Money Plato

There are generally two schools of thought in stock market investing. The first is to invest in the entire index by buying ETFs or similar mutual funds. These are instruments that track the whole stock market, ensuring that bad periods and underperforming industries are balanced out by bullish markets and thriving companies.

The other — and arguably less traveled — path is buying individual, single stocks, effectively building your own custom “fund” made up of a handpicked selection of companies.

Usually, this second strategy is still aimed toward long-term investing, but it carries the objective of significantly higher returns. In fact, while the historical average return of a broad market index (like the S&P 500) is about 7% to 10% annually over the long term, a highly successful single company can yield vastly higher multiples.

However, the potential losses are also higher if one of the few companies you’ve selected takes a turn for the worse. In light of this fear, most people prefer to stick to the safety of ETFs and buy indices instead of single stocks.

But as you probably know, highly successful investors like the ever-quoted Warren Buffett would disagree with taking the purely passive route. The strategy for Buffett and his late, great partner Charlie Munger has always been this: document well, study the company in depth, and if you truly believe in its underlying value, go for it — buy it and hold it. By trusting the potential of undervalued (yet fundamentally solid) companies, they built a fortune simply by investing.

So, can we all learn something from that? I am not here to endlessly dissect the strategies of billionaire investors. Rather, my aim is to offer a practical, accessible path for evaluating and selecting single stocks to increase the potential return of your portfolio.

I believe — not only by the books and historical stories but also from my direct, personal experience — that picking individual stocks is highly rewarding. Yes, inexperienced and hurried investors can make mistakes and poor choices in the beginning. That is entirely normal and just part of the learning curve.

Today, I want to give you a fresh perspective on how it is possible, and ultimately relatively simple, to choose stocks for higher long-term returns.

The Newspaper Method

Let’s say I want to pick one or a few stocks for my portfolio. I have a handful of thousands of dollars to invest, and I plan to put that money into the market for several years.

Well, the first thing I do is open up a physical newspaper. Not for the daily news, but for that old-fashioned page in the back with the stock market tables.

Then, I pick up a ruler and a pencil (or a highlighter). Those are all the instruments of a trader! Okay, maybe not all of them… but it’s a remarkably good start.

So, what are we actually doing with our ruler and pencil? We are doing a first, broad selection. The two main things we are checking are price and market capitalization (the total value of the company’s shares). The overall principle is simple: we want to pick companies with excellent long-term potential (hence, we look at high-cap, established companies), but that are currently undervalued. We are looking for moments where the current stock price does not reflect the company’s true, intrinsic value.

(Note: If you don’t have a newspaper handy, you can do this exact same exercise using a free online “Stock Screener,” filtering for large-cap companies trading near their 52-week lows).

How do we assess if the price reflects their true value or not? That’s the more difficult part! It is a matter of experience, of being able to assess the economy as a whole, and understanding the specific sector. But I promise you, it is not an impossible task.

Looking at Price Trends Over the Years

In assessing how “fair” a price is, a great starting point is to look at the price change over one year (usually a standard column on those newspaper pages). From there, open up your computer and check more extended timeframes, like the 5-year or 10-year charts.

At this stage, we are not applying complex technical analysis or drawing intricate chart patterns. We are simply looking at the chart with common sense.

• The Hopeless Slope: Does it look like, over the long term, the chart is a hopeless slope toward the bottom right? Meaning, has the company done nothing but lose value year after year? If so, it’s probably not very wise to put your hard-earned money into it.
• The Cyclical Waves: Or, have there been waves of surges and downward spikes, alternating periodically in a pattern of, say, 3 to 5 years? If the company is currently close to the bottom of one of those cyclical waves, and if other fundamental signals make you confident, you can risk betting that this company will rise again toward the peaks it reached in the past. This frequently happens in specific sectors that are highly sensitive to overall macroeconomic trends, like the energy sector or major banks.

A Word of Caution: Past Trends Don’t Predict Future Results

Overall, what I just described is only one ingredient of the recipe. You must always keep in mind that previous price trends and lines on a chart do not guarantee how the price will move in the future.

It could very well be that a company you hope is headed back toward a previous all-time high has actually encountered a definitive, structural downturn — a “value trap” spiral from which it will never recover. If you get caught in one of these, your investment will encounter a drastic cut, if not a total loss.

I’m not saying this to scare you. I just want to expose the inherent and normal risks of the markets. Risk is something you will be exposed to regardless of the kind of investment you make, but you are undeniably more exposed to it if you choose to pick individual stocks.

Making some poor choices is inevitable. But I highly encourage you to see them as learning opportunities. In the end, the gains from successfully picking individual stocks can be far higher than the losses, provided a trader learns to positively interpret financial situations and market data.

When you manage your risk well, it is completely normal to pick five to seven companies and end up with one or two that do poorly or perform under your expectations. However, the other well-chosen companies will carry the portfolio’s return well above the average, often surpassing 20% or 30% gains on those specific positions, which easily pulls your overall average above the standard 7-10% of the broader market.

There’s More to Choosing Stocks

Obviously, the decision to pick a specific stock should be weighted with more data. A combination of simple chart analysis and fundamental analysis is highly recommended. Fundamental analysis simply means assessing the financial health of a company by looking at a couple of key financial metrics, such as Debt Levels,  to ensure the company isn’t drowning in liabilities it can’t pay off during an economic downturn, Dividends,To see if the company pays you a portion of its profits just for holding the stock, and so on.

But the main point I want to leave you with is this: all of these abilities are completely within the reach of anyone willing to learn. It is not rocket science. Stay tuned and check out my other resources right here on moneyplato.com to gain more insights into the amazing, rewarding world of trading and investing!

MoneyPlato is my blog about finance, born from my passion for philosophy and business. In order to keep ads to a minimum, I’ve decided to make this a reader-supported blog. I may earn an affiliate commission when you purchase through my links. Thank you!