How to research individual stocks
The first time I bought shares, I bought an individual company. I did this mostly because I didn’t know about Exchange Traded Funds (ETFs), which weren’t really a thing back in the day, so it seemed like my only option if I was going to dive into the stock market. It was terrifying and exhilarating, and in hindsight, I didn’t have A CLUE what I was doing.
I really had no justification for choosing the company I did other than I liked the brand and knew people who bought the products. You can read all about how it was pretty much a disaster in ‘the first shares I ever bought.’ These days I wouldn’t recommend jumping into a single stock purchase decision utilising my previous completely uninformed strategy.
Over the years, I’ve learned a thing or two about how to evaluate whether to buy an individual stock. I’ve also listened to the experts. With that in mind, the checklist below comes to you from interactions I’ve had with Andrew Page, the brainbox behind the online investing platform, Strawman. Andrew is someone I consider to be one of Australia’s most informed stock market investors and he’s kindly allowed me to share some of his thoughts.
What to do before buying individual shares, a checklist
1. Ask yourself, “Do I understand the business?”
Whatever you do, don’t let the market tell you a stock is good because it’s gone up, or that a stock is bad because it’s gone down. To understand a business, you’re going to need to do a lot of reading. Part of what makes this easy is if you have an enjoyment of what you’re reading about in an area you’re interested in.
You should try to read the annual reports, as well as all announcements made by the company, which you’ll find on the ASX website. Apps like Stocklight will show you all this information, you can also check out forums like Strawman to get a sense of what people are thinking and why they like or don’t like a stock based on research. There’s also HotCopper, but you’ll have to sort through quite a bit of noise and opinions on this forum.
Get a feel for drivers, competitors, customers and funding. The best way to do this is to imagine you’re the owner of the business and the management team give you a briefing on how the business is doing – what would they tell you? Knowing this information sets you up to make better decisions and enables you to react to any news about the company you’re investing in.
The best thing about getting to understand a business is that your knowledge will compound - if you spend a lot of time doing research on a particular sector or company, there are a lot of lessons that will translate. It’s like exercising, you just get better and better at it the more you do.
Over the years, I’ve inadvertently become someone with a keen interest in healthcare stocks. This has mainly been driven by the fact that I’ve indirectly worked in this area for the last seven or so years. As an example, I own shares in one particular health technology stock that has led me to learn heaps about how hospitals manage information flows and how technology businesses get contracts in the health sector. It’s nerdy, but I’m into it.
2. Do management have skin in the game?
Do you trust the management of the business? An easy way to get a sense of this is to see if management have skin in the game – that’s shares that they’ve bought in the company, with their own money. You can find this out by looking in published company reports as well as in announcements on the ASX website.
Don’t assume that if a company director sells shares that it’s a bad thing. If there’s a pattern where a lot of directors are selling, that’s worth looking into. But if a director has 99% of their family wealth in a company and one day decides to take some money off the table, that’s probably not a bad thing. Management who know the ins and out of the business can sell for many reasons, but they buy only for one.
3. Is the balance sheet in good shape?
This can be simplified down to one question – how much debt does the company have? If a company has a lot of debt, they’ll be paying a lot of interest. You need to know how significant that debt is and how that’s balanced against other cash and assets the business has.
The great thing about businesses with strong balance sheets is that in a crisis, they don’t need to raise money to get them through. When cycles do turn, these companies are in a position of strength and this removes a lot of risk. You don’t need to be an accountant to find this out – take a look at the company reports.
4. Is the price right?
No business, no matter how wonderful, is worth an infinite amount. At too high a price, investors can still suffer big losses, even if the underlying business continues to perform well.
There are a few metrics around for valuing businesses, one of the preferred ways to do this is to look at the Price-to-Earnings (P/E) ratio.
You get the P/E ratio by dividing the share price, or market value, of a company’s stock by its annual earnings per share. You’ll then end up with a figure that represents the amount of money you are paying for each dollar of its earnings. Generally speaking, the higher the P/E ratio, the more overvalued you might say a company’s shares are.
There are a lot of other metrics around for valuing a business which you can Google to really get into it. Attempting to fairly value a business is an extremely worthwhile exercise. Not only does it help determine whether the market is presently offering good value or not, but the very process helps to better understand the nature of the business itself.
5. What are the risks?
Investors spend a lot of time thinking about what can go right for a business, but less time thinking about what could go wrong. We all suffer from confirmation bias - that means that we like to hear things that confirm our view. But you need to also know what can go wrong and when things aren’t going well, you need to revisit the reasons why you bought the business in the first place.
If things aren’t going well, you should distinguish between longer-term structural factors and inevitable risks that relate only to short-term factors. If there’s longer term structural issues that contradict what you bought the business for in the first place. You should ask yourself, “Would I buy this stock today?” Once it gets to a point that you wouldn’t buy it at, then it might be time to sell. There’s also opportunity cost. What’s it costing you to continue to hold this stock? If you sold, where would you put the money?
When it comes to short-term factors, a disappointing quarter for sales against a weak economic backdrop isn’t great, but probably says little about the enduring earnings power of the business.
To give you an example, in 2015 I heard of a company that helps treat sleep apnoea. In a world where obesity is on the rise and more people are requiring devices so they can sleep at night, I decided to do some research on it, and I ended up buying some shares.
Not long after I bought my shares, the company reported some bad clinical trial results, and the share price dropped quite a bit. I still liked the business, so I bought more. This is MUCH easier said than done. It was scary to do, and there were days where I really had to hold my nerve. The good news is that today the share price is around four times what I bought it for in 2015. I’m happy to say this has been one of my individual stock success stories.
So, when should you sell your shares?
When it comes to selling shares, there’s one really good reason to sell. It’s when a stock you own is doing so well that it's taking up too much weight in your portfolio (if you have one) leaving you overexposed to a single stock. That’s when you could sell some to trim it back a bit - plus reap the benefits of making some money in the market, woohoo!