Researching stocks comes down to finding good ideas, understanding the company, and using metrics to identify fair valuations. Good ideas come from a wide variety of places, and most importantly from your everyday experience. Good research comes from a good understanding of the company and using the proper metrics to determine its valuation.
IDEAS
The first step to research a stock is picking a stock to research. Coming up with investment ideas is the start of any great portfolio. There are many ways to find great companies to invest in. Some of these ways include stock screeners, sector driven research, and products you use.
Using a stock screener is a numbers driven approach where you set up a list of metrics you want a company to meet and a screener filters out all the companies that don’t meet your criteria. My favorite stock screener tool is FinViz. They can filter for many different performance metrics. Using this screener is going to be the place to find stocks and where your research begins, not where it ends.
Another method to find good investments is to do what I call sector driven research. For example you think your portfolio could really use a basic materials company for diversification purposes. The sector you are looking at is basic materials. Next, within the basic material sector you narrow it down further to the Industry. Now within this sector you think the chemicals industry is the best opportunity within that sector. Now you have a set of companies within that industry you can choose from for the best investment. This is a systematic way to narrow down what companies to look at.
My favorite idea for where to find stock ideas is with observation of the products you use. This organic research gives you the best advantage to finding high quality companies. If you use a product and like it then you can believe that others will like it and the company will succeed. An example of this is when I worked in a manufacturing machine shop a company would come and take our used oil and clean our tools. This service was highly useful and helped the company I worked for be environmentally compliant. This company is called Heritage Crystal Clean. They were a $500 Million dollar company trading for $27 a share when I found them and they recently have been bought out for $1 billion dollars. This means I doubled my money in the first year of owning the company. I only had heard of this company to invest in because of my observations of companies I see daily.
Chances are you see and use many publicly traded companies everyday. All these products and services are also investment opportunities. This is a great place to start for finding your next successful investment. I want to stress that this is the starting point of your research, not the end point. If you find a product you like and it is sold by a publicly traded company then you can move onto the next steps which is a deep dive into research.
UNDERSTANDING THE COMPANY
The first step of research is understanding what the company you are looking at does. How does it make money? What are its biggest costs? Who are its biggest competitors? What advantages does it have over its competitors? How are they funding their growth? These are all necessary questions for you to answer before any other research can be done. If you are going to invest in a company and become a partial owner it’s imperative that you know the company well. When investing in a company you need to have a thesis of why it is a good investment and answering these questions is a good place to start.
A place I always start my research for understanding a company is on their own investor relations page. A company will talk all about what they do, and how they make money. They will usually have power point presentations with nice graphics and easy to read tables. This will give you a good idea of what the company does before you even read a financial statement.
Another great resource is Yahoo finance. Yahoo finance has a profile section for each company and you can read a 1 or 2 paragraph summary of what they do. Another great thing that yahoo finance does is that it will show you companies that are similar to the company you are looking at. This is a great way to compare competitors in a given industry. These are all pertinent things to look at when deciding to invest.
One of my coworkers at a previous job was peddling a company to invest in called Up Start. He was giving me all kinds of reasons why it was a good investment such as its a blue chip stock, all the institutions own it, and it has high price targets from all the analysts. I asked him what does the company do? He couldn’t give me an answer. All he did was keep talking about the analysts and the message boards hyping the company up. Without knowing what the company did just following all the talking heads he invested a good portion of his portfolio into this stock around it’s all time high of $400. The stock fell all the way down to $12 dollars a share from its all time high. My coworker held onto the stock the entire time it fell. He didn’t have a good understanding of the company he was invested in and what kind of trouble to watch out for.
Share price doesn’t always indicate whether something is a good or bad investment, only time will determine that. My coworker’s holding in Up Start could come back. Amazon stock has dropped by 90% before and time has proven to be a great investment even through that down draft. The point is that if your investment thesis on Amazon didn’t change and you knew why you invested in Amazon then you would’ve bought more Amazon as the share price tumbled. My coworker hasn’t bought an Up Start since it collapsed because he didn’t have an investment thesis to rely on. He didn’t have a thesis because he didn’t understand his investment.
METRICS
Once you understand the company you want to invest in, it’s important to determine if the company is reasonably valued for their performance as a company. This is a big factor in determining an investment thesis. Valuation of a company matters. If you buy a great company at the wrong valuation it could be a bad investment. An example of this is Buying Cisco in 1999. Cisco is a great company that made a lot of money. The stock price went through the roof way further than it could have sustained by the company’s performance. The stock then collapsed in the 2000 dot com stock market crash. Cisco has just now 23 years later returned to its all time highs. This is a great example of buying a great company at a bad valuation.
A simple metric to use is the Price to Earnings ratio (P/E). This is the price of the stock compared to the earnings of the company per share. If a company is trading at $15 per share and has an earnings per share (EPS) of $1 then the P/E is 15. That means you are paying $15 for every $1 that the company earns. The reason you would be willing to pay more for the company’s earnings is that you have a share of the company’s future earnings.
Relating the company’s earning growth to its current P/E is important to determine a fair value for the company. If we look at our company from above with a 15 P/E, if that company’s earnings remain exactly the same then it will take 15 years for you to make your money back on your investment. This would be ok if you were planning to hold the investment for longer than 15 years but that isn’t very good performance for an investment. As a rule of thumb P/E should be around the growth rate of the company. This ratio is called the PEG ratio.
Earnings is an important metric but it isn’t the only metric that we can use to determine fair value of a company. Another metric is about sales and particularly sales growth. This is an important metric when looking at companies that don’t have earnings yet. Companies might not have earnings yet because they are starting up and the cost of starting up is more expensive than the money they are bringing in so far. When evaluating these kinds of companies it’s important to look at the cost of each sale gained. If the cost of each sale is down trending or remaining the same while sales gross revenues are increasing then they are on the way to profitability. Amazon is a great example of this because they have always had a very high P/E ratio or sometimes no earnings at all. With this being said you could see that Amazon sales performance and growth has always been growing at a sustainable level. They would be investing their money into gaining more sales and growing as a business.
Research and development is a major way for companies to invest into growth for their company. Research and development investments by companies are harder to evaluate since it is by nature a speculative endeavor. The only way to evaluate if a company is making good use of its R&D is its track record on previous R&D. Pharmaceutical companies are an important industry where R&D is part of the business. Each drug patent only lasts for 20 years, so every 20 years companies need to replace the income stream lost from losing that patent. AbbVie for example recently lost the patent exclusivity for their top money making drug Humira. To invest in AbbVie you need to trust that the company’s research will be able to produce another drug that will replace that earnings lost.
Knowing what metrics best represent the company you are looking at comes down to your understanding of a company. If you avoided Amazon or Tesla because their earnings weren’t high but they were constantly growing in sales.
TOP TOOLS
- Fast Graphs: Fast graphs is my absolute favorite tool to use to analyze company valuations. This tool charts different metrics vs share price on an easy to read graph. Easily worth the monthly fee every month. Check out my article on how I use Fast Graphs
- FinViz: FinViz is my favorite stock screener. You can see any and all metrics you want to know about any company. It has a powerful search tool to narrow down to companies based on the metrics you want to use.
- Yahoo Finance: Yahoo Finance is a great place to start your research to get an overview of the company and find others like it.