Stockmarket superstars like Warren Buffet and Peter Lynch have consistently beaten the market by investing significant time in getting to know every detail of the businesses that they buy into, enabling them to invest for maximum returns.
But with tens of thousands of listed companies to choose from, there is no way a single organisation (let alone an individual person), can conduct serious analysis of every listed company.
So in order to research the best opportunities, successful investors create a shortlist of potential market beaters, filtering everything else out.
Here’s how to create your own shortlist of potential market beating stocks:
The Process of Creating a Shortlist
The first thing to note is that shortlists will vary from person to person, depending on their investment objectives, their tolerance of risk and their personal experience.
There is no real right or wrong answer about the type of companies that should be included, provided their inclusion is based on sound business sense.
Creating a Shortlist can take place in four steps:
- Step One – Define your investment universe
- Step Two – Determine the type of stock you will want to buy
- Step Three – Select your preferred industry sector
- Step Four – Scan the businesses within the sector against your investment criteria
Step One – Define Your Investment Universe
You can quickly remove a large chunk of the tens of thousands of investment opportunities by selecting a geographic market to focus on, such as:
- Emerging Markets
The market you choose will be guided by your own tolerance to risk. For those living in the UK who are new to investment, the UK market (for which they will have the most knowledge), would be the least risky starting point.
More experienced investors may want to try their luck with higher risk emerging markets like China or Brazil, where the potential rewards can be greater.
Step Two – Determine the Type of Stock You Will Want to Buy
Different types of stock are traded on open markets known as Stock Exchanges and the type of stock you decide to buy into, will again depend on your investment objectives and attitude towards risk.
In the UK, two of the best known stock exchanges are the:
- London Stock Exchange – Where the shares of large, ‘blue-chip’ businesses are traded, such as those in the FTSE100 index. On the whole, share prices tend to be comparatively stable, presenting a lower risk of loss.
- AIM (Alternative Investment Market) – Where smaller, potentially faster-growing businesses are traded. Prices here tend to be much more volatile, which increases the potential to make larger gains or losses!
Deciding on the type of stock you will want to invest in will remove a further layer of unwanted investment opportunities.
Step Three – Select Your Preferred Industry Sector
Industry sectors are used to help investors categorise businesses by what they do and examples of well known sectors include:
- Financial Services (banks, insurance, credit card companies)
- Transportation (trains, planes, haulage, bus companies)
- Technology (software houses, computer manufacturers)
- Retail (supermarkets, fashion, home furnishings)
Often people build up their knowledge and become specialists in particular industry sectors, with this level of expertise helping them to identify good investment opportunities and reducing the risk of buying bad stock.
Some useful questions to help you decide on your preferred sectors are:
- Do I understand XYZ sector? (Warren Buffett famously avoided making massive losses during the dot.com crash, by completely avoiding technology companies because he could not understand how they made money)
- Is XYZ sector in growth or in decline?
- Is XYZ sector generally unloved by other investors? (sometimes certain types of businesses and sectors go out of fashion with investors and there could be an opportunity to bag some bargain shares, whilst they are unpopular)
- How could XYZ sector be affected by changes to: economy / technology / politics / legislation / society?
Try to limit the number of sectors you choose to 2 or 3 for your initial shortlist. You can always add more in the future as part of your diversification strategy.
Step Four – Scan the Businesses within the Sector Against Your Investment Criteria
By now your filter should look similar to the example below:
- Geographical Market – UK
- Share Type – Blue-chip, such as those listed in the FTSE100
- Sector – Transportation
Step Four, will turn the remaining businesses listed within your chosen sector into a handful of potential investment opportunities for you to track and investigate further.
This step involves deciding on a criteria that describes the types of businesses you want to invest in and once you have decided on the criteria, you can use financial ratios to compare the businesses against each other to identify those that provide the closest fit.
The criteria can contain as many different attributes as you feel necessary, but some popular ones to consider are:
Attribute One – Size of the Dividend Payment
Companies paying bigger dividends will provide the shareholder with a greater income and are naturally attractive to investors.
There are two ratios that can be used to help score businesses on their dividends:
- Dividend Yield – This ratio will tell you how much money the stock has paid out as a dividend over the year, expressed as a percentage of the share price.
- Dividend Cover – This ratio will tell you if a company has been able to earn enough income to cover the dividend payments it has committed to.
Be wary of companies paying an abnormally high dividend, as they could be using this to distract investor attention from other problems and may not be sustainable in the future.
Attribute Two – Business Efficiency
A good sign of a well-managed business is the ability to derive the most value from its assets and money borrowed, and this can be measured with a ratio called Return on Capital Employed (ROCE).
The higher the figure, the more efficient the business is. Comparatively lower and negative ROCE figures should raise a red flag and indicate potential problems within the business.
Attribute Three – Size of Borrowing
Most businesses borrow money to invest in their growth and this if often referred to as Gearing. However a highly-geared business can become very vulnerable, especially when the cost of borrowing rises or sales begin to fall – making it harder to service the debt.
A lower ratio of gearing, means the business should have a greater financial cushion to rely on if trading conditions become tough.
Attribute Four – Value for Money
Warren Buffett always advocates buying unfashionable or unloved shares that are trading below their real value and one way of spotting such opportunities is to use the P/E Ratio.
The P/E Ratio relates to the price paid per share against the earnings (dividends) it pays out.
When people expect a business to pay out a high dividend, they will begin buying more shares in that business, effectively driving the price per share up. Where the value opportunities lie is in finding shares with a lower P/E Ratio, suggesting those shares are trading cheaply.
A word of warning: This is a very popular ratio, but can often be used incorrectly. The best way to use the P/E Ratio is to compare the business to other similar businesses within the same sector.
Also you should avoid relying on any single financial ratio for making a buying decision. Ratios will help you find potential investment opportunities, but you should conduct more in-depth analysis of the business before committing your hard-earned money.
Scanning the Market Against Your Criteria
Now if the thought of churning through the financial data of a hundred or so companies, crunching ratios to find the best opportunities scares you then fear not, as there are a number of stock market scanning tools available that will provide you with your shortlist in seconds.
It is possible to buy some pretty sophisticated scanning software, enabling you to apply all manner of analysis, but most people tend to start with one of the many free tools available online, such as the UK Equity Screener at InvestorsChronicle.co.uk.
With your shortlist produced, you can now begin the process of getting to know the businesses that you have identified as if they were your own, before making your buying decision and if you are not happy with the investment opportunities you have found, you can always tweak your scanning criteria or produce a new shortlist of different opportunities to investigate.