How to Research Stocks
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2019 was a stressful year for investors to say the least. The Federal Reserve slashed interest rates four times, Trump continued his trade war with China, with neither side showing signs of backing down.
The market started on a low, but ended with the S&P delivering an incredible gain of over 28%. The word recession was thrown about, alot, and continues to be, although less so, going into 2020.
The year will be heavily influenced by the presidential elections, but so far, by the rapidly spreading coronavirus.
Investing in stocks isn’t an easy game for anyone, but if you want to take a step into the field, then you’ll need to at least know how to research stocks the right way. Picking a company you like, that seems to be doing well, just won’t cut the mustard. If you can learn how to research stocks in a way that helps you make strategic moves, minimizing risk, then you’ve won half the battle.
To help you out, we’re going to take you step-by-step through the best way to research stocks, but before we do, let’s start by giving you some tips on how to first choose the right stock to research. This may not always be the right stock for you, but that’s okay, at least you figured it out before investing in it.
We’ll also run through some potential risks of investing in stocks, and some lessons we can take from past mistakes.
How to Find the Right Stock
Before we research stocks, we need to find the right one, which is a skill in itself. To help you narrow down your search, here are some positives signs to look out for.
Stocks on Sale
Most of us love a good sale. Black Friday, summer sales? Sign us up! A 50% off Smeg kettle that I don’t need? Hand it over, baby.
Ironically though, discounted stock doesn’t generate the same excitement. This might be because we’ve been taught to avoid buying declining stocks, or because of the herd mentality that’s evident in the stock market. We tend to go off common advice that we hear from those we look up to, or the media, and neglect the true value of the stock.
In reality, discounted stocks are just as good as anything else that’s discounted. Once you’re smart about it, and have researched the real worth of the stock, you can make some great deals.
Determine the True Value of a Stock
Try to always estimate the value of a stock (often called its intrinsic value), as opposed to basing your decision solely off its price. This will give you an idea of whether it’s currently on sale and may potentially rise to its real value. Reaching a price target should not be a factor in your decision.
Instead, it’s better to establish a price range that you would consider once a stock falls into this, this leaves room for flexibility and is ultimately a more reasonable approach.
To establish a price range, analyst reports are a great place to start. Consensus price targets are another equally useful starting point, because they give you the average of all analyst opinions.
You can find these figures on most financial websites, and without them, you’ll find it very difficult to determine whether or not you should buy a stock.
Grab Stock You Think is Undervalued
Tons of research needs to go into determining a price range, such as an undervalued stock. A key way of figuring out if a stock is over or undervalued, is by looking at a company’s projections.
One key technique is a discounted cash flow analysis. This takes a company’s projected cash flows and lowers them to meet current prices.
The values you get will be a theoretical price target. From a logical perspective, if the current stock price is lower than your estimated future value then you might be onto a winner.
Other methods of valuation include making comparisons with competitors by looking at a stock’s price-to-earnings (PE) multiple. This demonstrates how many multiples of earnings per share (EPS) investors are willing to pay for a share of the company.
A high PE ratio might indicate a stock is overvalued relative to earnings, whereas a low PE ratio might indicate it is undervalued, this will vary from industry to industry.
It’s also a good idea to take other metrics into consideration, like how much investors pay for shares in comparison to how many sales a company generated per share (PS). This will give you some more insight into the stocks value in comparison to rival companies when it comes to pure revenue.
We all have a tendency to become emotional and base our decisions off of inherent biases.
Although we may not be able to completely overcome them, we can become aware of our weaknesses, and put the work in to help make our decisions more objective. This is another reason why research is so important.
Now, let’s get into the crux of it.
How to Research Stocks
Once you’ve identified a potential stock to invest in, you can start your research to help you determine whether or not investing in the stock is the best decision to make.
Here are some ways to do a thorough stock search, beginning with a company’s earnings reports.
Earnings Reports & How To Dissect Them
Reading a company’s reports’ is always necessary, and although it might sound a bit scary at first, fear not, we’re going to highlight the important ones, and the crucial information to look out for.
So, for reports, we advise you look at 10-Q, and the 10-k.
If you’re wondering whether every company will have these or not; both reports are legally required to be filed by all publicly traded companies, with the SEC.
The 10-Q is a quarterly report that will give you access to unaudited financial information. As it’s filed quarterly it is less comprehensive but still an important consideration for investors, at that.
Not only will you have access to quarterly financial statements, you’ll also gain insight into the company’s potential market risks, discussions from management, and any unregistered sales of equity securities.
As this document could work out at over 100 pages, it’s good to read the earnings to get a quick overall snippet and see where the company’s at.
Beyond this, key areas to focus on should include; earnings per share, net income, revenue, and earnings before interest and taxes (EBIT).
While these are all important to know, be sure you ask yourself these questions along the way:
- How was the company’s performance last quarter
- Was this better or worse than the quarter before?
- Have revenues increased from quarter to quarter? Why?
- Are the cost of sales going up, making it overall a more expensive operation
Asking yourself these questions will help you understand and analyse the report better.
The 10-K form is an annual report and unlike the 10-Q this is audited by a third party auditor. This form is bigger, with a lot more information. The same principles apply here although we get the assured benefit of comparing year on year audited financials.
In addition to the above, look at the stock chart, and take into consideration the last five years. Certain industries sell more in certain months, and lower in others.
To help you discover which trend the stock is trading in, ask yourself: is the stock trading higher or lower than its 50-day and 200-day moving averages? A moving average filters out the ‘noise’ caused by short-term price fluctuations, and helps you focus on the real price action.
In addition to this, ask yourself, what is the trading volume in this market, are we seeing a large volume of trades buying and selling? While volume does not directly affect the price of a company’s stock, it does indicate whether there is momentum, market consensus and liquidity.
Therefore, low volume of trades will likely result in higher volatility as buyers and sellers struggle to fill each others buy and sell orders, resulting in higher spreads. Share prices will have sharper ups and downs in a thinly traded market.
On the contrary, when the company’s stock is highly traded and there is a lot of volume, buyers and sellers will find it easier to fill their buy and sell orders, spreads will be lower and volatility may be lower.
You can also see when momentum gathers in the market and seeing a large proportion of buy orders come in may mean good news for the company.
Your perspective on this volume will be filtered through the research you have carried out above; does it have inherently strong fundamentals, and now the market is noticing? Asking these questions and more is an important part of stock research, often referred to as technical analysis.\
If you’re still with us, breath. That was a lot, I know. Once you know what to look for though, you’ll have that knowledge for every single research you conduct, ever.
Now, let’s talk about margins.
Within these reports, you can see whether a company’s margin is improving, or deteriorating, whichever it is, it’s usually because of its management.
If sales are increasing but a company’s costs are increasing more, then you might want to give that a second look.
But increased costs aren’t necessarily a bad sign.
At times, a company might want to keep costs, or shed costs so that they are spending only necessary, you can think of it like staying/getting ‘lean’. But when a company wants to grow, it will need to up their spend, or “bulk”, on resources, and/or services.
This means, a company might be purposely focusing on investing in the business, over revenue, to help it achieve long term growth, by taking actions such as launching a new product, or investing in new talent.
This means, a company might be purposely focusing on investing in the business to help it achieve long term growth by taking actions including launching a new product, or investing in talent.
Amazon is a prime example of a company who spent years focusing on investing in warehouses across the U.S, much to the frustration of investors, until the long term benefits started paying back – big time.
That said, it might just be that the company is not managing its expenses very well. You can find out which it is, and get a better overall picture of the company, by looking at the management discussion pieces.
Investopedia suggests, as a rule of thumb, any company with sales between $100 million and $1 billion should achieve a growth of 10% per annum. Bigger companies with more sales than this should grow, at the least, 3% a year.
Finally, when it comes to numbers, don’t just look at the company’s sales from last year, but from the last quarter, too. An upward trend in quarterly sales is another positive that a company is a good investment.
Stock Buyback Programs
A Stock Buyback Program, also known as a share repurchase, is often overlooked by investors, but it can be a sign that the management think the stock is undervalued. This is when a company buys back its shares from the marketplace with the cash it has accumulated.
Ultimately, it’s a way for the company to reinvest in itself, and it reduces the number of outstanding shares on the market. As there are less shares going around, investors have an increased relative ownership stake.
A share repurchase program should be a positive sign for the company, and generally, you should aim to see the number of outstanding shares either decreasing, or at least holding their value.
That said, it is good to question the ulterior motive for the stock buyback program. Sometimes, a company might advertise a buyback program to improve their finances, giving the appearance of boosted earnings.
In turn, making the company look great for any potential investors, despite the fact that the company’s fundamentals might not have improved at all. Just keep your wits about you.
Don’t Dismiss New Products
This is a tricky one because the success of a new product is never a sure thing. But, it would also be unwise to dismiss companies that make these.
New products can create a lot of media hype when done correctly, and attract interest from both consumers and investors, increasing shares in the short term. Sometimes though, the product attracts negative attention, or doubters, and you have to just ignore it and go with your gut.
For example, Apple’s first iPhone, released in June 2007, was doubted by many investors and the media. CEO at the time, Steve Ballet, said that it stood “no chance” of gaining a good share in the smart-phone market.
After its release, Apple sold 1.9 million iPhones and worked its way up to hold a dominant market position. In 2016, Ballet would go on record admitting that he was wrong.
However, it might not always go in the company’s favor. After Elon Musk’s chaotic launch for his cybertruck, shares plunged 6%.
Nonetheless, new products can be worth investing in as long as you stay on top of trends, know what to look out for, and jump in there early. It’s worth a try.
Take a Wider Look at the Industry
Beyond finances and product launches, what will really place you ahead of the game is looking at the market as a whole. Are taxes increasing, are consumers interested in the industry, will competition potentially affect revenue?
Taking Elon Musks’ Tesla company as an example again, we can see how competition has negatively impacted its stocks in 2020, after shares fell again due to new competition in a shrinking market.
Of course, it’s not always easy to predict what will affect sales, but looking at the company from a wider perspective will help you evaluate any potential threats to share prices.
When to Hold Stock
Once you’ve done your research, estimated a stock’s price range, and determined that it is currently worth more than its price then our advice is: be patient.
It can take awhile for stock prices to return to their real value. Any short-term predictions are simply speculation, and may not be accurate.
Stocks can often take years to return to their true value. If you’re patient, then you might just do well.
Risks of Buying & Selling Stocks
Investing in stocks will always be risky. Some risks are preventable, while others can only be hedged against. Making thoughtful stock decisions that meet your criteria and risk profile can help to keep stock risk at an appropriate level.
However, there are risks that are inherent in investing that you will not be able to control or influence, like the macro causes that we mentioned above. To get out of this alive try to stay aware, and on top of the market, and ideally make portfolio adjustments as soon as they come to light.
First and foremost, everyone knows that investing comes with financial risk. But not everyone knows how to properly check out the risks a company currently or potentially faces, or how to set themselves up to minimize it.
Once you’re familiar with the company’s finances, look for potential or current risks that the company faces, outlined in the risks section of the report. Within this, you’ll also find details about company’s legal proceedings.
To offer potential investors the truth, the whole truth, and nothing but the truth; any outstanding lawsuits that a company has must be reported, including a brief description of each one.
You won’t know exactly how much these are costing the company, but you can examine it yourself to get a rough idea. Try and work out the potential impact that these will have overall.
Although a lot of company’s go through small damage claims, what’s important to note is whether or not there are any larger expenses that might cost significantly more from ongoing litigation. This is the ongoing likelihood that the company may be taken to court.
After that, move on to the company’s Risk Factors. You might be thrown off by phrases like “inadequate liquidity could affect our future operations”, but try and work out if the risk is related to a market trend, such as increasing competition, or caused by a bigger problem, like a lack of diversified customers.
Keep in mind, there’s no right or wrong way to review or interpret a report, and different investors take different things from reports, depending on their needs, what they’re looking for, and even certain biases they may be subject to, all of which can affect how we view and interpret the information before us.
Commodity Price Risk
Commodity price risk is the risk of fluctuation in commodity prices affecting the business.
This affects companies that sell commodities, because when prices increase the company benefits, and when it drops the company losses out. You will see this happening in industries like the oil industry.
The opposite of this is true for companies that use commodities as inputs, such as fuel for airlines.
However, no company is safe from commodity risk. When the price of commodities increases, consumers tend to spend less, which in turn has a drastic effect on the whole economy, and not just individual companies.
You know when a particular company starts to make the headlines for unpopular reasons. That’s headline risk. And it’s usually bad news for a company because if the public start to dislike a company, then they probably won’t buy products or services from that company.
Although they say there’s no such thing as bad media, it certainly can affect stocks in the short term, as seen when Elon Musk smoked weed on Joe Rogan.
Elon again, we know, but what can we say, he’s the perfect example of so many things gone wrong (and right).
On a larger scale, when vapers were released they were promoted as being ultimately better for our health than smoking tobacco.
Since then however, company’s have invested heavily in research that possibly, but not conclusively, links vaping with some potentially worse health risks than tobacco, damaging vaping, and thus damaging vaping company’s sales.
Now, we can’t leave out political risk with all that’s happening, can we? I think not. If you’re thinking about investing in 2020 then this could be a major factor for you to take into consideration during your research.
Political risk affects company’s around the world, but especially when you have someone like Trump in power, or when the U.K vote to leave the EU.
The U.K government has predicted that its economy would shrink by 3.9% over the coming 15 years. This figure is based on an orderly exit with a ratified withdrawal agreement.
A hard Brexit on the other hand, could see an ugly decline of 9.3% in the U.K. This isn’t just bad news for Britain, it’s bad for the world when the 5th economy in terms of gross domestic product, suffers a contraction.
Overall, political risk is hard to avoid because it’s so unpredictable. Who was to predict that Trump would take out an Iranian commander, resulting in a slide in US stocks, and a surge in oil prices. We can only advise you stay aware that rising geo-political tensions can raise political risks.
Last but not least, make sure you research for any rating risk. This happens when a business either needs to achieve or maintain a certain number.
All businesses have this crucial number as far as credit ratings go and it determines how likely they are to pay back a loan, or financial obligation, without defaulting an agreement.
A credit rating directly affects the company’s chances of being approved for a loan or given favourable terms, not to mention affecting how much a business will pay for financing.
However, publicly traded companies must look out for another number just as much, if not more than the credit rating; the analyst rating.
The psychological effects of the analysts rating can be huge, and can really affect the market. It can also have a much larger impact on things than the actual reason for the rating in the first place.
Risks will always be there, you can just hedge against them and make the appropriate changes as they gain momentum.
Fortunately, others have made mistakes in the past that allows us to learn from, and avoid as a result.
What We Can Learn From Past Mistakes: Don’t Overreact on Price Volatility
“When investing, pessimism is your friend, euphoria the enemy.” – Warren Buffet
Each year, Warren buffett releases an annual shareholder letter that includes some golden nuggets of information. In a letter to Berkshire Hathaway in 2008 Buffet said, “When investing, pessimism is your friend, euphoria the enemy.”
While 2008 and 2009 were times of enormous pessimism in hindsight, it was in fact a time of great opportunity. As PNC Investments CEO Rich Guerrini said, “If you did nothing in 2007, you’d be in a great situation now.”
Here are some lessons from the year 2008 that we can take with us into 2020 courtesy of Buffett himself.
Diversify Your Stock
We’ve said it before, we’ll say it again, don’t just invest in one stock.
In 2008 Warren Buffett told shareholders, “During 2008 I spent $244 million for shares of two Irish banks that appeared cheap to me.” This resulted in an 89% loss by the end of 2008.
He continued, “The tennis crowd would call my mistakes ‘unforced errors.’” Not only this but, as the crisis ended, these Irish banks were both nationalized.
The lesson: keep a diversified portfolio so that if one of your stocks becomes nationalised, you won’t make a 90% loss.
Don’t Overextend Yourself
Another little golden nugget from this 2008 letter is that signs of aggressive mortgage lending the decade before should be considered as advanced warning for the housing market.
“But investors, government and rating agencies learned exactly nothing from the manufactured-home debacle…Instead, in an eerie rerun of that disaster, the same mistakes were repeated.”
Don’t repeat the same mistakes that others have already made, it’s not going to work out.
We’re all partial to some biases here and there. But being aware of your innate biases and emotions when investing can take your research to the next level.
An unfortunate example of this in 2008, is when people began panicking and selling off their portfolios in droves.
If they had of stayed objected and avoided acting on emotions they would have benefited from the large increase in stock value across the board that followed over the next decade.
Don’t take any drastic actions purely as a result of strong emotions. Look at the facts, stay objective.
Don’t Follow the Herd
This is a common one but it’s really, really important.
We can all have tendencies to get excited when we see people investing in trends in the masses, like bitcoin BTC, and cannabis.
But, if you’re doing this, is it really because you put the research in, or is it because everyone else is doing it, so it must be the right thing to do?
Choosing to invest in trends probably means that you’re not following your investment strategy fully, but instead, getting pulled in by the hype.
It’s not that you can’t do this every now and then but ultimately, your decisions when it comes to investments shouldn’t be based on what the crowd is doing. One of Buffets favourite phrases is, “The trend is your friend until the end.”
If you’re still reading, well done on making it this far, we’re nearly done.
The first thing to do before all of this is to make sure you’re with the right broker, and utilize all of its advice services, and research tools.
Certified financial planner with Palisades Hudson Financial Group, Benjamin Sullivan said, “Investing isn’t an all or nothing decision. Putting small amounts of money to work overtime reduces your market-entry risk and is an effective way to conquer investor paralysis.”
Speak to Your Brokerage Firm & Use Available Research Tools
If you’re just getting started in the industry then you’ll need the right stock broker by your side. A good stock broker should have all the research tools and resources needed to help you make the right decision. Depending on the broker, they might offer advanced reports, or an in-depth database of information that you should take advantage of.
Some brokers provide a qualified broker to offer you guidance and advice on any potential risks, and even assist with your strategy. If you’re still unsure about your investment then you could get some valuable advice from professionals.
Overall, although your bound to make more than a few errors on your journey, your broker should play a crucial part in helping you minimize risk and loss as much as possible.
The Bottom Line
While it’s important to do your research fully, you don’t need to be an expert to extract the right information. The amount of earnings reports can become too much if you’re not focused, so try and just look at the ones that are of interest to you.
Try to be aware of the bigger issues that might affect stock, like Brexit or the current coronavirus.
Of course, you can’t do any of this without a broker, and finding the right one will really put you in a powerful position going forward.
It’s worth noting, stocks are risky and therefore they’re not suited for everyone. To learn more about stocks you could check out our stock trading guide. Alternatively you could do some research on ETFs, bonds or mutual funds. Find one that suits your style and experience and go for it.