“If you give a man a fish, you feed him for a day. If you teach a man to fish, you feed him for a lifetime.” This post is to teach you how to pick a winning stock investment. Of course, you can do a quick google search for people’s opinions on great stocks to invest in, but how did they get to their conclusions? Here’s how to pick stocks to build a winning investment portfolio.
6 Steps To Pick Good Stock Investments
Investing in stocks is a predictable game if you know what you’re looking for. The idea is to invest in companies that are well managed, have a great product or service, are led by visionary and innovative founders, and have the potential to grow many times their current size.
If you were to analyze a family’s finances, you’d have a pretty good idea as to whether they were in good financial health or not. Likewise, if you examine a sports team’s teamwork and internal relationships, you’d have a good idea of its culture and how they interact on the field or court. The idea is to analyze these company areas to determine if they overall have a positive outlook and predictable growth trend. Follow these six steps below to identify winning stock picks for the long-term investor.
Step 1: Build A Shortlist of Potential Stock Investments
There are thousands of stocks that are publicly traded worldwide. If the objective is to pick winning stocks, we need to filter things out. Our goal is to narrow our focus from thousands of stocks to a list of under 100 stocks. So, where do you start? Start by going through a quick rundown of your average day to identify all the products and services you use regularly.
Here’s a hypothetical example. I wake up each morning to my iPhone (Apple, Inc.) alarm then get up and brush my teeth (Johnson & Johnson), shower, and put on my clothes (that I bought from Stitch Fix). Next, I eat breakfast, put on my shoes (Nike), and drive my car (Ford) to work. I log onto my Macbook Pro (Apple, Inc.) at work, open up my Google Suite for email and other Google products (Alphabet – Google’s parent company), and begin preparing for meetings. I go to lunch at Shake Shack (Shake Shack) for a burger and fries and end the day at work building data reports with excel (Microsoft).
When I get home, I play with my kids and their toys (Hasbro) and finally get a chance to sit down and turn on the TV (Netflix, Disney). After dinner, I put on my workout clothes (Under Armor, Nike), go to the gym for a quick run and weight workout (Planet Fitness), and return home to shower and get ready for bed again.
Throughout that hypothetical example of a day in the life of Cameron, I identified at least ten publicly-traded companies whose products or services I use regularly. I now have a starting point for a shortlist of stocks. Follow this process over a few times and in great detail, and you will find a plethora of companies to add to your shortlist. Once you get this process started, it’s easy to begin identifying even more companies. You’ll begin to notice competitor companies, industries you enjoy, stores you like to visit, and things you do in your spare time – all sparking ideas in new companies to add to your shortlist of stocks.
Step 2: Look For Stocks With Healthy Financials
The best place to analyze a company’s financials is by viewing the publicly filed 10-K and 10-Q reports. A 10-K report is a report on the company’s annual earnings and growth, including financials. The 10-Q report is the quarterly version of this document. You can view these reports on a company’s website in the “investors relations” section or by searching for them on Google or Sec.gov. The next best option is researching a company on Yahoo Finance. I usually resort to Yahoo Finance due to its simplicity, and I’ll resort to the company’s 10-K and 10-Q reports if questions arise or something seems off.
When researching a company on Yahoo Finance, I go to the “statistics” tab under the company’s page and review the following data and ratios first:
- Market Cap & Enterprise Value: The market cap tells me how large a company is in comparison to the industry and competition. If a company is worth $10 billion but its competitors are worth $100 billion, assuming all othe research shows positive signals, I can assume this company could at least grow by 10x if it grows to be the size of the competition. Furthermore, if a company has a lower “Enterprise Value” than it’s stated “Market Cap”, that means the company likely has less debt than it does cash which is a positive sign.
- Operating Margin: An operating margin that is above 15% or 20% is a good sign. This means that the company has a margin of say 20% on its sales AFTER paying the operating costs to facilitate that sale. The higher this number, the better.
- Return on Equity: Equity is the amount of ownership shareholders have in the company. In other words, if you invested $1,000 in a company, then your equity would be $1,000. A return on equity states the total return a company’s earnings had on your $1,000 investment. Generally speaking, I like to see at least 12% or more for ROE. Again, the higher the better.
- Quarterly Revenue Growth: If a company isn’t growing and expanding, then there is no point in investing in them. Quarterly revenue growth tells us how fast their sales are growing each quarter. Some companies see tripple or quadrouple digit growth in revenue in growth stages. A company with even 20% quarterly revenue growth is still a good sign indicating that sales are trending upward.
- Quarterly Earnings Growth: Is the company making money? The quarterly earnings growth tells us if the companies bottom line earnings are growing. Again, a double digit number here at minimum is usually a good sign.
- Total Cash: A company with little cash on hand could be a disaster should the economy go south. A company with a ton of cash on hand tells us they are savers and could withstand any market condition to maintain growth and operations. The more cash, the better. This number will vary depending on the size of the company. Perhaps what is most important, in my opinion, is comparing the total cash a company has in comparison to its debt.
- Total Debt: A company that is over leveraged can. be risky business. If they have 10x the amount of debt as they do cash, then its safe to say this company may be in a dangerous scenario if things take a nosedive for whatever reason. If they can’t pay their bills, then there is no sustainable business. This number will vary per investor, but I personally try to set my limit on the amount of debt a comopany has to no more than five or six times the amount of cash – assuming they are passing all other financial areas with flying colors.
- Levered Free Cash Flow: This is another very important ratio. Levered free cash flow is how much money a company has leftover after paying all it’s bills. This money can be used for whatever the company sees fit to accelerate growth and make even more money! The more the better in this scenario.
- % Held By Insiders: I like to see companies that have a decent amount of ownership held by company insiders – or company executives like the CEO, CFO, President, etc. – because it means they too have skin in the game of how the company performs. It aligns their interests with the interests of its investors.
Keep in mind these are general guidelines. If a company has excellent financials in all areas but has a lower return on equity than preferred, I may still invest in them because the benefits outweigh the risks. The goal here is to invest in companies whose financials are healthy to withstand any market condition and continue to grow their operations at an accelerated rate. If all indicate that this is the case, then we can move on to step 3.
Step 3: Identify Industry Moats
If you want to learn how to pick stocks successfully, then you need to learn how to identify when a company has a clear industry moat. An industry moat is anything that a company has that gives them the upper hand over their competitors. In other words, anything a company has or does well with that makes it difficult for competition to enter the market can be considered an industry moat. For example, Apple has its brand name and loyal customer base; Amazon has its two-day shipping; Facebook has its network effect (aka everyone is already on Facebook, so it’s hard to go elsewhere); and Tesla has its brand name and innovative product and leadership. Therefore, if a company enters a market, it will have to overcome the hurdle that prominent market leaders have created, making it hard to take over market share.
Step 4: Research Company Culture & Executive Team
A company with a great internal culture flourishes more often than not. Imagine investing in a business whose employees all hate working there. How do you think that company will play out long term? Not too well. A company with employees who are proud to wear their brand name and enjoy the positive culture naturally promotes growth and becomes free marketing for the business. One way to look for indicators of the company culture is to review job boards reviews. Websites like Glassdoor.com post reviews from employees about how they like working there and whether they approve of the company CEO. Positive reviews in this area are a good sign of a contagious and positive culture.
Step 5: Do You Believe In The Product or Service?
I find it challenging to invest in a company that I don’t intimately know and believe in. It’s one thing to understand the fundamentals of a company, but it’s a whole new playing field when you’re a loyal customer of that company. At the least, you need to believe in the company’s vision, product or service, and what the company is doing to make the world a better place. If you can’t say you would give them your full support, that may be a deal-breaker on whether they meet your investment expectations.
Step 6: Questions That Make or Break Your Investment Decision
Once you’ve followed steps one through five, it’s worth asking yourself some critical questions about the stock to confirm your belief in it as an investment. Some questions to consider asking yourself that may make or break your investment decision include:
Can you imagine a world without this company?
What would a world without Google look like? Or, how about a world without Facebook? Could you imagine a world without Netflix? Of course, most of us would think it hard to imagine any of these companies ever going away because they serve a huge part in the well-being of the global economy. But, can you say the same about the company you are investing in?
Do you understand how the company makes money?
Perhaps you’ve found a company that passes all the above steps with flying colors. However, it’s a semiconductor company, and you have no idea how a semiconductor works or what it’s even used for. Therefore, it would be unwise to invest in this company since you don’t understand the fundamental process by which it makes money. If you don’t understand how the company makes money, then don’t invest in it.
Where do you think this company will be in five or ten years?
This question takes a little creativity. After going through the above steps, you should have a pretty good vision of where the company is going. Based on this data, where do you see this company in five or ten years? Do you see them being a company that can grow 5x, 10x, or 20x its current market cap?
Do you see yourself investing in the company for at least 5-10 years?
Warren Buffet said it best when he stated, “If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes.” ‘Nuff said.
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