- Establish your investing goals
Successes advance in the stock market for various reasons. Some people want to build and maintain capital for their eventual retirement, some focus more on short term trading and speculation, and others may do a little bit of both. Deciding if you want to be a long-term investor or a short-term trader will have a huge impact on your approach when it comes to the stock market.
There are traditionally two kinds of stocks to consider: Growth stocks and value stocks. Generally speaking, growth stocks are companies that are growing revenues significantly faster than the average for the market, often have lofty valuations, and have tons of potential. These are generally more risky and volatile stocks because of huge shareholder expectations. Examples of growth stocks include companies such as Amazon and Shopify. Value stocks, on the other hand, are more stable companies with slower-growing revenues. Some risk-averse investors prefer value stocks because they are often undervalued relative to their fundamentals, and these companies generally reward their shareholders in the form of dividend payouts. Think of companies such as Johnson & Johnson or Proctor & Gamble.
Choosing to invest in growth or value stocks will depend on many factors including your investment time horizon and risk tolerance. If you are unable to stomach a stock going down 10 or 20%, high growth stocks probably are not for you. On the other hand, if you enjoy taking a bit of a risk, value stocks might not be the best option for your investment style. While both types of stocks have their pros and cons, it is incredibly important to understand both.
- Choose an Industry to Focus on and Narrow it Down to a Few Companies of Choice
A great way to seek out stocks is to start with a sector and begin to narrow down a list of companies within that industry. When choosing a particular sector to focus on, it is best to have a forward-looking mindset. The idea is to choose a disruptive industry that is growing and will be around for decades in the future. For example, a good sector to potentially choose is the vegan food industry. With more and more health-conscious people choosing to eat healthier, the vegan food industry is growing massively and the total addressable market is expanding exponentially.
Once you have a good idea of a particular industry you want to focus on, compare, and contrast the companies within that industry. Focus on which companies have better competitive advantages, more market exposure, better branding, etc. It is a good idea to choose companies that have the first-mover advantage as disruptive industries tend to become very competitive.
- Research and Understand the Company Inside and Out
Once you find a company you like, research the heck out of it! The reason you want to do this is that investing in a stock means you are technically part owner in the company. Therefore, you want to understand the company as though you are part of the management team. Understand the company’s business model, strengths and weaknesses, economic characteristics, etc. Studying a company’s strengths for example, may come in the form of evaluating their value proposition, the uniqueness of their products and services or their brand loyalty. Additionally, understanding the economic characteristics may involve a value chain analysis. This is essentially a way to visualize all of a company’s business activities involved in the supply chain. From the manufacturing and operations to the sales and marketing, you should understand the nuances that go into how a company operates and adds value to their end customer. It may be beneficial to study Porter’s Value Chain Analysis Model.
- Study the Financials
This is arguably the most important part of your stock analysis. This is where you start to dive into the numbers and understand where a company is at financially. Without understanding the financials of a company, you can not effectively make a smart investment decision. You should properly analyze a company’s balance sheet, income statement, and cash flow statements. You can easily find this information on Yahoo Finance among many other finance sites.
There are several very important financial ratios that I recommend learning and getting comfortable with. The first is the Forward Price-Earnings ratio. The ratio is calculated by dividing the company’s share price by its estimated future earnings per share. This ratio essentially helps investors assess the attractiveness of a particular company concerning its estimated future earnings. It is taking into account its future earnings to assess a company’s future performance. Another important valuation metric to consider is the Price-to-Earning Growth (PEG) ratio. This ratio is calculated by dividing the standard P/E ratio by the year-over-year growth rate of its earnings. Rather than just the price of a stock concerning its earnings, the PEG ratio also considers the company’s projected earnings growth. It is generally seen as a more complete and accurate version of the P/E ratio. While a desirable PEG ratio may vary by industry, the lower the PEG ratio is, the more undervalued and attractive the stock potentially is.
- Study the Management Team
Having strong management is the backbone of a company’s potential success. A company’s higher management is responsible for making long-term strategic decisions that greatly influence the future success of the company. Just like it is a baseball manager’s job to make tough calls within a game to ensure the team’s success, It is also the management’s job to ensure the overall success of a company. When evaluating the management team, It is important to look at the experience and average management tenure. The more experienced and aligned to shareholders’ interests a CEO is, the more faith you have and the credibility you subconsciously give to the company’s management. Looking at a CEO or CFO’s job history and credentials is also key to evaluating their credibility.
You also want to assess the management’s strategies and goals for the business. What is their mission statement? Does it set proper goals for its management and employees? Does the company have good, ethical intentions? These are all important things to consider when deciding if you should invest your hard-earned money into a particular company.
- Determine Target Price
Next, you want to determine the appropriate price you are willing to pay for a stock. It is one thing to find the perfect stock that you believe in and is willing to pay for, but how the heck are you supposed to know what price to pay??
Everyone wants to buy a stock at the cheapest possible price but sometimes it is hard to decide what is an appropriate price to get in at. This all goes back to studying and understanding valuations. You want to purchase a stock when its PEG ratio and forward P/E ratio is lower than other companies in the same industry. You also want to look at analysts’ future estimated revenue growth in the next 1-3 years. I recommend that you think about what price you think the stock can achieve within the next couple of years and if it is not substantially above the current stock price, your money may be better spent elsewhere. I like to buy stocks that I think have room to run at least 100% within 2 years so I can 2x my money at the very least.
- Stay Disciplined to your Investment Strategy
The most difficult thing to do when investing is to stay disciplined with your investing approach. This is because when stocks rise or fall our emotions can get the best of us. Emotions, fear, and misconceptions can have a huge influence on our decision making and can lead us to act irrationally and buy or sell stocks at the wrong time. For example, if a stock that an inexperienced investor had previously never heard of starts to go up and continue to rise substantially, that individual may experience what’s called “Fear of Missing Out” better known by the acronym FOMO, and buy the stock hoping to ride the wave up. This is a rookie mistake because usually when a stock price moves up unnaturally within a very short period, many earlier investors choose to ring the register because they feel the stock has reached unsustainable levels and want to take their profits before the stock potentially moves back down. This inevitably creates downward pressure on the stock and those investors who got in at those high levels are now potentially at a significant loss on their investment.
Stocks move up and down. This is the nature of the stock market. Realize that investing is a long term approach for most and that if you have a well thought out investment strategy and stick to it, chances are you will be rewarded and become a more objective and disciplined investor while you’re at it.