If you’ve ever searched for:
“How to research stocks”
Or even if you don’t want to admit it:
“How to research stocks for beginners”
Then this is the guide that’ll show you EXACTLY how to do so, in a simple, easy to understand, step by step method.
Table of Contents:
The Investment Idea Filter: How To Research Stocks And Minimize Mistakes
So you have an investment idea. Great! As many investors can testify, finding that new idea can be a rush of excitement.
But slow down.
While getting into stock analysis is a great thing to do when trying to figure out what can you do with a finance degree, that rush can cause you to make some pretty stupid mistakes. Let’s refer back to Warren Buffett’s first two rules of investing:
Rule #1: Never lose money.
Rule #2: Never forget Rule #1.
In other words, don’t be an idiot and try not to F*** up.
You’ll hear tons of ideas where people will pitch you on the ‘potential’ of a stock, but if the stock can go to zero just as fast, don’t waste your time.
You’re looking for ideas that are ‘asymmetric’ with a large margin of safety, or in other words, you still won’t lose money if everything goes to hell.
Get the idea? Take a look at the infographic below.
When it comes to learning how to analyze stocks, each step is in the order it is in for a very specific reason. (Notice how valuation is last)
Download The Free Business Analysis Spreadsheet to Follow Along
Analyzing The Business And SEC Filings
This may seem like a really silly question, but it’s the total opposite.
When it comes to learning how to research stocks, this question is so quickly forgotten.
Here’s an example:
Many inexperienced investors are enthralled with the idea of investing in pre-revenue biotech or pharma companies. They get sucked into the ‘potential’ of the company’s lead drug being the next ‘big thing’ and sending the stock through the roof.
Don’t be that guy.
Unless you are an MD or Ph. D who is 100% familiar with how the science behind the drug works, the structure of the clinical studies, and the FDA approval process, you’re wasting your time.
There are people way smarter than you and I that have unlimited resources from the funds they work for to do on the ground, primary research of the drug.
Or if you’re like the old SAC Capital, paying thousands and thousands of dollars for insider information behind these drugs.
It’s OK to just say “this is too hard” and put the idea in you’re too hard to understand bin. Buffett does the same thing.
So here’s what you want to do:
Pretend like you’re the CEO for a day
Ask yourself these questions:
- What are all the products/services am I offering?
- How much am I selling these products/services for?
- What does it cost me to make these products or offer these services?
- What kind of gross margins or gross profit am I expected to earn by selling these products/services?
- Who are my customers?
- Who am I competing against?
Where To Find Information To Analyze Stocks
In order to answer the questions above, you need to start doing your research.
For now, we want to start with two main documents: the company’s 10-K and their investor presentation.
Every publicly traded US company files a 10-K once a year, which basically sums up how the year went for them, but at the same time gives a great overview of the business.
Most companies also have investor presentations on their website (usually in the investor relations section) which provide much easier to understand summaries of the business. These are great if you’re just starting your research.
If you simply do a search for “company name” investor relations, this is pretty easy to find:
Clicking through on “Events & Presentations” should lead you right to some of their most recent presentations:
The 10-K is just as easy to find. Head over to www.sec.gov. You’ll see a picture like this:
Scroll over to the right and click “Search EDGAR for Company Filings”
That should bring you to another page where you can “Fast Search” for filings by a company’s ticker. Let’s check out MSFT:
There they all are. You can look through these for as far back as you’d like.
From there, you can navigate to the 10-K.
How To Read A 10-K
If you’re unfamiliar with a 10-K, take a look at the video below for a detailed overview:
Let’s look at an example:
Example #1: IBM
Everybody has heard of IBM right?
But how many people can actually list all the things that IBM does?
So let’s take a look at IBM’s business segments:
Looks like we got 5 fancy looking segments that still don’t really explain anything.
Let’s take a look at the description of one of those segments: Global Business Solutions.
So that includes everything from Watson to Blockchain. That still doesn’t help us.
And then that is even further segmented like this:
My point here isn’t that you should avoid IBM because it’s confusing (even though it is).
The idea is that you want to invest in things you REALLY understand and that you can explain to your husband/wife in a few sentences.
This is especially important if you’re just starting out. Know your circle of competence and keep your ideas simple.
Let’s take a look at another example:
Example #2 – Alarm.com
You may or may heard of Alarm.com, so let’s take a look at them from a very high-level point of view.
Why not just go to the website?
If we head over to the website, it’s pretty obvious what they do:
Simply put, they sell security and smart home solutions for the home and business.
The 10-K will tell you the exact same thing:
Get the idea? When you’re learning how to research stocks, you always want to keep it simple.
Make sure you’re able to thoroughly understand each company inside and out before you decide to invest.
How They Make Money
You might be thinking:
Isn’t this the same question as #1?
Oh no, no. Not even close.
You may understand what a company does, but figuring out how they make money is a totally different story.
At the end of the day, it’s cash flow that will propel both the business, and the share price forward. Therefore, you better damn well know where it’s coming from.
Let’s go back to Alarm.com for a second.
Example #1: Alarm.com
So we have a pretty good idea of what Alarm.com does, but how EXACTLY do they make money?
Now if you’re just starting to learn how to research and analyze stocks, I want you to get in the mindset that you can get EXTREMELY detailed when conducting your research.
Step #1) Look at how the company segments themselves
Let’s take a look at how the company segments their revenue:
The first bucket is what they are charging on a monthly basis to use their software, and any licenses they’ve sold.
The second is the revenue their receiving from selling different types of hardware.
Here’s how you can visualize it:
Step #2) Identify who they’re selling to
If you looked through the investor presentation, you’ll see that they sell to resellers:
What this tells us is Alarm.com sells their product to resellers at a discount, who then resells the product to consumers at market value, and makes a profit on the spread.
The same goes for how retailers sell their product in bulk to wholesalers, who make their profits by reselling the product at a higher price.
Get the idea?
Step #3) Identify what they’re selling and for approximately how much
So what they heck are they charging for everything? Their website gives us a quick overview:
Therefore, we can also assume resellers are getting a discount to those values based on the amount of volume they’re doing every year.
Now how about the different products?
Let’s start with the software side of the business.
Usually you can find info on a company’s products either directly on their website or by just googling around.
The bigger the company and the more products they have, the harder this is to do.
On the other hand, smaller companies with fewer products obviously make this much, much easier.
Just doing a google search can help us find what we need:
See all the options from this one reseller here
Alarm.com seems to have two primary options: basic interactive and interactive gold, which are essentially DIY versions.
They also have the same offerings for businesses at slightly higher prices.
If we add in the central monitoring with a gold package, that gets us to about $35 a month. Add in some video monitoring and extra sensors, and you’re closer to $50 a month.
Clearly each solution looks like it’s custom tailored to the customer’s home.
Let’s move onto the hardware side of the business.
The 10-K gives us a nice overview of what types of hardware they sell:
Notice that DOES NOT include the main security panels you’ve probably seen before.
Amazon can confirm that as well:
Alarm.com actually tends to use the 2GIG platform the majority of the time.
Step #4) Identify the types of revenue
This is also another really important question to ask. Why?
Because once you start getting into some modeling and stock valuation work, this will help you with your projections.
Here are a few of the main types of revenue to look for:
- Every investor’s favorite type of revenue. It’s easily predictable every quarter, and make your life very easy when doing your modeling and stock valuation work.
- You normally see this with software companies and SaaS businesses.
- This includes things like one-time setup/activation fees or any other types of revenue that aren’t expected to recur
- This is the most common type of revenue.
- If the segment’s revenue doesn’t fall into the first two categories, then it’s probably your standard lumpy, unpredictable revenue
Let’s start with the software business.
We want to do a search for ‘revenue recognition’ to see exactly what is being included here:
- Both SaaS and License revenue
- Software sold to resellers at a discount based on volume
- Also receive fees based on licensing intellectual property
Since the majority of this is SaaS, this would be our favorite: recurring revenue
Moving onto hardware:
- Primary comes from selling cellular radio modules
- Also sells video cameras, sensors, etc
- Hardware segment includes activation fees as well
Sounds like lumpy revenue to me.
Identifying Competitive Advantages
Competition puts companies out of business every day.
You also need to be looking 5, 10, 25 years out to see how durable a business’ moat or competitive advantage really is.
Think about these examples for a second:
Apple killed Blackberry, but couldn’t take down Microsoft in the PC market. Why?
Apple clearly has a more user friendly OS, but Windows is still dominant.
How does that happen?
Simply put: high switching costs.
While the Apple OS may be better than Windows, switching people off of Windows to a Mac would be very costly, both from a money perspective and psychologically.
Imagine a Fortune 500 company having to buy all brand new Macs AND have to train its employees how to use the new operating system.
That would be a nightmare.
It’s business models and competitive advantages like these that keep companies in business for very long periods of time.
So what makes a durable business moat?
Here are some types of competitive advantages you want to look for in a business:
1) The Monopoly.
This is the ultimate competitive advantage.
When a business has a monopoly, it can charge absurd prices, sell to who it wants to sell to, and crush smaller companies instantly.
But unfortunately they’re illegal.
Anti-trust laws were put in place to prevent companies from becoming monopolies and hurting the end consumer. Although, there are still cases where you’ll see companies with monopolistic traits.
For example, think about your local cable provider.
If you’re in more of a suburban area, sometimes you might only have one or two options to choose from, with one option only offering decently fast internet.
Why do you think your cable bill is so high? The cable co knows it’s your only realistic option, and therefore charges a hefty sum for its offerings. This is what I’d call more of a ‘local’ monopoly.
And then there’s Google.
If you have to go to court to argue that you’re not a monopoly, well, you’re probably a monopoly.
When was the last time you used a search engine other than Google?
You get my point.
2) The Middleman
Think about how Uber and eBay make their money.
They simply created a platform connecting people selling products/services and buyers.
Being in the middle creates a network of dependant buyers and sellers who need their platform to run their businesses.
It’s a great, simple, low overhead model that can be quite effective.
That’s unless you ‘squeezed’ out of the middle, but that’s a topic for another day.
3) High Pricing Power
High pricing power often results from a combination of a couple of these different models.
Got a monopoly? You got pricing power.
Got a strong brand? You got pricing power.
Got a niche product that no one else can offer? You got pricing power.
The reason pricing power is so powerful is because in economic downturns are even when new competitors enter the market, you’re still able to charge the same prices or even raise them.
Compare that to a commodity based business where you can go bankrupt if the product you sell crashes in price. I’m talking to you overlevered oil & gas co’s.
4) High Switching Costs
Earlier we discussed how certain software businesses like Microsoft and Apple can have switching costs.
Let’s take a different example now. How about medical devices?
Think about it like this:
If you’re a surgeon and you’ve been doing the same procedure with the same tools for years, how likely do you think you are to switch to a totally different tool?
Probably not very likely. (You better hope not as the patient!).
That’s why certain medical device companies like Medtronic can have high switching costs with some of the tools they offer doctors and surgeons.
5) Lowest Cost Provider.
Let’s go back to commodity based businesses for a second.
Take an oil and gas company for example.
When oil and gas prices drop and the whole industry is shocked, which company is going to be the one that survives?
The one that can get the stuff out of the ground for the cheapest (aka lowest cost of production).
6) Brand Strength
This one is pretty obvious.
When you have a great brand, you can charge ridiculous sums of money for products that only cost you a fraction to make.
Pricing power at its finest.
7) High Customer Service
If you’ve had a bad experience at a restaurant or any store, what’s the probability you’ll shop/eat there again?
Probably slim to none.
But how about if you had a fantastic experience and they treated you like royalty?
You’ll probably keep going back even if their prices are slightly higher.
Let’s go back to our example with Alarm.com.
What does their moat look like?
Well based on the competitive advantages/moats listed above, they might fall under the category of ‘high switching costs’.
Think about it:
Once you have their system set up in your house, sensors set up all over the place, and subscribed to the software, it would be a pain in the ass to try and switch to someone else.
That being said, it probably wouldn’t be as tough as going from a PC to a Mac, but nonetheless, still a pain.
In this case, it’d be fair to say their moat is above average.
Dissecting The Balance Sheet
For those who are still learning how to research stocks, the balance sheet is where the company’s assets and liabilities are listed.
So if you had your own balance sheet, your assets would be things like your cash, your car, your house, etc.
Your liabilities include things like bills you haven’t paid, and most importantly, your DEBT.
When researching different companies, it’s very important to understand if a company is able to handle their debt load, because we all know what happens when a person or company can’t pay their debt.
So how can we tell if a company’s balance sheet is stable?
Well pull up the 10-K and take a look.
If you’re new to reading financial statements, take a read through our financial accounting 101 guide to get an overview of what it all means.
So… How Do I Know How Much Debt a Company Has?
While I’m not going to go in deep on learning how to read a company’s financials, I’ll show you a few tricks to figure out how much debt a company has.
The biggest issues for new investors is figuring out which line items on a company’s balance sheet are debt.
The easiest trick to use is asking yourself this:
Do they pay interest on it? If they do, it’s debt.
Let’s look at an example:
If you’re thinking “WTF?!” in your head right now, yes, it’s because this is a confusing balance sheet.
So which of these items are debt related?
Here are some of the most common ones:
- Revolving Credit Facility/Revolver – It’s basically the company credit card
- Anything that says ‘Term Loan’ – Your standard company loan
- Anything that contains ‘Notes’ – Don’t confuse this with Notes Receivable on the Assets side of things, we’re sticking to liabilities remember
- Convertible Debt
- Anything that says ‘Debt’ – Obviously
So going back to our example, here’s the debt-related items:
Now that we can figure out how much debt a company has, here’s three ways to analyze the stability of a company’s balance sheet.
#1) The Debt to EBITDA Ratio (preferably want it lower than 4x)
Think about this:
Let’s say you have $100k in student loans, which probably seems like a lot to you.
If you’re making $50k a year after your expenses, your Debt / EBITDA (also known as leverage) would be 2x (100 / 50). That’s not too bad.
What if I told you there are stocks out there that have Debt / EBITDA multiples around 6x – 8x?
That’s like saying you have $800k in debt but only make $100k a year. It’s nuts.
Ideally, you want to try and find companies that have Debt / EBITDA lower than 4x (maybe even lower). Some people are willing to invest in stocks that are ‘highly levered’ (high Debt / EBITDA), but you’re better off staying away from those.
Highly levered companies can have things go very wrong, very fast. Not worth the risk.
#2) Look at total debt vs a stock’s market cap
Let’s keep this one simple:
If you see a stock whose debt is 1x – 2x its market cap, be careful.
Ideally, you want to stick to looking at Debt / EBITDA, but this can be another quick ‘eyeball’ indicator as well.
#3) Be careful if Assets < Liabilities
One of the first things they teach in Accounting 101 is Assets = Liabilities + Equity
So when you see a company that has more liabilities than assets that means they must have a negative balance sheet equity. That usually happens because of:
- They are making no money (usually you’ll see this with younger, small companies)
- The company was previously owned by a private equity firm who paid themselves generous dividends
So if you see that, be careful, and make sure you understand why.
You better make sure a company’s management team has your back.
If they’re not incentivized right, you’ll never get the results you want.
Think about this:
Who works harder for you? A CEO that owns 15% of the company’s stock or a CEO that owns 1%?
I think the answer is pretty obvious.
If CEO #1 doesn’t do his job, and the stock declines over time, he loses a lot of money along with you as an investor.
CEO #2 probably wont give a f***. He’ll probably have his massive base salary and generous stock options, which he probably exercises and sells for cash quick. He won’t care about the stock performance nearly enough.
So how do we know if we can trust management and that they are properly incentivized? Here are some main things to look at:
#1) How Much Stock Do Insiders Own?
We talked about why this was important earlier, so how can we find out how much insiders own?
Head over to openinsider.com and we’ll take a look at Alarm.com.
What does this tell us?
We can see which insider are buying/selling, for how much, and how many shares they own.
For example, Daniel Ramos an SVP, currently owns 127,627 shares out of 48,758,774 currently outstanding. A whopping 0.26%.
How about the CEO?
If we scroll down, we can find that too:
So, Stephen Trundle the CEO owns 2,768,136 shares, which is about 5.7% of the shares outstanding. Not too bad. That’s almost $100 million based on the current share price of $35.
If you keep looking through, you’ll notice some of the company’s directors, who part of the venture capital team invested in the company prior to the IPO, also own a big chunk of stock.
In Alarm.com’s case, insider ownership is pretty solid.
#2) Are Insiders Buying Or Selling?
A great way to try and get a sense of how insiders are currently valuing the stock is by looking at recent insiders transactions.
A bunch of open market purchases may mean insiders think the stock is undervalued and the share price will rise.
A bunch of open market sells could mean, well, the opposite.
So how does our Alarm.com example look?
Lots and lots and lots of sales.
Does that mean the stock is overvalued? No, not necessarily.
But it does tell us that clearly insider would rather dump the stock they own and get from option grants in the open market versus holding on.
Red Flags Checklist
We are all going to make mistakes when learning how to research stocks.
Even the best investors out there make mistakes. It’s human nature.
The red flags checklist is something investors use to just be a little less stupid.
While the first few parts we went through were meant to ask some common questions, the red flags checklist is used to ask odd/uncommon questions to catch any things we may have let slip through the cracks.
Many great investors use checklists to help reduce their mistakes, so here are a few odd/unusual red flag checklist items used by different types of investors:
Fast Grower Problem #1
What has the growth rate in earnings been in recent years? (My favorites are the ones in the 20 to 25 percent range. I’m wary of companies that seem to be growing faster than 25 percent. Those 50 percenters are usually found in hot industries, and you know what that means.)
Fast Grower Problem #2
Is the expansion is speeding up (ex: three new motels last year and five this year)? For stock companies which sales are primarily “one-shot” deals―as opposed to razorblades which customers have to keep on buying―a slowdown in growth can be devastating.
Maj Soueidan – GeoInvesting
Margin Red Flags
When I am looking at a company I want to know what inning the it’s product(s) are in, in their margin cycle. This is especially important when analyzing companies with commodity type products, such as in the tech industry (chips). Often, you will see tech companies IPO near the peak of a margin cycle (management is not stupid). I like to track historical margins over time to see if I can find trends on how long a margin cycle for new product introductions for a target company typically last. Make sure to also track changes in R&D spend to see if the company is building its “innovation pipeline”.
Inconsistencies Red Flags
I like to make sure that management’s comments across press releases, conference calls and SEC filings are consistent. For example, at times I will come across companies where management claims their company is well capitalized, then turns around and raises equity capital. We saw this from fraudulent U.S. listed China firms during 2009 to 2014.
Guy Spier – Aquamarine Capital
Management Red Flags
Are any of the key members of the company’s management team going through a difficult personal experience that might radically affect their ability to act for the benefit of their shareholders?
Also, has this management team previously done anything self-serving that appears dumb?
Financing Red Flags
How could this business be affected by changes in other parts of the value chain that lie beyond the company’s control? For example, are its revenues perilously dependent on the credit markets or the price of a particular commodity?
Preston Pysh & Stig Broderson – The Investor’s Podcast
Is the company performing better than its industry peers?
FCF / EPS Deviation
Is FCF tracking EPS? If not, how much is the difference? Why is there a difference?
Mohnish Pabrai – Dhando Holdings
Cheap Labor Red Flags
Is this a business that can be negatively affected by cheap, foreign competition or cheap labor?
Leverage Red Flags
Plain and simple, is the company too highly levered, aka have more debt than it can handle?
Last up we have valuation. Why is something as important as this last?
Buying excellent business at a fair price, is better than buying a fair company for an excellent price.
If you’ve gone through all the other pieces before this, you’ll dramatically reduce your chances of making a mistake.
Now this is too big of a topic to cover here, so that’s another topic for another time.
Anything you would add, or have questions on above?
Comment below and let me know what you think!