Welcome to lesson one of our course on how to pick stocks! Over the next 5 short lessons we will take an in-depth look at the process of selecting stocks to invest in. Lesson one will look at setting goals and choosing investment strategies. We will cover:

• Investment goals
• Different investment strategies
• Using stock screeners and watchlists

By the end of this lesson you should be able to:

• Set SMART investment goals
• Choose an investment strategy
• Be confident using screeners and watchlists
• Set up an investment idea funnel

Lets get started!

 

Developing an Investment Framework

As the COVID 19 Pandemic swept the world, an influx of new investors to share market trading followed. Here in Australia, retail trading on the ASX swelled from 650,000 to more than 1.25 million in 2020. In a 2023 study of their investment community, the ASX (Australian Stock Exchange) found that 23% of investors had started trading in the two years following the onset of COVID.

Some of these newcomers relied on available investor education sources to guide their investment decisions. Others chose to “follow the herd,” buying whatever stock had caught fire from social media posts.

Those who chose to learn market dynamics before buying found universal expert advice to begin by establishing an investment framework.

A workable dictionary definition of a framework is it is a structured foundation or system that supports or organizes ideas, or processes

Setting goals is the critical first step in establishing an investment framework, with everything that follows supporting those goals.

 

Setting Goals and Strategies

Some investors may be tempted to jump right into to learning different investing strategies covered in financial websites and online trading platforms, ignoring the step of setting goals that determine what strategies to adopt.

At first glance, the question that begins the process – why are you investing in the stock market – might be considered rhetorical. The glib answer to the question is to make money.

There are a host of considerations left unanswered by that vague statement. To work for an investor, goals should follow the universally advised view to follow the SMART framework in goal setting, as follows:

• Specific
• Measurable
• Achievable
• Relevant
• Time Bound

All these criteria are grounded in the first – a specific response to the question why the investor is looking to the markets and when the money earned will be needed. The response will set time frames for investing and lead to the best investing strategy.

Long term investors may have a goal of building a retirement fund by age 55. Medium-term investors may have a goal of earning $10,000 or $5,000 to buy a house or a goal of saving for university funds for children’s  education. Finally, there are investors looking for nothing more than earning monthly income at a rate higher than available through bank deposits. Fixed income investments may not be time bound.

In addition to time frames, there is another critical consideration rising from the investor’s specified investing goals – risk tolerance. 

The risk of losing money is inherent in all stock purchases, but some classes of stocks are riskier than others. Investors need to look in the mirror and ask themselves how they will react if one or more of their investments loses money. Some investors respond in a panic and sell a stock the moment it begins to drop. These investors have low risk tolerance and need to adopt an investing strategy that fits their risk appetite. There are three major investing strategies commonly available.

• Value Investing
• Growth Investing
• Income Investing
• Momentum Investing

Value and Growth investing in many ways are the mirror image of each other. The value investor looks for quality stocks at bargain prices, reducing the risk of loss as the market community does not favor these stocks. Growth stocks are those with the potential for substantial gains over time even if the current share price is high. These stocks are high risk as investors can flee once the stock fails to live up to its potential.

Income investing looks for dividend paying stocks to yield monthly income. Their risk is a reduction or elimination of the dividend payment in challenging times. Generally speaking, dividend paying stocks are among the lowest risk stocks money can buy. The ability to pay consistent dividends over time is a sign of a stable, financially sound company.

Momentum investing is generally not recommended to novice investors as the risks are quite high and the strategy relies heavily on technical analysis price indicators. The strategy involves buying stocks in strong upward trends and riding the upward momentum until selling when the trend reverses.

The investment framework needs to be a written document including specific parameters for holding periods, profit percentage desired, and class of preferred stocks – value, growth, dividend payers or a diversified mix, keeping risk tolerance at the forefront of the document. Now, where to begin the stock selection process.

 

Using Screeners to Create an Investment Checklist

Over 2,000 stocks trade on the ASX. A Stock Screener is in essence a search engine allowing investors to hone in on stocks that meet quantitative criteria fed into the screener. Both value and growth stocks have numerical metrics that can be spotted in a stock screener, as well metrics for share price movements. The screeners have valuation standards for selection along with an array of operational metrics that can be set to values that fit the investing framework. There are metrics suitable for identifying solid dividend paying stocks as well.

Online brokerage platforms from all four of the big banks offer investors stock screeners on their online trading platforms. CommSec from Commonwealth Bank is the country’s largest online trading platform and also offers an exhaustive set of investor educational courses via CommSec Learn. Big bank trading platforms generally have higher fees than discount platforms like eToro, which also offers stock screening capabilities. You can find reviews of eToro and other trading platforms here on thebull.com.au.

Using stock screeners can be challenging as setting the metrics you need too high can filter out too many stocks while setting them too low can produce a mountain of results. Experimentation is the key. Stock screener results should be considered the first step in a “funneling” process culminating in first a watchlist and finally an investment checklist, following further vetting. Screeners tell an investor nothing about the stock’s market penetration, new products in development, patents in place, competition, and quality of company management.

 

Where to find investment ideas

Stock screeners are only one of many sources for investment ideas. Financial websites feature daily coverage of positive and negative news from ASX listed stocks. The bull.com.au features a weekly column – 18 Share Tips – with BUY, HOLD, and SELL recommendations from six different prominent Australian stock analysts. Social media is also a source, but all of the news coverage, recommendations, or “tips” should make their way to a stock watchlist for further vetting.

 

Using an ‘idea funnel’ to filter potential investments

The “idea funnel” is the structured process beginning with the generation of potential stocks for further vetting. Vetted stocks make their way to a stock watchlist where potential targets are monitored for changes in the fundamental (valuation) metrics and technical metrics (price movements) set out in the investment framework. The final result is the investment checklist, where quality measures not seen with quantitative metrics are applied to the targeted stocks.in the stock watchlist.

 

Using watchlists

Think of the watchlist as a “holding pen” for targeted stocks awaiting a trigger point for executing the trade. Online brokerage platforms allow the creation of watchlists that will monitor decision points for each stock on the list, such a change in price, earnings, news, and trading volumes. Investing experts recommend a written log of the reasons a stock is on the list before setting alerts. Experts also recommends taking a breath once a stock triggers and conducting one final review before hitting the BUY button.

 

Key Points

• An Investment Framework is a written set of guidelines for everything involved in making a decision to buy a stock — from setting goals to selecting assets and managing the portfolio.
• Goal setting is the critical first step, setting SMART goals for the process beginning with answering the questions “why am I investing and what do I want to accomplish.”
• The “funnel” approach begins with using tools like stock screeners at the wide end at the top of the funnel for reviewing a large segment of available stocks to filter down through the funnel for further vetting and analysis.
• Near the bottom end of the funnel lies a stock watchlist of potential targets to be monitored for buying decision points.
• The Investment Checklist is the final review of a targeted stock against the investment framework prior to buying.