Professional portfolio managers and investment advisers dream of somehow learning or attaining the secret of picking successful stock investments. As Warren Buffett famously said, "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price." Even Warren Buffett, America's most famous investor, admits he has not always experienced successful investments, but he has suggestions regarding how to improve your chances. Picking stocks that become successful investments is more a science than an exercise in cosmic luck. It involves research and realistic evaluation, or you end up with a fair investment at a good price.
Warren Buffett's Basic Process
Examine the quality of the company's management. Read the quarterly and annual reports as well as the news releases about the company, then decide whether the managers have done a good job. Check to make sure they are experienced in the field they now occupy.
Examine the earnings capability of the company. If it makes a product that has been made obsolete by new technology, the company is not likely to have future earnings growth and would not be a good candidate for investment.
Avoid companies that do not have a history of strong return on investment. If shareholders' equity has increased steadily during at least the previous five years, and if the company's expenditures of capital on plant and equipment or research and development have been successful, then the company has demonstrated the ability to create value and a good return on investment.
Check the company's debt coverage. Companies need to borrow money to finance growth, but if they borrow too much money, they put the financial health and future prospects of the company at risk. Divide current assets by current liabilities to find a company's liquidity ratio. A healthy company will have one to two times the amount of assets over the amount of liabilities.
Invest in industries you know something about and companies with simple business models. There is no better investment tool than knowledge and experience. If you know something about the industry, you have a better chance of judging the quality of the company as an investment. It is wise to avoid complex companies or those with too many different businesses because too much can go wrong, and the complexity makes management more difficult.
- Maintain a skeptical, reality-oriented mindset while doing research. Evaluate only facts and do not let the greed factor influence your decisions. Keep your emotions and ego out of your investing activities.
- Never invest more money than you can afford to lose, even if you feel you have found the perfect stock. Never invest money you may need in the foreseeable future, because you may be forced to sell your stock at a temporarily low price, losing money on your investment, in order to pay for a surprise expense.
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