Investing in stocks is hard work. Those who say otherwise aren't doing their homework. It takes time to read, analyze a company's fundamentals, and think through the decision to buy. Given all that work and the huge selection of potential investments out there, it's easy to become overwhelmed.
That's why it's critical to organize your thoughts and invest with confidence. An overwhelmed mind is a recipe for investment disaster. So let's go over a stock-picking method that will help you keep a level head and make smart investing decisions.
My method for clear investment thinking
For me, the best way to fully flesh out an investment idea is to write my future self a letter explaining exactly why I am buying a certain stock. It's the only way I can wrap my head around all the various considerations that go into stock analysis. My self-addressed letters sometimes take only a page or two. Other times they go on for five or 10 pages. But the length isn't nearly as important as the process.
Where to start
The entire process starts with reading about businesses and listening to the great investors you'd like to emulate. Warren Buffett's annual letters, media appearances, and regulatory filings are a great place to start. I also follow Joel Greenblatt, another successful value investor, closely. Greenblatt has written several books on simple value-investing strategies, and he also runs a website with a free stock-screener that uses his methodology. The Motley Fool should also be at the top of your list of resources.
Once I've found a business I'm interested in, I dive in headfirst. That starts with a company's most recent 10-Q or 10-K filing with the SEC, as well as the most recent earnings conference call. Between the regulatory filing and the conference call, I come away with a pretty solid understanding of what exactly the company does and how the business is performing.
At this point, assuming I still like the company, I'll take some time to review its competitors and read up on trends in its specific industry. Here, a simple Google search is usually the best way to start.
Bringing it all together confidently
Using my notes, my next step is to draft my letter. First I define my investment thesis -- the fundamental reason why I think this company makes a great investment. I then create graphs, charts, and/or tables to help illustrate why this company is worth buying. I'll step away from my desk and come back later to reread it. I may ask someone I trust to read it and give me feedback on my argument.
By the end, I have a clear thesis and strong support for my opinion. I also understand the risks and what could go wrong. My decision is deliberate and unemotional.
How this method has worked for me
Let me give you an example of how this process has helped me make confident investment decisions in the past. In the fall of 2012, a friend told me about low-cost airline Spirit Airlines (SAVE -2.90%). They told me about the company's friendly service, no-nonsense approach, and incredible prices. At the time, I knew next to nothing about the airline industry except that the big players always seemed to be going bankrupt. I decided to investigate.
I got to work, reading Spirit Airlines' 10-Q and 10-K, as well as the most recent conference call transcript. The company was really doing something right. Profits were increasing at a 35% annual rate, driven by improving margins and rocketing sales. The financials were impressive, yes, but I also liked the company's strategy. The idea is to keep prices well below Spirit's competitors' (its ticker symbol is SAVE, after all). The airline researched various points of travel, did a competitor analysis, and determined whether it could materially undercut the prevailing prices to and from those airports. If it could, it moved in and dominated. If not, it went elsewhere.
I realized the company was a winner when I shifted gears and began looking at the competitors. For example, thumbing through Delta's (DAL -2.62%) SEC filings, I kept seeing company management lament their inability to successfully raise prices. (You can see for yourself on pages 11, 14, and 28 here). Compare that to Spirit's management, who take pride in lowering ticket prices even as the company's profits grow. Back in 2012, when I was doing this evaluation, Spirit had just successfully reduced its average ticket price by 2.6%, and that accompanied the revenue and profit growth mentioned above.
Be organized, succinct, and clear
How do I know remember all these details so well? Because I wrote them all down at the time.
By going through my process and writing my thoughts out in a clear, concise narrative, I was able to organize my thoughts and understand my investment thesis fully. And as a side benefit, I now have a record of my thinking so that I can learn from my successes and failures.
In a few weeks, companies will begin releasing their 2014 annual reports en masse. Those reports can run hundreds of pages. Layer on top of that the regular quarterly earnings reports, 10-Qs, and conference calls. Beyond those primary sources, you have thousands of media outlets covering company news and an army of financial advisors eager to give you their analyses.
For me, the only way to survive that avalanche of information is to take the time to write out my ideas. Through that writing process, I can filter out the noise and find what really matters. My thoughts become clearer, and I can make connections I would have otherwise missed. I can see the holes in my own judgment and correct them.
If you're looking for a simple and effective way to improve your investing right now, my advice is to take up this practice. I wouldn't invest without it.
