Author: Jason Hall | December 13, 2018
Finding great stocks takes work but it’s not impossible
If you want to build life-changing wealth, chances are the very best asset you can invest in is stocks. Over the long term, stocks have proven to generate better returns than bonds, gold, real estate, and cash investments like savings and certificates of deposit.
Furthermore, unlike many other assets, you don’t have to start out with a small fortune to build a large one with stocks, so long as you’re willing to put in the work to find great companies, and then maintain the patience to ride out the ups and downs the stock market can throw at us.
Step 1: Define what “great stock” means to you
There are a lot of great stocks out there that have -- and continue to -- generate great wealth for millions of people. But like many things, the beauty of a particular stock is “in the eye of the beholder.”
For instance, one person may love owning stock in a small company that’s trying to disrupt an industry. If it works out, the stock could go up substantially. But if it doesn’t investors stand to lose a lot of money.
That same stock might sound absolutely terrifying to someone else, who might find a boring, but high-yield utility stock far more attractive.
Still someone else might eschew both, instead preferring to invest in stocks that the market seems to be undervaluing, which also have a wide margin of safety in the value of their assets.
The point is, make sure you understand what your goal is -- i.e. high growth, income, or solid returns through value -- as well as how much risk and volatility you can stomach.
Step 2: Don’t reinvent the wheel
Once you’ve decided your goal, you can start building a pool of stocks to research. For instance, if your ideal portfolio would generate predictable dividends, a surprisingly good place to start is by plugging "best dividend stocks" into your favorite search engine. If you’re looking value or growth stocks, follow the same formula.
You can even get far more specific; for instance, if you’re interested in a certain industry, a web search for the kind of stock and industry you’re interested in can help you filter the results down even farther.
Here’s the thing: A Google search isn’t the finish line for your research -- it’s a starting point. But the reality is, there are a lot of stock jockeys out there (like me) already putting in a lot of time and effort to uncover great stocks. Use that work to your advantage.
In addition to a web search, there are plenty of handy -- and free -- stock screening tools available online. This can be a great way to get a bigger selection of stocks, for instance, from a specific industry, or generating a dividend yield above a certain level. A good screener also allows you to filter stocks by other metrics, including earnings, cash flows, revenue growth, and just about every other financial metric out there.
The advantage of using a screener is you’ll probably find some great stocks that don’t get as much coverage from the financial media, but you’ll also have to do even more legwork on your own.
Step 3: Look for great businesses
Investing legend Warren Buffett may have put it better than anyone, saying he would rather buy a “wonderful business at a fair price than a fair business at a wonderful price.” One of the easiest mistakes to make when it comes to finding great stocks is forgetting that these are businesses.
But when we lose touch with the business and only focus on the lines and numbers on a screen, it’s really easy to miss a company’s biggest strengths and weaknesses both. A few traits that great businesses often have include tenured executives, and often a CEO who collects a salary that may be average or even below average for the industry.
Even better, if the CEO and other high-level executives hold a large stake in the company, that’s often a good sign, particularly when shares have been held for the long-term and aren't just stock grants they get periodically. Best yet, companies that still have founders in leadership very often outperform their peers.
But what makes a good business? Does a company have pricing power? For instance, Netflix’s ability to raise its prices without losing subscribers is a powerful reflection of the strength of its business. Another example is the high barrier to competitive entry for many of Brookfield Infrastructure Partners’ toll roads, natural gas transmission pipelines, and maritime ports. Yet another is Nucor Corporation’s status as a low-cost leader. By being able to make a commodity product -- steel in this case -- at a lower price than most of its competitors, Nucor is better positioned to profit in most market conditions.
Step 4: Dig into the numbers
While getting too caught up in those numbers and lines on your computer screen can lead to investing mistakes, they do play an important role in finding great stocks.
For instance, if you’re looking for a great high-yield dividend stock, it’s a good idea to use the payout ratio metric to see how much of a company’s earnings it pays out. The higher its payout ratio, the thinner a margin of safety that a company will have to maintain the payout if something happens and its earnings take a hit.
Furthermore, it may seem smart to skip a growth stock that’s gone up sharply, assuming that the “easy money” has already been made. The reality is, very often the best stocks do continue to outpace the market. For instance, if a company’s stock is up 30% this year but earnings are up 50%, the stock is actually cheaper today, based on price to earnings. If that company is set to continue double-digit growth, you’d have missed an opportunity if you didn’t go deeper than the stock price.
Step 5: Prove yourself wrong
Another mistake people often make when picking stocks is spending their efforts looking for more reasons why they’re “right” on a stock. The problem is, when we focus exclusively on what can go right, we completely miss what can go wrong.
A far better -- yet harder -- approach is to figure out what you’re missing. Take your thesis for a company and tear it apart bit by bit. What happens if the company doesn’t hit the sales growth target management promises? What if that new product isn’t as well received as you think it will be? What happens if a competitor enters the market?
This is really hard to do, and one way to do better here is to not go at it alone. Even Buffett has Charlie Munger, the gruff curmudgeon to Warren’s eternal optimist. Find a fellow investor who you respect but often disagree with, and bounce ideas off one another. I promise they will help you find holes in your perfect investing thesis you never saw. You get to return the favor.
Step 6: Learn to say “no”
In yet another hat tip to Buffett, this may be the most-important step to investing success. Buffett has said "the difference between successful people and really successful people is that really successful people say no to almost everything." And while Buffett wasn’t specifically talking about stock picking -- he was making a more general comment about what you invest your time and resources into -- it absolutely still applies.
When picking stocks, it can be easy to fall for the trap of being too quick to say “yes” to every good idea you hear. And before you know it, you end up with a mish-mash portfolio of stocks you know little about, or even how to evaluate. But by being more disciplined in what you buy, you’ll find it far easier to follow and manage your investments, and that can make all the difference when it comes to riding out the market’s turbulence.
Step 7: Learn from your mistakes
When it comes to finding great stocks over a lifetime, you’re going to pick stocks that don’t do well. But that’s okay; one big winner can more than make up for being wrong multiple times. Even the best investors in the world get it wrong 40% of the time.
But instead of just selling and chalking it up as a “loss,” take the time to review what happened and learn from it. Many investors keep a journal, noting why they bought a stock, their expectations, and then explaining why they sold if and when the time comes. Others review their portfolios on a regular basis, measuring how their investments are performing against their expectations.
Step 8: Learn from your successes, too
It’s not just your losses that can teach you lessons: study your winning investments, too. There’s a very good chance some of them do well for reasons you weren’t counting on. If you take the time to identify what went right -- and then compare that to what you were looking for -- the knowledge you gain can help you identify future opportunities.
Furthermore, in the cases of both your successful stocks, and the losers, putting in the time to learn what’s happening can pay off in another way: learning that the next winning stock you need to buy is already in your portfolio. Sometimes a great stock is beaten down and set to bounce back; other times it’s a winner that’s set to keep winning.
In both cases, the difference is whether or not you’re putting in the work to learn more about the stocks you own, steadily building on your own knowledge base and experience.
Over the long term, investing in your own knowledge will pay off more than anything else when it comes to finding great stocks.
Jason Hall owns shares of Brookfield Infrastructure Partners, Netflix, and Nucor. The Motley Fool owns shares of and recommends Netflix. The Motley Fool recommends Brookfield Infrastructure Partners and Nucor. The Motley Fool has a disclosure policy.