Opinion: How to choose what shares to buy

Choosing what shares to buy is a personal process, and you’ll find a huge range of opinions about it. CommSec explains more about what’s involved and recommendations to help you get started.

Some investors use ratings from research providers like Canstar, some do their own analysis, while others might ask their friends for stock tips. If you’re looking for a balanced approach to choosing shares, you might consider a combination of self-reflection, stock analysis, and company research.

Here are some top recommendations on where to start.

1. Figure out your risk appetite

The first step before you buy is to determine what sort of share investor you are. What kind of goals do you want to achieve, and what is your appetite for risk? Are you looking for capital growth, or are you more focused on preserving your capital and earning income from your investments? Once you’ve decided how much risk you’re comfortable with, you’ll need to spend some time researching what shares will fit your criteria.

2. Get to know the investment environment

Understanding the macro investment environment is essential before choosing shares. Familiarise yourself with the current economic climate, and start researching how different economic conditions impact different types of investments.

Depending on what you invest in, your shareholdings could be affected by movements in other securities like bonds, currencies, and commodities, as well as offshore markets, short term interest rates, and changes in government legislation.

If you’re just starting out with shares, it might be wise to stick to blue chips or solid mid-cap companies. Avoid buying speculative stocks unless you’re comfortable with the higher risks involved.

3. Focus on what you already know

Try and invest in what you know and feel comfortable with. Do you understand how the company makes money? Are they considered top of their sector or industry? Concentrate on business models that are easy to understand, and do some research on what kind of things might affect them.

If you have done some research and you have a particular insight or market view, you could focus on exploring companies that would give you direct exposure to that view. For example, if your research tells you that the price of gold is undervalued, you could look into companies that are producers of gold.

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4. Look at ratios

Ratios can help you assess the value of a company, or compare different companies and sectors. Here are some common ratios investors can look at:

• Price to Earnings (P/E) – reflects the earnings potential of a company in the eyes of investors. A high P/E number generally suggests investors see high growth potential whereas a low ratio suggests the opposite.
• Price to Book (P/B) – an indicator of how fairly priced a share is at any given time. This tells investors whether a stock is cheap at its current share price, or expensive.
• Return on Equity (ROE) – shows how much profit a company has generated with the money invested by shareholders (in general, a falling ROE can be a bad sign).
• Dividend Yield – indicates how much cash investors are getting for every dollar invested in a company (effectively, your return on investment before capital gains).

→ Related article: 5 of the most common financial ratios

5. DIY analysis

Once you have an idea of what you want to invest in, it’s important to do an analysis to check whether your thinking is correct. If your analysis reinforces your opinion, you can invest with greater confidence.

If you’d like to do your own fundamental analysis, there are various methods you can use to assess companies. For example, you could try using a framework or model like Porter’s Five Forces.

This model was originally published in Michael Porter’s book “Competitive Strategy: Techniques for Analysing Industries and Competitors” in 1980.

The five forces are:

• Threat of new entrants – how easy is it for new companies to enter the same market? (e.g. it’s easier to start a clothing brand than a mining company).
• Threat of substitutes – to what extent can the company’s product be substituted for another? (e.g. if the price of beef rises, consumers could switch to pork or chicken).
• Bargaining power of buyers – how much power do the company’s customers have? (In a market with only a few buyers, they can name their price to a greater extent.)
• Bargaining power of suppliers – how much power does the company’s suppliers have? (If you produce cakes and there is only one supplier who sells sugar, you will be forced to buy from them at whatever price they charge.)
• Rivalry within the industry – how intense is the competition in the industry? Does the company you’re considering have a competitive advantage?

Other frameworks you could try include:

• The three Cs (Company, Competitors, Customers)
• The four Ps (Product, Price, Promotion, Placement)
• SWOT analysis (Strengths, Weaknesses, Opportunities, Threats)

6. Read company reports, news, and broker research

Companies issue annual reports and financial statements detailing their activities throughout the year. These can be incredibly useful sources of information when you’re considering whether to buy shares.

Remember, it’s important to keep up with current market events and reassess your investment regularly. So read financial news like you can find on CommSec, subscribe to investing updates, and make the most of broker research.

7. Don’t rush into it

If you’re not sure what shares to buy, don’t rush into anything. Take your time and keep learning about the market. You can use watchlists to keep an eye on stocks you’re interested in and set price alerts to update you if anything changes. When the right opportunity for you comes along, you’ll be ready.

Original article published 2018 at CommSec.com.au. Republished with permission.