15 Ways to Pick the Best Stocks for Your Portfolio

Quality matters. The best stocks can deliver a far superior performance than stocks you might have bought on a hunch or just after reading a positive mention of them somewhere. It's worth spending time getting better at reading financial statements and studying companies so that you can spot the most promising ones. Here are 15 tips.

5 Stocks Under $49
Presented by Motley Fool Stock Advisor
We hear it over and over from investors, “I wish I had bought Amazon or Netflix when they were first recommended by The Motley Fool. I’d be sitting on a gold mine!" It's true, but we think these 5 other stocks are screaming buys. And you can buy them now for less than $49 a share! Click here to learn how you can grab a copy of “5 Growth Stocks Under $49” for FREE for a limited time only.

For starters, stick to companies you can understand -- meaning you understand their opportunities and challenges, and how they make their money. Warren Buffett has explained how he and his partner Charlie Munger invest in his 1999 letter to shareholders, saying, "If we have a strength, it is in recognizing when we are operating well within our circle of competence and when we are approaching the perimeter. Predicting the long-term economics of companies that operate in fast-changing industries is simply far beyond our perimeter."

It's also effective to be a value investor, aiming to buy shares of stock for significantly less than their intrinsic value -- and thereby enjoying a margin of safety. That doesn't mean you can't buy some exciting, fast-growing companies. There can be times when even those seem undervalued. Shares of Netflix (NASDAQ: NFLX), for example, were recently down more than 50% from their 52-week highs, while Meta Platforms (NASDAQ: FB) (the company formerly known as Facebook) stock was also down 50%. A drop in price doesn't guarantee a bargain, but many investors see both Netflix and Meta Platforms as among those that are undervalued relative to their long-term potential.

It's well worth paying attention to value, but don't overdo it. As Buffett quipped in his 1989 letter to shareholders, "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price." Some signs of a wonderful company are sustainable competitive advantages, such as economies of scale or a powerful brand.

ALSO READ: Investing in Value Stocks

Dividend-paying stocks are another road to riches, because they offer multiple paths to wealth building. For starters, they pay out cash rather regularly, and that payout will likely increase over time, as long as the company paying it is healthy and growing. On top of that, the stock price itself is likely to grow over time as well.

When looking for attractive dividend payers, don't just look for the fattest dividend yields you can find. For one thing, an unusually high yield may be due to the stock having recently crashed. (A dividend yield, after all, is simply a ratio of annual dividend to recent share price.) Instead, focus on companies with robust dividend growth rates.

5 Stocks Under $49
Presented by Motley Fool Stock Advisor
We hear it over and over from investors, “I wish I had bought Amazon or Netflix when they were first recommended by The Motley Fool. I’d be sitting on a gold mine!" It's true, but we think these 5 other stocks are screaming buys. And you can buy them now for less than $49 a share! Click here to learn how you can grab a copy of “5 Growth Stocks Under $49” for FREE for a limited time only.

Growth stocks can be powerful wealth builders, too. They are tied to companies that are growing at above-average rates. While growth stocks may deliver explosive returns, they are also sometimes overvalued, and plenty of them end up disappointing investors. That's why our Motley Fool investing philosophy recommends buying at least 25 stocks and planning to hold them for at least five years. That can boost your odds of ending up with some big winners in your portfolio, as you'll be giving them time to grow and perform.

ALSO READ: Growth Investing: A Step-by-Step Guide for Getting Started

REITs -- real estate investment trusts -- are another good kind of stock to have in your portfolio, in large part for their dividends. They're companies that buy a lot of real estate properties (often focusing on a particular niche, such as apartments, stores, data centers, medical buildings, industrial sites, etc.) and then collect rent. By law, they must pay out at least 90% of their income in dividends.

Another way to pick the best stocks in your portfolio is to make sure the promising stocks you pick are diverse. In other words, don't just load up on, say, oil stocks, as you'll get whacked whenever calamity strikes the industry. If your portfolio reflects your love of airplanes and travel, a pandemic might send it down sharply, should people stop traveling for a while. Aim to be diversified across industries and countries and even sizes of companies. A diversified portfolio can reduce risk -- though you needn't overdo it.

For best results when studying companies in order to choose the most promising ones for your portfolio, you should know your way around financial statements. There are three primary ones -- the balance sheet, income statement, and statement of cash flows. Getting familiar with them can help you spot both green flags (robust growth rates, widening profit margins) and red flags (rising debt levels, inventory levels growing faster than sales).

ALSO READ: A Beginner's Guide to Financial Statements

Simply understanding profit margins can go a long way toward making you a better investor. Naturally, the bigger the profit margin the better, but it's a bit more complicated than that. Volume of sales also matters. Your product might have a profit margin of 50%, but if it doesn't cost much and you don't sell much of it, that's not so good. Many retailers have very low profit margins, but they can still generate a boatload of profits if they have great volume.

5 Stocks Under $49
Presented by Motley Fool Stock Advisor
We hear it over and over from investors, “I wish I had bought Amazon or Netflix when they were first recommended by The Motley Fool. I’d be sitting on a gold mine!" It's true, but we think these 5 other stocks are screaming buys. And you can buy them now for less than $49 a share! Click here to learn how you can grab a copy of “5 Growth Stocks Under $49” for FREE for a limited time only.

Optionality is a word you'll see bandied about frequently by investors when they're chatting with one another about stocks they like. They value optionality in candidates for their portfolios because it means that a company has multiple paths to profits. Lexico.com defines optionality as the "quality of being available to be chosen but not obligatory." My colleague Brian Stoffel has explained that companies with optionality have "a demonstrated ability to explore new ways of fulfilling their missions." As an example, consider Zoom Video Communications (NASDAQ: ZM). Some might think its best days are over, as the pandemic will eventually wane. But it has multiple other irons in the fire, such as Zoom Phone, a phone operating system that can be adopted by companies to better manage their communications, and the Zoom Developer Platform, which allows app developers to incorporate Zoom video technologies. Clearly, the company has multiple revenue-generating initiatives in place, and more are possible.

As you study candidates for your portfolio, pay attention to debt. It's not an automatic deal breaker if a company has debt on its books, but you don't want to see more debt than it can handle, or debt increasing at a rapid level. Learning about the quick ratio and the current ratio can help, as they compare assets and liabilities, with the quick ratio incorporating inventory levels as well. Debt can actually be good for a company, if it's managed well, as it can provide capital with which a business can invest in further growth. But a company with too much debt may find itself unable to pay it off or with limited ways to keep growing.

ALSO READ: 3 Stocks to Buy for 2022 That Are Practically Money Machines

An effective way to help yourself find the best stocks is to simply eliminate an entire class of risky ones from consideration -- penny stocks. Penny stocks are those trading for less than around $5 per share. They're risky because they're often tied to unproven, unprofitable, and shaky (if not shady) companies, and they are often manipulated by fraudsters who take advantage of naive investors. It might seem like a $0.30 stock must be a bargain, but it's not -- it stands a good chance of becoming a $0.03 stock soon -- or worse.

Of course, if you want to grow your wealth through the stock market, you don't have to do all the work yourself. You can opt to let financial professionals -- mutual fund managers -- do the work for you. They'll charge a fee, of course, so be sure to look not only for funds with managers in whom you have confidence and with impressive track records, but also for funds with relatively low fees. Be warned, though: Most actively managed mutual funds don't perform as well as simple index funds -- and that underperformance in many cases is due to those fees, as index funds often sport ultra-low fees.

ALSO READ: How to Invest in Mutual Funds

Index funds, then, are a terrific choice for many, if not most, investors, as they require little effort and little attention. Simply keep adding dollars to a low-fee, broad-market index fund over many years and you can do quite well. Some low-fee index funds (or their cousins, exchange-traded funds, known as ETFs) you might consider include the SPDR S&P 500 ETF, Vanguard Total Stock Market ETF, and Vanguard Total World Stock ETF.

5 Stocks Under $49
Presented by Motley Fool Stock Advisor
We hear it over and over from investors, “I wish I had bought Amazon or Netflix when they were first recommended by The Motley Fool. I’d be sitting on a gold mine!" It's true, but we think these 5 other stocks are screaming buys. And you can buy them now for less than $49 a share! Click here to learn how you can grab a copy of “5 Growth Stocks Under $49” for FREE for a limited time only.

We all have limited funds, so make your investment decisions carefully. Invest only in companies you've researched and have great confidence in, or just stick with simple but effective index funds. Or do a little of both!

Randi Zuckerberg, a former director of market development and spokeswoman for Facebook and sister to Meta Platforms CEO Mark Zuckerberg, is a member of The Motley Fool's board of directors. Selena Maranjian owns Meta Platforms, Inc. and Netflix. The Motley Fool owns and recommends Meta Platforms, Inc., Netflix, Vanguard Total Stock Market ETF, and Zoom Video Communications. The Motley Fool has a disclosure policy.