Analyzing Stocks: How Do We Do It?
Updated: Jun 9, 2020
Howard Marks said that successful investing is defined by three key characteristics: skill, hidden information, and luck. Given the fact that we – as young profit-seekers from home – seldom have access to hidden information, we’re down to skill and luck as our last two components.
If you rely on the latter, you might as well pursue gambling, the lottery, or any one of 146 other things to choose from because investments do not work based on strategies of luck.
The truth is that we need skill…but how do we gain it?
Within investing, it starts by learning the most basic and fundamental methods of identifying good companies: i.e. beginner investors need to have a somewhat definite criterion through which analysis can be undertaken. While this may seem like a tedious venture, here are some optimal places to start:
1. Judge The Market
Before you get into the intricacies of a company, consider the performance of the market as a whole. How much has it grown? Are there new companies? Can it potentially grow more? For prospective long-term investors, this is an essential part because companies can have poor fundamentals in the short run, but become good long-term investments simply due to the growth of the market in the future.
The most familiar example of this is perhaps that of Tesla Inc.: while Elon Musk’s prized possession faces extremely difficult market sentiment in the short term, the electric car market is set to grow tenfold within the next 8-10 years. This means that his company will likely begin to see higher sales and profitability in the near future, which is why Tesla investors are still holding on to their stakes despite the incessant volatility experienced with this company’s stock.
Figure 1: Electric Car Market Growth Projections
Source: (DIIS and Seeking Alpha, 2019)
In accordance with the diagram above, this proves why analyzing the market could produce profitable investments even when companies individually may not seem that attractive.
Additionally, the importance of analyzing the market is perhaps most effectively explained through the analogy of the "Shark in a Fishtank": whereby the growth of the creature is limited as a result of its surroundings. The constraint of the figurative "tank" suggests that the shark will be unable to outgrow the boundaries, which is exactly what occurs with companies that operate in a stagnant market. If the external surroundings - i.e. the markets - don't expand, how will the individual businesses sustainably grow?
Hence, strongly consider the potential of the market when analyzing the favourability of a stock: the brighter the future of a company, the greater the return on your money.
2. Cash is King
The importance of a company’s financials can be summarized into the aforementioned two words: without concrete finances, it is almost impossible to sustainably survive. Below, consider several key aspects that can begin your analysis of the three financial statements:
Figure 2: Basic Indicators from the Income Statement, Balance Sheet and Cash Flow Statement
A) Income Statement
- The Income Statement traditionally acts as the "Report Card" of the business: i.e. how did the business perform on an operating basis? Were they able to successfully execute what they are in business to do? Considering the key components such as Gross Profit, Expenses and Net Profit will allow you to build a thesis around these critical questions.
B) Balance Sheet
- The Balance Sheet, according to Rueben Advani, acts as a "Doctor's Report" for the business: it concludes whether the company is in good financial health or not. Considering what the company owes versus what it owns here will allow potential investors to comprehend whether a given enterprise has the resources to survive in the future: a clear criterion that needs to be addressed for long-term investments.
C) Cash Flow Statement
- Lastly, the CF Statement acts like a company's "Checkbook": it determines how much cash was generated in the last period, and ultimately, how much cash the company currently has. As the saying goes: "Cash is King", and therefore the final amount on this document needs to show that the business holds enough cash to sustain its level of operations (i.e. it should be somewhat close to the value of profit).
Considering the aforementioned parts of each statement will allow you to build a basic judgment around the favourability of a certain stock, as you will be able to dissect the data given and extract the key parts needed in order to build an opinion.
3. Leadership and Management Team
While all investors hold contrasting opinions on which aspects are most important before picking a stock, this particular criteria holds true for almost all successful investors. A company could attain attractive products and hold substantial cash reserves, but if the leadership team behind the curtains is inadequate, the future of said company is likely to be bleak.
Innovation. Processes. Technology.
These are the core competencies that grow businesses, and they are utilized optimally in the hands of vastly competent management teams. This is why researching the people behind a product will benefit investors when picking stocks, for without impeccable execution, an idea or business model is essentially futile. Things to potentially consider are:
- Number of Years at the company;
- Number of positions held previous to the current one (working “up the ranks” generally facilitates a more prominent sense of understanding the core mission and ambition of a company: for example, Robert Iger of Walt Disney and Satya Nadella of Microsoft)
Key point: It is also particularly effective to research whether the CEO and key senior executives hold stock in the company they represent. If they own a significant amount of shares, this gives them a financial motive to ensure that the company progresses and grows as much as it can. This is known as the Principal-Agent rule in Economics, whereby there is a clear incentive to ameliorate revenues, introduce new products, enter new markets and facilitate sustainable growth, all of which contribute towards pushing stock value higher and therefore improve the pay package of CEO's.
Before investing in a stock, research the industry and ensure that it’s one with potential for growth. Keep the “Shark Tank” analogy in mind and use it as a criterion before putting your money to work!
Briefly analyze the financial statements of a company: from its cash balances to its debt to the overall profitability of the business. There are several more aspects to consider, but these are some foundational starting points that most billionaires attest to as extremely effective at the beginning of one's investing journey.
Consider the effectiveness and monetary incentives of the management team: a product or business idea is technically worthless unless the right people are behind it. Therefore, considering the leadership team's personal stake in a company may aid in deducing future potential: both in terms of profitability and stock price!