Investing in stocks can be an intimidating endeavor. The research can be painstaking and tedious, SEC filings can be confusing for even the most experienced investor, and even when you get it right, the market can go nuts for almost any reason.
But often we make things more complicated than they need to be. Even after I’ve spent hours researching an industry and a company, there are three simple questions I ask myself before I’ll put an order in to buy a stock. They boil an investment down to its core and can spot risks we sometimes overlook.
Is this a company I understand and can believe in?
One of the great things about investing in stocks is that you’re buying a piece of a business -- a business whose products you might use or read about on a daily basis. Buying businesses we know and believe in can not only make research easier, it makes owning a stock more fun and rewarding.
Investing in what you believe in can lead you to stocks that crush the market in the long run. Not only do I love eating at former personal holding Chipotle (NYSE: CMG ) , I love its sustainable business model and organic foods. That combination has rewarded investors handsomely because Chipotle has customers that are almost a cult following.
But unfortunately, it doesn’t always lead to winners. At The Motley Fool, I cover the solar industry, an up-and-coming industry that’s not only fascinating to research every day, it’s something I believe in. Call solar power a pipe dream or me a tree hugger, but when I look at my portfolio and see solar stocks doing well (a rarity these days), I’m not only happy financially, I feel good about what I’m investing in. It doesn’t make it easy when two of my holdings, First Solar (Nasdaq: FSLR ) and LDK Solar (NYSE: LDK ) , have gone down recently due to concerns about the future of the industry, but it eases the sting a little bit.
A company also has to be easy enough to understand so that we understand the risks we’re taking. Chipotle is easy to understand, and if you’re interested enough to do the research, solar power isn’t beyond comprehension. But there are other investments I won’t make because I simply can’t get my head around their businesses.
For instance, I avoided disastrous bank stocks during the recession, mostly because I have no clue what’s really on their balance sheets. For a period of time, I worked at a hedge fund that traded derivatives with banks like JPMorgan and Goldman Sachs, and their risks are so complicated that no one can possibly fully understand them (I once spent an afternoon trying to understand a single derivative contract). And the way some banks calculated risk -- based on standard deviations of daily or weekly returns -- scared me even more. So banks are off the list.
Warren Buffett has famously avoided tech stocks because he admittedly doesn’t understand or care to understand them. So stick with what you know, understand, and believe in.
Is the company impervious to threats from dorm rooms and garages?
I like companies with big moats to prevent competition. What scares me most about investing in Internet-based companies isn't that Microsoft (Nasdaq: MSFT ) will put a target on a company’s back like it did with old browser rival Netscape. Rather, I’m worried that a kid in a dorm room or a garage has a better idea and can make that business irrelevant. Whether it’s Apple vs. IBM, Facebook vs. Myspace, or Google vs. Yahoo!, the dorm room/garage always seems to win.
I also prefer to stick with companies that make something tangible. If it requires capital equipment to make, it’s probably impervious to dorm-room competition. I already mentioned solar manufacturers, which require massive capital spending and research, but I’ve also invested in big-screen film venue IMAX (NYSE: IMAX ) and casino stocks like Las Vegas Sands (NYSE: LVS ) .
Maybe the next billionaire is inventing a better way to view motion pictures or plotting to build a casino in Las Vegas, but I like my chances with these companies versus an upstart.
Is there a compelling value?
This last question can be the hardest to answer. Value can be difficult to define because it changes depending on the companies we’re looking at. A low P/E ratio and lots of cash may be a value for tech companies like Intel (Nasdaq: INTC ) or Cisco (Nasdaq: CSCO ) . Value may be a low EBITDA/enterprise value ratio for Las Vegas Sands, where a P/E ratio doesn’t properly account for depreciation and debt.
What I’ve found is that there’s almost always a logical way to show a company has a value, especially when you compare it to similar companies. There are no hard and fast rules in valuation, though. This may be an opportunity to dust off a discounted cash-flow spreadsheet if you’ve got one.
Three sentences or less
There may not be a better way to tell if your investment decision is rational and prudent than answering these questions in only three sentences. If you have to write a novel to explain why you like a stock, there’s just too much that could go wrong in an investment thesis. Keep it simple.
To see what stocks The Motley Fool is putting its own money behind, take a look at our free report “5 Stocks The Motley Fool Owns – And You Should Too.”
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