The stock market is not a casino, though many people treat it that way. Warren Buffett, the retired CEO of Berkshire Hathaway, recently referred to the stock market as “a church with a casino attached,” and he has said that “It’s tough to find values when everybody is preferring gambling.”
For best results growing your wealth via investments in the stock market, you need to see shares of stock for what they really are: actual ownership stakes (albeit small ones) in actual businesses. When a public company grows, its shareholders will see their stakes grow in value, too — quickly or eventually.
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If you’re buying and selling rapidly without really having a good understanding of the stocks you’re trading, you’re gambling. So it’s best to research any portfolio candidates carefully. Here are some things I look for in a stock I buy.
1. Is the business understandable?
I’ve learned a lot about investing from Buffett, including this from his 1996 letter to shareholders:
You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.
Thus, I try to stick with companies I can understand. If I don’t feel savvy enough about the banking industry, for example, I try to steer clear.
A good litmus test is whether I can explain exactly how a company makes its money. It helps to read up on a company’s industry and to read a bunch of its annual reports, too — and even those of some of its competitors.
2. Growth in revenue and earnings
I want the companies I’m investing in to be growing — in terms of revenue and earnings, at a minimum. A good way to assess this is to check out their latest income statements (sometimes called the statements of operations), where you’ll see revenue near the top and net income farther down. You’ll also likely see numbers from the previous quarter or the previous year, or both.
Some financial information websites — such as Fool.com — will have calculated growth rates for you.
3. Robust profit margins
If you work on becoming a better investor over time, you’ll want to learn to crunch some important numbers, or you can look them up. Profit margins are a great example, with many investors assessing at least a company’s net profit margin, which shows how much revenue remains as bottom-line profit after all expenses are subtracted.
To get that figure on your own, simply divide net income by total revenue. You’ll also find it calculated for you on many financial websites.
4. Competitive advantages
Companies with sustainable competitive advantages are often terrific investments because they give them an edge. Here are some kinds of competitive advantages:
- A strong brand: If the company’s brand is well known and respected, that can draw more customers willing to pay for it and can often give the company pricing power.
- Switching costs: A company has this if it’s a hassle for customers to switch to a competitor.
- Economies of scale: Very large companies can often produce goods more inexpensively.
- A network effect: This edge occurs when a company grows more valuable as more people use it. With an online marketplace, for example, more sellers will draw more buyers, and vice versa.
- Barriers to entry: Some businesses attract few or no new competitors because it’s so costly to enter the industry. Examples include railroads and manufacturers of aircraft or semiconductors.
5. Manageable debt
A look at a company’s balance sheet will show you how much short-term and long-term debt it has, along with how much cash (and cash equivalents) it has. In general, the less debt, the better. But if there are far more assets than liabilities, some debt can be just fine. A look into notes in the company’s annual report can reveal details about its debt, such as the interest rates and terms to maturity.
You might also read up on debt-to-equity ratios to help you assess debt levels.
6. Dividend payments
Not every investor is looking for dividend income, but in my opinion, most investors would do well to do so. It’s typically more-established companies that pay dividends, and those dividends tend to be increased over time. That income isn’t handy only for retirees, either; young investors can collect it, too — and use it to buy more shares of stock.
As I’m getting older, I find myself much more interested in adding dividend income to my portfolio, so that it can one day help support me in retirement.
7. Attractive valuation
Lastly, it’s not enough to have identified an amazing company, with little debt, fat profit margins, and rapidly growing revenue and income. If you want to make money on it, you should also aim to buy it only when it seems undervalued — or perhaps when it seems fairly valued. Buying undervalued stocks gives you a margin of safety, whereas overvalued stocks can be more likely to pull back, perhaps strongly.
As Warren Buffett said in his 1989 Berkshire Hathaway shareholder letter, “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
These are the kinds of things I look for when seeking the most promising investments.
