How to Pick a Stock

The hardest part about investing in individual stocks is the research. Companies and their financial records can be incredibly complex – Johnson & Johnson, for example, has more than 250 subsidiary companies under its well-known brand name.

So how should an investor start their research? This is an incredibly important question for young adults to figure out as it can make a huge difference in their returns.

how to pick a stock

Picking a Stock is NOT like wearing a blindfold and swinging to win big!

Evaluating the Business

I like to start first with the softer side of finance: the business. You have to get a firm grasp of what the company does from day to day.

The perfect starting point is a company’s annual report. You can find an annual report on the company’s investor relations tab on its website. Larger companies also distribute printed annual reports for free through http://www.annualreports.com/

I stress starting with the annual report because it is where companies show off. Sure, there is plenty of financial information to be found in an annual report. But annual reports often show the softer side of the business complete with pictures of the company’s products, short and sweet future business plans, and even awards and recognitions the company received in the past year.

Publicly-traded companies are often involved in more businesses than you might think. Without an interest in finance, you might think General Electric just makes light bulbs and wind turbines. However, after looking through the company’s annual report, it becomes clear that GE is really just a bank that happens to make industrial products “for fun.”

So, in short, you have to actually know what the company does before you do anything else. You might be surprised to learn how complicated seemingly simple businesses really are.

Learn from the Pros

If you are new to individual stock investing, you can learn plenty by listening to what other people want to know about a company. I like to attend a company’s conference calls where analysts ask executives in-depth questions about a business.

If you cannot listen live, conference calls should be recorded and available on the investor relations section of a company’s website. Alternatively, SeekingAlpha has transcripts of conference calls for all large publicly-traded companies that you can read on your own time.

Focus on what the analysts want to know. There is always a good reason behind each question. If an analyst wants to know about a company’s debt level, it should be a sign that you should take a second look at the company’s debt in your analysis, for example.

Getting to the Numbers

Eventually, you have to get the nitty-gritty of breaking through a company’s financials. Here are a few key numbers to focus on:

1. Price-to-earnings ratios – How expensive is the company’s future earnings? A PE ratio is the price of a share of stock divided by its future earnings. A low PE is more favorable to a high PE. Realize that earnings can vary wildly from year to year. An average of the last 5 years earnings would give you a more realistic PE ratio than a single year.

2. Price to book ratio – How expensive is the company relative to its book value? A book value is to a business what “net worth” is to a person. A low book value may be a sign that the company is selling at a big discount, especially if it also sports a low PE ratio.

3. Return on assets – How much can a company generate in earnings for each $1 it uses to run its business? A high return on assets is indicative of a very productive company. A higher return on assets means the company will use less of its earnings on investments (factories, new storefronts, etc.) to grow a business.

4. Total share count – How well is the executive team managing the company for shareholders? In an ideal world, share count would not rise faster than earnings.

5. Earnings growth – How quickly is the company growing its earnings over 5-10 years? Is this growth sustainable? For example, Apple quadrupled its earnings over the course of 3 years from 2008-2011 from sales of iPhones and iPads. Is there really room in this world for Apple to sell 3 times more iPhones and iPads in 2014 than in 2011?

Attack Whole Industries at a Time

A great place to start is with companies and industries that you can understand. Everyone can understand the pizza franchising business. Here are some of the companies in that industry:

Pizza Hut owned by YUM! Brands (YUM)
Papa John’s (PZZA)
Papa Murphy’s (Privately owned)
Domino’s (DPZ)
Noble Roman’s (NROM)

Just off the top of my head, here are some questions that need to be answered before you invest:

• How do these companies make money? What percentage of their earnings comes from company-owned stores vs. franchises?

• Why would a franchisee pick one of the brands above? (How much does the average store earn? How much does it cost to start a pizza franchise from any given brand? Is Papa John’s franchising agreement noticeably different from competitors?)

• Why do customers favor a particular store? My grandpa likes take-n-bake pizza because he can’t eat a whole pizza at one time. Is this common? Will demographics favor one company over another?

• How big could one of the above companies become? (Noble Roman’s is a $14 million business. It could grow 88x over if it replaced Papa John’s. Can it do that? Can Papa John’s, which has thousands of locations, grow much larger? Where?)

• Can any of these companies raise prices in the future? Every pizza chain is running specials due to the recession, but if the economy improves, maybe they could manage to add $1 to the price of each pizza sold. Could this be a catalyst for heftier stock valuations?

• Frozen pizzas have become a big business, and their quality is improving over time. Do these pose a threat to the traditional pizza shop model?

You can read financial reports all day long and never answer any of the questions above. Investors have to go deeper to find information that the market overlooks or underappreciates. As you start looking through new investments, keep a detailed log of research and intriguing information you find about a business or industry – you may want to reference it later.

Knowledge Builds on Itself

The best part about investing is that knowledge and research compounds faster than your money. What you learn about one industry can help you in others. The factors that affect pizza chains aren’t all that much different from the burger business (Wendy’s and McDonald’s.) Wendy’s (WEN) and McDonald’s (MCD) aren’t all that different from “fast casual” restaurants like Chipotle (CMG) or Panera Bread (PNRA).

Health insurance companies will lead you to an understanding of health care delivery. Health care delivery will help you discover which medical products would make winning investments. The list goes on and on.

The most important point is that finance is not all about numbers. Investing does not require a tremendous amount of mathematical prowess. What it does require is a firm understanding of a business. Getting involved in business analysis early allows you to build a knowledge bank of information that you will carry with you your whole life – information you can use to find many more good investments in the future.

This was another post written by JT from MoneyMamba in the investing series that I am running.

5 Responses to How to Pick a Stock

  1. Good points. An important consideration is patience. Don’t expect to learn all about a company in 30 seconds. Lurking on sites like Seeking Alpha, Motley Fool and AAII helps one to absorb the “lay of the land.” What do other people look at? How do they make sens of complexity? I found it helped me a lot to observe what others looked at and how they looked at it.

    Over time you’ll develop a comfort and a feel that will allow you to size up a company in 30 minutes.

    Oh, and don’t feel bad if you reject the first 15 companies you look at. It might feel like you wasted your time, but you didn’t. You developed a feel for what you like and every company you look at adds to your experience and knowledge.

    It’s like starting out in rental properties. By the time you buy your third one, you know what to look for and how to judge what you’re looking at. And you don’t feel bad about the ones you didn’t buy.

    I’m always reminded of Warren Buffett, who values patience and saying “no” to 90% of the propositions people run by him.

    • JT says:

      Patience is definitely important – even before you buy. I had been involved in the markets for years before I felt comfortable buying my first position in an oil company. Slowly exposing myself to the industry allowed me to grow comfortable with the business to the point that I could finally put my money on the line.

      Other businesses were much easier to get into. I think retail, food service, and less technical businesses are a great place to start while building familiarity with other industries.

  2. Great info here. I have always been nervous about putting any amount of money into a single company, but just like with anything else, research is the key. Thanks for breaking it down for us JT.

  3. Nice intro! I think the best way to learn about picking stocks is to follow an entire industry and compare the different ratios and see how they trend over time. Looking into their financials and some of the competitive advantages each has (as you pointed out) is another good way to get used to analyzing stocks.

  4. Very well laid out! I agree with William, investors need to consider time horizon and be confident that they have done the proper research. It may take the market 3-5 years to realize how great a business is.

    Also, take a look at a company’s free cash flow. That is another indicator that gives you a feel for how well the company is performing.

    Lastly, great job on commenting that investing does not require a lot of math. If you can add, subtract, multiply, and divide you’re set!

    Keep up the good work man!

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