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What is the Best Way to Research a Stock?
Let’s say you have an investment idea. For example, you think green energy is the next big thing, and you recently heard a TV analyst talking about a certain company that makes solar panels. He believes that this company is well positioned to take advantage of the growing public demand for green energy sources. Since you believe this stock may have investment potential, you would like to do more research. But where to start?
This is a question that many investors grapple with. There are literally thousands of websites that offer stock information. You can find stock trackers, financial papers, analyst reports, charts, industry information, blogs, forums and much more.
Many investors are overwhelmed with all this information. Some may not do enough research before buying a stock. Others may spend too much time focusing their research on the wrong things. Still others may simply hear a colorful television analyst recommend a stock and decide to invest in that stock without even doing their own research.
On the other hand, most experienced investors will agree that if you want to be successful, you need to do a lot of research. There are very few serious investors who will invest in stocks without hours, if not days, of research before buying a stock. You would also probably agree that not only do you need to spend a lot of time doing research, but that your research needs to be focused.
But what exactly is focused research? Before we tackle this question, let’s gain some perspective by learning a little about how the financial industry makes money from you and how that relates to your success as an individual investor.
In the old days, before the internet, there were stockbrokers. Your stockbroker was in charge of buying and selling stocks for you. It was in your broker’s best interest that you: 1. trusted him and 2. bought a lot of stock from him because he earned a commission every time you bought or sold a stock. The whole system was based on trust.
Let’s say your stockbroker recommended a particular stock or gave you a “hot tip.” He urged you to buy the stock quickly before you miss the opportunity. How would you know that the stock your broker presented in his “hot tip” was actually a good investment? Well, to put it simply, most people didn’t. They had to trust that their broker would recommend the right stocks.
At that time, stock research was much more difficult. You didn’t have access to all the free information that is now available online. Because your broker was incentivized to make money for himself by getting you to buy the stock, you couldn’t be sure he had your best interests at heart when he recommended the stock. It must have been just that he was trying to earn as much commission as possible. The result of this system was that you could make some money if you were lucky enough to have a trusted broker who made good stock recommendations. But if you didn’t have a good broker and didn’t know how to find one, it was much more difficult to invest successfully.
Later, in the 1990s, the Internet came and with it a wealth of services and information related to stocks and investments. Traditional stock brokerage has slowly given way to online brokerage. People gravitated to these new online brokers because it was much cheaper, easier and faster to buy stocks there compared to traditional brokers. A trade that used to cost $100 at a traditional broker could cost as little as $10 at an online broker, and you could close the trade with the click of a mouse at the exact moment you wanted.
At first glance, this all seemed great. Online brokers have not only made it easier and cheaper to buy stocks, but have also encouraged people who were previously non-investors to start investing. The problem was that when people started switching to online brokers, they no longer had anyone to consult with before closing a deal. They had to rely more on their own knowledge and do their own research to figure out which stocks to buy. Although it was now cheaper and easier to buy stocks, it also made it much easier to make poor investment decisions. Talk to any investor who recklessly invested in a dot.com company that failed in the late 90s and they can attest to that.
In addition to all this, most online brokers, like traditional brokers, wanted you to buy and sell stocks as often as possible. This is because they also made a commission every time you bought or sold a stock. Because they wanted you to trade often, they started developing “research” tools that encouraged trading rather than investing. But why was this a problem? The short answer is that not everyone thinks trading is a good way to make money. Many people prefer to invest for the long term and do not have time to constantly monitor the market for trading opportunities.
Nowadays, online brokers are practically the only way to buy stocks. The tools they offer are still focused on trading and are now much more imaginative and complex than ever before. They try to convince you that trading is the only game in town and that you will only gain an advantage by using their proprietary trading tools. As a result, those of us who invest for the long term are left in the dust. Now more than ever, independent investors are forced to rely on our own research methods and develop our own rules for sound investment.
Now that we have some perspective on how brokers make money and have established the importance of doing your own research, let’s get back to the original question, which is: What exactly is the best way to research stocks?
While I can’t give you a definitive answer to this question, I hope I can give you some ideas based on what works for me. The first thing I recommend is to really think hard about what is important to you in an investment. Think about the information available to you and how you can use it to get to the heart of what you’re looking for in a company. Do you think management is the most important factor in determining what makes a company successful? Or are you a numbers person who loves poring over the details of financial statements?
Determining what is important to you in an investment is not easy. If, after thinking about it for a while, you still don’t feel like you know enough about investing to understand what’s important, I suggest you read a book or two on the subject before continuing. Now let me share with you some information about how I usually research stocks. To give you some basic ideas, I’ve outlined some of the steps I usually use below.
o Review the company profile and some basic measures. This is a verification step that helps me determine if I am even interested in the stock. There are several websites that publish basic company profiles.
o Analyze financial documents, including the balance sheet, cash flow statement and income statement. This step helps me determine the financial health and overall profitability of the business.
o Check income and income growth in time. If I see these measures increase over time, that’s usually a good sign that the stock price could follow suit.
o Research the industry and compare the company to its competitors. I like to do some basic research on the competition and the industry to assess whether the company is in a competitive position.
o Browse SEC filings, including the annual report and the latest quarterly reports. There is a lot of incredibly useful information in these documents that companies need to disclose at regular intervals.
o Listen to the latest investor conference call. An investor conference call is usually held each quarter after a company’s quarterly earnings announcement. An investor conference call is a great source of subjective and objective information about a company.
o Read the latest news and explore recent developments. Understanding what is currently happening with the company is also important to me. Therefore, reading the news and researching recent events helps me assess whether the company is on the right track.
o Review trading volume and insider buying activity. I like to look for recent institutional and insider purchases.
o Review key financial ratios and percentages. Some of the key items I look at include PE ratio, PEG ratio, ROI, ROA, ROIC and some balance sheet ratios.
o Explore dividend history. The dividend is important to me because I think it says a lot about the financial health of the company. I like companies that grow their dividend payout ratio over time.
o Explore the effectiveness of the management team. Is the management team performing well to improve profits? If the management team is new, I like to research their past performance at other companies or in previous roles.
o Analyze the share price. I like to look not only at the stock price itself, but also at the company’s historical stock price compared to its PE ratio. This gives me a better idea of whether I should buy the stock now or wait until it becomes a better value.
While these steps work for me, you may decide not to use all of them. Or you may decide to take some steps that I don’t use. Whichever steps you decide to follow, I encourage you to spend some time thinking about what is really important to you in investing, come up with a set of research steps that you can follow consistently, and then use them every time you research share. You’ll give yourself a better chance of picking quality stocks over time, so you’ll likely make more money in the long run.
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