What to Look For (and Avoid) in a Stock

What I’m Drinking as I Write: Lazy Eye Coffee

  • 2 shots of espresso
  • 1 cup decaf coffee
  1. Brew, combine, and enjoy

In a previous post I explained what a stock is, and now it’s time to go over a few factors that could be considered or reviewed when purchasing shares in a company. I will also share a few sites with you that I often use to view this information (but I encourage you to go beyond these). First, it’s important to note that there are literally hundreds of factors that could be taken into consideration when researching a company, so I will only be explaining a few basic ones. I would also like to note the importance of these factors will differ for stocks of different industries, but the main concept here remains the same – know the company you are investing in. 

What do they do?

I think the first, most obvious, and most important question that should be answered when researching a company is its business. What products or services does this company offer to its customers? How many products or services does this company offer? This is important to look into because some companies (like a drug company) may sell only one drug to all its customers. And what would happen if another company made an even cheaper, more effective version of that drug instead? Drug Company XYZ could lose most or all of its sales and go bankrupt.

Seek: A company that has a few/several products or services.

Avoid: A company that sells only/receives most sales from one product or service.

Where do they do it?

The countries in which a company does business is just as important as the business it does. Some companies only have exposure to customers or suppliers in the United States, while other companies have higher international exposure. While international markets typically grow faster over the long-term (for example, some countries are less technologically-advanced than the U.S., leaving room for growth), they also bring additional risks to the company. Some of these risks include regulatory, political, or currency risks. 

Seek: A company that has exposure to either only the U.S., or both the U.S. and international markets.

Avoid: A company that has a large amount of exposure to one country.

With whom do they do it?

How many suppliers does your company receive its materials from to manufacture its products? Does Bread Company ABC only get its wheat flour from one supplier? If so, what happens if that supplier suddenly goes out of business or chooses to do business solely with another bread maker? In a similar manner, to how many customers does your company sell its bread? Keep in mind if a customer or supplier makes up a large amount of revenue, it could be detrimental to the future business of that company if that relationship were to end. 

Seek: A company with many suppliers and customers.

Avoid: A company with very few suppliers and customers, or suppliers/customers that contribute a large amount of products/sales.

What other companies do it?

Another part of researching a company is not only learning about the company itself, but also about its competitors. How many other companies sell similar products or services? The larger the amount of competition, the less pricing power (ability to sell its products or services at the price it wants, rather than matching the prices of competitors to maintain business) each individual company may have. 

Seek: A company with very few competitors (or many, except the company is the best at what it does and is #1 in the industry).

Avoid: A company with many competitors. 

How well do they do it?

Does the company generate profits? How well is the company expected to grow its revenue (sales, top-line growth) and earnings (net profit, bottom-line growth) over the next year or so? Are its growth estimates increasing or decreasing over time? 

Seek: A company that has positive (and hopefully growing) revenue and earnings growth estimates.

Avoid: A company that has negative (or possibly declining) revenue and earnings growth estimates.

Does the company repurchase shares/pay a dividend?

  • Repurchase shares: Sometimes a company will have a share repurchase program with a share/dollar amount that the company has allocated to repurchase its own shares of stock. This is one way a company can return cash to its shareholders, because when the company repurchases its own shares, it reduces the amount of shares outstanding, therefore increasing each investor’s stake in the company. 
  • Dividends: This is another way to return cash to shareholders. Some companies will issue dividends (usually quarterly), which means each quarter the investor will receive a payment for each share of stock they own.

Seek: A company that returns value to its shareholders.

Avoid: A company that is expecting to halt or significantly cut its dividend yield/share repurchase program (look into this further).

What does the company’s balance sheet and income statement look like?

  • Balance sheet: This shows assets (what the company owns, i.e., inventory, equipment, etc.), liabilities (what the company owes, i.e., debt), and equity (the difference between the two). This is a good place to learn more about how much debt the company is holding, when it is due, and if the company has enough cash to adequately cover it.
  • Income statement: This shows profits (losses) for the company: revenue/sales, costs of goods sold, gross profit, expenses, and net income.

Seek: Companies that have a manageable amount of debt and sufficient cash flow. Companies with positive/increasing sales, gross profit, and net income.

Avoid: Companies that have a large amount of liabilities vs. equity, or large amounts of debt due soon with very little cash.

**Investor Estimates, Expectations, and Perceptions**

I think the most unconventional, yet most important factor to consider are analyst and investor expectations for the stock. Do analysts have high expectations and price targets for a stock? If so, do you agree and do you think someone else may be willing to pay more for this stock in the future? What would make this stock more valuable than it is to you today, and does this company possess those qualities?

Or, did the company just release a negative news report and analysts are selling out or lowering their price targets? If so, do you agree and do you think this bad-news selloff is a buying opportunity? If you have done your research and after the bad news still believe the company can manage and has additional growth opportunities going forward, why not buy when others are selling? Don’t be afraid to do the opposite of what other investors or analysts are doing if you believe in something. And don’t be afraid to purchase a stock you still continue to love after it’s been up 100% over the past year. Nobody knows what a stock will do over the next month, year, or decade. Every analyst in the world can guess, but unless they can read every investor’s mind also, there is a slim chance they’re getting all their calls right.


Lesson:

My first year at college I job-shadowed an equity research analyst (someone who spends most of their job researching stocks). She told me every morning she would spend a few hours reading a 10-K, and that was the best thing for me to practice in order to fully research a company. A 10-K is a report that a company releases annually, and it explains (in-depth) everything there is to know about the company, its business, and the numbers to back it up. I will walk you through how to read a 10-K later, but this single report provides you with a huge influx of information on a company. You will be able to answer most of the questions above (and more) from this one report alone. One winter break, I went to a cafe at 8:00 AM and found two similar companies that I was interested in. I went through each of their 10-Ks separately, then together. I wrote down as much as I could, comparing and contrasting the two. I wrote a summary of my findings and chose which company I liked better of the two. I didn’t leave the cafe until 9:00 PM that night – I had spent 13 hours reading through 200+ pages of information. 

Do this once, and never do it again.

Reading a 10-K is an absolutely great way to walk through a company step-by-step. You will learn about its business, competitors, supply chain, anything you can think of. However, there is also a lot of information in a 10-K that may not necessarily be meaningful to you or the research you are trying to complete. You can find most of what you need to know about a company in a much simpler, quicker, and more efficient way – the internet! In terms of readily available information, over the last 10+ years the internet has massively changed the way investors gain real-time access to research. It’s no longer necessary to spend hours reading a document when you could do a quick search via Google and find an answer within minutes. Yes, I will still pull up a 10-K when researching a company and do a ‘quick find’ with Ctrl+F if I’m looking for something specific. Continue to use this as one of your tools, but don’t let it consume your time (it is limited, by the way).

The home of the legendary 10-K:

https://www.sec.gov/edgar/searchedgar/companysearch.html

Websites that will provide you with the same information in a fraction of the time:

https://seekingalpha.com/symbol/

https://www.zacks.com/stock/quote/

Happy Sipping,


 𝘌  

4 thoughts on “What to Look For (and Avoid) in a Stock

  1. I’ve been reading a lot of finance blogs over the past few days. I can confidently say that this is one of the best articles I have read so far. It’s obvious that you know what you are talking about. It’s pretty cool that you shadowed an equity research analyst and are studying for CFA. Good luck with your blog and everything else. I’ll be keeping up with your posts.

    Liked by 1 person

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