If you are ready to buy your first stocks but aren't sure which ones to choose, you've come to the right place. There are a few characteristics of stocks that are good for beginners, as well as some practices beginners should specifically avoid when selecting the first companies for their portfolios.
Here's a rundown of what you should look for and stay away from when choosing your first stocks, as well as a few examples of excellent beginner-friendly stocks to help get your search started.
What makes great beginner stocks?
Stocks are a great way to build wealth over time, but not all stock investments are appropriate for beginner investors. We'll get to some of the characteristics that beginners should avoid later, but for now, let's take a look at some of the things beginners should look for when evaluating stocks.
Sustainable competitive advantages
You might hear experienced investors talk about the concept of a "wide moat," especially if you're reading anything about Warren Buffett's investment style. Just as a wide moat around a castle makes it difficult for enemies to invade, a company should have a "wide moat," too: a sustainable competitive advantage that will prevent competitors from stealing that company's market share.
These types of advantages can take many forms, but they aren't terribly difficult to spot if you know what to look for. The majority of sustainable competitive advantages typically fall into one of these categories:
- Network effects -- In simple terms, a network effect occurs as more people use a service or product, and the product or service itself becomes more valuable and desirable as a result. Think of companies like Facebook (NASDAQ: FB). As more and more people join Facebook, it becomes more difficult for people not to use the platform in their daily lives.
- Cost advantages -- A business can have a few different types of cost advantages. For example, an efficient distribution network can make it cheaper for a company to get its product around the country. A well-known brand name can give a company the ability to charge more than rivals. Or a proprietary manufacturing process can make it cheaper to produce a product. Coca-Cola (NYSE: KO) is a great example. Not only does the company have a massive and efficient distribution network, it has one of the most recognizable and valuable brand names in the world.
High switching costs are another potential advantage in this category -- if it costs a customer or client a ton of money to switch to a competitor, the original vendor will have an easier time maintaining market share.
- Intangible assets -- In addition to a brand name, patents are a great example of an intangible asset that can protect a company against its competitors. For example, having a portfolio of more than 44,000 patents is one of the main reasons Blackberry (NYSE: BB) still has quite a bit of value even though it doesn't sell many phones these days.
Other advantages to look for
In addition to sustainable competitive advantages, there are a few other things a beginner might want to seek out when picking stocks:
- Sector leader -- Most of the best starter stocks are either the leader in their respective businesses or very close to it. (You will note this later on in this article when we give some good beginner-friendly stock examples. There's a time and place to invest in up-and-coming companies, but it's smart to save those for after you've learned the ropes.)
- Mature business -- Beginners should focus on companies that have been around for a while and are out of the rapid-growth stage. Consistent revenue and profit growth are more important considerations than home-run growth potential for beginning investors.
- Dividend growth -- This is the most optional characteristic on the list, as there are some great beginner-friendly stocks that don't pay dividends. Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) is a great example. However, if a stock does pay a dividend, an established track record of dividend growth is an excellent characteristic for long-term-focused beginning investors to look for.
Three basic metrics beginners should know
To be perfectly clear, knowing how to identify great businesses is more important than being able to identify cheap stocks for beginners. A great business will typically be a good long-term performer, even if you buy in at a bit of an expensive valuation. On the other hand, a bad business that you invest in at a cheap valuation will seldom work out well.
Having said that, once you've learned how to find good candidates for beginners to invest in, some basic metrics can help you narrow them down:
- P/E ratio -- The price-to-earnings ratio is the most widely cited valuation metric, and for good reason. It's an easy way to compare similar businesses. Simply divide a company's current share price by its last 12 months' worth of earnings. You can also use the projected earnings over the next 12 months to calculate the forward P/E ratio. The key point to know is that P/E ratios are most useful when comparing businesses in the same industry -- such as comparing ExxonMobil (NYSE: XOM) and Chevron (NYSE: CVX).
- PEG ratio -- Companies grow at different rates, and failure to take this into account is one of the key shortcomings of the P/E ratio. The price-to-earnings-growth ratio, or PEG ratio, levels the playing field. Simply divide the company's P/E ratio by its projected earnings growth rate. For example, a company with a P/E of 30 and a 15% expected growth rate would have a PEG ratio of 2.0. Like the P/E ratio, the PEG ratio is most useful for comparing companies in the same industry but with different growth rates.
- Payout ratio -- The payout ratio is a good metric for dividend investors to know and is the company's annual dividend rate expressed as a percentage of its earnings. For example, if a company paid out $1.00 in dividends per share last year and earned $2.00, it would have a 50% payout ratio. A payout ratio can tell you if a company's dividend is sustainable or if a dividend cut could be possible.
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You can learn many other investing metrics, some of which can help you find value stocks and some that can help you evaluate fast-growing companies. You can learn as you go, but these should help you get started.
Stocks beginners should avoid
The last thing we need to cover before we get into some examples of great beginner stocks is what you should avoid as a beginning investor (and, in some cases, even when you become an experienced investor). Investing in the wrong type of stock can make your portfolio's value look like a roller coaster ride and can even cause you to lose your entire investment.
With that in mind, here's what you'd be wise to stay away from at first:
- Rapidly growing companies -- This is especially true for companies yet to turn a profit. Growth investing can be a great way to build wealth, but growth investing can be volatile. It's a good idea to wait until you've built up a base to your portfolio and understand stock evaluation a little better before you try to invest in the next big thing.
- Penny stocks -- Loosely defined as stocks that have market capitalizations (total market values) of less than $200 million, have share prices under $5.00, or don't trade on major exchanges, penny stocks should be avoided by all investors, not just beginners.
- IPOs -- IPOs, or initial public offerings, are how companies become publicly traded. Investing in newly public companies can be highly volatile and is generally not a good way for beginners to buy stocks.
- Businesses you don't understand -- Here's a great rule of thumb that works for beginners and expert investors alike. If you can't clearly explain what a company does and how it makes money in a sentence or two, don't invest in it. There are literally thousands of publicly traded companies to choose from, and you should be able to find plenty of opportunities in easy-to-understand businesses.
Five examples of great stocks for beginners
Now for the fun part. With the good and bad characteristics we've discussed in mind, here are some excellent stocks for beginners to consider:
- Berkshire Hathaway -- Berkshire Hathaway is a conglomerate with more than 60 wholly owned businesses, including household names such as Geico, Duracell, Dairy Queen, and many more. The company also has a massive $230 billion stock portfolio, much of which was hand-selected by Warren Buffett, arguably the most successful investor of all time. Berkshire specifically targets businesses and stocks with durable competitive advantages and has a fantastic 55-year track record of executing on its vision of using its businesses to generate capital to reinvest in other businesses and stocks.
- Amazon (NASDAQ: AMZN) -- Amazon is a great beginner-friendly stock for a few reasons. First of all, it is the clear leader in its fields. One of the largest retailers of any kind in the entire world, Amazon makes up nearly half of all U.S. e-commerce sales, and it is also the dominant provider of cloud services to businesses. The company is growing impressively and has several of the competitive advantages we like to see (network effect and cost advantages in particular).
- Alphabet (NASDAQ: GOOGL) (NASDAQ: GOOG) -- As a beginning investor, it wouldn't be surprising if you haven't heard the name Alphabet before, but it's likely you've heard of the company's main subsidiary, Google. As the dominant leader in internet search, Google has an effective duopoly on internet advertising, along with Facebook. Its massive stockpile of consumer data makes its ads extremely effective, and it's tough to imagine any competitor stealing any significant percentage of the market. And Google has the second-most-valuable brand name in the entire world, with an estimated value of more than $130 billion, according to Forbes. The fact that Google's brand has become synonymous with internet search and several other functions gives tremendous pricing power when it comes to selling ads.
- AT&T (NYSE: T) -- AT&T is one of the leading players in wireless communications and has built itself quite a media presence with acquisitions of DirecTV and Time Warner in recent years. The upcoming wide rollout of 5G technology should be a nice tailwind for years to come, and the company has a fantastic track record when it comes to dividends. AT&T pays a dividend that's well above the industry average, and it has increased the payout for 34 consecutive years.
- Intuitive Surgical (NASDAQ: ISRG) -- Intuitive Surgical is a healthcare company that makes surgical robots and is the clear leader in the space. There are tens of thousands of doctors trained on the company's da Vinci surgical robots and more than 4,400 of the robots installed worldwide. As more surgical applications are found for the technology, these machines become more valuable to the hospitals that own and use them.
How to get started
Once you've decided that you want to buy stocks, the next step is to open a brokerage account, fund the account, and buy the shares. After you've done that, it's important to keep a long-term mentality -- if your stocks go down, for example, it can be very tempting to panic and sell. Remember how carefully you chose your stocks, and avoid selling your stocks without fully exploring the company's situation.
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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Matthew Frankel, CFP, owns shares of AT&T and Berkshire Hathaway (B shares). The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Amazon, Berkshire Hathaway (B shares), and Intuitive Surgical and recommends the following options: long January 2021 $200 calls on Berkshire Hathaway (B shares), short January 2021 $200 puts on Berkshire Hathaway (B shares), and short January 2020 $220 calls on Berkshire Hathaway (B shares). The Motley Fool has a disclosure policy.