether to invest.
Here are a few tips to help you find better investments:
- If you're relying on the financial news to introduce new ideas, know that the companies covered will likely be experiencing some kind of change in their business -- that's why they're in the news. They may be introducing a new product, or welcoming a new CEO, for example. At times like these, their futures can be more uncertain.
- Realize that many lists of interesting stocks are the results of someone else's screen. You may or may not be given the parameters (such as: "These stocks feature high dividends and rapidly increasing earnings").
- Take some time to check out the source of the recommendation. Not every analyst or columnist has a spectacular track record. And why follow the advice if it's spotty? In a recent article, Rick Munarriz delved into the recommendation habits of Mad Money host Jim Cramer, examining how his rapid trade recommendations in and out of Intuitive Surgical (NASDAQ:ISRG) may have cost some investors.
- Consider checking out the Fool's investing newsletters. I detailed them in this article and described their performances, and you can try any of them for free. Our track records are rather impressive. (We've more than quadrupled investors' money with a few picks, and all the newsletters are beating the market.)
Longtime Fool contributor Selena Maranjian owns shares of Wal-Mart. The Motley Fool has a disclosure policy.
