Stock Research Part I
- Last Updated: Sunday, 26 July 2020
This is the first in a four-part series of articles that will cover the topic of stock research. In this article, we're going to discuss the fundamentals of investing, how to find excellent stocks, and the types of companies to avoid.
When we talk about conducting research in this series, we're talking about fundamental analysis. We're not going to cover the topic of technical analysis, which is the study of price trends and involves concepts such as candlestick charting and volume analysis.
Fundamental stock analysis is a very business-like, and logical, approach to investing. It involves finding companies that are very likely to return to the investor value in the form of profits. The challenge is figuring out what stocks to own, and the price to pay. The best way to explain this concept is with an example:
Let's say Haley visits her local Home Depot. She walks in the store, and they have ten brand new snow blowers lined up; they are all on sale for only $100. That is a fantastic price, but the problem is that Haley lives in Florida.
It's important to balance both factors: finding companies that appear to be operationally excellent, in addition to a price per share that represents a good value.
The starting place for this research is to figure out what kinds of companies we'd consider owning. There are two elements to this decision-making process.
The first is an individual factor, because we should own stocks of companies that are in a business that we understand. For example, if gene splicing is a foreign subject, then stay away from those companies. The second element of this question is philosophical. Here we're going to follow the advice of Warren Buffett, and invest in excellent businesses that have expanding value.
Let's explain why we need to look for an "excellent" business, and what that means. When researching stocks, there are tens of thousands of companies to evaluate. In that vast universe of stocks, there are excellent companies such as Coca Cola, Apple, and Walt Disney. But there are also many "commodity type" businesses that should be immediately screened out and avoided.
A commodity is generally described as a product that is essentially the same from manufacturer to manufacturer, and the primary consumer purchase motivation is price. Oil, rice, steel, lumber, paper, all these products are commodity items. These "second-rate" or commodity-type businesses have certain traits that will allow us to quickly identify them:
- Absence of Brand Loyalty: when brand loyalty exists, the company can demand a premium price, which should increase a company's profit margin.
- Multiple Producers: too many companies making the same product, or supplying the same service, translates into intense price competition.
- Excess Capacity: if there is the presence of excess production capacity throughout the industry, companies are usually forced to compete on price.
These three traits translate into low profit margins, and low returns on equity. Two attributes of companies that investors like to avoid. To be clear, just because a company sells a "commodity-like" item, does not mean that it is a commodity business. It must exhibit all three of the traits above to be a commodity business.
For example, let's say that our research leads us to the company Starbucks. They sell coffee, and coffee beans are traded on the commodity exchange. But Starbucks also enjoys a good deal of brand loyalty and does not compete on price; therefore, Starbucks would not be considered a commodity business.
Up Next: Prices Paid for Excellent Companies
Up to this point we understand that it makes sense to invest in excellent businesses, and how to identify one. In the next article in this series, we'll begin to explain how to figure out the price we'd be willing to pay for one of these excellent companies.
About the Author - Stock Research Part I