Lesson 20 of 43: How to Find the Best Stocks to Buy (with Handout Cheat Sheet)

We’ve covered a lot in this course so far, from investing styles, to dividends, to market myths, risks, and crashes.

Now it’s time to pull everything together and go find some stocks to buy!

This lesson is going to walk through a general framework for stock research. We provide you with a five step strategy for finding the best stocks and building a portfolio.

Included is a free handout “cheat sheet” to remind you of the stock research process (see below).

After we walk through a general framework for finding the best stocks in this lesson, we’ll dive into the specific winning formulas for finding the best small cap, large cap, blue chip, value, growth, and dividend stocks in the next six lessons.

We’ll also cover advanced strategies for how to profit during bear markets and recessions.

Now, let’s dig into how to find the best stocks.

5 Steps to Find the Best Stocks

There are nearly 9,000 stocks traded in the U.S. market – how are you supposed to narrow it down to a portfolio you can trade and profit from?

As we discussed in Lesson 16: How Many Stocks Should You Own?, most investors own between 10-30 stocks in their portfolio.

Less than 10 is too concentrated and risky, whereas more than 30 becomes a lot to manage.

So how are you supposed to pluck 10-30 sparkling gems from an ocean of 9,000 candidates?!

We suggest you use our five step process, which goes like this:

  1. Pick your investment strategy
  2. Create your stock universe
  3. Narrow using key criteria
  4. Hand research finalists
  5. Build your portfolio

Let’s unpack these five steps in detail, and then we’ll do a complete example so you can see the process in action.

As you walk through this process (now and in the future), feel free to use this handy “cheat sheet” as a guide.

Click on the image below to download a high-resolution PDF version for your personal reference.

Step 1: Pick Your Investment Strategy

Before you can start researching stocks, you have to decide what type of investment strategy you want to pursue.

We covered this topic extensively in two important lessons from earlier in the course:

We suggest you review those lessons as a refresher on the most popular investment strategies and how to find which are right for you.

We’ll also provide a quick refresher here.

First, let’s refresh the major takeaways from Lesson 8: Investing Styles & Strategies: 17 Ways Investors Make Money in Stocks:

  1. Value investors seek to buy companies that are currently trading below what they’re truly worth in hopes their price will move up towards fair value.
  2. Growth investors look for stocks with strong historical and projected future sales and earnings growth because they believe these companies will continue to deliver strong financial results far in the future.
  3. GARP (Growth at a Reasonable Price) investors combine the philosophies of value investing and growth investing into a single strategy. They look for stocks that have healthy growth but also appear to be undervalued.
  4. Dividend investors look for stocks that pay generous and sustainable dividends so they can collect the steady income.
  5. The Dividend Aristocrats is a dividend strategy that focuses on a specific group of 53 S&P 500 stocks that have delivered 25 or more years of consecutive dividend increases.
  6. Quality investing looks for stocks that carry the attributes of high-quality companies and management.
  7. Wide-moat investing aims to buy companies that have something about their business that acts as a defensive moat against competitors or new entrants to the market.
  8. The Dogs of the Dow strategy buys the top 10 high dividend yield stocks of the Dow Jones Industrial Average (DJIA) each year.
  9. CANSLIM is a growth investing strategy pioneered by Investors Business Daily which aims to buy high growth stocks that meet all seven of these key characteristics.
  10. Momentum investing buys stocks that have gained the most over the last 3-12 months and avoids stocks that have declined the most during that same period.
  11. Day trading involves buying and selling stocks within a single trading day. Rather than buy and hold, day traders aim to quickly compound lots of small profits, adding up to a large profit over time.
  12. Swing trading involves buying stocks that are seeing a positive movement in their price and selling them after just a few days or weeks for a small profit.
  13. Penny stock investing involves buying obscure stocks trading under $5 per share (and often under $1 per share) in hopes of a large and fast gain.
  14. Sector (or industry) investing involves buying stocks in a particular sector as a way to gain from the strong profit potential of that overall sector.
  15. An emerging markets strategy aims to buy companies located in fast-growing overseas markets in order to capitalize on the emerging country’s rapid economic expansion.
  16. Dividend capture strategy involves buying a dividend-paying stock right before the ex-dividend date and then selling it right on (or after) the ex-dividend date so that you’re eligible to receive the dividend.
  17. Buying story growth stocks involves finding companies that appear poised to grow very rapidly in the near future and somehow completely disrupt or take over an industry.

And here are the major takeaways from Lesson 14: What’s the Best Investment Strategy for You?

When it comes to investment styles, there are many approaches that can work. It all depends on what’s right for you.

Beginner investors often try a few different investment styles before finding the right fit:

  1. Value investors look for companies that are undervalued by the market.
  2. Growth investors look for stocks with strong past and future growth.
  3. Dividend investors look for high dividend stocks that will provide steady income.
  4. Quality investors looks for stocks that are financially strong and well-managed.
  5. Blue chip investors look for well-known industry leaders with a long history of safe returns.
  6. Our research suggests combining strategies can be an incredibly powerful approach that performs better than any individual strategy on its own.
  7. Our research suggests that buying value, growth, dividend, and quality stocks has offered higher returns when they’re small companies than when they’re large companies.
  8. However, higher small stock returns come with greater volatility and less consistency.
  9. The barbell strategy will allow you to invest most of your money in low-risk / low-reward stocks and a small portion of your money in high-risk / high-reward stocks.

Most investors are interested in buying stocks in the following areas:

  • Large cap stocks
  • Small cap stocks
  • Blue chip stocks
  • Dividend stocks
  • Value stocks
  • Growth stocks

Of course, many are also interested in combinations from the above, such as small cap stocks with high dividends or undervalued blue chip stocks.

And as we discussed above, it’s fine to pursue multiple strategies at once. For example, buying aggressive small cap stocks in one account and defensive dividend stocks in another.

Whatever you decide to pursue, this first step is a very important one. This is where you pick a direction for what type of investment strategy you plan to implement.

It’s important that you have a clear investment strategy in Step 1 so that you know which stocks to screen out and which stocks to explore further.

We recommend you have both a “what” and a “why” as part of your investment strategy.

The “what” describes what type of stocks you plan to buy and the “why” describes the reason you’re pursuing that strategy.

An example of a clear investment strategy from Step 1 might look like any of the following.

“I want to build a portfolio of…

  • stable blue chip companies because I think a bear market is coming.
  • aggressive small cap stocks because I want to earn maximum possible profits.
  • high-yield dividend stocks because I want to collect steady dividend income.
  • undervalued large cap stocks because I think the market is currently overpriced.
  • high-quality growth stocks because I think we’re in a strong bull market.

Note that each investment strategy starts with “what” you want to buy and is followed by “why” you want to buy it.

When it comes to buying the best stocks, having a clear investment strategy will define your next four steps and determine which stocks end up in your portfolio.

Once you have a clear vision for Step 1, it’s time to move on to Step 2.

Step 2: Create Your Stock Universe

In Step 2, we make the first big cuts to refine the nearly 9,000 stocks trading in the U.S. down to a more reasonable number of candidates.

Let’s start by understanding what we mean when we say “stock universe.”

A stock universe is a large pool of stocks from which you’ll fish for companies to buy.

Companies outside the universe are stocks you absolutely won’t consider buying for various reasons. And companies within the universe are all potential candidates.

Put another way, defining our stock universe puts in place a set of rules to eliminate certain stocks that you absolutely are not interested in buying.

For example, many investors will want to rule out companies that are too small, or that trade on over-the-counter exchanges, or that have never realized a profit.

Your universe rules should eliminate stocks that don’t fit your investment strategy from Step 1.

So if you’re interested in high-yield dividend stocks, you would want to eliminate all stocks that don’t pay dividends, leaving you with a stock universe of dividend-paying stocks.

You might even take it a step further and eliminate all stocks with a dividend yield below 2% (including those that don’t pay any dividend at all), so that you have a stock universe of high dividend yield stocks. 

Here are some common rules to consider when defining your universe. You may want to eliminate all stocks that are:

  • Too large or too small (market cap rules)
  • Too much or too little trading volume (liquidity rules)
  • Too high or too low of a dividend (dividend yield rules)
  • Part or not part of certain indexes, such as the S&P 500
  • Profitable (earnings rules)
  • Not growing sales or earnings (sales / earnings growth rules)
  • U.S.-based or international (country rules)

These are just a few examples. There are thousands of possible rules you could choose from and they should all be driven by your investment strategy in Step 1.

One important note: Don’t confuse defining your universe (Step 2) with narrowing using key criteria (Step 3).

Defining your universe (Step 2) is about completely eliminating from your consideration all companies that have certain attributes you definitely don’t want.

On the other hand, narrowing using criteria (Step 3) is a more delicate process of filtering the companies you’re considering based on which is the most attractive. 

In order to define our universe of stocks (and then further narrow in Step 3), we’re going to use a stock screener.

A stock screener is a tool that allows you to instantly filter and sort all the stocks on the market based on criteria that YOU define.

There are many stock screeners to choose from, each with their own advantages and disadvantages. We provide a full list of many screeners at the end of this course in our lesson on investor resources.

For now, we’re going to use the free stock screener from FinViz.com because it’s powerful and easy to use (we have no affiliation with FinViz).

Take a quick look around the FinViz screener to get a sense of how it works and what metrics are available. We’re going to walk you through a complete example below and show you exactly how to use the stock screener from start to finish (with screenshots).

By clearly defining your stock universe, you should see the total number of stocks you’re considering shrink from nearly 9,000 candidates down to several hundred, or maybe several thousand.

This should give you an attractive pool of stocks that fit your strategy. From there, we can begin to narrow your choices.

Step 3: Narrow Using Key Criteria

Now that you have a strategy and a clearly-defined stock universe that fits your strategy, it’s time to narrow and filter your stocks based on which are the most attractive.

Here we’re going to use powerful metrics, specific to your investment strategy, to find the best stocks.

The goal of Step 3 is to take your well-defined universe of stocks and filter them so that you can focus on the most attractive candidates.

For example, if you’re looking for big, safe companies that are growing quickly and you’ve already refined your stock universe to companies in the S&P 500 that are profitable, now would be a good time to experiment with applying metrics like these:

  • Sales growth
  • Earnings growth
  • Cash flow growth
  • Earnings per share forecasted growth
  • Analyst growth estimates

Or, to look at another example, if you’re looking for undiscovered small cap companies that pay huge dividends and you’ve already refined your stock universe to small companies with a dividend yield over 5%, now you can start ranking your results with metrics such as:

  • Dividend payout ratio
  • Debt
  • Dividend growth
  • Cash flow growth
  • Cash on hand

As you narrow your list of candidates, we have one very important tip to consider:

Be careful with how restrictive you are when applying your criteria.

While there are many stocks on the market to choose from, once you apply criteria to narrow your universe you may find that your list of candidates has shrunk too small (maybe even to zero).

For example, there probably aren’t many (or any) S&P 500 stocks with a dividend yield greater than 6%, no debt, high earnings and sales growth, and a strong history of share buybacks.

That set of criteria is probably so restrictive that you won’t get any (or many) results.

To combat this problem, consider loosening your criteria just a bit. For example, rather than no debt, perhaps you require that your candidates don’t have excessive debt. And rather than high earnings growth, you instead require consistent positive profitability.

Based on your investment strategy, you’ll have to play with your criteria to see how many stocks you end up with. If you end up with too few (or even none), consider going back and loosening your criteria. 

The entire Step 3 process will take some trial and error.

Once you narrow your universe using your key criteria, you may find that you still have many results that look like attractive candidates and it’s hard to decide which are best.

For example, maybe you’ve narrowed it down to 50 high-quality stocks all have very high dividends. So how do you decide which is best?

In order to further differentiate between many stocks that seem like they would all fit your strategy, you can start to apply other metrics beyond your immediate strategy (but still important) to rank your candidates even further.

Keeping with our example above, if you have 50 stocks that all offer highly attractive dividends, you might consider filtering them by valuation to try and buy the cheapest among them. Or, you could filter them by cash on hand to focus on those with the strongest balance sheets.

The point is that in Step 3 you definitely want to focus on narrowing your candidates based on your most important criteria from Step 1 (your investment strategy). But once you do that, if you still have too many results to choose from, consider bringing in unrelated metrics that are still powerful predictors of profitable stocks.

In the next few lessons we’re going to walk you through the most powerful metrics to consider for each investment strategy. We’ll give you a step-by-step guide to finding the best value, growth, dividend, small cap, large cap, and blue chip stocks based on our extensive testing and research.

Keep applying relevant metrics until you reach a list of roughly 10-50 stocks that you can now research more closely.

Step 4: Hand Research Finalists

Now that you’ve narrowed your list of stocks down to 10-50 attractive candidates, it’s time to take a closer look at each.

Based on the metrics you applied, these should all be highly attractive companies that fit your investment strategy extremely well. The purpose of further research is to apply your skills, knowledge, and experience to pick the very best among them.

While you can start anywhere, you might want to sort your finalist results by a certain criteria that you consider to be MOST important. For example, you might want to sort your 50 finalists by the highest dividends, or the most undervalued, or the fastest sales growth.

Sorting your final results using a metric that’s highly representative of your investment strategy can help you focus on researching the best candidates first.

We’ll walk you through a detailed example (with screenshots) below so you can follow along.

Start going through your list of companies and researching to learn more about them. You might consider checking financial sites for research, reading their earnings reports, checking investor discussion forums, or Googling for analyst opinions.

There are many ways to research stocks and we provide a full list of dozens of investor resources at the end of this course.

The most important thing is to make sure the company you’re researching is a spot-on fit for your investment strategy (Step 1).

In other words, if your goal was to focus on small-cap high-dividend stocks, your hand research should show your final candidates are all strong dividend payers.

What often happens is that during this Step 4 hand research phase, you discover things you hadn’t considered earlier in the refinement process.

Maybe you discover that your top candidate is a nano cap stock with so little trading volume that it seems far too risky to hold.

When you find such gaps during the hand research phase, simply go back and further refine your universe and narrowing criteria.

So in the example above, you’d want to go back and eliminate all stocks that are too small for your consideration.

Similarly, you’ll often come across criteria you overlooked during Step 2 and Step 3.

Perhaps an analyst is criticizing one of your top dividend stocks because it has too much debt and you hadn’t considered the risk of excessive debt for a dividend paying stock.

Again, use this new insight to go back and further refine your criteria in Step 2 and Step 3. This will shorten your list for further research.

As you find highly attractive stocks that successfully pass your universe, narrowing, AND hand research, mark them down as companies to buy for your portfolio.

Keep doing hand research and criteria refinement until you build a list of 10-30 stocks you want to buy.

And if there are stocks that seem like good candidates, but just barely miss your cutoff, note them down. You can keep an eye on them for future consideration. Their performance and profile could improve in the coming months, making them highly attractive candidates for your future investment.

Now that you have your finalists, it’s time to build your portfolio.

Step 5: Build Your Portfolio

This is where you take the results of all your thoughtful research and refinement and create a complete stock portfolio based on your investment strategy.

At this point, you should have 10-30 stocks that are the absolute best fit for your investment strategy.

Now all you have to do is buy them!

In three upcoming lessons we’ll go through exactly when to buy and sell stocks, and which brokers are best.

But for now, let’s go through a step-by-step example of the process we outlined above so you can see exactly how to use a stock screener to find the best stocks to buy.

EXAMPLE: Step 1: Pick Your Investment Strategy

Let’s start our example by picking a clear investment strategy. Just for illustration, let’s focus on dividend stocks.

Let’s use this statement as our investment strategy:

“I want to build a portfolio of high-quality dividend stocks because I want to collect dividend income from low-risk companies.”

There are three parts of that investment strategy statement that can inform our Step 2 and Step 3 refinement:

  • High-quality stocks
  • Dividend-paying stocks
  • Low-risk stocks

Let’s start by building our universe around these three pillars of our investment strategy.

EXAMPLE: Step 2: Create Your Stock Universe

First, let’s figure out what types of stocks we want to exclude vs. include.

As discussed above, we’ll be using the free stock screener at FinViz.com to show you each step.

Keep in mind, your numbers will likely differ from ours in this example because stock data changes every single day.

Since we want dividend income, the first cut in our universe is to eliminate all stocks that don’t pay a healthy dividend. Let’s say that we’re only interested in stocks with a dividend yield of 3% or greater.

And to find high quality / low risk stocks, we’re ONLY going to focus on stocks within the S&P 500.

So, to build our universe in FinViz, let’s focus on S&P 500 stocks that have a dividend yield of at least 3%.

Below is a picture of how you filter to focus on just those stocks. Or, we’ve provided a pre-filtered link to the screener right here.

Notice that with just those two simple universe rules, we’ve already narrowed nearly 9,000 stocks down to just 144 high-quality dividend-rich candidates!

EXAMPLE: Step 3: Narrow Using Key Criteria

Now that we’ve created a universe of 144 high-quality high-dividend stocks, it’s time to narrow using some key criteria.

Since we’re focused on dividend companies, let’s make sure they have a healthy payout ratio.

In our Profit Lab series (a strategy series where we share proven ways to profit from stocks) we posted a research article on how the cross section of high dividend yield and low payout ratio is a powerful combination for finding the best dividend stocks.

You can read the full article here: Buy the Best High Dividend Stocks with This Research-Backed Formula.

As a reminder, payout ratio measures how much a company is paying out in dividends vs. how much money the company made in earnings.

It’s essentially a measure of dividend sustainability because it examines whether a company is paying out too much in dividends compared to how much it’s making through its regular business operations.

Armed with this knowledge, let’s filter our results further by payout ratio.

In general, a top dividend company should aim to keep its payout ratio below 50% so that they’re retaining at least half of their earnings to reinvest in the business.

So, let’s filter for stocks with a payout ratio under 50%, which brings us from 144 stocks down to just 54.

Click here to see the results in FinViz.

Finally, let’s add a metric to focus on our goal of low-risk stocks.

Beta is a metric which measures how much a stock’s price moves relative to the overall market.

A beta of 1.0 means the stock moves up and down exactly as much as the market. A beta of less than 1.0 means the stock is less volatile than the market, whereas more than 1.0 means the stock is more volatile than the market.

Since we want safe and stable stocks, let’s filter for stocks with a beta of less than 1.0, meaning they tend to move less than the overall market.

This brings us down to a short list of just 23 candidates, all of which are members of the S&P 500, pay a high dividend with a low payout ratio, and are more stable than the market.

Click here to see our final results in Finviz.

Now, with just 23 attractive candidates, it’s time to move to Step 4 – hand research finalists.

EXAMPLE: Step 4: Hand Research Finalists

As discussed above, in Step 4 you’re going to take your short list of 23 highly attractive stocks and apply your knowledge, wisdom, and experience to decide which deserve a spot in your portfolio.

One helpful tool in FinViz is the ability to see charts, data, and recent news for the stocks in your screener with a single click.

Simply click the “News” tab (shown above) and your list of candidates will show the information above. All you have to do is scroll down to begin your research!

Or, click here to jump directly to the “News” results in FinViz. 

From here, you might decide to buy all 23 stable high-yield stocks or you might continue to refine based on your research and buy as few as 10.

In our upcoming lessons, we’re going to walk through detailed examples of how to find the best value, growth, small cap, large cap, dividend, and blue chip stocks.

We’ll provide you with the best metrics for each investment strategy, as well as direct links to FinViz with pre-filtered results. 

Lesson Summary: How to Find the Best Stocks to Buy

We covered a lot in this lesson, and most important was our five step process for finding the best stocks:

  1. Pick your investment strategy
  2. Create your stock universe
  3. Narrow using key criteria
  4. Hand research finalists
  5. Build your portfolio

Next up, Lesson 21 (Growth Investing): A Step-by-Step Guide to Picking the Best Growth Stocks

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Author

Todd Lincoln

Author

Passionate stock market investor with deep experience trading small cap, dividend, and growth stocks.

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