Stock selection is an important step in building a quality portfolio. The stock selection criteria an investor uses to identify stocks for their portfolio is a major factor contributing to their investing success. This article provides a proven stock selection guide that is easy to understand and follow.

This is the third part of a five part series on how to beat the stock market the Trading Online Markets way.

1. The Business Cycle Phases
2. Stock Market Trend Analysis
3. Stock Selection Guide
4. Disciplined Investing
5. Stock Portfolio Management

It is very important to have the business cycle along with your preferred sectors and the trend of the stock market in mind as you look for the right companies to consider to buy.

Fundamental or Technical Analysis

Where did you find the last five stocks you bought? From your broker, or a good friend, or a web site promising fantastic returns, or a well known news letter? Were these good companies selling at a substantially discounted price? Why were these companies the best available investing candidates? Did they perform as you were led to believe they would? If you cannot answer these questions or are not happy with the answers, then you might want to reconsider your stock selection criteria.

Basically, there are two ways to find stocks of companies that might offer profit potential. One is to use technical analysis (the examination of the chart of a stock seeking to forecast the movement of the stock price based on the past volume and price movements). Technicians use a wide variety of price formations that provide indications on future price movements. Technical analysis helps to identify key areas of psychological support and resistance where buyers and sellers battle over the direction of the price. This allows a trader to time their buys and sells based on the price formation.

The other method to find stocks with profit potential is called fundamental analysis. Investors use fundamental analysis to examine a company's financial statements, seeking to gain insight into the company's future performance. While financial statements can be intimidating, when you know how to read them, they reveal important insights into the operations of the company and its potential for success, or failure. A quality company whose stock price is undervalued usually offers excellent appreciation potential.

Each method has their proponents that are widely used by professional investors and traders. The method that works best depends on the type of investor you are.

Type of Investor

There are many types of investors. Some like to buy and hold for the long term. Others focus on value or growth. Then there are the technical traders that day or swing trade. Each type of investor has their preferred method. Most of these methods depend on the the investor's personal views to investing, appetite for risk, and confidence in the approach.

Long term investors typically buy and hold a stock for many years. Then there is the income investor who seeks to generate high income without risking their invested capital. Some are growth investors seeking to find those companies that are growing faster then the market. Value investors search for good companies that are selling at low prices. Most of these investors use fundamental analysis to find and assess their opportunities.

Swing traders look to make quick profits by holding shares for a few days to a few weeks. Day traders move in and out of a stock in the matter of minutes or hours. Also, there are many investors that do not follow a specific approach. They seem to wander from one method to the other, seeking the best return. Unfortunately, they fail to apply the best of any one method in their efforts to find the "holy grail" of investing.

So what do all these diverse type of investors and traders have in common? They still must find the right stocks that meet their criteria before the can make their buy.

Stock Selection Screens (Fundamental & Technical)

So far so good. Let's see, there are more than 8,000 stocks to examine in order to find the 30-50 or so top ranked value stocks. Where does one start? Fortunately there are a number of web sites that offer investors a way to select stocks based on a number of factors that meet their investing criteria. Called stock screens, they offer a wide variety of ways to find stocks. Most of the screens that are available fit a particular type of investor, such as value or growth. It is important to understand the characteristics of the approach used by the screen.

Stock screens are a way to search for companies that meet a selected list of quantitative criteria. Most screeners have a large database of financial figures, price and volume data, a set of selection criteria that you can customize to meet your criteria and a search engine that seeks companies that meet your criteria. Here are some popular stock screening sites:

Stock screeners greatly simplify the search process for companies that meet your criteria. However, be careful when using stock screens:

• They use databases that are updated on different schedules possibly making your screen out of date;
• Some of the scans are difficult to use and may generate unexpected results;
• Read the definition of the criteria carefully as these variables might not mean what you think;
• Keep in mind that screening criteria can exclude companies that might be of interest;
• Remember that they only are as good as the criteria that is available. There are many other qualitative factors such as law suits that are not included in a screen.

Stock scans are a place to start your search for potential investment candidates. These scans should not be used exclusively. As in any investment analysis, it is important to do further research before making decision.

Stock Selection Criteria

So how does Trading Online Markets select stocks to be included on its Watch List? What works the best is a blending of the two methods, taking the best of each: Fundamental analysis to find quality companies whose stock is undervalued and technical analysis to time entry and exit points.

There are several ways investors can approach fundamental analysis. Some of the most common are to focus on growth or value. Growth is a strategy where an investor seeks out stocks with what they hope will be good growth potential. In most cases a growth stock is defined as a company whose earnings are expected to grow at a rate that is above average, greater than its industry and the overall market.

Value investors actively seek stocks of companies that they believe the market has undervalued. They believe the market overreacts to good and bad news, causing stock price movements that do not correspond with the company's long-term fundamentals. The result is an opportunity for value investors to profit by buying when the price is deflated.

The big problem is estimating the value. Keep in mind, there is no "correct" value. Two investors can be given the exact same information and place a different value on a company. For this reason, another central concept to value investing is a "margin of safety." This means you buy at a big enough discount to allow some room for error in your estimation of value.

Also, keep in mind that the very definition of value investing is subjective. Some value investors only look at present assets/earnings and don't place any worth on future growth. Other value investors base strategies completely on the estimation of future growth and cash flows. Despite the different methodologies, it all comes back to trying to buy something for less than its worth.

Although it is often said that growth investing and value investing are diametrically opposed, a better way to view these two strategies is to consider a quote by Warren Buffett: "growth and value investing are joined at the hip."

Another very famous investor, Peter Lynch, pioneered a hybrid of growth and value investing with what can be termed as Growth At a Reasonable Price (GARP) strategy. Another successful investor, Joel Greenblatt wrote The Little Book That Beats the Market, an easy to read book that identifies the financial concepts that identifies growth and value stocks. A portfolio of approximately 30 stocks used in a study covering the years 1988 through 2004 handily beat the market, averaging 30.8% vs. the S&P 500 at 12.4%. Each stock was held for approximately 1 year, selling the losers just before their one year anniversary and selling the winners just after their one year anniversary, to take advantage of the tax rules.

So how do we find stocks that possess the best features of growth and value? Actually, all it take is some hard work that follows a well conceived discipline. First, look for companies that are good businesses (Return on Capital) and companies that earn more relative to the price being paid (Earnings Yield) than others. Good business have high Return on Capital. Companies that earn more relative to the price being paid have a high Earnings Yield. Return on Capital is the ratio of pre-tax operating earnings (EBIT to tangible capital employed (Net Working Capital + Net Fixed Assets). Earnings Yield is the ratio of pre-tax operating earnings to enterprise value (market value of equity + net interest-bearing debt).

To find good companies at discounted prices, you do not have to use Return on Capital and Earnings Yield. Instead you can substitute Return on Assets (ROA) for Return on Capital and the company's Price Earnings ratio (P/E) for earnings yield. The Price to Book ratio can also be used to help identified good companies at discounted prices. You can also use the Price to Cash flow ratio in place of Earnings Yield. Cash flow is consider a better indicator of a company's financial earnings power than net income. A company can show positive earnings and not be generating cash to pay bills. Cash flow and especially operating cash flow provides a better financial measure of financial performance. How To Make Money In Stocks: A Winning System in Good Times or Bad, 3rd Edition by William J. O'Neil and Value Investing: From Graham to Buffett and Beyond by by Bruce C. N. Greenwald, Judd Kahn, Paul D. Sonkin and Michael van Biema are good sources for more on using financial analysis to evaluate financial statements.

While stock screeners are very helpful to potential investment candidates, they are no substitute for good old fashioned homework. Some of the best sources for information on a company is their Securities and Exchange Commission (SEC) filings, especially the 10K (annual report) and 10Q (quarterly report). Their other filings with the SEC can make interesting reading since they must report such actions as changes in executive management, new financing, changes in significant ownership, insider buys and sales, and acquisitions or divestures.

It is helpful to know if management has an existing and growing stake in the company through stock and option ownership. If management is positive on the prospects for the company, then investors should be as well. The percent of management ownership is noted on the Watch List for our Premium Members.

Also, important is the year-over-year (YOY) revenue growth. I review the current and projected growth of revenue. Some of the questions I like to investigate are: If weak sales is the reason the company's stock is selling at a discount, then what is the company doing to correct the situation? Is this a temporary situation or is it more permanent? Are revenues growing at a sustainable pace or are they likely to slow down? Will sales grow faster? Ideally the company has strong revenue growth along with good Earnings Yield and Return on Capital. If these are solid, then the next step is to resolve why the price of the company's stock is down.

As mentioned earlier, sector rotation is an important factor to consider when making an investment decision. The stock of a good company can be down just because it is a member of an out of favor sector. These stocks can be good opportunities when the market rotates back to the sector.

While not critical to the analysis, the dividend yield can offer a good return and help hold the stock from further declines if it is supported by earnings. Besides, it is always nice to receive extra income while holding the stock of a good company with great appreciation prospects.

Finally, I review each identified company looking for any red flags that might indicate why the stock price is selling at a discount. Some of these red flags are questionable accounting practices and questionable management activities. The best place to find this type of information is to read the footnotes to the SEC filings, especially the financial footnotes. Some people call these cockroaches, since when you uncover one you know there are many more around.

When this analysis is complete I have either decided to add the company to my watch list or eliminate from further consideration. I try to have 15 to 30 companies always on my watch list. This watch list is available to Premium Members.

Next, I look at how to time the entry of your selected stock. Please read Part 4, Timing the Entry.