Over the last seven years, I've analyzed hundreds of stocks and cryptocurrencies to see if they might be worth an investment. At the end of the day, I only end up buying a select few, like two of my longtime favorites, Costco Wholesale (COST -0.84%) and Apple (AAPL +0.32%).
Here's an abridged version of my research process -- hopefully it'll contain something useful to adapt as your own.
Image source: Getty Images.
Steps 0 to 4 -- First, build context
I typically start by getting the lay of the land regarding the company in question.
Step zero is comparing the stock's total returns to the S&P 500 over a range of different periods, starting from one month and extending to five years. Ideally, like both Apple and Costco, the company being evaluated will have outperformed the index over the last five years.
The first real step is skimming the company's latest financial reports, taking note of key figures like cash on hand relative to annual expenses, debt, and also the gross and net profit margins. Revenue growth and free cash flow growth are especially important. I'll revisit these numbers throughout the rest of the research process and examine any other metrics specific to the business in question or its industry.
Step two involves mapping the company's business model, growth drivers, upcoming catalysts, and addressable market size. This is where some important nuances start to emerge, so if I haven't found anything critical but subtle, I keep digging.
For instance, Costco is nominally a wholesaler that sells goods at close to their cost, which is reflected in its narrow gross profit margin of 11% in Q3. But that elides the critical nuance, which is that membership fees of $1.3 billion equaled roughly half its operating income in the quarter ending May 10. Thus, its bottom line is actually somewhat insulated against headwinds to its sales, which is a big point in its favor.
NASDAQ: COST
Key Data Points
The third step is examining the competitive landscape that the company operates in, specifically who holds market share, why, and how each company's strategy differs. Here, I begin to assess whether there's an economic moat or another durable competitive advantage that could place a company in a privileged position. Often, such advantages are the result of multiple factors working in concert.
For Apple, the power of its brand is the centerpiece of its competitive positioning. In combination with its large ecosystem of integrated applications and interoperable hardware, the branding helps Apple to retain customers in ways that its rivals can't.
NASDAQ: AAPL
Key Data Points
Step four is weighing how macro trends like artificial intelligence and climate change could affect the business. A bad macro setup isn't automatically a deal breaker. The point is to evaluate the company's ability to compete in future time periods where conditions could be very different.
Steps 5 to 7 -- Find the flags, whether red or green
The fifth step is examining a company's leadership, backers (especially venture capital for younger companies), and noteworthy insider purchases. In my analysis, I place no special value on elite credentials or other associations with high-status markers, but high value on demonstrated execution in similar prior concepts, especially within the same organization.
John Ternus, Apple's new chief executive, joined the company in 2001 and oversaw the iPad and AirPods launches. Similarly, Costco CEO Ron Vachris started as a forklift driver at Costco's predecessor Price Club in 1982. These two CEOs are exactly the profiles I'm looking for, and the same goes for what I like to see from the other members of the management team and the board of directors.
Step six is where things get serious because it's the risk review. Here, I dig through the company's annual filings to gauge each risk's likelihood and potential impact, keeping my understanding of the organization's finances up to date along the way. I'm generally quite tolerant of high risk if I think there's a proportionate (or disproportionate) amount of growth to be had.
The seventh step is to analyze the stock's valuation by looking at comparable companies and historical data. I am usually of the opinion that a dirt-cheap valuation means the stock could be hiding a big red flag or major risk that I haven't discovered yet. A rich valuation is acceptable when the growth on offer justifies it.
Step 8 -- Closing the loop
The last step is the hardest, and most assets don't pass.
After wrapping up any unanswered questions I have, I rank the company against my other opportunities at the moment, including stocks or cryptocurrencies that I already hold. If the candidate can't top that list, buying the asset would mean passing up on a return that I expect to be better, which rarely makes sense.
If it's the best opportunity I have, I make an investment shortly afterward.
