Knowing How to Pick Winners

Once you get past the basics, you can get to the “meat” of stock picking. Successful stock picking is not mysterious, but it does take some time, effort, and analysis. It’s worth it since stocks are a convenient and important part of most investors’ portfolios. Recognizing stock valueImagine that you like eggs and you’re willing to buy them at the grocery store. In this example, the eggs are like companies, and the prices represent the prices that you would pay for the companies’ stock. The grocery store is the stock market. What if two brands of eggs are very similar, but one costs 50 cents while the other costs 75 cents? Which would you choose? Odds are that you would look at both brands, judge their quality, and, if they were indeed similar, take the cheaper eggs. The eggs at 75 cents are overpriced. The same is true of stocks. What if you compare two companies that are similar in every respect but have different share prices? All things being equal, the cheaper price has greater value for the investor. But the egg example has another side.What if the quality of the two brands of eggs is significantly different but their prices are the same? If one brand of eggs is stale, of poor quality, and priced at 50 cents and the other brand is fresh, of superior quality, and also priced at 50 cents, which would you get? I’d take the good brand because they’re better eggs. Perhaps the lesser eggs are an acceptable purchase at 10 cents, but they’re definitely overpriced at 50 cents. The same example works with stocks. A badly run company isn’t a good choice if you can buy a better company in the marketplace at the same or a better price. Comparing the value of eggs may seem overly simplistic, but doing so does cut to the heart of stock investing. Eggs and egg prices can be as varied as companies and stock prices. As an investor, you must make it your job to find the best value for your investment dollars. (Otherwise you get egg on your face. You saw that one coming, right?)Understanding how market capitalization affects stock valueYou can determine the value of a company (and thus the value of its stock) in many ways. The most basic way to measure this value is to look at a company’s market value, also known as market capitalization (or market cap). Market capitalization is simply the value you get when you multiply all the outstanding shares of a stock by the price of a single share.Calculating the market cap is easy. It’s the number of shares outstanding multiplied by the current share price. If the company has 1 million shares outstandingand its share price is $10, the market cap is $10 million. Small cap, mid cap, and large cap aren’t references to headgear; they’re references to how large the company is as measured by its market value.Here are the five basic stock categories of market capitalization:Micro cap (under $250 million) - These stocks are the smallest and hence the riskiest available.Small cap ($250 million to $1 billion) - These stocks fare better than the microcaps and still have plenty of growth potential. The key word here is “potential.”Mid cap ($1 billion to $5 billion) - For many investors, this category offers a good compromise between small caps and large caps. These stocks have some of the safety of large caps while retaining some of the growth potential of small caps.Large cap ($5 billion to $25 billion) - This category is usually best reserved for conservative stock investors who want steady appreciation with greater safety. Stocks in this category are frequently referred to as “blue chips.”Ultra cap (over $25 billion) - These stocks are also called “mega caps” and obviously refer to companies that are the biggest of the big. From a safety point of view, the company’s size and market value do matter. All things being equal, large cap stocks are considered safer than small cap stocks. However, small cap stocks have greater potential for growth. Compare these stocks to trees - Which tree is sturdier a giant California redwood or a small oak tree that’s just a year old? In a great storm, the redwood holds up well, while the smaller tree has a rough time. But you also have to ask yourself which tree has more opportunity for growth. The redwood may not have much growth left, but the small oak tree has plenty of growth to look forward to.