Picking Stocks: For Beginners

If you read my last post  you may have a few ideas for stocks you might like to own. If not, you can check that post out here. So, you have an idea for a stock but how do you know if it is a good one? Here are a few rules for beginners that will help you separate your good ideas from the bad ones.

Go with what you know: Being intimately familiar with a company, its products or services is crucial for the beginning investor. The incite gained by being a customer is invaluable and can make up for a lack of financial education to some degree. Let's look at McDonald's (Ticker Symbol: MCD). You have probably been to McDonald's a few dozen, if not hundreds of times over the course of your life. If you haven't think of a fast food chain that you have.

You would notice if the prices went up or the customer service went down. You can probably identify when a new item is put on the menu or an old one removed. You might have tried the new item and have an opinion or heard opinions from your friends and family about the new item. You probably noticed that quite a few McDonald's are selling specialty coffee now and it is pretty good. Many McDonald's stores have been renovated to look more upscale. You probably drive buy one or more McDonald's on a weekly basis and would notice if they were shutdown. You can probably list at least 5 competitors and have an opinion on why McDonald's is better or worse than they are. Wow, after looking at all of that, you seem like an expert, don't you? Furthermore, you have friends, family and co-workers that have incite that you can leverage by having a casual conversation.

For example, I was talking to a family friend today that works as a mail carrier. He told me that at one point a couple years ago a few of his co-workers were discussing the huge increase in the number of Netflix envelopes they were delivering. That is a pretty good indication of that the company was doing very well.

Understand the business:
This is an expansion of the first rule but it is important and distinct enough to warrant a few paragraphs of its own. When I say "understand the business", I don't simply mean knowing what a company sells. I mean understand how they make money. For instance, movie theaters make most of their money in concessions. Tickets sales largely go to the studio that produced the film. The extra $3 (or so) that you pay for a 3-D movie might go the 3-D technology company (but not necessarily).

You should also understand what sets them apart from their competitors. This rule is why I avoid pharmaceutical companies. It isn't that they are not profitable companies, I just don't understand why Merck is any better than Pfizer. I do have a pretty strong opinion when I choose an airline though. I can explain why I prefer Southwest Airlines (Ticker Symbol: LUV) over every other domestic airline.

You should also think about who a companies primary customers are. This will help you understand what events (global, national, regional or local) might impact a stock. For instance, we are currently experiencing extremely high unemployment. Certain companies actually benefit from these conditions. For instance, Monster Worldwide Inc (Ticker Symbol: MWW), is the company resonsible for Monsters.com, the website that assists job seekers find employers and vice versa. Discount stores are another industry that does well in tough economic times, companies like Walmart (Ticker Symbol: WMT).

Go with established companies: I always recommend folks new to the stock market choose companies with a history of success and a solid brand name. Companies like Walt Disney (Ticker Symbol: DIS) or Coca Cola (Ticker Symbol: KO) This does not guarantee success (nothing really does) but it will help you avoid companies that that don't have staying power or are fads or fly-by-night operations. These are companies that have been around long enough to see difficult economic times and have survived or even come back stronger. They have made mistakes and recovered. They are mature, stable and generally return cash to their stockholders in the form of a quarterly dividend.

SIDE NOTE: Stay away from penny stocks (stocks priced under $4.00).