Financial Fitness: Be systematic when choosing stocks for your portfolio

Courtesy of stock.xchg

It’s easy to get emotional about stocks – especially with the roller coaster rides global markets can take. That’s why it’s a good idea to stay disciplined in your approach to stock selection. It sounds simple, but the fact is that ignoring short-term gyrations and holding an array of quality stocks for the long term is a time-tested, successful strategy.

It’s important to make sure that stocks do not represent your entire portfolio. Stocks should be complemented by other assets such as bonds. With that in mind, some of the most attractive stocks for your portfolio are those providing dividend income (though keep in mind dividends may be increased, decreased, or eliminated without notice) while providing the potential for long-term growth.

Individual investors who want to own stocks might be best served by owning a basket of at least 20 to 25 of these stocks, selected from a variety of industries and geographies, including Canada, the U.S. and Western Europe. An alternative is to own mutual funds that follow a similar approach. This is to ensure adequate diversification, which does not guarantee a profit or protect against loss, but has proven over time to be prudent.

How to identify quality companies

• Operation in Attractive Industries – You might find that certain industries are particularly appealing because they have high barriers to entry, low capital intensity and beneficial types of regulation. At the same time, it might be best to avoid highly cyclical industries that are overly dependent on a strong economy to produce good growth opportunities.

  • Strong Competitive Position – If a company doesn’t command a leadership position within its industry, it should offer other competitive strengths that could help it sustain long-term profitability. Typically, companies with a strong “franchise” or a special niche tend to generate higher returns on capital.
  • Experienced Management Teams – Companies led by strong management teams that have a track record of success are most likely to be deploying the firm’s capital in ways that will consistently generate attractive returns for shareholders.
  • Solid Financial Positions – Keep your eye on companies that have historically demonstrated consistent growth in sales and earnings while maintaining a solid balance sheet and strong cash flow. While these stocks might decrease in value during market declines, they may be in the best position to bounce back when markets recover.

Once you’ve determined that a company is of high quality, you still need to buy it at the right price. To assess whether it’s attractively valued, you might want to start by looking at traditional valuation approaches such as comparing a stock’s price-to-earnings ratio (P/E) to its historical P/E range and to that of its peers. Then there are a number of other, more sophisticated measures and tools. Check with your financial advisor to learn more about these techniques.

Be prepared to periodically add or remove stocks to maintain proper industry weightings, adjust foreign content, reflect rating changes or take advantage of new opportunities. But avoid being too reactionary by making changes based on short-term setbacks or expectations. Remember that a long-term focus and systematic process may be your most valuable guiding principles.

Past performance is not a guarantee of future results, but it’s safe to say that investing in quality companies at attractive prices has historically been a successful way for individual investors to own stocks over time. Speak with your advisor to learn more about which stocks might be appropriate for you.

Last month, details on the TFSA were outlined. There are differences in the estate treatment of TFSAs in Quebec. To clarify how they might apply to you, consult your financial advisor or estate planner.

Deborah Leahy is a Financial Advisor with Edward Jones. Edward Jones, Member Canadian Investor Protection Fund

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