5 Ways to Pick Great Stocks

Strong sales growth and high return on capital are solid indicators of a good company.

By + More

SmarterInvestor_Campbell.jpg
Kelly Campbell
For decades, people have tried to buy and sell the right stocks at the right time. However, most investors—including brokers—don't have any system to pick the right company, or know when to buy it and when to sell it.

Here is a glimpse into a stock picker's rule book. This is not the Holy Grail, because even though I will give you a few secrets to finding the best companies, it still takes experience and discipline to make the right decisions. Here are some characteristics you should look for in companies you invest in:

[In Pictures: 6 Numbers Every Investor Should Follow.]

High return on capital. Not return on equity or return on assets, return on capital. Start out with earnings before interest and taxes (EBIT) and divide it by net working capital plus net fixed assets. This calculation allows you to compare companies without looking at differences due to debt levels and varying tax rates. The divisor of the equation reflects the capital actually used by the business to bring in revenue. Now you are making a better comparison between companies—the higher the number, the better for your portfolio.

High levels of free cash flows. It's a good thing when a company has money left over after everything is paid for. This "extra" money shows the company is making more than it spends, and also that is has additional capital for expanding operations to potentially make more money.

[See 50 Best Funds for the Everyday Investor.]

History of increasing dividends. A company states what its dividend will be each year, a number they must be comfortable making public. If the company makes that number, then it looks good to investors and the market, and the stock goes up. If a company misses that number, the stock loses value as soon as the information becomes known. Companies with increasing dividends not only know their number, but they are comfortable raising it each year. Now that's quality and stability.

Sales growth. It is often said that nothing happens until a sale is made. This is absolutely true. The more sales, the better the revenue, so a company with growing sales is a company I want in my portfolio. Consistent long-term growth is not just a trend, it is usually based on a consistent, long-term process.

[See How to Value the Stock Market.]

Upward revisions to stock growth or earnings estimates. This is less of a standard measure, but the value here is that usually analysts do not want to change their original estimates. But when a company begins to do things that could propel it through the roof, the analyst does not want to appear as though he missed some significant data point. So when you see a favorable analyst revision, that is a very good sign for that company's stock.

Realize that these points are not the only things you should be doing to pick a good stock, but it gives you some great tools to put in your stock picking tool kit.

Good luck and happy investing.

Kelly Campbell, CFP® and Accredited Investment Fiduciary, is founder of Campbell Wealth Management, a Registered Investment Advisor in Alexandria, Va. Campbell is also the author of Fire Your Broker , a controversial look at the broker industry written as an empathetic response to the trials and tribulations many investors have faced as the stock market cratered and their advisers abandoned their responsibilities to help them weather the storm.