THE rise of passive investing has been great for the individual investor as it means they can get wide diversification for low cost with a single purchase. The low cost is the key part and that is why passive indexes have outperformed the more actively managed and more expensive mutual funds. If you are an investor with no time, can’t tell the difference between a balance sheet and profit and loss account and don’t want to do the research, a low cost index approach is the best option for you to build wealth long term.
But not all investors want to blindly buy the whole market via an index fund. Some investors like me want to own individual stocks; especially in times like these where markets are overpriced thus making looking for value in individual stocks all the more rewarding.
If you want to take the active route of picking individual stocks, read on to find out what factors to look for in the stocks of companies you buy. The factors cut across a number quantitative, qualitative and psychological parameters to ensure the first stock you buy holds you in great stead for the rest of your investing career. I also give examples of stocks that fit the bill.
Things To Look For In The First Stock You Buy
- Growing profitability and strong free cash flow – the first thing to look at is the profitability history of the company. As a beginner, don’t waste your time on turnaround stories. Instead, invest in tried and tested companies that make profits in all market environments. Whilst profits are important, look at the free cash flow figure as well. FCF is the amount of spare cash a company has after all essential costs including capital expenditure. This spare cash is what is used to pay the dividend or fund growth.
- Bullet proof balance sheet – But a company with low debt relative to profits / free cash flow. The last thing you want is for your investment to go bust. The idea of your first stock purchase is to be conservative so you get a good grasp of what investing is about; as opposed to speculating.
- High Return on Investing Capital (ROIC) – Have a look at this article to see the importance of Return on Invested Capital. The ROIC figure is more or less the amount your wealth will compound by over time. So if you invest in a company with a ROIC of 20%, you would expect a return of 20% per annum considering nothing drastic happens.
- Valuation – The rule most investors should follow is to never buy a company trading at a price to earnings ratio (P/E ratio) of more than 20. The P/E ratio basically gives the amount of earnings you are buying with every £1. So is a stock has a P/E ratio of 10, it means that you are paying £1 for every £10 worth of profit.
The cheaper you buy a company, the more value you get and the higher returns you make. But note that if the P/E ratio is very low, under 10, it indicates that the company is facing problems. It is also worth noting that high quality companies like Nike, Visa and Starbucks hardly trade below 20 due to their fact growth and high rates of ROIC.
- Stable Predictable Growth – You ideally want companies growing in the 5%-10% range. As a first time investor, you want to avoid fast growing companies due to the higher volatility in their share price. Investing in slower growth companies helps your investment temperament by you not checking your stocks everyday to see if it doubles. This also removes the temptation for you to make quick decisions and selling at the bottom. Mature blue chip companies with low volatility make ideal first time purchase as you are less likely to make spur of the moment decisions on the buy or sell side.
- Easy to understand business – Invest in companies whose products you use. Whenever you buy the companies product or see someone else buying that product, you’ll feel good as you know you are benefiting. You feel like you are owning an actual business instead of just a ticker. In times of recessions, this helps. For example, if you own stock in Coca Cola, you are less tempted to panic and sell in a downturn. Supermarkets continuing to stock the product and customers continuing to buy should give you confidence in the underlying business.
- Economic Moat – A company needs to have a competitive advantage to sustain profitability. Have a look at my article on competitive advantage / economic moats to see if the company you want to invest in ticks and of the boxes.
- Pays a dividend – so it fells like you are receiving a profit from the products sold by the business. You need to feel like an owner. Have a look at the dividend champion list to see companies that have paid increasing dividends for 25 or more years. The longer the dividend record, the better the prospect on this regard.
Examples of stocks beginner investors should buy.
I make this list with the caveat that you have to do your own research, These are just examples and facts may change from the time of this article. In comping up with the below list, I have left out valuations as P/E ratios change on a daily basis due to the price factor.
In essence, you don’t want a company that will make you a millionaire overnight. Instead, you want to invest in a company that gets you in the mindset of being a patient long term investor. The best sectors to invest in in this regard are consumer staples.
Consumer Staples – Coca Cola, Procter & Gamble, Unilever, Nestle, Mondelez, Pepsico, AG Barr, Hershey’s, Kraft Heinz, Reckitt Benckiser, Colgate Palmolive, Clorox.
The alternative to consumer staples for beginner investors are healthcare, telecoms and utilities as they are all defensive industries.
Healthcare – Johnson & Johnson, Astrazeneca, Glaxosmithkline, Pfizer, Novartis, Roche
Telecoms – BT, AT&T, Verizon, Deutsche Telekom, Orange, MTN
Utilities – National Grid, American Tower, Severn Trent Water, Pennon Group