How to pick stocks: A practical guide for smart investing

How to pick stocks for long-term investing

Long-term investing focusses on steady growth and financial stability, aiming to build wealth over years, if not decades.

Here's how you can select stocks that are likely to perform well in the long run:

1. Focus on strong fundamentals

Start with the company's financial health. Look for businesses with consistent earnings and revenue growth. Financial metrics like Price-to-Earnings (P/E) ratio, Price-to-Book (P/B) ratio, Earnings Per Share (EPS), and Return on Equity (ROE) provide clear insights into how well a company is performing compared to others.

• P/E ratio. A ratio between 15 and 25 is often considered healthy. Too high may mean overvaluation, while too low can indicate weak market confidence.
• P/B ratio. A good range is typically between 1 and 3, showing a fair valuation. Anything higher might suggest the stock is overvalued, while a low P/B could signal undervaluation or financial instability.
• EPS. Look for companies with consistent or growing EPS over time. This shows that the business is not only profitable but also expanding.
• ROE. A good ROE falls in the 10-20% range. This tells you if a company is effectively using shareholder equity to generate profits. A higher ROE can indicate strong profitability but watch out for excessive debt that drives this number up artificially.

Also, a solid balance sheet with low debt (a debt-to-equity ratio of 1 or lower) and healthy cash flow indicates a company less likely to struggle during economic downturns. Companies like this often grow steadily and reward shareholders over time.

2. Assess the company's competitive advantage

Also known as the economic moat, this represents a company's ability to maintain its edge over competitors. Businesses with a strong competitive advantage often have some form of protection, such as intellectual property, brand loyalty, or cost leadership. These characteristics can make them more resilient and less susceptible to market disruptions.

Companies with high market share and barriers to entry, like large tech firms or dominant consumer goods companies, often provide stability and long-term growth prospects.

3. Prioritise dividend stocks for stability

Dividends are a crucial indicator of a company's health. Look for businesses with a strong track record of paying and even increasing dividends over time. The dividend payout ratio is also important—it tells you whether a company can sustain its dividends without overextending itself. A good rule of thumb is looking for payout ratios comfortably below 60-70%.

Dividend-paying stocks can offer a regular income stream and act as a buffer during market volatility.

4. Avoid highly speculative stocks

Steer clear of companies with unpredictable earnings or volatile stock performance. Speculative stocks may promise high returns, but they often come with increased risks, and market changes can heavily impact their value. Focus on businesses with a history of steady growth and proven performance rather than chasing stocks that might be the next big thing.

How to pick stocks for short-term trading

Short-term trading is about catching fast price swings rather than holding onto stocks for long periods.

Here's what to focus on when making short-term stock picks:

1. Use technical analysis for timing

Instead of looking at a company's long-term financial health, short-term traders focus on price action and market sentiment. Tools like moving averages (e.g., 50-day, 200-day) help identify the direction of price trends, which are useful for spotting potential entry or exit points.

• Moving averages. If a stock's price is above its moving average, it may signal an upward trend, while falling below could indicate a downward trend.
• RSI (Relative Strength Index). RSI is a momentum indicator that ranges from 0 to 100. A reading above 70 suggests a stock might be overbought (potential for a drop), while below 30 may indicate oversold conditions (potential for a rebound).
• Bollinger bands. These help traders identify volatility and potential reversal points by showing when a stock is trading outside its typical price range.

2. Focus on catalysts

Catalysts such as earnings reports, product launches, or mergers can cause quick price movements. Traders often look for stocks with upcoming announcements or news that could drive sudden increases or drops in price. Monitoring news feeds and economic events is crucial for staying ahead of these shifts.

3. Ensure liquidity for quick trades

Liquidity matters when you need to enter and exit positions quickly without large price changes. In short-term trading, a stock with a healthy trading volume allows for smoother transactions and more reliable trade execution. Avoid stocks with large bid-ask spreads, as these can significantly eat into profits, especially in fast-moving markets.

4. Set stop-losses

Given the rapid price changes in short-term trading, setting stop-loss orders is essential to protect yourself from significant losses. A stop-loss order automatically sells a stock once it hits a predetermined price, helping you limit downside risks if the market moves against you.

How to pick stocks for day trading

Day trading focusses on capturing fast, often minute-by-minute price movements within a single trading day. To succeed in day trading, you must be nimble and rely on real-time data and volatility.

Most of what we mentioned about short-term trading matters here, too. But here are a few extra points you should consider when day trading:

1. Focus on high volatility

Volatility is crucial for day traders because it creates profit opportunities. Stocks that regularly experience price swings of 2-5% or more within a single day are prime candidates. You can use volatility scanners to identify such stocks, which are typically influenced by market sentiment, breaking news, or sudden events.

2. Use real-time data and news feeds

Day traders rely heavily on real-time price data and news updates. Pre-market and post-market scans are vital for spotting stocks that are likely to experience sharp price movements. Earnings reports, regulatory changes, or geopolitical news can all serve as triggers for major price changes throughout the day.

3. Select stocks with high volume

For day trading, the higher the volume, the better. You need stocks that trade millions of shares per day (at least 1 million) to ensure you can quickly move in and out of trades.

High volume provides liquidity but also reduces slippage, which is when the price of a stock changes between the time you place an order and when it gets executed. This helps you execute trades at or close to your desired price.

Avoid low-volume stocks, as they can cause price swings that may be harder to predict or take advantage of in a short timeframe.

4. Avoid holding positions overnight

Day traders close all their positions by the end of the trading day to avoid risks associated with holding stocks overnight. Unanticipated news after the market closes could lead to unpredictable price changes when the market reopens, creating potential losses.

How to select stocks for swing trading

Swing trading is about benefiting from short- to medium-term price movements, typically holding stocks for a few days to a few weeks. This strategy seeks to catch the "swings" in stock prices (upward or downward) while avoiding long-term exposure to risks.

The principles of short-term trading apply here, too, but here are some tactics you should pay extra attention to when picking stocks in swing trading:

1. Look for trend reversals

Swing traders focus on identifying patterns that suggest a stock is about to change its price direction. Patterns like double tops, double bottoms, and head-and-shoulders formations are often signs of these reversals. These technical indicators help traders anticipate when a stock will move from a downtrend to an uptrend or vice versa.

2. Watch for support and resistance levels

Unlike day traders, swing traders pay close attention to key support and resistance levels, as these are the price points where stocks often reverse direction. By buying near support or selling near resistance, traders can enter or exit trades with a favourable risk-to-reward ratio.

3. Focus on price consolidation

Swing traders may benefit from price consolidation periods, where stocks move within a narrow range before making their next big move. Identifying stocks that are consolidating can help traders enter positions before a breakout or breakdown, maximising potential gains from the next price swing.

4. Timeframe alignment

Swing trading is unique in its balance between shorter and longer timeframes. Traders usually analyse both daily and weekly charts to ensure that their trades are aligned with broader market trends. This multi-timeframe approach ensures that swing traders can benefit from intermediate price movements while staying in line with the overall market direction.

Managing risk in stock picking

When investing in the stock market, it's easy to get caught up in chasing returns. But without a strategy to limit potential losses, even the best stock picks can go wrong.

Here's how you can achieve sufficient risk management:

1. Diversify across sectors and asset classes

Don't put all your money into one stock or sector. When you spread your investments across different industries—like technology, healthcare, and consumer goods—you reduce the risk of one area dragging down your entire portfolio. Diversification helps to minimise the impact of poor performance in a single stock or sector and balances out the risks.

2. Use position sizing to limit exposure

No matter how confident you are about a stock, allocating too much of your capital into one position is never a good idea. A good rule of thumb is to invest no more than 5-10% of your total portfolio in a single stock. This strategy helps you avoid heavy losses if a trade goes wrong.

3. Set stop-loss orders

A stop-loss is an automatic sell order that activates once a stock hits a certain price. This tool is essential in limiting your downside risk, especially in volatile markets. As a stock's price rises, you can adjust your stop-loss to lock in gains while still protecting your profits.

4. Understand market volatility

The stock market can be unpredictable. Prepare for short-term fluctuations without making impulsive decisions. It's essential to stay patient and avoid panic selling during temporary market dips. Being too reactive to market volatility can harm your long-term gains.

Conclusion: Picking stocks according to your investment style

Effective stock picking requires a disciplined approach based on careful research and strategic thinking. Investors need to focus on solid fundamentals, understand market dynamics, and, most importantly, prioritise risk management to secure their investments.

If you're thinking long-term, go for companies with a good track record and steady growth. If you're after short-term gains, pay attention to market trends and be ready to move quickly. Whatever your strategy, building a well-diversified portfolio across sectors and asset classes can protect you against downturns while ensuring growth opportunities.

Keep in mind that success in the stock market is by no means guaranteed by any single strategy. However, you can achieve it by continuously improving your strategy and remaining flexible to shifting market conditions. Thoughtful stock selection and sound risk management techniques can lay the groundwork for long-term success.