Guide to Buying the Right Stocks (for Humans)
While investment analysis has been increasingly turned over to machines (scary thought) finding and buying stocks to beat the market (S&P 500) can still be done with a basic human brain. I wrote a simplified version here in 2018 that includes some resources to help you learn.
The following is our step-by-step guide to finding good stocks on your own. This guide goes beyond just reading the news and hearing about what the media wants you to know. There are still tens of thousands of stocks that never make the news until they’ve already gained significant traction.
The reason you still want to invest in the stock market is simple: stocks have historically offered the best way to generate wealth both actively and passively with the least amount of long-term volatility thanks to inflation.
There are two ways to screen for stocks. You can either read through the business and financial news publications or SEC filings until a company comes across the radar that piques your interest, or you can go out and find them. To proactively screen you can use Finviz, Morningstar, Valueline, or Gurufocus.
For historical information, reading the annual reports is a great source to understand a business, plus Morningstar and Gurufocus (and now Stockrow) offer long historical financial results for quick data analysis.
Positive growth 5 years (or longer)
The average returns generated by owning the S&P 500 over the last 50 years were roughly 10% annually including dividends. To do better than that, you have to look for better than average companies where the stock is trading at undervalued prices. Value is an estimate based on many factors, but the following is a core framework of 12 tenets to help guide you. As with anything, the more you do this, the better you get.
Core Traits to Look for…
- Consistent Growth in Sales
- Consistent Growth in Earnings
- Consistent Growth in Book Value
- Debt to Income Ratio under 5
- Return on Equity Average over 12%
- Operating Costs to Income under 75%
- CapEx to Income under 75%
- Gross Profit Margins over 25%
- Price to Earnings Ratio under 12
- $1 for $1 retained to market growth
- Meet 15% baseline growth estimate
- Never buy at 52 week high prices
Determining value comes down to a general estimate of the future aspects of the business. Once again, this is why consistency is vital. The stronger and more reliable a company’s past, the more easily predictable is its future. With that in mind, the high yield system uses a combination of traits to specifically determine value. Every single company is valued by a multiple of its cash, earnings, and equity values. After using the core tenets to narrow down your selection into a short list, ask these questions to complete your analysis.
What is the estimated future EPS?
One way to determine the number, calculate the historic growth rate and price multiple, then after discounting the growth rate, extrapolate a future EPS figure. Finally, multiple that EPS number by the historic price to earnings ratio to get an estimate. Two follow up questions are: Will the company be around in 10 years selling the same products or services? Will the need for those products and services still be relevant?
Can the company produce at least 15% year?
Coca-Cola (KO)… priced at $38.87 as of January 28, 2014, would need to reach $155 in the next decade to produce 15% a year for the owner. The current price is $44 and analysis has estimated that the range will be between $71 and $111, so in order to meet that the stock would need to be bought around $28.00.
Is it a High Yield Stock?
The future is what matters, not the past. Yet in most cases, a company cannot grow earnings faster in its future than it did in its past. This is the reason I look for low price to earnings (P/E) multiples. The reason to look for P/E ratios under 10 is that the S&P 500 index normally trades with a price multiple around 15. Logically, finding companies that momentarily trade for less than the market, or their own historical average, is a good sign of a mis-priced investment. P/E Ratios alone do not determine value, but they are always a good starting point.
Has the company added value to shareholders?
While there is no magic bullet for success, it is worth noting that every year since 1977; Warren Buffett has mentioned the upward growth of the shareholder equity (book value) of his conglomerate — Berkshire Hathaway. If every dollar in retained earnings can generate at least the same in market value, then the company has added value to shareholders.
A good rule of thumb is that if you’re not outperforming the S&P 500 Index over a 10 year period, you should place the majority of your assets in an Index Fund, and if you want, speculate on trades with less of your assets.
Portfolio management is all about the risk you are comfortable taking on. If you can psychologically handle volatility, then a base of 5 stocks bought over time using the core framework should be adequate. However, if you’re super risk adverse, a base of 30 stocks should be sufficient. Or, if you plan on investing incrementally as you have money, then just buying stocks as they come and holding them forever or until you have 50 positions isn’t a bad idea either.
That said, while there are definitely companies that turn into Apple, Amazon, Google, or Berkshire Hathaway, there are thousands of others that have shorter term gains based solely on an adjustment in price to value.
For example, let’s say XYZ Inc. meets all the core tenets and has a historical earnings multiple of 15x, but for whatever reason, the market (aka traders, investors, etc.) has pushed that down to 10x. If the price is $30 and the company has $3/share in earnings, what happens if in 3 years, it grows to $4.00 with a normal 15x multiple? You get a 100% price gain.
- Divide investment capital into equal dollar amounts
- Build a stock portfolio (on cash) as you find bargains
- Leverage stock portfolio to trade options and arbitrage (optional)
- Hold winning stocks for at least a year
- Selling losers before year end
Stress Relief Guidelines
- Never Invest On Borrowed Money
- Never Short-Sell Stocks
- Avoid BUYING Options
- Always Think Long Term
Leveraging your cash positions to trade for short-term gains is something that great money managers have always done.
Writing Covered Calls
When you write (i.e. sell) a Covered Call Option, you give the right to someone else to take the stock away from you. This is beneficial when you already own a stock and want to make money while waiting for the price to reach a specific level. For example, if you own XYZ at $10 and write a call at $12, you collect a premium from the contract. If the stock is called away at $12, you keep the premium and the $2 profit. If the stock doesn’t reach $12, you still keep the premium. Writing covered calls is a great way to exit positions when the stock price is relatively stable.
Writing Naked Puts
When you write (e.g. sell) a Put Option you provide the right for someone else to give you the stock. This is beneficial if you want to own a specific company’s shares at a specific price, but the stock is not yet trading at that price. For example, if XYZ is trading at $10 and you want to own it at $7.50, you can write a put at $7.50 and collect a premium from the buyer who may be trying to protect his/her position in the stock. Naked put writing is a great way to buy into positions during volatile markets. Writing puts is a great way to get paid to wait for the right price in stocks you want to own.
Arbitrage arises from corporate activity. During a typical year, there are hundreds of corporate mergers taking place. It’s the nature of the business. In these trades, there is a specific price that is agreed upon by the parties before the buyer conducts due diligence. This price is rarely reached before the deal actually closes, leaving a percentage of profit to the investor. The risk with arbitrage is associated with the deal not closing. So, always keep up to date on events that surround the deals you trade. The rate of return will be different for each situation. For instance, if XYZ Corp. is paying a 25% premium for ABC Inc., and if the two companies are merging in 4 months, you will receive an annualized return of roughly 90% as long as you can put the money back to work in similar deals.
- Only trade stocks in companies that have already announced a merger deal. Never speculate as to the possibility of a merger.
- Stick to all cash deals in stocks with trading volumes above 50,000 if possible.
- Only buy when the rate of return is over 15% annualized.
Dollar Cost Averaging
If you’re buying companies that you think are going to be much more valuable long term, you will experience short term pain. Anytime you find that a company can produce above average investment performance based on thorough analysis, you should consider owning it, regardless of whether you already own it at a different price. I can’t tell you how many fucking times I’ve been in a stock at $1.00X and it dropped to $0.60X only to get back to $3.00X. If it’s down and you believe in its long term prospects, buy more at the lower price using the same amount of capital you initially bought in with.