With over 7,000 different publicly traded companies to invest in, picking just a handful for your own portfolio can be like trying to find a needle in a haystack. In fact, it's enough to make some throw their hands in the air and turn the whole process over to "professionals."
While that might be the right decision for some folks, we here at The Motley Fool believe that -- given enough time to research and experience in the markets -- you can personally build a better portfolio to meet your family's financial needs.
One way to help winnow down your investment choices is to ask the right questions. Below, four of our contributors share the most important question they ask themselves before deciding whether or not to invest in a company.
Dan Caplinger: How much do insiders own?
The executives that run a company have the best view of its potential success, and when they put their money where their mouths are, shareholders can be more confident that the actions that those executives take will be in their collective best interest.
Yet some types of insider ownership are better than others. When insiders amassed their stakes in companies through low-priced, option-based compensation, they have different incentives than original founders who retained a portion of their initial ownership positions in their companies. By contrast, executives like Howard Schultz at Starbucks (NASDAQ:SBUX) and John Mackey at Whole Foods (NASDAQ:WFM) have chosen to stay on not only to defend their financial stakes in their respective companies but to carry on what they've chosen as a lifelong mission in support of their companies' visions. When you have leaders who think for the long haul, long-term investors can count on them thinking beyond the next quarter's results and instead seeking out ways to generate sustainable growth.
Some companies succeed without high levels of insider ownership. But when key people have big stakes in their own companies, you can often get a big leg up by joining them.
Vincent Shen: Who is driving the company’s performance?
As Dan put it so well, the executives running a company tend to have the best view of its potential success. For investors, those executives are themselves a key component of that success, which is why investors should also research the company’s leadership. Ultimately, buying stock isn’t just a vote of confidence in the products or services a company offers – it’s also a bet on the people in charge.
Ron Johnson, ex-CEO of JCPenney (NYSE:JCP), serves as a perfect cautionary tale. After launching the incredibly successful retail operations for Apple (NASDAQ:AAPL), Johnson was tapped by JCPenney to reenergize the aging brand. Over the next 17 months, Johnson would change nearly every aspect of the company from its promotional strategy and store design to the management team and culture.
The result? Year-over-year sales fell more than 20% the first quarter his changes took effect. By the following year, sales were down another 17%, and Johnson was quickly ousted from the company.
Johnson failed to realize that his successful strategies at Apple would not carry over perfectly to the much larger and more complicated retail operation at JCPenney. Shoppers shunned his new vision, but Johnson ignored their feedback and aggressively moved forward. Shares of the department store lost over half their value due to poor management.
On the other hand, strong leaders will not only drive a company on a path of continued success, but they also know how to right the ship when disaster strikes. Investors must be careful not to neglect the “who” in their investment thesis.
Tamara Walsh: How is the stock valued?
Before buying any stock it is important to first understand how the market is valuing said stock. Shares of Zynga (NASDAQ:ZNGA), for example, look extremely cheap on the surface with a stock price of just $2.64. For comparison, Zynga's rivals carry much higher share prices, including King Digital (UNKNOWN:KING.DL), which trades at around $12.84 today, or Electronic Arts (NASDAQ:EA), which trades around $47 a share.
A deeper look, however, reveals that Zynga is trading around fair value given its price-to-sales ratio of 3.47, which is in line with the industry average. King Digital, on the other hand, looks undervalued or valued at a discount, with a price-to-sales ratio of 1.7 and a price-to-earnings-growth value of 1.15 -- one of the lowest in the industry. The reason we don't use price-to-earnings ratios when determining Zynga's current value is because the company doesn't have positive earnings.
Therefore, while Zynga boasts a cheaper stock price, it is actually more richly valued than rival game maker King Digital, which currently trades at a discount. By using pricing metrics to uncover how the stock is valued, investors can better understand how much they are truly paying for a company.
Brian Stoffel: Are there sustainable competitive advantages?
The most important part of the question above is the word sustainable. If you want to invest in a company that can remain relevant and profitable for years to come, investigating competitive advantages -- sometimes called a "moat" -- is an absolute must.
On one side of the spectrum, we have companies like Groupon (NASDAQ:GRPN), which burst onto the scene in 2008 and took the nation by storm with its steep group discounts. By 2010, the company went public and surged more than 50%.
Since then, however, the stock has lost about three-quarters of its value. The main culprit is the simple fact that Groupon doesn't have a sustainable competitive advantage. While it might have been the first mover in group discounting, before long many cities had companies popping up with their own versions of Groupon.
On the other side of the coin we have a company like Amazon (NASDAQ:AMZN). What many might not realize about the company is that it has built out an impressive network of massive fulfillment centers. These centers enable the company to ship just about anything to your doorstep in two days or less -- and cost billions to build.
If anyone were to try and challenge Amazon's lickety-split delivery, they would first have to spend copious amounts of cash building out a network. That's a losing proposition for potential competitors, and an enormous -- and sustainable -- competitive advantage for Amazon.