This post is about how to buy stocks. But it’s not about how to place orders, instead it’s about how to buy stocks that are more likely to go up in value in the future and avoid buying stocks that are likely to go down.
Finding stocks likely to go up is a bit of a dark art. Only a select few of the top mutual fund managers have managed to repeatedly beat the index returns. If these experts have a hard time buying winning stocks, how can the average investor expect to beat the markets?
The average investor actually has an opportunity to outperform mutual funds because they’re smaller. Big mutual funds can’t pick all the best small companies as they grow quickly, they have too much money. Instead they buy everything, and place small bets on which will do better and which will do worse. Mutual funds can’t find that one killer stock and put everything on it, but the individual investor can.
So how to buy stocks that are going to grow your investment? Well the general strategy is to buy low and sell high. To do that you have to be able to identify what is low and what is high.
“Value Investing” is a method for determining when stock prices are good for buying and when they’re overvalued and should be sold. I’m going to share a simple method for finding stocks that have historically returned an average of 15% per year.
This is based on Ben Graham’s process for evaluating stocks. Ben Graham is the father of value investing. Back in the 30’s he pioneered the disciplined practice of valuing stocks. His quantitative approach proved to consistently perform well since then.
The idea is to find “cheap” stocks. Cheap stocks are relatively safe because at the time you buy them the value should actually be higher than the price paid. Graham defined cheap stocks as one with an earnings yield that was at least twice as large as the average yield of long-term AAA corporate bonds.
As of this writing AAA corporate bonds are at 6.1%, so look for stocks with earning yields of 12.2% or greater.
The earnings yield is simply the inverse of the price-to-earnings ratio. To convert earnings yield to PE ratio: 100/(earnings yield) = PE ratio. So 100/12.2 = 8.2. So look for stocks with a PE of 8.2 or lower.
If you’ve filtered a list of stocks by looking for only those with a PE < 8.2 the next step is to add a margin of safety. The safety comes from again sifting out companies that are highly debt leveraged. Look for companies with leverage ratios of two or less.
That’s your list of stocks to pick from.
That’s how to buy stocks that are likely to go up according to Ben Graham.
When to sell? Graham recommends selling when the stock is up 50% or two years have passed.
You can use the MSN deluxe stock screener to help find stocks that meet the criteria.
There are many ways to do well on the stock market. I recommend reading as much as you can about different approaches to find the one that suits you best. Then dive in. Try starting with Secrets of Successful Traders. Hit the book store and devour as much as you can.
