5 Golden Rules for Choosing the Best Stock

With the popularity of exchange-traded funds (ETFs), buying individual stocks seems to be falling out of favor. But for rugged, self-directed investors, it’s still a preferred route to investment success. But if you’re new to investing in individual stocks, what are the rules for choosing the best stock?

Here are a few that will help.

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1. Invest in Companies that Dominate their Industries

Have you noticed that the same companies keep coming up in different portfolios? It doesn’t matter if we’re talking about index funds, actively managed mutual funds, or individual portfolios designed by investment managers. Names like Amazon, Apple, Mcdonald’s, and Facebook come up again and again.

There’s a reason why that happens, and it’s not just because investment managers all gather information from the same sources. It’s because certain companies dominate their respective industries. That makes an investor’s job a lot easier.

Not only do such companies have a strong track record of industry domination, but they have an uncanny knack for coming out with new products and services that are well received by consumers.

This isn’t an accident. Such companies have the capital, know-how, and energy to turn out winning products and services. There’s never a guarantee they’ll continue doing this going forward. But the fact that they have a track record of doing it consistently in the past is an excellent indication of continued success.

2. Invest in Businesses You Understand

There are literally thousands of different companies you can buy stock in. Some of them are well-known companies, selling everyday products and services. Those are the companies you should invest in.

There’s a close correlation between the success of a product or service, and the performance of the company stock. And when a product is common, it means it’s well understood and accepted by the consuming public. If you understand the company’s products, and particularly if you already use them, you have a solid understanding of how the company works.

Another category includes companies engaged in industries where you have an above-average understanding. It could be because you’re employed in the industry, or have been in the past. Or it might be because you have a particular interest in a certain industry, even if you don’t currently use any products and services it produces.

On the other side of the spectrum, stay away from companies you don’t understand. For example, there are a lot of upstart drug companies that may be showing considerable promise. But many of them are selling on promise alone. That is, they’re working on an experimental drug that’s expected to make a major medical advance. But until they actually have a breakthrough, and begin marketing the product, they’re not profitable--they may not even have a cash flow.

This is just one example of an industry or company you may not understand. There are plenty of others, particularly those that involve a high degree of research. But there may also be very practical industries that involve complicated business models.

If you’re having difficulty grasping exactly what it is they’re doing, or how they make money, those stocks are best avoided.

Related: The Best Stock Research Tools

3. Don’t Overload in Two or Three Sectors

This is virtually a disclaimer on the previous recommendation. Yes, you want to invest in industries that you understand. But at the same time, be sure your portfolio isn’t overloaded with stocks in a very small number of industries.

For example, if you work in IT, you may be tempted to overload your portfolio with tech stocks. After all, that’s your business, and what you understand. But any industry, no matter how well you know it, is subject to the ups and downs of the market. Just because technology is flying high today, doesn’t mean it will forever. (Remember the dot-com bubble?)

If you plan to hold say, 10 different stocks, make sure they’re diversified across six or seven different industries. The worst thing you could do is have half or more in a single industry. While it might serve you well when that industry is on the upswing, the backlash can be financially punishing when that sector turns down.

Realize that for a host of reasons we cannot predict, a specific industry can go into a bear market, even while the general market is flourishing.

It’s all about diversification, and that matters whether you’re in funds or individual stocks.

4. Buy Companies with a Solid Track Record

The ultimate stock market fantasy is buying penny stock of an obscure, upstart company, then watching its stock price soar past $100 in just a few months.

But fantasy is all that is. Sure, it happens in real life. But it’s only recognized in hindsight, after the stock price has taken off. Rest assured that for every such success story, there are 1,000 would-be fantasies that never got out of the starting gate.

For that reason, go with companies that have a proven track record. Obviously, this will move you out of the realm of new companies. But the first rule of making money in the stock market is not to lose any. Any company that’s relatively new and unproven, is more likely to result in a negative outcome.

To be an established company, the business should be around for several years--the more the better. Even more important, they should have a steady track record of increasing both revenues and profits on a consistent basis. For example, you might look for a company whose revenues and profits have grown in eight of the last 10 years.

A company like that puts time on your side, because it’s showing a steady growth pattern. Other investors see that too, as well as fund managers. Chances are, they’re either already holding that stock, or plan to buy it in the near future. All of that bodes well for the long-term prospects of that company.

5. Dividends DO Matter

Dividends represent the return of a portion of a company’s profits to investors. They provide an immediate return on investment, so the investor is not entirely reliant on capital gains. They’re particularly attractive to income investors, and do provide some measure of protection in market downturns.

As well, a company that pays dividends to its investors on a consistent basis is a healthy company. They’re able to continue operations, and even expand, while returning some of the profits to their investors.

Kiplingers puts out an annual list of dividend aristocrats that are well worth considering. Dividend aristocrats are described as companies in the S&P 500 that have increased their payouts every year for at least 25 consecutive years.

They’re also referred to as dividend growth stocks,” which might be the optimal combination. You’ll undoubtedly notice that many of the companies on that list are well-known, and meet other criteria in this article.

Warning: There are No Guarantees

If there’s a strategy that guarantees picking only winning stocks, it has yet to be discovered. With that in mind, understand that your best strategies can still produce losses. Investing requires a large measure of accepting reality, and that’s that both markets and stocks rise and fall.

The best any of us can do is to create guidelines that will govern what stocks we’ll purchase. That will only improve the chances of picking winning stocks, but it will still fall well short of avoiding losses.

Related: The Best Stock Tracking App

If you decide choosing your own stocks isn’t for you, consider using a robo-advisor to do it for you. Read our Betterment robo-advisor review to find out if this might be the better avenue for you.