Stock Selection is THE MOST IMPORTANT part of the Automatic Investor strategy. If you are investing for the long term, you must choose a high-quality stock. While the Automatic Investor technique will work with any stock, the risk to your capital is dependent on the quality of your choice. The higher the stock’s quality, the lower the risk.
Of course if you are aware of the risks, you can use Automatic Investor to manage second tier stocks, or even speculative penny stocks. Automatic Investor is a portfolio management tool. What you put into it is entirely up to you.
We do, however, recommend you use high-quality selections – because we feel that capital preservation is paramount.
For an excellent overview on the fundamentals of selecting stocks, we highly recommend Benjamin Graham’s classic book, “The Intelligent Investor” (click on the book cover to purchase it directly from Amazon.com).
Now let’s look at some key points for selecting a good stock.
Two investment styles
When looking for solid stocks, investors tend to use one of two basic styles – value investing or growth investing.
Value investors look for stocks that are priced at less than what they are actually worth, whether it’s because they are out of favor, had a bad quarter, or whatever. The value investor will search for companies that have assets valued higher than the total value of the company’s stock, look at fundamentals that suggest the company’s stock price is temporarily under-valued, or buy companies whose stock price has been driven down by outside factors.
This style requires absolute logic and a willingness to go against the crowd. It also requires a fair amount of research and basic accounting skills. In general prices have already fallen, so value investors minimize their downside risk.
(Fortunately there are now computer programs that can do much of the tedious research for you. See our Value Stock Selector software that pops out a list of solid, undervalued stocks with just one mouse click.)
If you can’t stand the thought of paying a high premium for a company’s future growth potential, this is probably the route for you.
Growth investors, on the other hand, look for companies where earnings are growing, markets are expanding, and the stock has momentum. They like companies that have a faster growth rate than the market as a whole, a leading position in a fast growing sector, or a new technology that will provide a distinct advantage.
This style of investing usually carries a higher level of downside risk, because growth stocks tend to get all the media attention, be in “hot” sectors, and draw the speculators to them. They also tend to be more volatile, than value stocks, and are thus better suited for use with Automatic Investor.
However either style will work with Automatic Investor. The key point to remember is that there are good value stocks and bad value stocks. Similarly there are good growth stocks and bad growth stocks. Choose the good ones.
Once you’ve found some good stocks, what do you look for next?
The key ingredient is volatility. A stock that fluctuates notably in a short time period will work extremely well with Automatic Investor. There are stock screening tools available on the Internet that can find volatile stocks for you. If you look at a chart, U and V patterns (and their upside down counterparts) visually signal volatile stocks. You can also look at the percentage gain or loss each day. High percentages indicate good candidates.
A cyclical stock usually operates in an industry that runs on cycles. In good times, the price rises, in bad times, the price falls. If you can find a stock with a reasonable period, it should be a good choice for Automatic Investor. Be aware, however, that these stocks generally accumulate returns over a longer period of time – compared with their volatile cousins.
Some stocks trade in a very noticeable range. They rise until they meet a certain price, then fall until they reach a lower bound. Then they rise again. These stocks are ideal Automatic Investor candidates because they fluctuate in a very precise manner. This allows you to time your price updates accordingly.
Automatic Investor takes care of the rest
Automatic Investor will use these price fluctuations to generate a profit. The more fluctuations that occur, and the greater the price change, the larger the returns will be. And therein lies the beauty of the technique. You don’t have to choose a stock that will continually rise (such as in the buy and hold system), nor do you have to choose one that will go down (as with short selling strategies). Rather you choose a high quality stock and reap rewards whether it goes up or down.
Some additional tips
In addition to fluctuating share prices, here are some other points to consider.
Buy, don’t be sold. Do your own due diligence and don’t listen to others unless they can back up what they say with facts.
Be a realist. Let your priorities be the sole reason for an investment. If you know you will need your money in 2 months, put it in a guaranteed investment vehicle.
Use margin sparingly. Margin can help you take advantage of unique opportunities. But always remember you are taking out a loan. One that will have to be paid back. In addition, if your holdings go down, you may be required to deposit additional funds – or risk being forced to sell your stocks at a poor price. If you do decide to use margin, buy only high-quality stocks, and pay it off as soon as possible.
Use knowledge. Purchase stocks based on facts, not rumors or tips. Above all, don’t try to predict the future, rather concentrate on minimizing risk.
Don’t try to get-rich-quick. It doesn’t work. Over time, the disciplined investor wins the race every time. Use Automatic Investor and follow its recommendations unless you have a good reason not to. You’ll likely do much better and will definitely experience less stress.
Take action. Review your portfolio regularly. If the fundamentals change, and your stock choices need improving or upgrading, do it right away. Delayed action translates into delayed benefits.
Don’t doubt. Once you’re convinced Automatic Investor is the superior system (and you should convince yourself before using it to manage your money), stick with it through the ups and downs. Don’t second guess Automatic Investor’s recommendations.