Follow this process to identify the best stocks to buy for 2022

Investors and traders alike are a worried lot. They have suffered huge losses. The only people making money in the market these days seem to be short sellers.

Investors are trying to figure out when the stock market will recover and of more immediate concern, when it will bottom out. Many are still unsure why the stock market is falling so much.

While we have covered these topics in past editorials at Equitymaster, we haven’t quite addressed an important question on the minds of some market bulls.

Many smart investors are seriously considering buying stocks in a big way. Some have already taken the plunge. Others are cautious and buying stocks selectively in small amounts. Yet others are keen to invest if the markets correct some more.

This editorial is for these investors.

Most investors who are either buying stocks now or are thinking of doing so in the near future, have a long-term horizon. And that’s a good thing. It’s the first step to investing successfully in this market.

Unless there is a quick and strong market recovery, short-term investors are unlikely to make money.

Thus being a long-term investor is the way to go.

But of that’s just the first step. You will need to identify the best stocks for the long term. These stocks may not deliver sharp profits quickly, but they will compound your wealth over time…and will also beat the market handsomely.

If you’re clear that you want to buy these stocks then you will need to follow a solid process to find them. You will also need buy them at a reasonable valuation.

The second part shouldn’t be too hard because the market has brought the prices of many fundamentally strong stocks to reasonable levels.

But the first part is a bit difficult. Not only will you need a proven process to find great long-term stocks, but you will also have to follow it diligently.

So let’s get straight to it. Here’s the process you should strictly follow to identify the best stocks to buy for 2022.

Process to identify the best stocks for 2022

The first thing to look for are companies with the best fundamentals in the market.

Check the following points…

Debt

Start with debt levels. It’s always a good idea.

Ideally the company should have very little debt or should be debt free. Many fundamentally strong stocks have zero debt.

Also it’s a good idea to look for companies that are actively reducing their debt. While they may have some debt today, they are unlikely to be badly affected by rising interest rates.

Check out the top companies reducing debt.

Dividends

Next check the dividend payouts. The best companies, the fundamentally strongest, have rock solid cash flows. They often generously share this cash with investors.

The best companies usually have a long track record of dividend payments.

In a stock market downturn, dividend paying stocks are in high demand as investors prefer the safety of the cash flow that dividends provide over capital gains.

Also these stocks can provide good dividend yields during a market crash as they tend to fall initially along with the rest of the market. But as soon as their yields become attractive enough, investors jump in and buy them.

This means high dividend paying stocks have an in-built stop loss.

There are also excellent companies that raise their dividends every year. In these stocks you get the benefit of capital appreciation as well as rising dividends.

They are called dividend growth stocks.

Growth

Companies that maintain good sales and profit growth during a stock market downturn as always in demand. Check for good growth in topline and bottomline. The higher the better.

The market knows these stocks are essentially getting cheaper. This is because high growth increases per share earnings at a fast pace. This combined with a falling market makes these stocks attractively valued. At a certain point, deep-pocketed invests start buying these stocks.

In fast growing stocks get to this point sooner than slow growing stocks. Unfortunately, these stocks tend to be overvalued at the start of the correction, so they more downside.

It’s a waiting game with high growth stocks. If you invest too soon you may end up buying the stock before its valuation has corrected sufficiently.

But if you are patient, the stock market will present you with a golden opportunity to buy these stocks at a great price.

Check out the list of fastest growing companies as well as the top growth stocks in the market.

Past Track Record

While no investor makes profits in the past, it’s still important to look at the past as a guide.

If a stock has been a multibagger in the past, it’s worth checking out if it was driven by fundamental reasons or by speculation. 

If the reason was strong fundamentals, and those fundamentals are still intact, you could have a multibagger stock on your hands.

Return on Equity

The return on equity is one of the best measures of a quality company. If you rigorously filter out low ROE stocks, you will get a list of stocks with high ROE.

High return on equity along with low debt is a great combination to focus on when looking for stocks with the best fundamentals.

All great long-term stocks have good ROE. Just be sure to use it along with metrics like high growth and low debt.

You may have heard of 20-20-20 stocks. These are an elite group of stocks with minimum 20% sales growth, 20% profit margin, and 20% ROE.

With this checklist you are already ahead of 90% of investors in the stock market. It won’t take you long to identify the best stocks to buy for 2022.

Happy investing!

This article is syndicated from Equitymaster.com