Picking Stocks 101 — How We Choose What Stocks To Buy

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You’ve read our articles. You’ve seen the news headlines. Stock markets are crashing, and everyone keeps saying stuff like;

And this

Alright, you’re sold.

This is the time you’re going to start investing.

But how?

How do you navigate around the complex maze of picking stocks?

An easy yet effective way is to buy index funds.

But what about the rest of us who want enjoy picking stocks that we know are oversold and are at prices that don’t justify their valuation?

In this article, we’ll be sharing the things you need to know when picking stocks, and how we choose stocks to buy that peak our interest.

Picking Stocks, Easier Than It Seems?

Picking stocks doesn’t have to be complicated.

We’re not hedge fund managers, so we don’t have to worry about pouring hundreds of millions of dollars into a stock and affecting its price.

Even if you aren’t looking to invest, it’s always good to know how to evaluate a company’s financial position and it’s future projections.

You can even use this analysis on the company you’re working at! (Granted they’re a publicly traded company).

So here are things to consider when picking stocks.

1. Buy their product, buy their shares

The easiest and first thing we should always do when picking a stock is by identifying products that you personally enjoy.

Over here, we’re big Apple fans. We tried switching to a host of other brand names but nothing seems to come close.

We’ve got the iPhone, then the Apple Watch, and now I’m considering getting some Airpods.

And it’s not just me, there’s a whole bunch of Apple fanboys/girls that swear by the product and vow to never use an Android ecosystem in their lifetimes.

They may be annoying and irrational but when a company’s product has its own cult like following, betting against them can be foolish.

Warren Buffet owns >$1 billion worth of Coca Cola and is known to drink up to 5 cans a day (take it easy old man).

He enjoys the product, he bought the company.

If only we had that amount of money…

Hol’ up.. this isn’t the only basis we use when picking stocks.

If this was it, we’d all be picking stocks like Xing Fu Tang, TikTok, & Instagram.

No one would picking stocks of Visa cause let’s face it, who loves their product so much anyway?

But these companies working in the background also have tons of potential, which leads us to our next step.

2. How does the business work?

Once we identify a potential stock to buy, it’s crucial to know how the business works.

You don’t need to start ringing up HR to enquire about how long their employees work in a day or what they eat for lunch.

But you need to at least understand how this company makes their money.

For example, Google’s Youtube makes money through advertising spend on the platform.

On the other hand, Clorox makes money through the sale of their cleaning products and bleach.

Once you know this, it’s time to think what the potential of growing this revenue is.

For the case of Clorox, let’s say you really love the product and wouldn’t use any other brand if your life depended on it.

The problem is though, you won’t be buying more than you need, would you? There’s no need for increased consumption.

In the case of YouTube, I guess it should be self explanatory.

The more you like watching videos, the more time you spend on it, and the more money YouTube makes.

They have an incredibly important aspect of their product; the ability to make people want to “spend” more.

From 2015-2019, Clorox has seen their revenue go up by 8%. In the same time period, Google grew theirs by 54%.

As a result, you can expect much more growth in the stock price of Google (Alphabet) compared to Clorox, as they have more opportunities to grow revenues and profits.

To understand how a business works or their future prospects, we usually like to go through websites like MotleyFool, MarketWatch, or just Google to find related articles by market analysts.

It’s simple, just type in the name of the company you’re eyeing in the search bar and the related articles will pop up.

Here’s an example of an article that talks about Google’s prospects.

Note that Google’s parent company is named Alphabet.

3. Know their moat

Wait.. Aren’t moats the things people buy to waste their money on?

No, that’s a boat.

A moat is a deep, broad ditch, either dry or filled with water, that is dug and surrounds a castle, fortification, building or town, historically to provide it with a preliminary line of defence. (According to Wikipedia)

The term economic moat refers to a business’ ability to maintain its competitive advantage over its rivals to maintain market share.

Essentially, it’s something you have that your competitors can’t replicate easily.

Usually, economic moats aren’t things that can be valued by a dollar amount, but have unseen values that prove to be priceless.

A company with an extreme network moat that laid the foundations of its business is Amazon.

Jeff Bezos recognized quickly that the more suppliers they have on their marketplace, the more customers they have.

And when they have more traffic to their website, more suppliers would want to get in on the action.

It’s a never ending cycle which leads to their massive database of both customers and suppliers.

Imagine wanting to start a company to go against Amazon’s marketplace. Where do you even start?

Why would a supplier want to get onto your platform with 2 customers (your mum & dad) vs Amazon with >150 million customers on Amazon Prime?

Even competitors find it difficult to penetrate their base due to the loyalty built through Amazon Prime.

Companies with weaker moats are usually involved in the process of selling commoditized products.

For example, companies in the insurance, telecommunication, and mining industries usually have weak moats.

Without an economic moat, products are generally similar, and there’s little to no loyalty from customers.

When picking stocks to buy, we always look at companies that have successfully built strong moats.

We aren’t able to identify this ourselves as these things can be hidden, but a simple Google search of “Company XXX moat” does the trick!

4. Financials

Bear with me on this one.

I know I know, it can be boring.

We have to do this when picking stocks to buy though.

We’ll try to make it as simple and easy to follow, tackling what we feel are the most important things to look for in financial statements!

a) Revenue and Earnings Growth

When looking for stocks to buy, we like companies that are showing strong trends in revenue and earnings growth. Duh.

To do this, we look at our go-to site, Marketwatch.

Look up the stock you have in mind using their search bar, and scroll to their financials tab.

First up, we see sales/revenue.

Growing revenues are key in selecting stocks to buy

Adobe has seen nice revenue growth in the past 5 years, with the 5 year trend clearly showing an upside.

Be careful with companies that show strong growth 4-5 years ago, but have seen it slowing down more recently. This isn’t the case for Adobe, so it passes the first check!

After this, we look at gross income margins.

Gross income is essentially revenue from sales less the cost of goods sold.

In 2019, Adobe reported a gross income of 9.26B vs a revenue of 11.13B. This brings their gross income margin to an incredible 83%.

This is a good sign since it’s an indicator that selling their products will bring in more profits.

Next, we go to net income;

Net income is gross income less all operating expenses such as employee salaries, research & development, and rent.

Again, we see nice solid growth in terms of their earnings. This is a good sign that the company is not only growing revenues, but are also profiting more from it!

To summarize these 3 terms, imagine you’re looking to start a lemonade stall.

You price your lemonade at $10 a cup, meaning your revenue is $10. The ingredients required to make a cup costs you $3, bringing you a gross income of $7 or 70%.

However, you have other operational costs such as paying municipal rent and transportation that isn’t directly linked to the cost of making your lemonade. This comes up to $3, bringing down your net income to $4.

Why we say gross income is important is because for every cup of lemonade you sell, you get an additional $7.

The municipal rent and transportation costs won’t go up though, meaning the more you sell, the quicker your net income grows!

b) Balance Sheet

After looking at our income statement, we look at our balance sheets, which shows our assets and liabilities.

Assets are possessions that the company owns such as cash, property, and machinery.

Liabilities are things that the company owes such as loans, bonds, and payables.

First thing to look out for when looking for stocks to buy is their cash & short term investments.

Our watchlist of stocks to buy all have strong cash positions

Just like how we always talk about having liquidity and setting up a rainy day fund as an individual, cash & short term investments are the equivalent for a company.

Especially in times like these when we’re expecting a demand shock for most products, a company’s cash position will help it weather the storm.

Then, we look at their short term and total liabilities.

Adobe has a short term liability of $3.15B.

This is important because we want to compare this to their cash position.

In the short term (<1 year), they have to pay off debts totaling $3.15B. With a cash position of $4.15B, they have enough and more to cover this, which is good!

However, having $10.7B worth of total liabilities is something that we need to watch out for.

Based on their net profits of $3B a year, it would take them roughly 3.5 years of profits to pay it back.

A silver lining is that Adobe also has $21.2B in total assets, which can be sold off to pay back debt if necessary.

To summarize, we look at a company’s balance sheet to make sure they’re not over leveraged to fund their growth.

If a company borrows too much and can’t afford to pay it in the short term, they’d be stuck in a debt trap.

Just think about it from a personal point of view.

You never want to be in a position of having high credit card debt (short-term) with insufficient cash to cover it.

You also don’t want to have too much long-term debts as it’ll make you inflexible in terms of spending.

These are our ways to identify potential stocks to buy in the market.

Of course, there are many other variables that we have to take into account, but we’ll leave that for another day.

Remember, we’re not experts and you shouldn’t take our word blindly.

Do your own research and you’d probably find out more!

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