"I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful." -- Warren Buffett
Have you every caught yourself saying – “I wish I invested in that stock before it took off”? We’ve all wanted to kick ourselves for not buying the latest stock to take the market by storm. Mine is Amazon. On May 30th, 1997 Amazon made is debut on the Nasdaq trading at $1.50 per share. Fast forward 20 years, Amazon now trades above $1,700 (as of October 2019). If I only had invested in 100 shares of Amazon during it’s IPO, that one-time investment would now be worth over $170,000.
In all fairness, Amazon wouldn’t have hit my radar in those early days of the company, it’s not easy picking the next Amazon. Why is that? Before companies make it big they are still unproven, and with all the variables that go into determining whether a company will rise to the top of a fast-growing industry no one can really predict who will win. Legendary investor Peter Lynch thinks about this investor conundrum in terms of baseball, suggesting investors should wait until the third inning before getting into the game as buying before the lineup is announced introduces unnecessary risk.
How to Invest Money Wisely
While there are no guarantees in stock market investing, you can dramatically improve your batting average by bringing a sound approach focused on the fundamentals to the game. Read on below to learn more about the checklist I follow when picking stocks, plus a link to the spreadsheet I use to screen and compare stocks I’m considering buying. And, I promise – no more baseball analogies.
The Informed Investor’s Checklist:
1. Always have an investment hypothesis: You must understand why you are buying shares in a company before you make the final purchase. “Because my friend recommended it” is NOT a good enough answer to why you bought a stock. An investment hypothesis is the reasoned justification for purchasing shares in a company. Having an investment hypothesis also helps you set the time horizon for when to sell a stock. You should only sell a stock when the hypothesis is realized, or when the hypothesis is no longer reasonably achievable.
There can be several types of investment hypothesis’s, you might think a company is undervalued, or that a company is in a high growth industry that they are poised to capture, or you may choose to invest in a company because it historically has grown its dividend payouts and you want the income stream in your portfolio.
One of the more successful investment hypothesis I had informed my purchase of a company called Western Digital. It was my belief the market was undervaluing the company. Western Digital develops data storage solutions, anything from flash drives, to devices, to large enterprise solutions. Many of the metrics used to help indicate if a company is properly valued or not - its Price to Earnings (P/E) ratio, Price to Book, and others, were all signalling Western Digital was being undervalued by the market. What was driving this discount was Wall Street’s belief the storage market was undergoing a major transformation from local storage solutions, which was Western Digital’s traditional bread and butter, to cloud storage solutions. What I felt Wall Street missed in its low valuation of Western Digital was that the vendors who were providing cloud storage services themselves needed the same storage hardware from companies like Western Digital to be able to provide these services at scale. As soon as Western Digital recovered to a more “fair” market valuation, I exited the stock and looked for other opportunities to invest my gains.
2. Understand what the company you are investing in does to make money: When it comes to choosing what stocks to invest in, sticking to companies that you understand is a prudent strategy. Just as you wouldn’t set up a legal practice without going to law school, you should not invest in companies where you are not able to explain how the company makes money.
Before you say, “I don’t know much about companies outside of the industry I work in”, consider all the products and services you encounter throughout your daily life. The bank you use, the restaurant chain you visit regularly, the smartphone you check every five minutes, your Internet provider, the hotel chain you remain loyal to. I only started to look at Starbucks as an investment opportunity after I realized that I was not the only person who had an expensive habit of regular visits to Starbucks.
Sticking to what you know is not only the safer investment strategy, but it also won’t limit the returns you can generate. Even Warren Buffet, billionaire CEO of Berkshire Hathaway, was wise enough to admit that he isn’t smart enough to predict what the future of the tech industry will look like, so he chose to avoid it almost entirely over the course of his investing career. He’s done OK.
Of course, just understanding how a company makes money is not enough. You need to assess if they will make more money in the future.
3. Assess the quality of the business: You get what you pay for in life. It’s no different with stock investing. This is not to say you shouldn’t buy stocks at an attractive price or look for bargains when a quality company goes on sale due to market corrections. Warren Buffet put it best:
"It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."
My search for quality companies focuses on two key factors – i) Does the company have a defensible moat to protect it against competitors, and ii) Is the company led by strong leaders?
Defensible Economic Moat
A moat is a long-lasting competitive advantage. When company’s have a defensible moat, they can generate strong and consistent profits. There are many ways company’s can create a defensible moat – a strong brand, a patent, a low-cost advantage, high switching costs, etc. Facebook has created a strong moat due the network effect it has created. People are less likely to leave the social network because most of their friends and family are on Facebook.
Strong Leadership
When you are investing in a company, you are also betting on the ability of the company’s CEO and leadership team to deliver strong results. Look for companies with experienced leadership that has vision and a track record of driving growth and navigating through tough times successfully. I also prefer companies where management has a material equity position in the company themselves. You can trust them to be good stewards of the company’s financial position given their “skin in the game”.
4. Focus on the fundamentals: When I decide to invest in a company I tend not to look at macro economic events like what the government is likely to do with interest rates in the future, or will inflation rise soon? Not only is predicting these events impossible, but if they do occur the affects will be felt across the stock market (not just the company you are investing in) and they will pass in time. By focusing on selecting quality companies trading at a reasonable price, and investing for the long term, your bets are likely to endure despite a few small setbacks along the way. While I don’t look at macro economic conditions in my investment decisions, I very much analyze the micro economic conditions of a company. The top financial metrics I review when considering a stock investment are listed below. Many of these metrics for individual companies can be found on financial websites, including my favorite Morningstar.com.
a) Earnings growth: As company earnings (after tax net income) grow so too should the stock price. I want to see growth in the companies I invest in, preferably earnings growth, but I do on rare occasions make exceptions for the right high growth tech companies. In these seldom cases I will settle for revenue growth provided the company is re-investing its profit into growing the business.
b) Earnings yield: A company’s earnings yield helps determine if a stock is reasonably priced based on current earnings and is calculated by:
Earnings per Share
Price per Share
I look for earnings yield that are 7% or more. Although I’d prefer a company’s earnings yield to be 10% or higher, with today’s high valuation of the stock market this is harder to come by.
c) Price to earnings growth (PEG): The invention of investing legend and Warren Buffet teacher Ben Graham, the PEG ratio is another indicator of a company’s current valuation. It’s distinction from other valuation methods, such as the Price to Earnings (P/E) ratio (basic valuation ratio of a company’s current share price compared to its per-share earnings) is that because the PEG ratio factors in earnings growth it provides a more forward-looking view of a company and its growth potential. The PEG ratio is calculated as:
Price to Earnings Ratio
Annualized Earning Per Share Growth (over five-year period)
The lower the PEG ratio the better. A PEG ratio below 1.0 implies the market is not fully valuing the company’s growth potential. (Source: Forbes)
d) Debt-to-Equity Ratio: This metric gives you a sense of whether a company has taken on too much debt. If a company is too leveraged, high debt loads can become problematic in an economic downturn if the company is not generating enough cash flow to service its debt. The debt to equity ratio is calculated as:
Total Liabilities
Shareholder Equity
While lower debt-to-equity ratios are preferred, there can be good reasons for companies to use debt. Increasing debt during expansion can help new companies scale much faster than they would otherwise. And, context matters – certain capital-intensive industries that are well established such as utilities and industrial manufacturers generally have higher debt-to-equity ratios than fast growing companies. Compare the company’s debt-to-equity ratio to its peers in the industry to put it in relative terms. e. Return on Equity (ROE): Assessing the effectiveness of a company’s leadership can be difficult from afar. That’s why I rely on ROE to help me evaluate how effective management is in generating profits from the money invested in the company. Basically, is leadership effective at generating returns from the capital invested by the company’s owners (i.e., it’s shareholders). The ROE is calculated as follows:
Net Income Shareholder Equity
A word of caution, ROE is not an effective measure for early stage companies that are not yet profitable due to their strategy of growth re-investment.
Putting it into Practice
I place equal importance on each of these measures – if a company seems to be undervalued, as measured by it’s earning yield, but if the debt-to-equity ratio is too high, I will pass on the investment. You should use these, and other financial metrics, to screen stocks. If a stock you are considering does not meet the minimum threshold you’ve set for each of these measures then move on to evaluating other, more attractive investments.
While I view these metrics as the most important, there are several other measures I use in analyzing the fundamentals of a stock I am considering. For example, I often favor dividend paying companies, so I will look at it’s historical dividend growth rate. To hopefully help make your life easier in evaluating stocks I have posted the Excel stock screener spreadsheet I’ve created myself here. There are also other good stock screener apps and programs that are freely available. However, I have yet to find a free one that includes all the financial metrics I track. If you know of one, please share 😊.
While I cannot promise following this checklist will lead you to finding the next Amazon and generating a 1,000% return, following this approach will help make you a much more informed investor. And, that’s much better then the alternative.
Important Disclaimer: Before buying individual equities you should ask yourself – Am I willing to invest my time to do the research necessary to make an informed investment? If the honest answer to this question currently is no, then it’s critically important to adopt an investment style that is suitable – in this scenario that would be the “Couch Potato Investor”. There is absolutely no shame in adopting a couch potato strategy, only shame in losing all of your retirement cushion due to playing the stock market like it’s one big casino!
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