Anyone can pick a stock. A monkey with a newspaper and a dartboard can pick a stock, or so I’ve been told. The goal is to buy stocks that will go UP in price. Easier said than done or everyone would do it.
There are a million or so reasons that influence a stock’s price over the short and long-term. On a day-to -day basis, the biggest influence on a stock’s price movement is generally the overall market of ALL stocks. In the short-term — most stocks move together.
Over days, weeks, months and years you see these returns develop their own independent patterns — some winners, some losers.
How do you decide if an individual stock might be a good or bad pick?
First off, at this point, I assume you have decided to buy individual stocks instead of a diversified fund, you understand the risks, and you have saved adequate cash reserves. Buying individual stocks are MUCH RISKIER than buying a diversified fund. Investing without adequate cash reserves is a recipe for failure. My article Financial Planning: The Thing You do Before You Buy Stocks discusses both of these issues and more.
When considering stocks to purchase, it is important to know and understand that stocks represent real businesses with real people behind them. Therefore, it is important to think like a prospective business owner when analyzing a stock, because that’s exactly what you are!
With a goal of simplifying the thought-process for those new to the idea of picking individual stocks, I came up with a three-word system to follow.
I’ll dig deeper into each of these as we progress, but these three words summarize the stock picking process: Story, Numbers, Expectations.
Story. Numbers. Expectations.
The stock picking process includes evaluating the story, numbers, and expectations for the business you are potentially purchasing.
1. What’s the story? What makes you want to own this business?
2. What are the numbers? How much money are they making?
3. What should our expectations be for the company and stock?
It is also a good time to point out, these aren’t three individual steps we move through like we’re following Lego instructions. Stock picking is not a simple math equation.
These three steps represent themes that are woven together to help answer the first question: What’s the story?
What’s the story?
It can be overwhelming to think about narrowing the universe of stocks from over 10,000 to one. Let’s keep it really simple.
Start by doing nothing but watching.
“You can observe a lot by just watching.” –Yogi Berra
Watch for good business. Watch for a good story.
What makes a good business? Look for companies you think are probably making money — selling lots of whatever it is they provide. The more the better. Is there a line out the door of people waiting to buy? PERFECT!
It should be simple. You don’t have to know that XYZ Company just made a new organic, solar-powered, Bluetooth-enabled, titanium, artificial heart valve. You just need to notice what YOU know and YOU understand in YOUR everyday life.
Look Around the Corner
Good stocks start with a good story, but always be aware of “the next chapter” and any potential plot twists that could occur.
One of my key reminders to myself in investing is to “always be looking around the corner.”
You want to ask yourself questions about the future prospects for the company, “What do I think will happen next?”
The point in asking these questions is to think about where you see this business in three, five, or ten-plus years.
Questions to consider:
• What do you know about the company?
• How do they make their money? (Do they make money?)
• Will they be making more or less in a few years?
• Are they part of a new trend that will continue or a fad that will last only a few years?
• Will other companies try to copy them and if so, can your company withstand the competition?
• Will the story last long enough for you to be a long-term stock investor?
• What could go wrong or right?
Don’t try to talk yourself in or out of the investment. Do your best to take an objective view. You may find the process reinforces your position that you are onto something good with your idea.
You just want to keep in mind that history is littered with companies that go from boom to bust because markets change every day just as tastes change. You want to make sure you aren’t buying a fad right at the height of its popularity.
Numbers
You’ve started on your stock’s story, now let’s continue and dig into the numbers. Numbers keep you grounded. It can be easy to get caught up in the hype associated with a company, and the hype associated with investing, in general.
Many companies are good at not only promoting their business, but also promoting their stock through carefully worded press releases and buzz words. All of these things can impact your decision-making and make you forget that you’re buying a business that you need to understand on a basic level.
The numbers can keep you grounded and focused on the fundamentals of long-term, buy and hold investing.
There are no shortage of numbers and ratios and other things we could cover, but I don’t want to cover more than we need. It really can and should be simple to pick good companies for investment.
The most important numbers to investigate in stock picking: earnings, dividends, the PE ratio, and debt, in that order (arguably).
Earnings represent company profits — and they are the heartbeat of good stock picking. Stock prices tend to follow the same path as company earnings. Learn more in our article titled Stocks Follow Earnings. Dividends represent the portion of earnings paid to shareholders in cash.
The PE ratio (calculated as Stock Price ÷ Earnings Per Share) represents how cheap or expensive a stock is relative to its earnings. Generally speaking, a higher PE ratio reflects market expectations for a higher rate of growth than a lower PE.
Debt is not a bad thing for a company. Too much debt is a bad thing. That’s reasonable. Most companies have debt, and it is way above the paygrade of this article to get in their face about it, but be aware.
Rarely is debt alone the reason a company goes bankrupt or gets in trouble. Bad businesses get into debt problems. Good businesses rarely get into debt problems. Good businesses attract additional investment money before debt becomes a problem, in my experience.
Don’t get me wrong, too much debt can slow growth and slow stock price growth. However, if the stock’s story is legit enough for you to notice it, and they have earnings to back it up, they can usually deal with debt.
The Direction of Numbers
Those are the most important numbers to the market and to investors — but the market wants to know more than what the numbers are today. The market is always looking ahead, and it wants to know what the numbers will be in the FUTURE. You will find THE DIRECTION of the numbers is often more important to the market than the actual numbers.
As I will explain, thinking about the direction of those numbers is where the numbers weave into expectations and where the math weaves into psychology.
Expectations
Stocks are all about expectations. The story and numbers we’ve discussed have expectations built into them. Your frame of mind as an investor has expectations built into it. It takes successfully navigating both to be successful as a stock picker. You must find the company you want to buy, but you must also behave properly after you buy it to have long-term success.
The Direction of Numbers: Predicting the Future
As we discussed, the direction the numbers are moving are as important to the market as the numbers themselves. The direction of the numbers implies some level of expectation or assumption on what the future will look like. Thinking about the direction of things is where story, numbers, expectations, and psychology come together.
“It’s tough to make predictions, especially about the future.” — Yogi Berra
You’re predicting the future when you assume earnings will be the same next year, or higher next year — or anything at all next year.
Stocks tend to follow the direction of company earnings, with heavy influence from the direction of company dividends and the relative value of the company Price to Earnings ratio (PE ratio).
Investors have expectations for the direction of earnings and the direction of dividends and PE ratios. The expectation of the direction of these numbers determines stock price performance. That’s a brain twister, but it’s the truth.
As an example, companies report earnings quarterly. If a company surpasses the expected earnings numbers, but tells investors future numbers will be weaker than expected, the stock will likely be punished. That’s because investors found their expectations for the direction of the future numbers was wrong, even though the current number was better than expected.
Important: Be aware of your expectations, the expectations of others, and where these expectations may be right or wrong. To over-simplify, when expectations change, stock prices change.
Recency Bias
When it comes to our expectations for the future, things that have happened more recently have greater influence on our expectations than things that happened long ago. There is a natural tendency for humans to assume life will continue as it has in the recent past. If a stock has been going up and all the news is good, it’s easy to feel like it will keep going up and the news will stay good forever. The same is true when it’s going down and all the news is bad.
Previously, we discussed that as an investor, you should “always be looking around the corner.”
I gave you a list of questions to consider with the point being to think about where you see your company over the long-term so you can set your expectations for the future. This is an example of making sure you understand expectations. What are your expectations of the story?
All the things we know, as well as our expectations regarding those things, are relevant. One change to our expectations for earnings or dividends or PE changes the story.
Know Your Stock
Expectations can make all the difference in a lot of things, right? This isn’t a stock picking thing. This is a life thing. If you’re too pumped up for something, it can be a letdown. If you aren’t expecting much, you might be pleasantly surprised.
It’s similar to “perspective.” Seeing something from a different perspective can certainly change our behavior. Looking from a different angle can give an entirely different point of view.
It is no different in the stock market. Every now and then, investors get a little too pumped up, and a stock goes up too much. It hurts when you find you were too optimistic as well and bought it right before it came back to reality.
Sometimes investors don’t expect much and are pleasantly surprised. If you expected more than others in the market and bought, it feels good because the stock will go up as expectations change for the better.
The reason the market is always moving is that the expectations are always changing.
Remind yourself what type of business you are buying. Are you buying something new and growing or old and established? It is logical when you’re starting a new business to expect your sales to fluctuate a little more than they will in 12 months or 12 years. You may need to remind yourself of these expectations if the stock price goes the wrong way for a while.
One more thing
Remember what we’ve learned: Stocks Follow Earnings.
There is one more very important thing: Stocks Follow “The Market”.
Most of the time, the overall market will be moving your stock as much as anything else. When the market is up, you will be up. When the market is down, your stock will be down. Even if nothing changes with your company, when the overall stock market moves, so does your stock.
From day to day it can be difficult to notice any difference between your stock and the stock market as a whole. Over time, you begin to see the returns diverge between “stocks” and the “stock market.”
It can be quite frustrating if you did everything right when it comes to selecting the right company. You may have found the best company ever at the best price ever only to find yourself losing money on the wrong side of a market-wide sell-off.
That sell-off may have zero impact on your stock’s earnings or the value people will eventually put on those earnings over the long-term. That doesn’t matter. Risk is risk when the bears have the ball. Your stock is probably going down with everyone else’s that day, week, month or year.
You might as well have your expectations set ahead of time that times like this are not just possible, but probable. It will keep you from freaking out at the wrong time.
If you’re invested, it isn’t much fun when it’s happening, but a clear head and a long-term perspective can turn these events into bigtime money makers. If you can, try to take advantage of down markets because you can buy stocks “on sale.”
Stock Charts
The stock chart is an incredibly useful tool to help give perspective on a stock’s price. Reading left to right, stock charts graph the historical price movement of a stock, giving you quite a bit of information in one picture. Most of us are visual learners on at least some level. Looking at a chart can help us better remember historical performance.
Look at where the stock has been lately. Where was it priced six, 12, 24 or more months ago? Are you buying a $20 stock that was $10 six months ago? Are you buying a stock that just doubled or tripled in value in the last six months? That might influence your expectations for how volatile the next six months might be. If the stock just had a big run, there should be expectations that you could see that price come down without anything changing in the story.
Imagine buying 100 shares at various points on the chart, and ask how much money you would have at that time? What would you do in each of those different scenarios?
If I bought 100 shares of The Stucco Bathtub Company at $10 per share and watched it go to $5 per share, that means my $1,000 just turned into $500. Could I live with that? What if my $10,000 turned to $5,000?
The rate of return was the same in each of those examples, but one hurt quite a bit more than the other.
If the price is lower, see if you can figure out why. If it’s a good company with a business you believe in, you may want to take advantage of the lower price to buy shares. Just make sure the story is still intact if the stock is down.
Discipline
Expectations can have enormous influence over our behavior regarding when we buy and sell stocks. If we expect our stock to drop, how can we be surprised if it happens? If we know we need to focus on long-term performance, we should probably focus on long-term performance.
We want to be in a disciplined frame of mind to prevent making emotional decisions. Unlike charts and PE ratios, emotions are not helpful tools for investors.
Discipline means:
Ground yourself in the story and numbers.
Expect the stock and the market to go down.
Don’t freak out, man. Keep your emotions in check.
In Closing
Remember where we started, the stock picking process includes evaluating the story, numbers, and expectations for the business you are potentially purchasing.
1. What’s the story? What makes you want to own this business?
2. What are the numbers? How much money are they making?
3. What should our expectations be for the company and stock?
While we just scratched the surface of what it takes to be successful investing in stocks, hopefully you can see that many of the concepts are very simple in nature. You don’t need a lot of math IQ to be able to recognize a line out the door of a popular business, and sometimes that’s all it takes to recognize a GREAT stock pick.
Consider these quotes from Warren Buffett, aka The Oracle of Omaha. Buffett is one of the most successful investors in history and has repeatedly tried to tell the world that investing is much simpler than we make it:
“If you have to go through too much investigation, something is wrong.”
“You don’t need to be a rocket scientist to be a shrewd and successful investor.”
“There seems to be some perverse human characteristic that likes to make easy things difficult.”
“You should invest in a business that even a fool can run, because someday a fool will.”