Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

5 Steps to Finding Winning Stocks and Avoiding Losers

Winning stock pickers share a few common strategies. We all like to scrutinize companies' financial statements. We all love dissecting earnings reports to see a stock's value compared to its peers. But when it comes to picking the right stocks, I have five additional steps I take to gain a winning edge.

In my experience, the insight from these five steps can mean the difference between a profitable trade and a painful mistake. If you want to know whether or not the time is right for investing in a particular company, ask yourself these five questions.  If used properly, the knowledge you gain will lead you to high-quality and informed decision-making.

1. What is management saying? As in, what are the words actually coming out of their mouths?

You answer this question by listening to conference calls. I recommend no fewer than three. You may be thinking, "Three conference calls? Who's got a few hours to do that?" You do. It's the only way that you can really understand the key issues involving the company; the only way to see how those issues are tracking over time; and the only way that you can be assured that management has a consistent story to tell.

Audio versions of these calls are archived on a company's website in the investor relations section. You may get lucky and find occasional transcribed versions on seekingalpha.com or other sites.

I'll explain why three is the important number. If you listen to three calls, and you notice they change their tune from quarter to quarter regarding stubborn problems that will "soon be fixed," you should question whether this problem can or will be fixed. On the other hand, I love management teams that under-promise on calls and over-deliver in execution. The bottom line is, tracking a company's progress over time is the only way to develop trust in their management team.

2. What is the herd saying?

You can't fight the tide. If a company has just been hit with negative press or pessimistic analysis, chances are good the stock will fall (and keep falling) as investors digest the sobering commentary. You need to be patient -- wait until the impacts are felt and the herd works through them.

I have no problem buying into stocks that are in trouble, as long as I think the problems can indeed be resolved. And only when I'm convinced that all of the selling pressure is over do I spend my hard-earned money. As a good rule of thumb, wait for the stock to perk back up a bit. You may have missed the very first stage of an eventual rebound, but you're less likely to get caught trying to catch a falling knife.

3. Are insiders putting their money where their mouth is?

Nobody understands a company and its prospects better than the management team that is running it. That's why you should always swim in the same direction as company insiders. Buy stock when insiders are buying, and go on high alert if they are selling.

Of course, some insiders sell because they have to, not because they want to -- especially company managers that have much of their net worth tied up in company stock. When analyzing an insider transaction, be sure to place it in the proper context. An insider who routinely sells 1% of his/her total stake every now and then is probably just diversifying out of company stock. But if that same insider suddenly sells off 25% of his/her holdings, then that could be a big red flag that the company is headed for trouble.

For example, the chairman of clean-energy firm First Solar (Nasdaq: FSLR) dumped $119 million of his company's stock in just the first three weeks of March, 2011. Should you be in a hurry to invest in that company after a person of his insider status has made such a hefty sell? No way.

There are several free online tools for tracking insider trading, including Finiviz.com's insider trading list of American companies and CNBC's Market Insider Activity chart.

#-ad_banner_2-#

4. Does the market seem greedy? Or fearful?

It's a widely held maxim that you can't time the market. I'm not sure that's true. In my experience, I've lost money on stocks when buying them after the market has had a very good run. Conversely, I've generally fared better buying into stocks when they've been dragged down by a weaker market.

That's why I tend to look for stocks to buy when the market is doing poorly -- and look for reasons to sell current holdings when the market has fared well. Surging stocks can surge yet higher in the short term, but you need to pay attention to longer-term historical trends.

For example, heavy equipment maker Caterpillar (NYSE: CAT) has seen its stock surge from $30 in the summer of 2009 to a recent $110. Investors are giddy over the fact that Caterpillar is projected to earn a record $8 per share in 2012, even though the company has never earned more than $5.66 a share in any year in its history and Caterpillar's average earnings per share over the last ten years are just $3.66. The current stock price is very high in relation to those average earnings, so to buy shares now (or even hold on to current shares) seems awfully risky once investors start to focus on the eventual reversion back to typical earnings.

5. Are a lot of investors betting against this stock? 

I don't like controversy. That's why I avoid stocks that have a very heavy short interest. These short sellers may be wrong, and the company may be perfectly fine, but it's usually impossible to know what they know that makes them so bearish. So investing in heavily shorted stocks is a little like betting at a card game in the dark.

Information on the number of shares held by short sellers can be found on The Wall Street Journal's website, shortsqueeze.com, Nasdaq.com and elsewhere.

This may all seem time-consuming, but it's a necessity if you are going to try to pick winning stocks. And the process doesn't stop once you hit "buy." Post-purchase, you still need to monitor your holdings for indications that it's time to sell. These indicators -- whether they're overly rich valuations, a recently surging market, heavy insider selling or rising short interest -- should give a reality check on your holdings. And keep you on the winning side of a trade.

[InvestingAnswers Feature: 7 Red Flags That Say It's Time to Sell.]