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Top Stocks for Beginner Investors: Ready to Start Investing?

Beth McKenna, The Motley Fool

If you're a beginner investor who wants to start investing in stocks, it's easy to feel overwhelmed, but know that with some time and patience, things will get progressively easier. 

The key to any successful long-term venture is to break things into steps -- and trite as it might sound, by taking one step after the other, you'll be well on your way before you know it. I'm going to walk you through some basic steps.

  1. Why should you want to invest in stocks?
  2. Before you start investing
  3. Selecting a discount broker
  4. When investing in stocks, "buy what you know"
  5. How should beginner investors select stocks?
  6. Best stocks for beginners
  7. Some top-quality investing ideas for beginners
  8. A screening process to use when investing in stocks
The word "invest" spelled out in red on wood blocks.

Image source: Getty Images.

Why should you want to invest in stocks?

Over the long term, the stock market has historically been the best place to grow money. On average, the market has returned about 7% annually when adjusted for inflation and including reinvesting dividends. Of course, the market's average return can be much more than 7% in any given year and it can also be negative. But over long investing periods, the market has averaged returns in the ballpark of 7% per year. Your personal returns, however, could beat or lag the market.

Before you start investing

Before you begin investing in stocks, you should have these things in place: 

  1. An emergency fund 
  2. Money for your initial stock investment
  3. A stock brokerage account -- discount brokers are the way to go 

Before you tie up money in stocks, you should have an emergency fund so you can pay for your expenses if your income is interrupted. A general rule of thumb is to set aside enough money to cover three to six months of expenses, but anything is better than nothing. 

Decide how much money you want to invest. Some brokerages require a set amount of funds to initially open an account -- for example, $500. If you're new to investing, it can be wise to start out with a small amount to invest; you can always invest more money in that stock in the future. In fact, investing the same dollar amount in a stock at some set time interval (such as monthly or quarterly) to build your full position -- called dollar-cost averaging -- is a great way to invest in stocks. This way, if your initial purchase turns out to be at or near the stock's high for some time period, you won't be buying all your shares at that price. 

Selecting a discount broker

You'll need to sign up for a stock brokerage account if you don't already have one. Using a discount online broker is the way to go if you have the time and interest in researching your own investments. The advice that full-service brokers provide isn't generally worth paying for the hefty stock trading commissions they charge -- although there likely are exceptions. 

There are many online discount brokers, with E*Trade Financial and TD Ameritrade among the ones that are better known. You'll need to decide if you want to open a regular brokerage account or an individual retirement account (IRA) -- either a traditional one or a Roth.

If you don't have a retirement account through work, you should first open an IRA. When selecting an online discount broker, consider the commission cost per trade and the minimum amount needed to open an account. Most online discount brokers charge $10 or less to execute a basic stock trade; roughly $5 seems typical. 

When investing in stocks, "buy what you know"

I subscribe to legendary investor Peter Lynch's mantra "buy what you know" with a twist: Buy what you know -- or are genuinely interested in learning about and will put in the time to learn about. If you're on board with this thinking, keep your interest and motivation levels in mind when choosing stocks. I'd highly recommend you get hold of Lynch's most well-known book, One Up on Wall Street, where he covers his investing approach and expounds on his "buy what you know" philosophy. 

How should beginner investors select stocks?

Once you're armed with the "buy what you know" philosophy or some twist on it, here are some things to keep in mind when selecting stocks to invest in: 

  • Consider starting with stocks that have relatively simple business plans that you can easily understand. 
  • Favor companies that are led by their founders. Studies show that founder-led companies tend to outperform in the stock market. 
  • Favor companies that are leaders in their core business.
  • Look for companies that have a durable competitive advantage in the form of a wide and deep economic "moat" or barrier to entry, in order to keep competitors at bay. Moats include such things as economies of scale, a valuable brand name (many top consumer-goods companies), high cost of entry (automakers, theme parks), regulatory hurdles (utilities), and patents and intellectual property (IP). As for patents, they're mighty moats in the pharmaceutical and biotech spaces, but alone, they're not enough for technology companies. 
  • Look for companies that have catalysts for long-term growth. This could be that they're poised to start or continue benefiting from huge trends. They also might be poised, for some reason, to take market share from other companies in the industry.
  • Consider a stock's valuation. You'll need to learn the basics of valuing a stock using some common metrics such as the price-to-earnings (P/E) ratio, the forward P/E, and the PEG (P/E to earnings growth). 

What are the best stocks for beginners?

While this is a question that many folks are searching for, it's not really the best question. It's not possible -- or at least not desirable -- for someone else to determine what the best stocks are for you. This goes back to the "buy what you know" discussion.

Moreover, different investors have different risk tolerances, life situations, and so on. Keeping these big caveats in mind, below are stocks of some top-quality companies. I believe nearly all beginner investors will be able to find at least one stock on this list that's a great fit for them. 

Some top-quality investing ideas for beginners

Company

Market Cap

Dividend Yield

Projected 5-Year Average Annual EPS* Growth

5-Year Return

10-Year Return

Alphabet  (NASDAQ: GOOG)(NASDAQ: GOOGL) $780 billion/$784 billion -- 16.8% 161% 288%
Amazon.com (NASDAQ: AMZN)  $797 billion -- 27.1% 510% 1,910%
American Water Works (NYSE: AWK) $14.6 billion 2.12% 8.2% 131% 409%
Apple $935 billion 1.56% 13.5%

226%

693%

Disney (NYSE: DIS) $148 billion 1.69% 11.6%

68.5%

239%

Facebook (NASDAQ: FB) $562 billion -- 26.2%

697%

**
Nike $117 billion 1.15% 7.6% 151% 391%

S&P 500

 --

1.85% -- 86.1% 142%

Data sources: YCharts and Yahoo! Finance. Data as of June 1, 2018. *EPS = earnings per share. **Facebook has not been publicly traded for 10 years; it's returned 407% since its initial public offering (IPO) in May 2012. Boldfaced returns have outperformed the market. 

Let's define some terms:

  • Market cap, which is short for market capitalization: This is the market value of a company's outstanding shares of stock. It's calculated by multiplying a stock's price per share by the total number of shares outstanding. For context, Apple has the largest market cap of all stocks trading on a U.S. stock exchange, Amazon is No. 2, Alphabet and Microsoft have been duking it out for No. 3, and Facebook is fifth. (All other things being equal, companies with large market caps tend to be less volatile than ones with smaller market caps.)
  • Projected five-year average annual earnings per share (EPS) growth: This commonly used metric refers to the consensus among Wall Street analysts who follow a particular stock. The key thing to keep in mind is that projections are just that -- not actual numbers. A company's earnings results could surpass or fall short of the consensus estimates. 

Something important the above chart illustrates:

  • Shares of American Water Works, a so-called "stodgy utility," have slightly edged out shares of Nike and comfortably outperformed tech giant Microsoft over the 10-year period. Don't fall into the common trap of thinking that the tech space is the only place to fish for big long-term winners. 

A screening process to use when investing in stocks

This simple chart shows the type of big-picture thought process you might start off with when looking for promising stocks. 

Company

Founder Led?

Industry leader in core business? Primary Trend(s)  Key competitive advantage(s)
Alphabet Yes Yes Internet and mobile use, cloud computing and artificial intelligence (AI), smart home, driverless vehicles Industry-leading size/network effect*, top brand name, IP
Amazon Yes Yes E-commerce, cloud computing and AI, smart home Economies of scale, IP, Amazon Prime 
American Water Works No Yes Consolidation in the water utility industry

Industry-leading size, regulatory

Apple  No Yes Mobile use Top brand name, IP
Disney No Yes An increasingly entertainment-hungry world, expanding middle class in China  Top brand name, IP
Facebook  Yes Yes Social networking  Network effect*, IP
Nike  No Yes An increasingly casual world Top brand name

*The network effect occurs when a company's product or service becomes more valuable as more customers use it. 

These stocks all have something to offer beginner investors, but I'm going to delve further into four of them. I'm leaving out Apple and Nike because most folks are quite familiar with them. Athletic-shoe specialist Nike, which also sells athletic clothing, could make a solid beginner stock for the sports lovers or just sneaker lovers among you. And iPhone specialist Apple is a good choice for the many iFanatics out there.

As for Disney, its brand strength and IP are top-notch, but the turnaround of its cable business -- which has been struggling because consumers are increasingly ditching cable TV in favor of video-streaming options -- will likely take some time. So many beginner investors might want to put Disney stock on their watch lists rather than buying it now. You might want to consider diving in upon seeing early signs that the company's new (ESPN+) and slated-to-be-released-in-2019 streaming products (a more broad offering) are gaining traction in the market. 

Alphabet

Google parent Alphabet is probably best known for its flagship internet search-engine business. This extremely profitable advertising-based business contributes the bulk of the company's revenue, with all advertising revenue comprising 86% of Alphabet's total revenue in the most recent quarter. Google has long dominated the search market and currently commands a whopping 86.3% global market share, according to Statista. 

Alphabet has expanded into many businesses. These include its Android mobile operating system, Pixel smartphones, Nest smart-home products, Google Home smart speaker, online video and music platform YouTube, cloud-computing service provider Google Cloud, and others.

The company's voice-activated, artificial intelligence (AI)-powered Google Assistant is incorporated into Google Home and some Android-powered smartphones. Alphabet's "other bets" segment -- formerly called "moonshots" -- brought in 0.5% of the company's total revenue in the most recent quarter and includes Google Fiber, which provides high-speed broadband internet service in nine U.S. cities, life sciences research company Verily, and its Waymo driverless-vehicle subsidiary

Amazon.com

Amazon is the global leader in the e-commerce market. Not only is this a fast-growing space, but there's lots of room for future growth. In 2017, online sales accounted for only 10.2% of retail sales worldwide, according to Statista. 

The company's Amazon Web Services (AWS) also is the leader in its market, the rapidly growing cloud-computing service space. This is a phenomenally profitable business that generates the cash the company uses to grow its empire. Amazon also holds the top market position in the smart-speaker market, with its Echo line that incorporates its Alexa assistant.

At the heart of the company's e-commerce success is its Amazon Prime membership, which for $119 per year in the U.S. gets customers free two-day shipping and in some cases, even faster shipping, and various other benefits. Prime members spend considerably more money per year on Amazon's site than non-members, making the program very successful for the company. 

Amazon stock is ultra-pricey no matter what valuation metric is used -- and typically, richly valued stocks tend to be volatile. That said, the stock has historically sustained a sky-high valuation because the investing community has much faith in founder-CEO Jeff Bezos' ability to continue to grow the business. 

American Water Works

American Water Works is the largest publicly traded water and wastewater utility in the U.S. It operates in 47 U.S. states -- 16 of them as a regulated utility -- and Ontario, Canada. Its market-based businesses include building and operating water systems for military bases throughout the country and supplying water to energy companies working in the Appalachian Basin.

American Water is a top choice for investors looking for a lower-risk stock that offers good total capital appreciation potential. There will always be demand for the critical product and service it provides, and its revenue stream from its core regulated business is very stable. Moreover, the company's industry-leading size provides it with more resources than its peers to grow its regulated business by acquisitions.

This is a big advantage because the water and wastewater industries in the U.S. are consolidating, as many municipalities are selling off their systems. The cherry on top is that American Water Works stock pays a decent dividend, currently yielding 2.12% annually. 

You should be aware that utility stocks are quite sensitive to changes in interest rates. There are several reasons for this, with a major one being that rising rates increase borrowing costs -- and utilities borrow heavily to finance capital investment, so higher rates can dampen their profits. Because we're in a rising-interest-rate environment, investors should dollar-cost average their way into their full investment and have a long-term focus when investing in American Water Works. 

Facebook

Facebook received a good amount of negative press recently due to the Cambridge Analytica data scandal, which involved the unauthorized sharing of personal Facebook data of about 50 million people. But don't let that scare you away from investing in the ultra-profitable, social-networking juggernaut.

Multiple surveys have found that users of its core platform have largely shrugged off the fiasco, and in fact, user engagement increased in March 2018 -- which is when the scandal exploded in the news -- over March of the previous year. Moreover, it seems likely top management will markedly improve data security and privacy in order to lessen the chances of repeat incidents of this magnitude. After all, users might not continue to be as forgiving.

Facebook, which regularly makes 97% to 99% of its revenue from advertising, continues to grow revenue and earnings at a breakneck pace, and its key user metrics continue to climb. In the first quarter of 2018, monthly and daily active users of the company's flagship platform increased 13% year over year, to 2.2 billion and 1.45 billion, respectively. Its Instagram platform continues to gain momentum, while total messages sent daily on WhatsApp and Messenger are nearing 100 billion. 

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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. Beth McKenna has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Amazon, Apple, Facebook, Nike, and Walt Disney. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool has a disclosure policy.