How to Choose Stocks: 4 Strategies

This article is an excerpt from the Shortform book guide to "The Intelligent Investor" by Benjamin Graham. Shortform has the world's best summaries and analyses of books you should be reading.

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Do you want to know how to choose stocks to buy? How can you choose the best strategies for buying stocks?

Learning how to choose stocks takes discipline and practice. According to The Intelligent Investor, there are several strategies you can follow to make good investments.

Keep reading to find out how to choose stocks to invest in and how to pick good stocks.

How to Choose Stocks to Buy

With these cautionary notes out of the way, which stocks should the aggressive investor choose? Graham describes four general strategies that aggressive investors take and offers his opinion on each for how to choose stocks to invest in.

Market timing: buying in bear markets and selling in bull markets
Growth stocks: identifying stocks with high potential to growth
Bargain stocks: finding that have fallen out of favor of the market and are trading well under a reasonable price (this is Graham’s preferred strategy)
Special situations: idiosyncratic situations, such as acquisitions, bankruptcy, and legal proceedings

One strong general theme runs through: when you consider the wisdom of investing in a stock, you cannot ignore its price when considering how to choose stocks.

A very promising company with bright prospects may still be a bad investment, if its high price already reflects the market’s enthusiasm for the stock.
“Buy your stocks like you buy your groceries, not like you buy perfume.”

(Shortform note: While Graham focuses his advice on choosing stocks, the principles for choosing specific bonds are analogous.)

Market Timing

Market timing has a strong allure: buy when the market is down, and sell when the market is up. The trouble is determining when exactly the bottom or the peak of a market is. This often seems obvious in retrospect but is exceedingly difficult to predict in the future. You should take it into consideration when deciding how to choose stocks to buy.

Graham notes that markets have resisted any reliable mathematical diagnosis of when a market is poised to collapse or to boom. In his commentary, Zweig adds that even professionals who spend their entire careers attempting market timing are empirically unsuccessful at it. So think carefully: why should you do any better?

We’ll cover more of market timing in Chapter 8, when discussing Graham’s famous Mr. Market idea.

Growth Stocks

Growth stocks are stocks that have grown earnings well in the recent past and are expected to continue growing them into the future. These might be part of your strategy for learning how to pick good stocks.

The simplistic strategy is to choose a basket of stocks that have recently outperformed the market, expecting them to continue outperforming. However, growth funds specializing in this strategy have not been shown to outperform the market and often do worse.

Why doesn’t this work reliably? There are two major issues:

Because the company has already outperformed in the past, the market has already developed an optimism for the stock, and so the stock may already have its current price inflated. Buying in at this point is risky: If the company fails to meet the market’s lofty expectations, its stock price may tumble.
- Graham suggests that stocks with a price-to-earnings ratio of over 20 already have significant growth accounted for in the stock price.
It’s difficult to extrapolate future growth from recent history. In practice, growth cannot continue forever. The larger the company, the harder it is to grow at the same rate. Beware of breathless enthusiasm for infinite growth possibilities.
- In the 2000 dotcom bust, countless reputable investors forecast unlimited growth and considered traditional investing principles obsolete. Some stocks reached a price/earnings ratio of over 100! In hindsight, this was a gross overestimation of growth prospects, and the stocks crashed back to earth.

Graham also advises against buying stocks based merely on industry growth. It’s hard to consistently pick the best companies in the best industries—even experts fail at how to pick good stocks.

In the 1950s, airline traffic was poised to grow by multiples. But investing in airlines would have been a mistake—despite rising revenues, airlines were chronically unprofitable.

Beware the Fantasy Stories

Investing history is rife with fantastical stories of early investors in companies such as Microsoft and Apple, who grew their initial stakes 100-fold into fortunes. These stories should not be taken into consideration when deciding how to choose stocks.

While it’s tempting to find opportunities like this as a public outsider, Graham notes that these fortunes are usually made only by people with a close tie to the company, such as the founders, employees, or family members of either. These insiders have stronger reasons to hold onto the stock than you would as an outsider; they held onto the stock through its fluctuations, while you would face significantly more psychological pressure to capture your gains or stem your losses.

In his commentary, Zweig adds that many of these fortunes were made by heavy concentration in one stock, as with Bill Gates and Microsoft. However, history is unkind to people who concentrate so heavily. Take the 400 richest people on the Forbes list in 1982 and look 20 years later—only 64 (or 16%) remained on the list in 2002. The rest had most of their worth tied to their business and enjoyed a temporary fortune; when their businesses went south, their worth followed.

Now that you have ideas for how to choose stocks to invest in, you can can decide that best stocks for you.

How to Choose Stocks: 4 Strategies