- Trader vs. Investor – The two major market participants are traders, who are focused on short term price speculation,and investors, who are focused on long-term fundamental analysis.
- Investing Strategy – Develop a long-term investment strategy and Understand the concept of price and value.
- Idea Generation – Different techniques used to uncover undervalued stocks.
- Analysis – A structured approach to analyzing a stock.
Where to begin?
I started investing when I was 18. Armed with a $1,000 dollar E-Trade account and the pride of a recently minted high school graduate, I was ready to kick some ass. Although I barely knew anything about investing, I decided to pull the trigger on a company called Kodiak Oil & Gas after people were pumping it up on an online investing forum. My first trade netted me a 600% gain. That’ll get your heart pumping. I thought I was going to be the next Warren Buffet. Unfortunately for me, luck has its limits, and it was only a matter of time before Mr. Market humbled me. My next trade in a penny stock wiped out that 600% return and then some. Looking back, it was a good learning experience. Every investor has a few battle scars – that’s how you learn. More importantly, I was more motivated than ever to learn how to invest so I wouldn’t get wiped out again.
I love the challenge that comes with investing. You’re competing against some of the smartest people on the planet as you’re trying to figure out where the best opportunities are to deploy capital. It’s not easy. If you want to stand a chance then you need to have a solid understanding of what makes a stock, or any other investment, look attractive. That’s why I created this guide to help you become a little stock investing guru. Like most things in life, to be successful you have to put in the work. I can’t promise you’ll be a millionaire in a day, but if you follow this investing guide you’ll be able to achieve solid returns over the course of time.
This investing guide is broken down into easy to follow steps. The first part in this series is a high level conceptual overview of how to approach investing, how to generate investment ideas, and an introduction to the investment framework. Part two will dive deeper into the actual analysis of a stock as I will walk you through a real life example of a stock I purchased. I hope you enjoy.
First we need to start with the basics. To keep it simple, the investing world is divided into traders and investors. Traders are focused on the short-term and typically buy and sell stocks throughout the day. Traders will analyze stock charts, use fancy software to spot trends, and look for short-term market events that could drive a stock higher. As a trader, you are speculating on the future price. Investors are focused on the long-term and use fundamental analysis, which means analyzing financial statements to understand what’s “under the hood” of a company. Investors will hold a stock for years, collecting dividends while also benefiting from any increase in share price.
I focus on long-term fundamental analysis. Investing and building your wealth with a long-term focus will keep you out of trouble. You will also be able to generate much more consistent and stable profits, and rely less on luck. People tend forget that when you buy a stock you are buying a piece of a real business. If you approach investing as if you’re a business owner, you’ll think more logically and improve your results. There will always be an allure to getting rich tomorrow by trading penny stocks, but if it was that easy, we’d all be rich.
There are a ton of investing strategies out there, most of which are just garbage. After reading The Intelligent Investor, I was immediately hooked on an old-school strategy called value investing. This is the same strategy Warren Buffet uses (the author was Buffet’s professor at Columbia University). Value investing is the idea of buying a $1 bill off of somebody for $0.75. Its pretty ingenious. You make money by capitalizing on the arbitrage between the price of an asset and the value of an asset. The whole point of investing is to buy low and sell high, but ironically most people end up doing the exact opposite! I recommend reading this book as its easy to follow and will put you into the right investing mindset.
So why would someone just give you a $1 bill for $0.75? People tend to have a short-term mentality. As such, they overreact to things without regard to the long-term implications. Here’s a real life example. In September of 2016, Wells Fargo announced that is was paying a $185 million fine for creating fake bank accounts. The stock dropped from about $50 to $43, a 14% decline. This is when I started buying Wells Fargo stock (in my Roth IRA, not shown above). First, Wells Fargo generates about $55 billion in sales, making that $185 million fine nothing more than pocket change and some bad press. Second, the company actually has one of the best business models in banking. Banks make money by borrowing money from customer deposits and lending that money out at higher rates, like home loans. The difference between what the bank borrows from the customer and what it lends out in loans, the interest spread, is where most of their revenue comes from. Wells Fargo has one of the lowest costs of funding due to its large branch and ATM network which allows the bank to maintain a top position in most markets it serves in. This helps the bank maintain a wide interest spread which produces consistent and stable profits. Saving you the full story, Wells Fargo is still a solid company and will continue to be well into the future. The stock price has already bounced back to $53 per share, which is a 21% increase from where I bought the stock. As a value investor, I love negative news. It usually means it’s a great time to bargain hunt for good stocks selling at cheap prices.
Value investing also reduces risk. A stock selling for $1 has a lot less room to fall than a stock selling at $100, all else being equal. I define risk as a permanent impairment of your principal (ie. the company is going bankrupt and you’ll never get your money back). This is a lot different from what most financial professionals advocate, which is that volatility equals risk. To me volatility just means a stock price fluctuates, up some days and down others. Volatility is just part of the market and how stocks work, but volatility and risk are two separate concepts.
Everyone has their own style, however, and whatever strategy suits your style the most is what you should rock. As a value investor I follow old and boring companies that produce consistent profits and cash flow. The more boring the better. I take a pass on all those cool tech stocks, because they’re usually way overpriced and most aren’t even profitable companies. From my experience, that’s the easiest way to get burned.
I don’t like losing, especially in regards to money. Notice the snapshot of one of my investment accounts above. Although the stock market is volatile, my returns are pretty consistent. Picks that I have held for more than a year, about 3 years on average, are JLL, BNS, UNP, and EMR – all up over 30%. This doesn’t even include dividends. The remaining stocks you see have been owned for less than a year. DIS has been owned for only 6 months and is up 14%. This is just to give you a general idea of my long-term performance. I may not have any 600% gainers in this portfolio, but more importantly I don’t have any significant losers either.
There are two main types of approaches to generate investment ideas, top-down and bottoms-Up. The top-down approach is when you start with the big picture or a theme and then narrow down companies that fit that particular theme. For example, a hot topic during the 2016 U.S. presidential election was when Donald trump consistently endorsed “Build that Wall”. As Trump continued to collect more votes, the value of the Mexican Peso along with Mexican stock market started to drop. This created an opportunity to buy Mexican stocks that were being oversold due to political rhetoric. In this case, I would then proceed to look at Mexican stocks that have been beaten down and determine if any of them were worthy of investment. The bottoms-up approach is when you start with a specific company and jump right into the analysis to see if it’s a good investment. An example of this would be coming across an interesting stock while reading a financial news website and then moving forward with your research on that specific company.
To be honest, it doesn’t really matter which approach you use. You have to generate ideas whichever way you can. As famous investor Peter Lynch puts it “The person who turns over the most rocks wins”.
The main sources I use to generate ideas are from Seeking Alpha, Morningstar, sell-side research reports (most online brokerages offer them for free), stock screener from FINVIZ, and just reading financial news sites like Bloomberg. I also want to point out a website called ValueWalk. This site will post quarterly investor letters from the top hedge funds which contain a treasure trove of information. These letters will give you solid insight into the market and where some of these guys are seeing opportunities.
There are thousands of stocks out there, which means you need to have an efficient method of filtering through the hundreds of bad ideas before finding a good stock worth analyzing. Its kind of like finding a gold nugget, you have to sift through all the dirt before finding that little spec of gold that can make you rich. Equity research reports and stock screeners are the best way to achieve this. Research reports condense information about a company into a nice short read to help make decisions quickly. However, you should take all research reports with a grain of salt and still do your own analysis and due diligence. Stock screeners are another efficient way to filter through stocks. You basically set parameters of what your looking for (ie. stocks trading below a P/E of 15) and then scroll through the filtered list and see if any stocks catch your eye. Screeners have their downsides too as some stocks might not screen well, but this is still a useful tool to use. The whole point of generating investment ideas is efficiency. As you’re going through a list of stocks, the second you find something wrong or unappealing about a particular stock just dump it and move-on, don’t waste your time.
When it comes to investing its important to create a structured process to consistently analyze stocks to make sure you’re covering your basis. It also helps out with efficiency so you don’t waste time.
Below is a general framework that I use to analyze stocks.
Once you find an investment idea, its important to understand the components that make a stock a good investment versus a bad one. Utilizing the framework above, lets dive into the main sections of the analysis.
Investment Thesis – You need to understand why you are interested in making an investment. As simple and logical as it may seem, most people can’t even tell you why they own a particular stock. If you don’t know why you bought, you sure as hell won’t know when to sell. Your thesis should clearly define the opportunity and why you think this is a good investment. Using our previous example of Wells Fargo, the stock of a high quality and stable enterprise fell 14% due to a short-term scandal which has no material impact on the business. Therefore, a disconnect between the price of the stock and the fundamental value of the enterprise provided an investment opportunity.
Economic Moat – A term coined by Warren Buffet that refers to a company’s competitive advantage. Back in the day castles used moats to keep enemies away. The wider the moat the better. Businesses aren’t much different in that competitive advantages keep their rivals in check and help to ensure stable profits. When analyzing a stock I want to invest in solid businesses that have strong moats. It makes my life easier as I sit back and watch the company generate excess returns and smile as my investment continues to grow.
Potential Risks – There will always be risks involved with investing in any company. The trick is to separate the real risk from the perceived risk. A recent example of this is physical retail and the rise of Amazon. Amazon will certainly lead to the downfall of some companies that can’t adapt (ie. Macy’s, Sears, etc.). However, the fear that all retailers are dying is an overreaction. One example is Home Depot, which operates in such a way that protects itself from online competition. Buying a bunch of 2×4’s online just doesn’t logistically make sense, at this point anyway. So understanding the fear that is priced into the stock versus what is structurally wrong with the company is important. By properly knowing the risks, you will also have a better idea of when to sell the stock as well.
Valuation – My favorite subject. At the end of the day it all comes down what a company is worth. As good ol’ Buffet says, “Price is what you pay, value is what you get”. Believe it or not even if a company is total pile of junk, depending on the price it could be a great investment. I typically invest in higher quality companies that may never sell at dirt cheap levels, but cheap enough. Valuation is part art and part science and everyone looking at the same numbers can come up with completely different valuations. There are also multiple types of valuation techniques that can be used, some being more quantitative than others. Whichever way you decide to value a stock, you just need to make sure the methods and inputs you are using are logically sound.
Alright, I’ll stop here and let you soak in steps 1, 2, 3 and 4. Pretty basic stuff so far. We’ll pick it up again in Part two of this series which will dive into actually analyzing a specific stock from square one. That’s where the real fun begins.