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The stock picker’s guide to the market

We look at how to create a shortlist of investible stocks

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

This article is more than 6 months old

It was correct at the time of publishing. Our views and any references to tax, investment and pension rules may have changed since then.

There are thousands of options when it comes to investing in shares. But knowing where to begin can be daunting. We’ve put together a guide that should be able to help.

This is by no means an exhaustive list of everything investors should consider before buying shares. But it should help create a shortlist for further scrutiny.

This article isn’t personal advice, if you’re not sure whether an investment is right for you, seek advice. All investments and any income they produce can fall as well as rise in value so you could make a loss.

Investing in individual companies isn’t right for everyone – it’s higher risk as your investment is dependent on the fate of that company. If a company fails, you risk losing your whole investment. You should make sure you understand the companies you’re investing in, their specific risks, and make sure any shares you own are held as part of a diversified portfolio.

Think big

The global economy cycles through periods of growth and stagnation. An important but often overlooked part of the stock selection process is taking time to think about the bigger picture. Having some idea of the general direction of travel can help highlight promising industries.

When the economy is on the upswing, cyclical industries tend to do well. These are sectors whose fortunes are tied to the health of the economy – they benefit from increased spending. Construction is a good example. When the economy is booming, governments have more money to spend on infrastructure. Businesses build new factories. But if times are tough, these projects are often put on hold.

By contrast, defensive industries outperform when the economy is sluggish. They include goods and services that people buy no matter what. Healthcare is a good example of a defensive sector. Come rain or shine, medical spend will always top the list of priorities.

Below are a few examples to get you started.

Cyclical Sectors Defensive Sectors
Travel & Leisure Healthcare
Construction Insurance
Property Utilities
Retail Pharmaceuticals
Automotive Household Goods

Diversification is key for long-term investors. That means a strong portfolio will have a mix of cyclical and defensive industries. It’s very difficult to time shifts in the economy, so it’s a good idea to own lots of investments across different investing styles, geographies and industries.

Trends that matter

Outside of the general economic direction, it’s also important to consider whether there are any trends worth watching. Remember, it’s best to take a long-term view so these should be things that will develop over the next five to ten years.

Inflation, for example, is something everyone’s talking about. The rapid inflation we’ve experienced so far is likely short term. Most expect it to slow down with time. But it might not fall below the bank’s 2% target for some time.

UK consumer price inflation

Source: ONS, February 2022.

Inflation makes everything more expensive, no company is completely immune. But there are some that benefit more than others.

Miners, for example, have enjoyed price hikes because it makes their products more valuable. The cost of everything from iron ore to diamonds is rising faster than the cost to dig it out of the ground, bringing a windfall of cash for those in the industry.

Other industries that have tended to perform well when inflation is high are energy, consumer staples and financials.

Inflation might be grabbing headlines, but it isn’t the only trend to watch. Regulatory changes, consumer preferences and the impact of an aging population are all worth thinking about.

Our share research team explores trends like these and the companies that might benefit from them, offering updates and insight on a wide variety of the most popular stocks. Most recently we looked at what’s happening with tech and growth stocks.

Sign up to the Share Insights email to get research like this sent straight to your inbox every week.

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Drilling down

Once you’re comfortable with the bigger picture, it’s time to start narrowing the field. Looking at valuations is one way to do this. Comparing stocks is best done by industry. Look for stocks with reasonable valuations compared to their peers.

The most common way to assess valuation is looking at a price to earnings (PE) ratio. This tells you how much investors are willing to pay for each pound’s worth of profit. The higher the PE, the more valuable investors believe the company is. A low PE suggests investors don’t think as highly of the company’s future prospects.

But when it comes to assessing PE, it’s rarely as simple as that. A PE that’s through the roof suggests the future benefits have already been priced in. These stocks tend to be more volatile because of the market’s high expectations.

On the other hand, a PE that’s ultra-low suggests there could be a problem on the horizon. The market can be irrational at times, but it’s rarely dead-wrong. Look for stocks you think are fairly valued. Whether it’s shares or pizza, you often get what you pay for.

Looking at the PE ratio for two companies within the same industry doesn’t guarantee an apples-to-apples comparison either. Other factors, like their expected growth rate and dividend payments should also be part of the equation. And figures are only one part of the story – it’s important to consider the bigger picture.

More on how to value shares

Financial check up

If you’ve found a share you like, it’s time to give it a thorough look. Part of doing this is assessing the company’s financial health. A hefty dividend payment can be a big draw if income is what you’re after. But dividends aren’t guaranteed and yields are not a reliable indicator of future income. It’s important to look under the company’s hood to decide whether they’ll be able to continue paying and be happy with the risk they may not.

The easiest place to start is free cash flow. This tells you how much money is flowing through a company each year. It can be calculated using the cash flow statement.

Free Cash Flow = cash generated from operations - investments in the business.

If free cash flow is positive at the end of the year, that means there’s cash left over after paying for business expenses. If it’s negative, it means the company is spending more than it earns. The important thing to watch is the direction cash flow is moving. Lots of very young companies are free cash negative for years, and this isn’t necessarily a problem as long as there’s a path to positive.

Companies that pay a dividend should be free cash positive, ideally with more than enough free cash to cover dividend payments. Looking at the dividend coverage ratio is another way to assess whether a dividend is sustainable.

Dividend Coverage = earnings per share/dividend per share.

This tells you how many times over the group can pay its dividend using profits. Anything over two is generally considered to be ‘well covered'. Anything below one suggests the dividend might not be sustainable. And remember no dividend is ever guaranteed.

Speaking of loans, debt is another important factor to consider. Some degree of debt is no bad thing, but too much can be crippling. This is especially true when interest rates are on the rise – borrowing is becoming more expensive. A quick way to assess debt is to look at a company’s debt-to-equity ratio, which can be calculated using the balance sheet.

Debt/Equity = total Liabilities / total Shareholders’ Equity.

This tells you how much of the business is funded using loans. In general, the higher the number, the riskier the business. This ratio can vary wildly from sector to sector, so it’s important to compare two companies within the same industry.

Strategy session

Before choosing an investment, you should also read the annual report. This will give you an idea of the company’s strategy and priorities moving forward. It will also call out potential risks to the business. Even the most financially secure company is sure to have some bumps along the way. It’s important to understand the company strategy and focus on the longer term.

The annual report is also where you’ll find Environmental, Social and Governance (ESG) data. As we move toward a more responsible, sustainable future, ESG performance is becoming just as important as financial health.

Not only is it important to make sure you’re comfortable with the company’s ethos. It’s crucial to consider how these measures will impact the company’s future. Regulations are changing to hold companies accountable for their social and environmental impact, so ESG considerations are becoming an important part of the overall strategy.

The share research team does a lot of this legwork for you. From comprehensive updates on the shares that you own to market insight, we offer investors the tools they need to make more educated investment decisions for themselves.

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    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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