Trying to figure out the right stock to buy? Rack your brain no more with this simple professional technique today.
Stock trading is not really that difficult. With stocks, there’s always the golden adage whispered time and time again — buy low, sell high. It’s easy to say, but how often are we able to pick gems like Apple and Amazon from the Sundial Growers? How do people do it?
We need to develop a strategy. Like Warren Buffet says, “if you don’t feel comfortable owning a stock for 10 years, then you shouldn’t own it for 10 minutes.” Let’s delve deeper into the psyche of the stock trader.
The Stock Trader 📈
When buying stocks, traders use a combination of fundamental and technical analysis to judge a stock before buying it. The most successful traders don’t rely on word-of-mouth or news when buying a stock — they put their trust in data, history, and performance. As the popular saying goes — don’t always believe the hype (I’m looking at you Tesla, Gamestop and AMC).
So how do we do this? I’ll take you through the two most important techniques used by stock traders — fundamental and technical analysis.
Fundamental Analysis
Fundamental Analysis allows you to make decisions by taking the company’s financials and profitability into account. My go-to website that I use to screen stocks is called Finviz.
Finviz allows you to screen every stock listed on the New York Stock Exchange (NYSE), NASDAQ and AMEX. With this screener, you’ll be able to view over 8,000 stocks listed worldwide! Now, the question is — how do we know which ones to buy? Simple, we key in the right fundamentals into the screener to find which stocks are suitable.
For simplicity’s sake, I will key in the fundamental analysis metrics that I use and explain my reasons for choosing said metrics. My preset link on Finviz can be accessed here.
Fundamentals to look out for:
Here are three fundamentals that I look out for before selecting a good stock. I’ll explain in the following below:
- Positive Past & Future Growth Earnings
First of all, we always want to pick a company that has a history of making money. If given a choice, would you want to invest in a company that is bleeding money, or one that has a proven track record of profitability? For that reason, we’ll set all our growth rates for the past 5 years to positive.
When Earning-Per-Share (EPS) growth in the next 5 years is set to be positive, it shows that polled analysts and experts have confidence that the company will continue to grow in the future.
2. Low Debt
Next, a good company’s debt should be either zero, at same level, or lower than the industry’s standard. Certain industries, like telecommunications or financial services, tend to have a higher debt due to huge capital sums required to make money. Plus, it just makes clear sense to steer clear of any companies laden with heavy debt. For that, we’ll set our Debt-to-Equity (D/E) and Long Term D/E ratio to under 1.
3. Above Industry Sector
The last fundamental will cover various metrics like Price-to-Earnings (P/E), Forward P/E, Price-to-Earnings-Growth (PEG), Price-to-Sales (P/S) and Price-to-Book (P/B) ratios. P/E ratio is an indicator that shows the price in which the market is willing to pay for a stock.
A high P/E would mean that a stock is overvalued, while a low P/E means that a stock is undervalued. However, a stock cannot be chosen based on this metric alone, and I’ll explain why.
The P/E ratio (together with the other metric ratios listed above) is applied across all industries. As brought up in point 2, you cannot conduct an apple-to-apple comparison of a company’s performance in different sectors against each other. For example, you cannot compare Google’s P/E ratio (32.43) directly to Tesla’s P/E ratio (624.12). This would make it seem like Tesla’s stock is grossly overvalued. Only when you compare Tesla with a direct competitor like Toyota (11.30) then would you know that Tesla is overvalued, and Toyota undervalued. This principle goes the same for all other metrics as listed above.
Here are the list of recommended ratios for each industry (subjected to time-to-time change):
Thankfully, Finviz has made our jobs much simpler. Instead of having to compare the stock with a ratio list every time you want to buy a stock, all you need to do is remember a metric colour code:
- Green (Undervalued)
- Black (Around industry average)
- Red (Overvalued)
To compare these ratios, click on the valuation tab of the screener. From here, select a stock that has no red metric ratios (not overvalued). This leads us to one stock: Johnson Outdoors (JOUT).
Let’s click on the stock and further examine it:
JOUT has very healthy financials. It has zero debt and long term debt (a good sign), constantly outperforming its EPS for the past 5 years (profitable), and is undervalued (forward P/E of 14.45). The reason for the price decline could either be profit-taking (people collecting profits after long move up), or the -5.30% insider stocks that the directors sold off. Either way, these fundamentals are signs of a well-performing stock.
However, hold up! These are not good enough reasons alone to buy this stock yet. We need to conduct our technical analysis to find out what is the best price to buy this stock at.
Pro Tip: Use fundamental analysis to create a watchlist of stocks, and use technical analysis to find the perfect price to buy the stock at. I usually compile a stock watchlist to compare which ones have declined sharply. Treat this as your discounted shopping list.
Technical Analysis
I’ll be splitting my my technical analysis into two parts: Finviz’s technical analysis screener and drawing trendlines on Thinkorswim.
Finviz: Technical Analysis Screener
Finviz’s technical analysis screener can be used to identify oversold stocks. I use three main metrics: Relative Strength Index (RSI), 200-Day Simple Moving Average (SMA), and the 20-Day High/Low.
- 20-Day High/Low
The 20-Day high/low is a metric that shows stocks that hit their lowest point today in 20 days. Many of these stock featured have sudden sell-offs. However, this is not necessarily a bad thing. Most of the time, these price declines are due to insider transactions.
If you’re worried that this might be a ‘falling knife’ situation, have a look at the institutional ownership column. The red box circled below shows that the 92.50% of the shares are still owned by big institutions like hedge funds and private equity firms. You should only be worried if there’s a huge decline in this box as well.
Coupled with fundamental analysis, this metric is very effective for finding good bargains.
Pro tip: If there are not enough stocks listed in the screener, you can consider switching this 20-day High/Low metric from “New Low” to “Any”.
2. 200-Day Simple Moving Average (200-Day SMA)
The 200-Day SMA acts as a support band and allows us to determine the long-term trend of the market. By setting our SMA to be below the 200-day mark (long-term period), our stocks are also under the 50-day and 20-day SMA mark. This is helpful as it prevents cases of “Death Crosses” from occurring, setting up our trade for a “Golden Cross” opportunity.
3. Relative Strength Index (RSI)
The RSI is an oscillator graph that measures recent price changes to determine if the stock is overbought or oversold. By default, we want stocks to be under 40 and below (representing oversold).
Technical Analysis Case Example: Dollar Tree (DLTR)
Using my preset link (viewed on 5/30/2021), four stocks are listed in Finviz’s stock screener. I’ll choose DLTR as it is relatively undervalued (there are no red metric ratios listed).
If we look at DLTR, we’ll notice that the stock fell quite a bit — it took a dive of almost 16% from the start of the month. As a trader looking for a bargain, we’d love to buy this stock. However, as the saying goes — never catch a falling knife. So the question is, what’s the right price to buy this stock at?
Thinkorswim: Trendline Drawing
For illustration purposes, I’ll be using TD Ameritrade’s Thinkorswim platform to draw the trendline. I highly recommend downloading it as it charges 0% commissions for trades, has plenty of analysis tools and is a platform most trading professionals use. Now, back to primetime:
Key in the stock DLTR on Thinkorswim.
Use a 10-year:1-month candlestick chart. Watch this video if you need to learn how to set it up.
By using a 10Y:1M chart, all volatile daily fluctuations are absorbed into the month — allowing us to plot long-term trendlines better. In this chart, 1 candlestick represents 1 month.
Select the trendline function under your drawing tools.
Draw a line that connects at least 3 troughs together. The more troughs you can connect with a single line, the better.
Pro tip: Always pick stocks that have an upward movement. You can determine the price movement through the trendline that you’ve just drawn.
Here, we can infer that the stock price would most likely hit the $90 price point before bouncing up again.
Pro tip: The market loves round numbers. So always remember to round up your price to a “nice” number, e.g. $90, $100, $85, etc. Don’t look at me! I don’t set the rules.
The last step is to queue up a buy order at $90.
Trendlines determine the direction of the market by creating a visible support. Just imagine, thousands of other traders are looking at DLTR and identifying this support line as well. It’s better to err on the side of caution and follow the masses.
Pro tip: If you feeling pro, you can use functions such as Thinkorswim’s Level II or Active Trader function to see orders that other traders have lined up.
Price to Sell
The price to sell? It depends on the type of trader that you are. There are two types of people:
- Investor: People that think their stock can become the next Apple or Amazon. Must be prepared to hold for more than 10 years, according to Warren Buffet.
- Trader: Basically buy low, sell high. Hold your stock between a few weeks to a few months.
I prefer to be a trader. My exit strategy is to sell at the stock’s target price as listed on Finviz (red box below). This target price is usually derived from professional sources such as the Wall Street Journal. My take is that people who read the Wall Street Journal and Finviz and would sell it at that price too.
However, determining your selling price is entirely up to you.
There are many other technical indicators that I use when buying stocks, like the Moving Average Convergence Divergence (MACD) indicator, Bollinger bands, and RSI graphs, but we’ll save that for another blog post.
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Read my other articles here:
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