Choosing Stocks: Psychology and Finance Tips for Investors

Stockopedia-sponsored video emphasizes using a rules-based approach and primary data to choose stocks, avoiding narratives and unreliable sources.

### Stockopedia: A Systematic Approach to Choosing Winning Stocks
* 🧠 " Investment is as much about **psychology** as it is about **finance**.
* 💡  It is crucial to control inner demons and adopt a **systematic approach** to choosing stocks that **outperform**.
* 📊  Stockopedia provides easy-to-use research tools that **save time, help make decisive actions**, and **improve success rates** in the stock market.
* 📉  Narratives can be detrimental when choosing stocks, as they can lead to **emotional attachment and misjudgments**.
* 🚫  Sources of information like broker forecasts and tips from influencers are often biased and should be **avoided**.
* 📚  The best source of information is reading individual company reports to understand their **financial health**.
* 🎯  The key attributes of winning stocks are **value, quality, and momentum**.
* 🔍  A systematic approach involves ranking stocks based on these attributes and choosing stocks that **perform well across all criteria**.

Investment is as much about psychology as it is about finance. How can we control our inner demons and create a system to choose stocks that perform well? In this video, I'll show you which sources of information to use and also which sources to avoid. But also which attributes of stocks you should focus on and why. This video is sponsored by Stockopedia, which provides easy-to-use research tools that save you time, help you act decisively, and improve your success rate in stock markets. Now, as many of you know, at heart I'm an index investor. Most of my wealth is in a single Global Equity Fund. However, I do dabble in single stocks in my fund portfolio. That makes up about 10% of my wealth. So even if I get it wrong, it doesn't matter. But it is fun, and I do enjoy analyzing stocks and learning about how to invest. So what I'll be talking about in today's video is the method I've been using recently in order to buy those single stocks. What works for me and what I found doesn't work.

let's begin with a word of caution. Narratives are your enemy. What do I mean by narrative? Well, it's just a story about a stock, and that's often what makes people buy the stock in the first place. Now, the most storied stock of all, I'd argue, is Tesla, and the narrative around Tesla is ever-changing, but it never fails to push up the stock price. Initially, the story was that it wasn't a car company, it was a tech company which was selling software with an associated piece of hardware, which was a car. Of course, if that were the case, then the margins would be much higher than they would be just for a standard auto manufacturer. An extension of that narrative became the fact that Tesla was collecting huge amounts of on-the-road data from its sensors, and Tesla, for example, boasted about the fact that it had collected a billion miles of fully self-driving data. Another reason given for the success of Tesla was Elon Musk and his approach to innovation. The most recent narrative is to do with Robo-taxis, saying that

instead of a one-off sale, Tesla would be able to generate recurring fees by creating a fleet, a global fleet, of Robo-taxis. However, the problem of buying a stock where the price is inflated by a story, a narrative, is that the reality may fail to live up to that narrative, and in the case of Tesla, that's been the case several times. If we look at the price-to-earnings multiple, it's gone sky-high at times, but then recently (and I make this video in 2024), the price has plummeted as reality failed to meet expectations. But I think the real problem behind a narrative stock is that it weds you to that stock emotionally, and that's because the story is usually as follows: you read about a stock in the press, perhaps, or you see a YouTube video, and you think, Yeah, that sounds interesting, and you go out and buy the stock. Then it becomes validated, your belief that it's a good stock, because the share price rises. But then if the stock price does start to plummet and the story changes, then you stay wedded

to the stock. You don't sell when you should, and that's because selling means that you were wrong somehow. This stock has become tied to you. If it fails, then that means it's a failure of your judgment. And as humans, we hate to admit we're wrong. So, I'd say you're better off having a really disciplined approach to investing, where instead of using some kind of narrative, you use a set of rules to determine which stocks you buy. And you stick to those rules. And you have to be really disciplined about it, because if you follow this process, you'll no longer be emotionally wedded to a stock. Now, the process is different. The rule tells you when it's time to buy or sell the stock. Share prices might rise, so you do get some validation. But then if things reverse and the rule tells you to sell, well, even if it gets it wrong, it's not you that got it wrong, it's the rule that got it wrong. Now, if you do adopt a rules-based method for investing, you have to feed those rules with

information. So, what kind of information can you use? Now, some people rely on broker forecasts. These are produced usually by investment banks by very well-trained and well-resourced analysts. For example, if you look at what the FT produces, it shows the broker consensus forecasts. So, these are classified as buy, outperform, hold, sell. And these are supposed to tell you when it's a good time to buy or sell a stock. However, I think this is a poor source of information. And that's because of conflicts of interest. So, let's imagine there's a company called IT company X. And sometimes they raise capital in capital markets. They issue debt, they issue equity. And they do that with an investment bank. Well, that investment bank will also publish research in a different department, of course, but it's still the same bank. Now, let's say that the bank publishes a research note saying that you should sell company X's stock. The management of company X is not going to be happy about that. So, when they do need to raise capital, they're unlikely to go to this investment bank.

investment Bank a. In order to do that business, but let's say there's Investment Bank B, whose analysts at their research Department came out with a research note that said buy company X's stock. Well, the management will be much more favorable to Investment Bank B, and they're much more likely to go to it when they need to raise capital, and that way the Investment Bank bags some pretty big issuance fees. Now, who is it that's going to be issuing a lot of debt? Well, it'll be early stage growth companies, so it's unusual to see research notes which are negative about those companies because there's an incentive for these investment Banks not to publish that research. There are informational barriers at the bank to ensure this doesn't happen, but I still suspect that it does. Some investors get their tips from influencers, so these might be people on Tik Tok, or they could be on X, or it could be on TV. Jim Kramer's TV program mad money has been run on CNBC for many years, and he's now kind of Infamous for his bad calls. He doesn't

always get it wrong, of course, but sometimes he has got it spectacularly wrong. There was even an ETF that was set up, the Inverse Kramer ETF, where you could profit from his bad calls. But the thing to remember is that these people, if they were incredibly good at choosing stocks, wouldn't be on TV selling you their ideas. So I think this source of information is also probably best avoided. The best source of information is a primary one, which is reading the company reports of individual companies. Fortunately, these are also aggregated and sold by data providers, and a really useful skill is to understand how to read these financial reports. There are three types of information that you can get. The first one is the balance sheet that tells you what assets the company owns but also how it funded them, so those are the assets and liabilities of the company. You can also see the difference between them, and that tells you the value that's left over for shareholders, so the balance sheet is like a snapshot of the company's capital structure. Another really important piece of information is about how money is

flowing into the company and making its way through as costs all the way through to profit. So, Revenue comes in at the top. We siphon off costs, and we're left with some profit at the end of the day. That's called the income statement. And then, finally, we might want to see the cash position of the company and how it's changed by inflows and outflows of cash. That's called the statement of cash flows. Now, if you're new to this, I think visualization tools like this one from Sanart are really valuable because they show you the flow of cash from revenue all the way to profit. And you can see the costs being siphoned off on the way. So, you can see the cost of Revenue here for NVIDIA. You can see the operating costs. And then, you can also see the sources of revenue. And you can see the net profit at the end of the day. And in this case, you can see that a lot of the money that comes in as Topline Revenue makes it through to profit.

that's because Nvidia has a high margin. Now, if this data, which some people call fundamentals stock data, is a good source, then which items of that data source should we focus on? Because there are many, many line items in these statements. Now, today's video is sponsored by Stockopedia, and it's a system which allows you to filter stocks and choose them based on precalculated ranking criteria. Now, you don't have to use the stock ranks in Stockopedia, but personally, I find them very useful. For example, here's Nvidia, and you could drill into all of these numbers and use your own criteria to choose which ones to buy. Here are all the ratios and numbers that feed into the stock rank system, but personally, I'm quite happy to use those precalculated measures of quality, value, and momentum combined into one stock rank. The way I've been using it is to create a screen which goes through these criteria. So, I'm looking for Quality, value, and momentum rank over 50. I'm looking for small caps with a market cap between 100 million

and a billion. In my case, instead of using us Focus, I use the UK. I can also Track Performance using folios. So here are some of the stocks I chose in a previous screen so that I can very quickly monitor whether the stock ranks are still high. Here, for example, you can see one company where the stock rank has started to move South. Now, for viewers of pensioncraft, you get a special offer from stockopedia where you get 25% off your annual subscription. You can either use a promo code pc25 or you can use the link in the description below. And that offer also comes with a 14-day free trial and a 30-day money-back guarantee. Which of those pieces of information tell us what is a good stock? The classic book on this is by Jim O'Shaughnessy, and it's called What Works on Wall Street. Now there's lots of academic research about which stocks outperform. However, what Jim O'Shaughnessy did was produce a super practical way of approaching this selection process. And what he did was to combine four

different sources of information. The first one was the stock price and how it was changing over time. And then the rest of the information was based on things derived from financial statements: balance sheet statistics, statistics from the income statement, statistics about cash flows, and also combinations of those which are called ratios. What Jim then did was to see which of those factors and ratios predicted stock price movements the best. So that's a process called back testing, and this is what the results looked like on the individual rows. Here you can see different strategies, and then the rows you can see the bars are the returns that were generated by choosing stocks that satisfied those criteria. For example, the top bar is the return you'd expect from buying small cap stocks but which also had high net margins, in other words, they were very profitable. So now let's look through three sets of criteria which I think are incredibly valuable and which these back tests show are valuable when it comes to choosing stocks. And the first one we'll look at is value. So it's all very well finding a

good stock, but if everybody else has bought it and pushed up the price, the return you'll get will be lower as a result. So, how can we choose which stock are fundamentally reasonably priced? Well, what we can do is look at what you want as the numerator of a ratio divided by what you pay for it, which is the stock price. And the thing in the numerator, the thing you want, could be something like the profit that the company generates. Profitable companies are good ones, after all. Another thing you could look at is the amount of free cash flow which the company generates. Think of that as the amount of money the company has left over from its revenues after it's paid for its operating expenses but also its capital expenditures. Because what it can do with that money is things which benefit you. It could pay you a dividend, it could reinvest it back into the company and generate increasing profits in future, it could pay down its debt, or in the case of some companies, it might choose to buy back its own stock and concentrate your holdings in the company.

another thing which you might like would be Book value, which is the equity value of the company. Stockopedia defines a composite value measure, which combines three different things. The first category is the price relative to what the company earns. So, price to free cash flow would be one of those measures, price to earnings would be another, and of course price to sales, that's the revenue that the company generates in the first place. It also measures price relative to what it owns, that's Price to Book value, and price relative to what it pays out, which is dividends. As an investor, you get those dividends, so that's a good thing from your point of view. So, if we use Stockopedia to look at the stocks in an index like the S&P 500, and we sort the index by market capitalization, which is the way we usually sort the index, you can see Nvidia's at the top at the moment. Then we've got Microsoft, then Apple, then Google. So, the Magnificent 7 at the top here. Notice when you look at something

called stock rank. They aren't particularly high. Is that because these are bad companies? Well, no. Let's drill into Nvidia. The quality rank of Nvidia is high. It's seen as a good company. Its momentum is also high in terms of ranking. But notice its value ranking. It's just one. And that's because people have overpaid for the stock. In fact, if we look at the top five entries in the S&P 500, notice how all of them have a low value ranking because they're quite expensive. The reason why that's a problem is because over the long term, these stocks usually underperform. It's best to buy stocks when they're relatively inexpensive because that way you generate higher returns in future. Another criterion which is incredibly important is quality. Think of this as answering the question: Is this a good business? For example, is the company profitable? Does it generate a steadily increasing profit? It's not just about a snapshot of profit today. What percentage of revenue makes it through all of the costs to profit at the end of the day?

that would be the margin for the company. Ideally, its costs would be small relative to its Revenue, so a lot of the money makes it through to profit at the end of the day. How efficiently does a company use Capital? Does it have to borrow huge amounts of money to generate a very small sliver of profit, or does it generate a lot of profit with very little equity and debt capital? And then finally, will the company survive? Because as an equity investor, you stand to lose everything if the company goes into liquidation. And Stockopedia composite Quality Index combines three different types of measure based on the quality of the franchise, the health trend is it improving, and then finally, will the company become bankrupt. And the last Factor we'll consider is called momentum. One of the things Jim O'Sharesy noticed, for example, is that value on its own isn't great because you have value traps company which are cheap for a very good reason and not improving. However, if you combine that with momentum stocks which are trending upwards but also cheap that

gave you a much better outcome. Stockopedia definition of momentum combines price movement, but it also includes things like whether brokers are upgrading their forecasts, or whether earnings are improving. Also, whether earnings beat expectations, that's called earning surprise. So, how do we put all of this together to come up with a strategy? Well, as Jim O'Shaughnessy says, investors are best served by buying stocks that have jumped a series of hurdles, rather than just one. In other words, we don't just use one factor or one set of criteria, we use multiple criteria. So, if we see that as a Venn diagram, this is what Stockopedia does, which is to combine three different factors: quality, value, and momentum, to find the stocks that do pretty well on all three criteria, and it calls those super stocks. Now, of course, if you're a spreadsheet whiz and you have access to fundamental data, you could come up with your own ranking system. But what I find useful about Stockopedia is that it creates these stock ranks for you, and that way

it saves me a lot of time when I'm trying to choose single stocks in my fund portfolio. But the way you do that would be to come up with some kind of composite score for Value, say, and then you'd rank all of the stocks in your Universe. It could be UK stocks, European stocks, US Stocks. You'd rank them all according to that Criterion from number one, the best, down to the worst. Then you do the same thing for your second Criterion. It could be momentum, say. So you could use the price change over some period of time and again rank your stocks from number one to the one which is bottom. And then to create the rank of ranks, what you do is add those rank scores and rerank the list such that you come up with a composite rank based on all of the criteria you care about. Here we're using quality, value, and momentum, but you could use other criteria too. Maybe you're a growth investor. Now Stockopedia has looked back over the last decade for the UK Market, but also others to see whether

this stock rank system works. All of the stock ranks, whether that's quality, value, or momentum, all beat the FTSE All-Share on average. But what works best is to combine the three criteria: quality, value, and momentum. So these are companies which are good, they've got good quality, you're not overpaying for them, so the value criterion is also satisfied, and also they're not value traps, so they have some kind of momentum, there's a turnaround there. So intuitively, you can see why this approach works. Now, there are existing multi-asset funds if you don't want to do this single stock approach yourself, but unfortunately, there you have to pay a fee, and the lowest fee for a multi-asset fund in the UK is about 0.25%, and that's going to eat away at some of this outperformance. Plus, because this is part of my fund portfolio, it's just more fun playing with the single stocks anyway. So I hope that's been useful to show you the sources of information to use in order to choose.

stocks, and which ones to avoid, but also to decide on the qualities of stocks which outperform. Now, of course, no filtering system is guaranteed to perform well. If there's a general stock market move downwards, it's not going to protect you, but this does filter out the stocks which have least chance of success. And a system like Stockopedia can save you a lot of time in identifying those stocks. Don't forget our offer from Stockopedia. If you want to get 25% off your annual subscription, then use the link in the description below. And as always, thank you for listening.

What Makes a Stock Good To Invest In? (Stock Analysis)

My name is Ramin Nakisa and I started PensionCraft in 2016 as I felt strongly that I wanted to teach people how to invest well for themselves so they could stop making costly mistakes and losing their money through having to pay unnecessarily high fees.

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Mastering Stock Selection: A Psychological Approach

Stock selection is influenced by psychology and narratives, which can emotionally wed investors to their chosen stocks, leading to poor decision-making.

Using a rules-based method for stock selection instead of narratives can help investors remain disciplined and avoid emotional attachment to their stock choices.

A disciplined approach to investing, based on a set of rules, allows investors to make buying and selling decisions without becoming emotionally involved, ultimately improving their success in the stock market.

The Problem with Broker Forecasts and Other Stock Tips

Broker forecasts, while seemingly informative, are plagued by conflicts of interest, as investment banks may be biased in their recommendations to attract business from the companies they cover.

Stock tips from influencers and TV personalities, like Jim Cramer, may not be reliable, as their motives for sharing this information can be questioned.

The most dependable source of information for stock investment is to directly analyze and understand the financial reports of individual companies, particularly focusing on the balance sheet to assess the company's capital structure and financial position.

Understanding Company Financial Statements and Stock Selection

Company financial statements include the income statement, showing revenue, costs, and profit, and the statement of cash flows, illustrating cash position and flow.

Visualization tools like the one from Sanart can help understand the cash flow process.

Stockopedia offers precalculated ranking criteria based on quality, value, and momentum, which can be used to filter and choose stocks.

Jim O'Shaughnessy's book, "What Works on Wall Street," provides a practical approach to stock selection based on combining four key performance factors.

Analyzing Stock Selection Criteria for Investors

Jim analyzed stock price movements based on financial statement statistics and ratios to conduct back testing.

The back testing results showed the value of three key criteria for choosing stocks: fundamental value, company's free cash flow, and composite value measure.

The composite value measure combines price relative to earnings, book value, and dividends, providing valuable insights for investors.

Stock ranking involves three key criteria: value, quality, and momentum.

The value ranking of a stock is affected by its price, with overpriced stocks typically underperforming in the long term.

The quality of a company is determined by its profitability, efficient use of capital, and likelihood of survival, which are crucial factors for investors.

Momentum, the third criterion, takes into account the stock's price movement, earnings forecasts, and surprises, with the combination of value and momentum providing better outcomes for investors.

Stockopedia offers a composite stock ranking system based on quality, value, and momentum.

This approach has consistently outperformed the FTSE All-Share, making it a valuable tool for stock selection.

The system provides a time-saving way to identify and filter out underperforming stocks, offering a potentially more engaging alternative to multi-asset funds.