What to look for when you start investing
When you first start investing you might feel a little bit overwhelmed with all the information that is out there and available, this is completely normal. These days the problem is not a lack of information, but a lack of information-processing capacity. There is so much out there, you need to filter the good from the bad, the useful from the time-wasters. But how and where do you start?
For this exact reason I always preach the idea of staying within your circle of competence. Start small and narrow and expand as your knowledge grows. I like to take the example of a gamer, especially because this is going to be a huger market in the near future, and it is still an obscure industry to a lot of investors. If you are in the gaming community, you will probably know where to get reliable information.
So, you have figured out your circle of competence, now what… what are the next steps?
I can’t give you an exact answer because every industry is different, but below I will share some general guidelines that I use, and I believe them to be very useful benchmarks or points to hit when you are first starting to investigate stocks. These critical points can be divided into 4 main categories: business, the financials, management, and other.
When I invest in a company, they do not need to meet all these standards, but it helps if they do.
Business
These are elements that are related to the business itself, the environment, or product.
Is it a leader/influencer in its industry? I want to invest in those companies that have large market share and are able to exert some power over the market. For example, I want you to do a little experiment with me, try to think of the companies that come to mind when I say: fast food, coffee, soda, technology. Now check your answers with those listed at the bottom of the page. Are they the same? I bet that at least 2 of the ones listed below are the same, and the others were close seconds. That’s because these stocks have built a reputation (good or bad) but they are always there, and you can count on them to be there in the near future.
Cyclicality: personally, I do not like cyclical industries for a few reasons: 1) I don’t use enough leverage to profit from them and I don’t want fees to eat away at my profits when I trade the ups and downs, and 2) I don’t invest enough money to make it worth my time. That’s why I do not invest in steel or construction stocks. Also, they are not within my circle of competence. Similar to this, I also try not to invest in current fashions or trends because they can die out very quickly and then you are required or forced to sell them to avoid losses. This does not work with my long-term buy and hold strategy. For tax on capital gain reasons, I want to hold my investments for a longer period of time rather than short.
Innovation: This is a difficult one, I want the company I invest in to be innovative so it can keep a competitive edge, but I do not want it to be in a too innovative industry. This means that successful innovation needs to occur much more often in order to stay competitive and this is difficult to do. Therefore, I look at the supply chain of these innovative companies and see what companies benefit the most from this innovation? That is one of the reasons why I like the semi-conductor industry (I do realize that they still require high innovation, but less than some other tech companies that use the semi conductors). Also, if innovation is usually along the same line or idea, I am ok with that (for example: processing power) but if it requires to completely innovate the field in a new direction, it becomes more difficult (for example: Apple when they came out with the Iphone - I still invest in Apple though)
Financials
This information is crucial and can be retrieved from their SEC filings, but do realize that management has discretion and fraud does happen. That being said, a letter by the external auditor should provide you with some insight on how credible the statements are.
Look at any of the liquidity and debt metrics and make sure that they are not carrying above industry-average debt levels. This is usually a very bad sign, especially when a recession or downturn hits.
Look at their coverage ratios, are they able to pay their interests?
Finally, two important metrics for me are:
ROA: net income / (average assets). It is an efficiency ratio that tells you how well the company is able to generate net income, given their assets. I also want this to be above the industry-average, indicating that they are efficient.
Current ratio: current assets / current liabilities. I like a ratio > 1 as well as above the industry average. I use this as a filter when selecting possible investment opportunities.
Management
This is probably one of the most crucial paradigms that I look at, good and ethical management is essential to me. Why? Think of Enron or WorldCom, they had excellent financials and their business seemed to be very good, even their board of directors was “amazing”. The problem was management and their auditors (Arthur Anderson).
They have a vested interest in the company, meaning they are shareholders themselves. If a portion of their compensation is linked to the performance of the company (they are both agent and principal) they have more incentive to make decisions in the shareholders interest and reduce shirking.
Develop managers from within, people who know the industry and the company. Closely related to this, but more difficult to discover is the succession planning within the company. When they do not promote from within, is it because there are no qualified candidates due to a lack of training by current management, or did the board of directors not spend enough time and resources on succession planning?
Have board members that are shareholders as well, they should act in the best interest of their shareholders.
The executive compensation package needs to be competitive, but not excessive. It is important to pay enough so they have incentive to stay and not look for a job elsewhere, but it can’t be too excessive so that it takes away from the shareholders. However, it is important to realize that sometimes the large compensation packages are justified, but that the news likes to dramatize inequality between CEO and worker pay.
What are the motivations or intentions of top management and the CEOs. What drives them, is it personal gain or do they also have a greater cause?
Other
Finally, these are some other points to consider that in my opinion did not fall within the 3 previous classifications.
The price must fall below the intrinsic value: it must be a bargain. If it is a strong and solid company, but the market has overpriced it, it is still not a good purchase in my opinion. The difficulty is, how will you determine the intrinsic value? In the future I will have some posts addressing this question. I will show a few different methods to do this and it is up to you to tweak these to your personal style or industry. You might have heard about a few of these, such as the discounted cash flow or dividend discount model.
I do not like to see a lot of mergers and acquisitions; these can be used to cover up some elements in the financial statements and usually they tend to overpay for an acquisition. Depending on the company, a few are possible, such as Google or Microsoft acquiring an AI start-up company.
Finally, how clear are the financial statements? Do they make sense when you read them, and can you find everything or is it a bunch of legal gibberish? A lot of legal terminology is usually done to confuse the reader and to hide certain elements.
This is a quick overview of some key things I look at when I am investing. This list is by far not exhaustive and complete, but it provides a good starting point and I hope it helps you as you start your journey. Let me know in the comments below what you think and whether or not you agree. What are some of the things you look for?
Experiment
Fast food: McDonalds
Coffee: Starbucks
Soda: Coca Cola
Technology: Apple