How to choose the shares to buy: the 6 criteria for a perfect stocks selection

The stock selection has the purpose of filtering a limited number of stocks meeting the characteristics desired by the investor. It is a so-called top down investment methodology because the analysis starts from all listed securities, or at least of which information is available, to arrive at specific shares to invest in, while avoiding going into the details of each title, and the prospects of the companies.

The stock selection can use information of various kinds, for example technical indicators, balance sheet fundamentals and market multiples. To become familiar with this interesting investment strategy, you need to know the stock selection criteria, their strengths and weaknesses, and then combine two or more selection criteria in order to generate a list of stocks to invest in.

Stock selection criteria to find the best shares to buy

There are six stock selection criteria: capitalization, return on capital, price / earnings ratio, price / book value ratio, beta (systematic risk or non-diversifiable risk indicator), dividend yield. I describe them one by one, with some numerical examples taken from the US and Italian markets, but valid everywhere.

Capitalization: Big vs Small

A first criterion for selecting stocks to buy can be the capitalization of companies: although it is a criterion that “says little” if used individually, it is worth emphasizing that the size of the company is in any case an index of market power, of the ability to make of scale, ownership of brands or technologies exploited globally.

For example, on the US market in 2011-12 a selection of companies with a capitalization of more than 100 billion dollars achieved a performance of more than 10 points above the S&P 500 index, driven by the technology giants Apple and Google but also by companies such as Ibm and Coca Cola.

If you analyze the Italian market, you notice a lower correlation between size and performance, but the smaller size of the whole market must be considered. Also in these cases, capitalization can be a useful filter to narrow the results of stock selection, using it with other parameters to evaluate companies of a certain size level.

Return on capital: an important parameter for choosing the best stocks to buy

Return on equity (Roe) is a measure of business profitability and is calculated as the ratio of net income to equity (the company’s assets, net of debts and other liabilities). The value of the Roe is normally expressed as a percentage and is a measure of how much the company’s net assets “produced” in terms of profits, during the last financial year.

A return higher than the cost of capital (return on other investments, comparable in terms of risk level) is an indication of the ability of the company to create value and should be a guarantee of greater capacity for growth of the securities in the bull market and / or of resistance in the most difficult periods.

This theory is confirmed by the real data: from a selection of Italian companies with Roe higher than 15% it could have been obtained a return, in the last 12 months, of 9 points higher than the Ftse Mib index, while companies with Roe lower than 5% achieved a performance of 13 points lower on average.

Price / earnings ratio to correctly set the stock selection range

The price / earnings ratio is perhaps the most used indicator by those seeking to approach the analysis (and choice) of securities according to the fundamental criteria. A low P / E indicates that you are “paying less” for the company’s earnings, so the stock in question is affordable but it could also mean that future earnings expectations are not particularly positive.

From an analysis of 50 stocks on the US market, those showing a ratio greater than 15 (a value normally considered to be the watershed between cheap stocks and not cheap) appear to perform better than those with a ratio between 0 and 15, while logic would suggest the opposite; also the P / E therefore must not be the only parameter for the selection of stocks to buy.

Finally, a practical note: when using the P / E to choose the shares to invest in, it is always advisable to set both extremes to avoid obtaining unwanted results. With P / E < 15, for example, you will also end up extracting companies at a loss, while if you set the P / E between 0 and 15, only companies that have an affordable price-earnings ratio will be extracted.

Price / book value ratio: a low value is not always an indication of convenience

The price-to-book ratio (or price / book value ratio) relates the stock price with the value of the net assets resulting from the latest financial statements. A ratio of less than 1 means that you are paying the company less than the value of the balance sheet assets net of liabilities, but this does not automatically mean that you are also making a deal, at least until you verify the company’s ability to produce profits. I give an example taken from an analysis of the Italian market, dating back to 2012 but performed by the rating agency Fitch.

An extraction was made of companies listed on the Ftse Mib, with the P / BV ratio of less than 0.5: many companies were in the red, practically all listed banks and several municipal companies; these companies in the last few years before the analysis had disappointed the economic results and in the previous 12 months produced a performance of over 20 points lower than the already poor result of the Ftse Mib.

Instead, the selection of companies with P / BV greater than 3 included highly successful made in Italy brands such as Tod’s, Ferragamo, Luxottica, and Saipem (energy, infrastructures), one of the best performing companies in recent years. But not even this selection is a sure indication of quality, because a high P / BV ratio can sometimes be determined by a deteriorated denominator due to losses that have reduced it to a flicker: in fact, even if selecting companies with P / BV> 3, a third of the total was with the accounts in red.

Beta (systematic risk or non-diversifiable risk indicator): when to choose high or low risk values

Systematic or non-diversifiable risk is the amount of risk that a security adds to an investment portfolio and that cannot be reduced by choosing other securities even if they belong to other sectors.

A beta of less than 1 indicates that a stock moves on average less than proportionally to market changes (with a beta of 0.5 we can expect that when the market rises or falls by 1% the stock will rise or fall by 0.5 %), while a high beta indicates particularly cyclical securities, more influenced, for example, by changes in the economic cycle or by the market itself (as is often the case for securities in the financial sector).

It is logical to expect that in growth phases of the market high beta stocks are preferable, and vice versa, but not always: the beta can therefore be used profitably more as a control parameter or in combination with other extraction filters.

Dividend yield to find stocks to buy: can be used alone or as a filter

The dividend yield is calculated as a percentage ratio between the current dividend (latest approved dividend) and the share price. The dividend yield measures the remuneration to shareholders that the company gives in the last year (an alternative form is the repurchase of own shares).

A healthy company is generally able to distribute dividends to remunerate its shareholders, the dividend yield measures the ability to do so. But be careful: in some cases, a high dividend yield may indicate little reinvestment or poor growth prospects.

This is partly confirmed by the analysis made by Fitch a few years ago: stock selections based on different levels of dividend yield (0% -2%, 2% -4%, 4% -6%,> 6%) found that only in the range between 2% and 4% were the performances better than those of the Ftse Mib index, while in the one with a dividend yield above 6% there were many companies in stable sectors but with limited opportunities for expansion.

Therefore, the dividend yield also does not provide unique answers on its own but must necessarily be used in combination with other parameters.