Getting started in picking stocks that are worth buying can be confusing. My sister Kai called me yesterday and said, “Hey, Alvin, I’ve been reading a lot about investing, can you teach me how to buy stocks?” So this blog is for my sister, and for all of you out there who want to learn more about how to smartly buy individual stocks. Let’s dive right into it. I am going to share five steps on how to select which stocks are worth buying.
Step One: Look at industry trends.
You want to buy companies that have favorable trends in the industry it’s operating in, and not the opposite. So for example, you don’t really want to buy DVD rental companies because nobody prints DVDs anymore, right? Some trends are not as straightforward to figure out. For example, a popular one these days are airline stocks. They have gone down significantly since last year, by like 60% or somewhere in there. You might be thinking, oh, maybe it’s a great time to buy airline stocks. But the thing is, we don’t really know whether there’s going to be a permanent change in behavior. For example, people have started traveling more now that there is a COVID vaccine, but for companies, maybe they’re going to say that we can conduct business by doing conference calls and don’t need to pay all these expenses to travel. So that’s probably why Berkshire Hathaway, which is Warren Buffett’s company, sold all their stake in the four big airline companies in the United States back in April. It’s worth a couple of billion dollars. So, if you want to buy a company or a stock, ideally, it’s operating in a favorable industry trend.
One of my favorite trends right now is in artificial intelligence (AI). When I say artificial intelligence, I’m not talking about robots that are going to be cooking for us. That might happen, but it’s probably years from now. I’m talking about AI algorithms that companies are using now. For example, banks are using AI algorithms to determine whether to make a loan to the person applying. They’re using AI to detect fraud early on. In China, they’re using AI in traffic lights, and that’s shown to increase traffic flow by around 10 to 15%. An AI algorithm was developed by Stanford scientists where this algorithm can read chest x-rays as accurately as human radiologists can. And it does so with less time than it takes me to finish this sentence. So if you want to learn more about AI, I strongly recommend reading a book by Kai Fu Lee and Barnard Marr.
Step Two: Look for companies that have a competitive advantage.
Does the company you are looking at have a strong brand? Do they have a loyal following? If they don’t have a strong brand, maybe they’re the lowest-cost producer in the industry. Once a customer has bought their product, is it hard to switch? So for example, a low switching costs example would be buying face masks. So I actually recently bought face masks from my friend. Looks really pretty. But if my other friend told me next month that “Hey, I have this great face mask that has a really cool design,” I might decide to buy from her instead. That’s a low switching cost, right? An extreme example of a high switching cost is maybe you adopted a dog you named Rover. And you see a cuter dog over the week when you were walking in a dog park. You can’t just go return Rover right? You’re gonna stick with your dog. That’s an extreme example, but it’s an example of a high switching cost.
Step Three: Look at financial metrics.
Looking at metrics will give us a clue on how good a company is at making money. Buying stocks is essentially buying into a business. So when someone offers you a great business idea, you might wonder if this company will make money. You don’t want to invest in a business that’s going to lose money, right? One metric that I pay close attention to is called free cash flow. Free cash flow is the cash that’s leftover after a company pays for all its operating expenses and capital expenditures. So going back to our face masks example. Let’s say you’ve created a face mask that has this really cool design. It has skyrocketed on Etsy, and you’re making $50,000 in revenue. Let’s say you have $30,000 in expenses, maybe you pay a couple of people to create these masks and you pay rent and other materials expenses, and so after all of that, you have $20,000 in profit. That’s not all free cash flow because, for example, maybe you need to spend $10,000 to buy more sewing machines, so you can expand your business. The remaining $10,000 after all of this is your free cash flow. You want to invest in a company that has consistent free cash flow over the years.
The other metric that I pay close attention to is the return on investment capital. Return on investment capital (ROIC) gives us a sense of how well a company is using its money to generate future returns. You want to buy into a company that is a good steward of its money, right? There was a study by JP Morgan that estimated that the ROIC of S&P 500 firms (500 large companies in the United States across many different sectors) hover around 9 to 13%. So anything within that range or above that is a pretty good number.
Step Four: Look at the selling price of the stock.
When looking at a particular company to invest in, you may want to ask yourself if it’s selling at a good price. For example, if you’re out there going shopping for clothes, you’re typically looking at a 10% sale, 20%, 30%, right? You don’t pay $700 for a bag of clothes that are worth only $500. It’s the same concept with stocks. You don’t want to overpay, and ideally, you want to buy a company at a discount, or a fair price. The simplest metric when analyzing whether a stock is selling at the right price or not is called price to earnings ratio (P/E Ratio). Let’s say you own a sausage food truck. Maybe you had this great recipe that was developed by your Italian grandmother and you’ve turned it into a food truck business. You’re raking in the money, you make $10,000 a year and your food truck costs $100,000. If you’re making $10,000 using $100,000 in capital, you’re essentially making 10% on your money. So that’s a decent return, right? Especially if you compare it with a bank that’s giving you 1% or less. To calculate the P/E ratio, you would divide your 100,000 capital by your 10,000 earnings and get 10. Your P/E ratio is 10, which is a good number.
Now, I want to share two caveats on P/E ratios. The first one is not all cheap stocks are worth buying. Some call it a value trap where it looks like it’s giving you good value, but it’s actually a trap. Maybe it’s a declining industry or maybe there’s some kind of accounting scandal that the company is involved in. So that’s something to keep in mind. Another limitation of P/E ratios is it’s kind of a poor metric to analyze growth stocks. Growth stocks are companies that are growing at a really fast pace, 20-40% a year. So think of Zoom, for example. At the end of 2019, Zoom had 10 million subscribers. As we all know now, they have more than 300 million subscribers. So that’s an example of a growth stock. P/E ratios of growth stocks typically are like 30 or 40. In the Zoom example, it’s 400 or more. It’s hard to determine whether or not they’re expensive because it looks like they all are.
I typically look at something similar and it’s called PEG. Essentially, it’s the P/E ratio divided by the growth rate. So if you have a company that has a P/E ratio of 20, and it’s growing at a pace of 20%, 20 divided by 20, it’s one. So a PEG ratio of one or less is a good number to have. I know what you’re thinking, you’re like Alvin, I don’t have time to compute all of these P/E ratios and free cash flow. To be honest, I don’t either. So what I do is I subscribe to Morningstar premium, and they compute all of these ratios for us. All you have to do is type in the ticker symbol or the name. It will have all the numbers on free cash flow and ROIC. They’ll even tell you whether the company has a competitive advantage or not. Morningstar will even tell you if the company is selling at a premium or discount. It has all that information and that will make your analysis much easier.
Step Five: You don’t have to commit to buying the stock.
The fifth and final step is to ask yourself if you are sure you want to buy this stock. If you aren’t sure, then you don’t have to buy. It’s not like baseball where if you don’t swing three times then you’re out, right? Warren Buffett uses this baseball analogy and he says the trick in investing is you don’t have to swing at every pitch, you can just sit there and wait for pitch after pitch and you wait for the right one in your sweet spot and swing, and more than likely you’ll hit a home run. Make sure you take the time to really think if the stocks are worth buying.
Are the stocks worth buying?
So that’s it my friends. I hope these five steps help you find stocks worth buying. It’s the end of the video but I do have one disclosure: all of these things that I shared should not be construed as investment advice. It’s only used for educational and informational purposes. Past performance is not indicative of future performance. And please consult with a professional advisor before making any investment decision. If you would like help looking at your investments, schedule a free discovery call today!
Alvin Carlos, CFP®, CFA is an investment advisor and fee-only financial planner, in Washington, D.C that works with clients across the country. He has a Master’s degree in International Relations from SAIS-Johns Hopkins. Alvin is a partner of District Capital, a financial planning firm designed to help professionals in their 30s and 40s achieve their financial goals through smart investing, reducing taxes, retirement planning, and maximizing their money. Schedule a free discovery call to learn how we can help elevate your finances.