How might I know which stocks are good and which are bad?

Knowing the stocks to buy and to avoid is one of the first questions a retail investor has; everyone wants to make the biggest return with the least amount of risk. How do I know if buying Astrazeneca today is going to be a good idea or a bad idea? If I'd invested £5000 in Astrazeneca in August 2015, then by this time last year, I'd have made over double the 'ideal' return. But that was largely due to the positive impact that the pandemic had on pharmaceutical stocks, which I'd not have necessarily seen coming in 2015.

The short answer is that you won't ever know for sure when buying whether your investment will pay off in the way you imagine. At the same time, there are a few questions you can ask before investing that may help you decide if a stock is worth your time and money.

Will the market still care about or need this company in 10 years?

Ask yourself whether the company is likely to survive and thrive throughout the next decade. Only 20% of stocks have excellent staying power; when purchasing, you should reflect on whether the company you are considering is likely to be one of these. This then begs the next question of what companies are most likely to survive the next decade. A few attributes that indicate survivability include:

• Size, or Market Cap. A larger company run well likely has more assets at its disposal to buffer against economic downturns, and to deploy in the creation of better, more competitive, goods or services.

• Market share. A company with a market share of great monopolistic proportions, over 33%, has less of a threat from competition so long as it is in an industry with high barriers to entry.

• Innovation. A company consistently producing better products is more likely to survive than a one-trick pony that does not innovate. A sign of an innovative company includes research and development (R&D) expenses as a proportion of revenue - investing regularly in innovation signals management's commitment to keeping the business relevant.

Is it clear what the company does?

Never risk your money on something that either you don't understand or that is neither clear nor consistent about what it does. Good companies win investment by demonstrating a clear purpose and consistently reinforcing their missions or values. Public transportation company Laidlaw is an example of this - they previously specialised in intercity and public transport - buses - however, the company ran into issues after looking to go beyond their long-held specialism by expanding into ambulances. The result was a failure and was a key factor in their declaring bankruptcy.

Is the company in a strong, sustainable, financial position?

A company with good performance and an outstanding financial position is preferable to a company with brilliant performance that is unsustainable and cannot be afforded. For Jason Zweig, who provides commentary on Benjamin Graham's The Intelligent Investor, marathon runners are better than sprinters. In other words, look for companies with smooth and steady growth; a 15% growth rate is not sustainable in the long run. 15% growth year-on-year forever is 'delusional', like a marathon runner trying to run a whole race as if it were a 100-meter dash. In this sense, Zweig's advice is to look for companies with a post-tax 6-7% earnings growth rate, and if earnings per share have grown by the same rate over the previous 10 years.

Sustainability is also heavily influenced by factors like debt. A lower debt-to-equity ratio, all things being equal, is less risky than a higher one. When looking at companies, ask: 'if all its debts were called in tomorrow, would this company still have flexibility?' The ideal debt-to-equity ratio varies by industry but, generally, a ratio below 1.0 is quite safe. Such a low rate, however, could indicate that the company is not enterprising enough to take on debt to use for growth. Between 1.0 and up to 2.0 could be considered a 'reasonable' ratio, depending on industry and other circumstances. Above this point, higher risk sets in, and the company is at a much higher risk if interest rates were to suddenly change.

And the rest...

The above are the bare minimum you should be considering when picking a stock. After this point, other important matters like: consistency of dividend payments, consistent performance from good upper management, geopolitical and regulatory risk, and short-term indicators like Price-to-Equity ratios and 200-day moving average, should be considered. In this sense, the above are just the start when looking at portfolio candidates. The good news is that many stocks are likely to fail all these tests. The bad news is that very few are likely to pass all these tests flawlessly.

To address this, it's good to get a sense of the direction of travel for a company. For example, a company should be considered against its recent history; if it is debt-free, has it been debt-free for just the last year, or has it been so for ten years worth of consistent financial improvement? For a company with one underwhelming quarterly result, is this an explainable one-off against five years of consistently great results?

At the end of the day, you have to make a judgment of what matters most to you. To some, they may consider that any company one invests in should have a flawless track record of exactly 6% growth per year, others may take a more aggressive approach and seek out companies that are highly debt leveraged, with 18% annual revenue growth figures, but that have very compelling mission statements. What should be kept in mind, however, is that studies show that long-run investors are more successful even with 'big but boring' companies than 'flash in the pan' fads.