In the past couple of years, many new investors became captivated by the appeal of meme-stocks — an investing mania that looked more like a game of chance than a well-planned strategy to build wealth. Companies with no earnings and questionable growth prospects saw their stock prices skyrocket simply because they were promoted on social media. Investors looking for the next big thing hoped to find it in the boastful banter that filled internet online forums, but for some investors it proved an expensive lesson. Many of those stocks returned to earth with little to show for their mercurial rise in 2020.
If online forums aren’t the answer, where should investors be looking for investment ideas?
While it may feel like you need a degree in finance to build a portfolio, learning how to research companies may not be as complicated as you might think. Here’s a look at what to consider and how you can do it too.
How do seasoned investors find stocks that are right for them?
Peter Lynch, the renowned fund manager known for overseeing the management of more than US$12 billion of other peoples’ money, is one person investors look to for wisdom. In his 13 years as head of the Magellan Fund, his fund had an average annual return more than double the S&P 500 Index. Even as a top-ranked mutual fund manager, he believed individual investors could be equally successful in managing their own stock portfolios. One piece of advice he’s shared often? Consider companies you are already familiar with.
This could mean observing the long line at a coffee shop or noticing increased demand for products in your own trade or business. Lynch says he looks at the story behind the company and uses that as a catalyst for further research. An investing super-sleuth can begin by using this bottom-up approach. In English? That means being alert to companies you might want to invest in based on your own observations and expertise. You don’t necessarily need a complicated strategy, he says. With this approach, stocks are chosen one-by-one and thoroughly researched as potential candidates for portfolio inclusion.
Lynch is not alone in this method of identifying companies that could make good investments. Warren Buffett is known as the Oracle of Omaha due to his nearly 60-year track record of making very good investments, and the fact he runs his business far from New York’s famed centre of finance. Buffett’s folksy demeanor and uncomplicated approach to investing help to reinforce the concept that picking good investments is a skill people can learn. Buffett considers what he calls a “circle of competence” as the core skill every investor should aspire to. Here’s how he described this in his annual letter to shareholders:
“You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.”
Both Lynch and Buffett suggest investing in what you know. Having a strong grasp of a firm’s business prospects — and potential pitfalls — is key to figuring out whether an investment is right for your portfolio.
What’s important to look at when researching stocks?
Investors may find it helpful to research companies that can maintain profitability over a long time period. These metrics can be a good place to begin your investigation:
- Year-by-year earnings: Look at the historical record of earnings with an eye for stability and consistency. Since the price of a stock is tied to the company’s level of earnings, a pattern of earnings growth can help reveal the stability of a company.
- Price-to-earnings ratio (P/E): Earnings potential is an important factor in a company’s value. It measures the price of a stock relative to annual earnings. A high P/E suggests investors are willing to pay a premium for a company. A low P/E could suggest further research is needed to see if the company may be undervalued. This ratio can be a way to keep perspective as it may help you better understand the relationship between the price of a stock and the earnings-per-share.
- Dividends and payout ratio: Buffett is a big fan of companies that distribute dividend earnings to shareholders. Not all companies pay dividends — it is typically larger companies at a mature stage in their industry. These are businesses that don’t need to spend as much on things like buildings or equipment (this is known as capital investment), which puts them in a good position to pay shareholders a dividend from the annual profits. The payout ratio measures the percentage of a company’s earnings paid to shareholders through dividends.
Repeat after us: Financial statements are not boring
Most fundamental research depends on data you will find in a company’s financial statements. This is where many would-be investors get discouraged. Warren Buffett made his first investment at age 11, so he’s been reading financial statements for a very long time! While it’s true that financial statements can look daunting at first, they don’t have to be. Here’s what you need to know to read the research like a pro, if not like an Oracle.
At their most basic level, financial statements have two components: an income statement and a balance sheet. Both offer important clues to the health and profitability of a company, but it helps to know what you’re looking for.
How to read an income statement
One of the easiest ways to understand an income statement is by thinking of your own household — let’s call this “The Corporation of You.” The very top line is all of your income before any expenses (rent, transportation, entertainment, taxes). Corporations operate in much the same way: Start at the top and work your way down the income statement subtracting expenses. In “The Corporation of You,” that bottom line tells you what’s left after all your expenses are paid. You hope for a net earning, but it could be a net loss or losses. Just like different households won’t have the same expenses, different industries will have different expenses. A clothing manufacturer will see fabric as a primary expense, while a computer company will have very different costs. Those types of differences are factors you will become more alert to when you start comparing different companies.
How to read a balance sheet
The second component of any corporate financial statement is the balance sheet. In the “Corporation of You,” the balance sheet is a snapshot of what you own and what you owe. What you own are your assets. What you owe is — logically enough — your debt. What you own could be your Tax-Free Savings Account (TFSA) and Registered Retirement Savings Plan (RRSP), your car, or a rare collection of Pokémon cards (especially the ones you didn’t scribble your name on). What you owe could include things like a student loan, your outstanding car loan payments and unpaid credit card debt. You tally up each side of the balance sheet to get total assets on one side, and total debt on the other. By subtracting what you owe (debt) from what you own (assets), you now have a picture of your equity. A corporation’s balance sheet offers the opportunity to do the same math.
Here are some examples of ratios that use financial statement data. These metrics help to provide insights about a company’s financial health.
- Current ratio: This measures current assets/current liabilities and can help answer questions about how easily a company can manage expenses related to day-to-day operations. This is known as a liquidity
- Interest coverage ratio: Operating income/interest expenses. This is a leverage ratio — which means it measures how debt is used by a company — and can help you determine if a company’s income after operating expenses can cover interest payments.
- Return on Equity (ROE): Net Income/Total Equity. This measures how much profit is generated from the money invested by shareholders. This is a profitability ratio and is expressed as a percentage.
Ratios can be most effective when comparing similar companies, or the same company over a specific period of time. They help investors flag changes to corporate performance.
Do financial statements tell the whole story?
The short answer is no. Financial statements are the foundation of good fundamental research, but there’s more to consider in order to get a full picture of a company’s prospects. Your research needs to also include an awareness of changes that could impact future earnings and profitability. This is not information you will find in a company’s financial report, but the clues are all around. A good starting point is to observe the spending habits of your family and friends. Are you and your friends spending more time and more money at your favourite coffee shop? Are your kids asking for a specific type of running shoe? These might be clues to a great investment. Other places that reveal information that could impact the performance of potential investments include:
- News articles about sales and earnings reports
- New product releases
- Economic indicators, such as consumer spending trends
- A shift in popular trends such as streaming videos instead of heading to the movie theatre
- Observing how wars could create resource shortages or supply disruptions
OK, I think I’m ready to do my own research. Now what?
Successful DIY investors are active learners. TD Direct Investing’s Learning Centre has many videos that can help build your knowledge — and confidence — to become an investing super-sleuth. Just like this one:
How to research value stocks in WebBroker
TD clients can use these tools to help determine if a value investment is right for them.