Researching stocks occupies most of a value investor’s time, and when done well, it can give him an edge over the market. The following are the benefits a value investor receives when he has a solid process to research stocks.
- Make less mistakes
- Access dependable data
- Think through scenarios, or mental models,
- Make confident decisions, and,
- Find more investable ideas than others
Each one of these benefits improves the value investor’s returns incrementally. Added all together, these advantages can be worth a considerable sum of money over time.
So the question becomes …
How to Research Stocks Well?
There is likely not a best way to research stocks. Every investor learns to optimize his research process over time through trial and error. What works for one may not work for other. Therefore, what follows is the process I use to do my stock research. Try it out and see if it will work for you as well. If not, there are certainly parts of the process that you can use or adapt to your own style.
3 Main Steps to Research Stocks
I break down my research process in 3 holistic steps. As you read through the content on Value Stock Guide, you will find articles that reflect these various steps of the research process.
- Run stock screens to find potentially interesting stocks
- Review short listed stocks in detail – analyze financial statements and SEC filings, and,
- Build an investment thesis for the stock
Let’s consider each of these steps in detail.
Step 1: Run Stock Screens to Find Potentially Interesting Stocks
Screening stocks well can seem like black magic. One has to decide on the filters and attributes to look for. Then one also has to worry about false alarms and how to avoid value traps. There are so many moving parts to a business. When one metric moves a certain way, it likely affects some other metric in a different way. A company may look attractive by one metric and look terrible when seen in a different light.
Most investors take the short cut and just screen for stocks with either a low P/E ratio or a low P/B ratio. But this is not only inefficient, but it will also lead you in the wrong direction often times. Fundamental analysis of stocks is much more than looking at just a few key financial ratios, although they are very important.
Value investing is an art, but we can also learn from great investors that have gone before us. If we know the screening criteria that Warren Buffett uses, wouldn’t we want to use it as well? Fortunately, there are many such examples of different screens designed by some of the best value investors in the past and the present.
Once you run a stock screen, you will get a list of potential stocks that fit your criteria. Your job is not yet done. Do not just go ahead and invest in these stocks yet.
Give Each Stock a Quick Review
Take each of the stocks in your shortlist and quickly scan through their financials. Again, if you use Stock Rover, you can simply click on the stock and review the insights panel.
This quick review will help you eliminate a vast majority of the stocks that you found from the screen. This is important. Screening stocks with a pre-defined set of criteria gives you stocks that pass that set of criteria. These stocks may not be a great investments when you look at other metrics that were not part of the screen.
The stocks that you want to keep and review further can be moved into a watchlist that you maintain. You may have multiple watchlists to reflect various traits that you want to track. For example, Dividend Stock Watchlist, or, Stocks with Large Moats Watchlist, etc.
I am very selective. So generally I am predisposed to rejecting stocks at every step. Only if I cannot make a case to reject a stock, I will consider doing a deeper due diligence for a potential investment.
It is a lot of hard work. Using a solid stock research platform makes it so much easier.
Step 2: Review Short-Listed Stocks in Detail
In Step 2, we will work primarily off our watchlists.
The only goal at this point to understand the business of each of the companies.
The way I do this is to review the recent news stories, review the most recent Quarterly statements as well as the most recent Annual Report. I will also review any events that are material to the company business, insider transactions, etc. I will go to the company website and find their recent conference call recordings and listen to them.
- Can you understand the most pressing issues that the management is facing?
- Do you know if and how the management is addressing these issues?
- Can you understand the business model and the business strategy of the company? Do you agree with it?
- Do you have confidence that the management strategy is sound, and they are capable leaders to help the company execute the strategy?
You need to be able to answer as many of these questions as possible. Some questions may be unanswerable at this time – there is always a reason why the stock price may trade at a discount to the intrinsic value, and sometimes these issues take time to resolve. That is okay, as long as you know and can use this knowledge to guide your understanding of the company’s future business strategy.
There is no specified time you should spend on this. By experience you will know when you know enough about the company. If at any time you do not feel comfortable about something in the business, either answer this question somehow, or move on to the next stock.
Step 3: Build an Investment Thesis for the Stock
By the time you arrive at this step, you may have decided that the company and the stock seems to be an appropriate candidate for your investment dollars.
Now all you have to do is to put it all down on paper and make sure the numbers back up the story you are telling in your mind.
If the numbers do not support your thesis, your investment thesis is not defensible.
Often you will realize some errors in judgement you made earlier. This is a good time to make a note of this and back out of the investment if necessary.
If everything checks out, you still have a few more things to do:
- Do you think there is a catalyst that will unlock the value for you as a shareholder? If yes, what is it, and when it is likely to occur?
- If there is no catalyst, how long are you willing to wait for the value to materialize?
- If everything goes according to your expectation, at what point will you sell the stock to take profit?
- At what price will you buy, and how much of your capital will you allocate to this stock?
These are all very critical questions that you need to answer after you complete your stock research, but before you buy the stock. My book goes into a very specific process by which we determine the exit points and position sizes, if you wish to learn more.
Stock research may appear to be a complex topic, however as you do more of it and gain experience, you will know what is working and what you need to tweak. Over time, your stock research process will change and become more aligned to your investment philosophy. It is a very worthwhile exercise to do as an investor as this is one of the few things that gives you an edge over the market.