In order to make maximum gains from our investments, we need to learn how to find the best stocks to invest in. However, with thousands of stocks publicly traded in the market, it might be difficult to identify the best stocks in the market to actually invest in.
There are many different methods investors use to identify the best stocks. Before we dive into the different methods, it is important that we have a business owner mentality when it comes to buying a stock. We want to identify great businesses and invest money in these businesses.
1. Invest in what you know
Some investors believe that they can identify a great stock by looking at the company’s financial statements. However, if you do not understand how the company makes money, and their business, you shouldn’t be investing in this company.
Without fully understanding a company, you wouldn’t be able to identify the competitive strength or weaknesses of a company. Additionally, you wouldn’t be able to identify the reason for their current cash flow and predict any future cash flows. As a rule of thumb, you shouldn’t invest in companies if you can’t easily explain what the company is doing in a few sentences.
So now the question is, how do you the best stocks to invest in or find companies that you can understand?
First you have to identify your area of interest and expertise. For example, if you work in the Automotive industry, you might understand companies such as Ford Motor Company, Tesla, and Ferrari a lot better than people who do not work in this industry. Then you could move on to researching further on these companies.
Another way to identify is to take a drip down to your local shopping mall. Be attentive to where the crowd is, what your favourite shops are or where your family enjoys shopping. One of the most successful investor, Peter Lynch, managed to identify great companies by paying attention to the shops his wife frequently bought items from.
2. Good Management and Culture
An important factor that people seem to ignore would be the Management or the Culture of a Company. A business cannot grow without good management.
A strong CEO or a strong leader is required to successfully run a business. Let’s take a look at great stocks/businesses such as Facebook and Alibaba. The founder of the business is also the CEO for both of these companies. This allows the business to be led by passion. It is crucial to find a company where the ownership structure is vested and aligned with the interests of shareholders.
Hence, before buying a stock, it is crucial to evaluate the company for this criteria.
In addition to looking at the CEO, the companies culture is also very important. More motivated and happier employees generally produce better results. This increases the efficiency of the business. (Allowing the business to grow).
The Employee Retention Rate is one way to see if employees are staying in the company. This will give us a gauge on whether they are motivated and happy to work in the company.
There are also websites such as Glassdoor.com that can be used to see the culture of a company.
3. Company’s Strategy for Growth
Before you buy any stock, you have to think long term. Would this company still be profitable in the future, 5 years, 10 years and 30 years down the road?
Is this company affected by other factors/ conditions. An example would be Airline companies. These companies are affected by the price of fuel. As the prices of fuel fluctuates, the stock prices of Airline companies will fluctuate along with it. Of course I am not saying that Airline companies are not profitable or are not great businesses. But it is important to understand that external factors will affect the stock prices.
For safety, we generally want to identify businesses that are not affected by external factors or highly dependent on other businesses to perform in order to grow. Hence, finding businesses with a clear growth strategy is important.
Another way to identify good stocks would be to ask yourself this question. Let’s take Starbucks for example assuming you buy your morning cup of coffee from Starbucks everyday. Would you still buy your regular Starbucks drink even after the price has increased by 10 cents, 20 cents or $1?
If you can identify companies where consumers will still purchase the product even after the price has gone up, you have found a great company that is able to expand with inflation in the future.
4. Good Financials and Valuation
There are a few factors to take into consideration when evaluating a company for its financial and valuation to identify the best stocks to invest in.
There are 3 key financial statement that we can take a look at.
- Income Statement
- Balance Sheet
- Cash Flow Statement
From a company’s Income Statement we can calculate a company’s growth and profit margin. We want to identify a company that has consistent growth over the years with a high profit margin.
From a company’s Balance Sheet we can see if the company has ample cash. We can look at a company’s current ratio (which compares the company’s total current assets to its total current liabilities), company’s debt to equity ratio (where you can analyse if a company has high debt or no debt) and a company’s book value per share. Click here to read more about how to read a Balance Sheet.
As a rule of thumb we want to invest in a company with a debt to equity ratio of less than 0.5 and a current ratio of 2 or more.
From a company’s Cash Flow Statement we can calculate owner’s earnings. This will determine if a company is generating enough cash. We would want to identify a company that has free cash flow [Meaning it is generating Profitable Cash Flow]
Conclusion
With that, you are ready to start identifying your multi bagger stocks. Start to research on the companies that you have identified for their respective Strategy, Management and the Financials. If any of these companies has passed your evaluations, then you have successfully identified the best stocks to invest in.
