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How to research a stock

Created:
29 September 2006

Of all the shares in all the world, you have to pick just a few. And they'd better earn you more than the stock-market average - or you may as well stick with an index-tracker fund. So you decide to get down to some active stock-picking.

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Before you begin, though, your first task is to decide what sort of investor you are. Only then can you start to research stocks in the most appropriate way. And although that may sound like boring and obvious advice, there is reason to this mundanity.

As you'll see in the rest of this supplement, there are a number of different ways of finding stock-market winners. Some of them try to make the investing process as impersonal and automatic as possible. Stock-screening, for example, tries to sidetrack all subjective judgements about the worth of a stock. Instead, it concentrates on the cold, hard numbers generated by the interplay between a company's accounting data and its current share price. If the ratios fit, you buy. It's as simple as that - almost.

There are dilemmas. For example, you may screen the universe of companies looking for value stocks but end up with a shortlist that includes companies teetering on the brink of bankruptcy. Do you exclude them, or blindly obey the rules of the stock screen?

The decision is yours, proving that even stock screening relies on the use of discretion from the investor. However, as an approach to picking shares, it is ideal for novice investors because you do not need much experience (see our introduction to stock screening on page 8).

By contrast, if you feel you have plenty of experience and are knowledgeable about companies, business, stock markets or economics, then you should adopt a research technique that plays to your strengths.

For example, people who have set up and run their own businesses should enjoy a comparative advantage over other investors when it comes to analysing business models. They should have more of a feel for the right questions to ask, where to probe and when to walk away.

Also, if you're richer in cash than you are in time, you will want an approach that generates a few very strong buy signals, but does not require day-to-day monitoring. You will buy significant quantities of a stock (in relation to the size of your portfolio) and hold for years at a time. The kind of research suited to this approach will differ markedly from the sort of information needed for a shorter-term, more hands-on trading strategy.

Buy-and-hold investors should therefore consider the research approach said to be used by Warren Buffett, which focuses on 10-year records of earnings, dividends and returns on equity.

For anyone who has been an active investor across a number of economic cycles, it will also make sense to exploit that experience. You will have learnt - perhaps painfully - the lessons of which stock market sectors tend to do well or badly as interest rates, business investment or consumer spending wax and wane. Our companies editor, Simon Thompson, explains how he often starts with this top-down approach before moving from the big economic picture to particular sectors and stocks within sectors (see page 10).

Dominic Connolly, author of the UK Trader's Bible, illustrates a different approach in his article starting on page 12. In a way, his recommendation is to let someone else do all the hard work for you. Only once they are happy to pile in to a stock, do you follow suit.

Of course, the snag with following the smart money is that there will be times when it is not as clever as it seems. That's why you need to treat this information with caution, as Mr Connolly explains.

There are other ways to piggy-back on other people's opinions, too. City analysts devote thousands of man-hours to the cause of company research, and often enjoy privileged status when it comes to posing questions to the management.

As a private investor, you cannot always read every word of an analyst's research note, but it is easy to find out a host of related information. There are services that will tell you how many brokers rate a particular share as a buy, hold or sell. You can also watch how consensus estimates change for earnings per share, pre-tax profits and net dividends.

The question is, what does all this information tell you, and what good is it in deciding which stocks to buy or sell? We asked Andy Yates of DigitalLook to explain how to interpret analyst data to best effect.

Finally, we show you where to get all the information you need to carry out the various research approaches. Some of the information is free, but in order to get quality, timely data, there is often a cost. Ultimately, you get what you pay for.

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