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How we pick our five shares to watch

A look behind the screen at how our analysts pick the five shares to watch.

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.

When it comes to picking shares, there’s no shortage of information. A big part of the process is filtering through the noise. We think investors should take a long-term view when investing. But there’s an extra lens to look through when we’re picking our five shares to watch – they need to hold their own over the coming year.

With that in mind, here’s a look at some of the tools we use to choose the five shares to watch.

This article isn’t personal advice. If you’re not sure if an investment is right for you, ask for advice. All investments and any income they produce can fall as well as rise in value, so you could get back less than you invest. Past performance isn’t a guide to the future.

Looking at the bigger picture

We tend to take a ‘top-down’ approach to choosing shares. First, we zoom out to big-picture trends, finding sectors we’re comfortable with. We then drill down to find strong, individual companies. We try to look for several sectors with potential tailwinds, so we can highlight picks from across the market.

Playing Defence

The stock market is intrinsically linked to the wider global economy. Throughout history, it’s grown and shrunk over time in a natural cycle. When it’s grown, people generally had more money to spend and when it’s shrinking, they have tended to save more.

So, it makes sense to think about how the economy will fare to get a better idea of the sectors worth evaluating.

UK GDP

Scroll across to see the full chart.

Source: IMF, October 2021. Green denotes estimated value

The pandemic’s made it difficult to tell exactly where the economy is headed over the next year, particularly with the Omicron uncertainty looming. Even in light of the new variant, we’re expecting things to return to somewhat normal in the year ahead.

We can’t be sure what the recovery to the economy could look like though. This led us to concentrate on defensive sectors that have tended to fare well in good times and bad.

Defensive sectors, like healthcare, household goods, food and support services, won’t shoot the lights out when the economy’s booming. But they usually hold up whatever the weather. Remember though, as with all investments there are no guarantees.

The impact of inflation

It would be impossible to ignore the impact inflation could have on the market’s performance next year. The past 12 months have seen consumer prices marching ever higher. And even though experts have said the bump is temporary, it’s been enough to push the Bank of England to raise interest rates from historic lows.

Bank of England Base Rate

Source: Bank of England

While we don’t see high inflation lasting for the long term, it’s likely to continue moving markets over the next 12 months. That led us to look to sectors that offer some shelter from the effects of inflation, like commodities. And those that could benefit from a rate hike, like financials.

Trends that tip the scales

It can be difficult to pinpoint specific trends to make investment decisions. On one hand, no one could have predicted the massive shift to online working that saw companies like Zoom rise substantially in 2020. Other trends however, like a shift to e-commerce, had been in the works for some time.

Sectors with growing momentum are typically crowded and uncertain – you only need to glance at the market for electric cars for evidence. But identifying budding new trends can be helpful in choosing investments. The lockdown pet boom was one of the reasons we chose CVS in 2021.

This year, we’ve noticed several big trends worth watching in the year ahead – Artificial Intelligence, the Internet of Things, cloud computing, and the metaverse to name a few. In that way, the sector itself has become somewhat of a trend worth following.

The tech space is full of potential opportunities but could be one of the first to fall amid uncertainty in the economy. It can get even more complicated by the specific risks created by the pandemic.

The economy might suffer from rising new variants, but remote working and people spending time at home will be a good thing for cloud computing, pushing the metaverse on. With that in mind, we thought it was sensible to include a broad-reaching tech name on our list.

Drilling down to the picks

With a few key big-picture ideas in mind, we take a deeper dive into each sector to find potential candidates for our list. But it’s rarely as simple as finding the best player in the industry – ‘best’ can have different definitions.

The first step is choosing a company with solid financials – this means a strong balance sheet with manageable debt levels. With rising interest rates on the table, debt was particularly important this year.

When interest rates rise, so does the cost of new loans. For companies who’ve gotten used to refinancing at low rates when their loans are due, a higher rate environment could mean higher repayments.

The underlying business is equally important. We look for strong free cash flow, or at least the potential for strong free cash flow, and revenue and profit growth. Remember ratios and figures shouldn’t be looked at isolation, it’s important to consider the bigger picture.

Why now?

There’s more to choosing investments than only finding quality businesses. Not only are we looking for companies that could perform well over the next 12 months, but companies that have a lot to offer over the long-term. When we say long term, we mean at least five years.

Valuation plays an important role in making this decision. Shares trading ahead of their long-term average mean the market is expecting big things. This isn’t necessarily a bad thing, but it does increase the chance of volatility in the short term. A sky-high valuation suggests potential tailwinds have already been priced in.

Then there’s the nitty gritty of the business itself. Take miners, for example. Because commodity prices typically rise when inflation is growing, they offer protection from the effects of inflation. Commodity price inflation is a rising tide that should lift all boats, but that doesn’t mean all miners offer the same investment case.

Those that rely heavily on iron ore could see their performance subdued if the economy stalls and construction slows. Miners with high exposure to platinum group metals, used in electronics and batteries, on the other hand, could experience an additional tailwind from an uptick in electric vehicle production.

A final word on stock picking

The most important step in choosing our five shares to watch is understanding the bear case. Playing devil’s advocate and highlighting the risks ahead is a key part of the process.

Investors must be comfortable with the risks they’re taking and to do that, they must fully understand them. We spend time stacking the odds against our potential picks and discussing worst-case scenarios. This means we can highlight potential pitfalls, so readers can make investment decisions with their eyes wide open.

HL’s share research team can get you one step closer to making these informed investment decisions. We break down company statements and identify emerging trends on over 100 stocks so you can decide what the next step is for your based on your circumstances. Sign up for the share insight email to access to their latest research every week.

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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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