2-Step Framework for Picking the Best Stocks
Updated: Jun 23
There's an infinite number of ways to choose your next investment.
A personal favourite? It's a two-step process that allows us to look at stocks from different - but important - lenses.
It's because of this framework that we were able to pick companies like PayPal, Shopify, Amazon, Wix.com, Mastercard and others last year:
All of which have gone up 100%-400% in the past 16 months.
Let's get straight into it.
The Macro Level
Looking at the "Macro" level essentially means starting off broad:
In other words, we're not going to look at specific companies or stocks, but rather specific industries or markets that have huge potential for growth.
We do this because of our "Balloon in a Box" analogy:
Consider a balloon that's placed in the centre of a closed cardboard box. If the balloon is growing in size and the box around it does too, we've got an ideal situation: i.e. no concern about the balloon being in danger.
However, if the balloon consistently broadens but the box around it remains the same, we'll come to a point whereby the balloon is stuck: unable to grow further because it's tightly constrained by the cardboard surrounding.
This is why we would ideally want a situation whereby the balloon (a stock) and the box (the industry or market) are growing together. If an industry is growing well, it's likely that the players inside it will do too.
Here's how you can find areas that are likely to grow.
In which countries are stocks not performing well at the moment?
Which industries look like they'd have a solid future 5-10 years from now?
Doing so will allow you to look forward and find markets where there is future potential for growth, as opposed to investing in the things that are solely hot now.
P.S. Note that just because we're targeting markets/companies with potential 5 years from now, this doesn't mean that we need to wait 5 years to reap the rewards. Stocks are valued based on discounting future cash flows: basically a fancy way of saying that the benefits coming in 5 years will be reflected in the price now, not actually at that time.
Think about Tesla: its record prices this year is a reflection of the potential to come 5-10 years from now, not because the company's actually worth that price today.
The Micro Level
After we've settled on a market to look at, now we can zoom in and see which companies are ripe for investment.
As mentioned before, if the industry you've picked has good future potential, you could pick almost any stock and you'd be likely to benefit in the long-term: because as the box grows, the balloons inside have space to grow with it.
We just need to make sure that the companies can survive the ride and not "pop" as they grow bigger. Here's the checklist I use to find the right stocks.
In the companies financials:
Do they have enough cash to survive the next few years?
Are their debt levels low?
Is their balance sheet strong? I.e. does it look more like the first one as opposed to the second one?
Figure 1: Good balance sheet (assets exceed liabilities)
Figure 2: Bad balance sheet (liabilities exceed assets)
There's obviously a myriad of other things to analyze but I find that considering these 3 questions is a solid start, because they target the exact things that a company needs to survive in the worst-case scenario.
Let's examine how this strategy has worked in the past:
Macro Level: Looking forward and considering future potential made me think of Fintech as a viable industry to target.
Micro Level: With Fintech locked in, I tried to look for companies that could satisfy my 3 questions above: allowing me to buy into PayPal at $108 per share (now $270) and Mastercard at $210 (now $362), since both have strong balance sheets and manageable debt levels.
Macro Level: Biotech clearly has a positive future because of its necessity as medicine as well as its innovation side. In other words, two characteristics that bring great potential.
Micro Level: This industry is filled with companies that have soaring debt and cash-burning operations. We need to instead find companies that have enough cash to survive the next few years and low debt levels: through which I came to find Zynerba Pharmaceuticals and Vertex Pharmaceuticals.
Zynerba: up 100% since first trade.
Vertex: 52% undervalued according to Simply Wall Street analysis (i.e. potential to double in the near future).
Macro Level: Looking forward again, it was clear that e-commerce is a growing theme and that it's likely to continue flourishing in the next few years.
Micro Level: Briefly researching e-commerce, I saw that Shopify was a frontrunner in the space, which is why we recommended buying it in November 2019, when the price was $297 per share.
The price now? $1300.
Almost a 5X return.
In other words, the 2-step process we've laid out here has clearly (and repeatedly) materialized into decent profits. My latest application of this mindset is noted below:
Macro Level: Looking broadly, the US and European stock markets have done incredibly well this year. The country lagging behind? China.
Micro Level: We've seen that China has opportunity from a broader perspective, so let's zoom into some companies that have great cash levels, strong balance sheets, and low debt.
Top picks → Alibaba, Baidu, Vipshop, MoMo and more.
Will these perform as well as the previous examples have?
We'll find out soon enough. In the meantime, try out the two-step thinking for yourself and see if you're able to come up with some interesting stock picks.
Have a great day ahead - I'll see you in the next article 2 weeks from now 👋
Interested in starting to invest? Choose from over 5000+ stocks, commodities, index funds, ETFs and crypto-assets on eToro today! 👇
*67% of retail investor accounts lose money when trading CFDs with this provider. You should consider whether you can afford to take the high risk of losing your money.