Basic Questions to Ask Before Buying Stocks

When you first start looking at the stock market, it looks like a big pile of random numbers and jargon that you think will take forever to sift through. The truth is that a lot of the numbers are distractions for most investors, and the jargon isn’t necessary to know to succeed.

By the time you’re done with this tutorial, I hope you can say that you have a better understanding of stocks and what makes them high quality or poor quality.

This isn’t a tutorial for hedge fund managers picking stocks, this is intended for beginners who are just now jumping into buying stocks or more confident buyers who want to optimize their stock picks and make sure they aren’t making any major mistakes.

Which Broker Should I Use?

Before you can buy stocks, you need some sort of brokerage, someone who buys and holds the stocks you request. You should find the broker that suits all of your needs as an investor according to your strategy and experience level.

I personally use M1 Finance for all of my stock purchases because they have three features I really like.

  1. Automation of deposits. I can invest an amount each month that will be instantly put into the stocks I currently have selected.
  2. Automatic diversification. They organize your account into “pies” where you essentially say you want a certain percentage of your overall portfolio in each stock, and you can customize that however you want. As you deposit money, it gets distributed to keep your pie slices at the place you want them.
  3. Fractional shares. You don’t have to have $1,000 to buy a single stock that costs $1,000 per share. You can buy fractional shares instead, maybe 0.1 stocks of that $1000 stock, and 0.1 of another stock. This is done automatically for you. It means you get perfect diversification which we’ll discuss the importance of later.

The main disadvantage of M1 Finance is a lack of advanced stock options for day-traders. You can’t put automatic buy/sell orders in there to buy or sell at certain prices, you can’t buy with leverage, and you can’t short stocks if you think they are about to fall.

I personally don’t use any of these features, so it isn’t a disadvantage for me.

The biggest disadvantage I personally struggle with on M1 Finance is that I use a financial tracking platform called Personal Capital to keep track of all of my finances, but they do not currently have an integration between the two services. Both parties have indicated they are interested in it, but Personal Capital requires a threshold of people asking for a financial partner before they consider integrating.

What Industry is the Stock In?

One of the easiest yet missed aspects of stock picking is to pay attention to the industry the stock is in.

If the stock’s industry is going to grow more than other industries in the next year, it passes the test. If it is in a declining industry, it fails the industry test.

Let’s use an analogy with the real estate market. If you reside in a poor or declining neighborhood and your house improves drastically in physical value, that doesn’t mean it will be sellable. Let’s say you invest $100k in your house, and it already was worth $100k, but the most expensive house in the neighborhood is only $120k, guess what? Your house will not sell for $200k.

The same is true for buying a stock in a declining industry. Even if all of the other indicators look great, the demand to purchase the stock will remain low because people aren’t buying into those industries.

Instead of personally analysing industries, I use Zacks Industry Rank. Zacks rankings are based on earnings expectations. They have individual stock rankings, which we’ll talk about later, and industry rankings.

A good industry rank means the industry may earn more than previously expected in the near future. A low industry rank means it may earn less than expected in the near future. Personally I think it is a perfect proxy for the immediate performance of stock industries.

My current standard is that I will only buy stocks in the top 50% in industry rank.

How Diversified is Your Portfolio?

There are a couple aspects to diversification you may want to consider. First of all, I hear from people all the time that they “bought a stock” in some major company.

Typically they like a product the company sells, or heard some positive news. No other stocks are considered, just the one. They are hoping that company increases in value over time.

So what happens if that company has some bad press, or its numbers start to look worse? Buyers will drop that stock, and price will fall fast. You’ll be stuck with major losses on that single stock.

It is better to be invested in 10 stocks. If the portfolio on average increases 10%, but one of the stocks experiences bad news, you’ll still be up overall.

Now, what if you have $10k in your portfolio but want to buy a stock that costs $6k per share. How will you diversify? You’ll need a broker like M1 Finance that allows fractional shares, or the ability to buy a portion of a share. So instead of dropping $6k to get one stock, you could get 0.15 of that stock instead for $900.

Similarly, let’s say you’re invested in only a single industry. It could be the best industry, the top earner, but if some piece of bad news hits that industry ALL of your stocks will drop. It is better to be invested across multiple industries. The likelihood is that most of those industries will do well, but at least one will have a rough time. You do not want to be caught investing in only the stock or industry experiencing a rough time.

The common myth is you’ll limit your returns if you diversify. However, note that buying a single stock is based on speculation, whereas buying a portfolio of stocks should be based on a strategy instead.

I try to have at least 10 different stocks across more than 5 industries at all times. If more stocks fill my criteria, I’ll hold more than 10.

One way to diversify is to buy into a mutual fund. They typically buy a very large range of stocks, and some of them will mimic entire indexes like the S&P 500. However, their volume handicap and risk aversion typically limits their returns, so they are only a good option for the hands-off investor or investor with high risk-aversion.

Personally I have a risk-averse retirement fund that buys mutual funds. I also have my personal portfolio that tries to achieve the top returns by buying individual stocks that meet my criteria.

Thus you can further diversify by using multiple strategies at the same time.

Is the Company in Good Standing?

I’m not a fan of speculative investing based on news, but some companies simply have a bad mark on them that will take a couple of years to recover from.

A company could have really good financial metrics, but if they have an issue fundamental to their business it typically will destroy stock market confidence.

Take for instance, the company that accumulates financial data to issue credit scores, but got hacked and leaked 143 million people’s data. Their stock dropped 40% in a week, and hasn’t recovered in ½ a year and likely won’t for another year or two.

My standard is to simply scan the headlines to make sure there is nothing too bad. Usually it has to be really bad to scar the company’s stock price for the long-term, but you should make that judgement yourself. Luckily most brokerages have the headlines for whatever stocks you pick, and that includes M1 Finance.

Is the stock overvalued or undervalued?

This is also one of the biggest mistakes people make when purchasing stocks. They buy into the huge companies because they see them put out a new product that they approve of or make positive news headlines.

If a company seems to be worth $5B, but their stock market cap is $10B, and you think they’ll someday be worth $6B, it may not actually be realized in the stock price because the stock is still overvalued. People may not jump into the stock because it is still not a discount.

If a company is worth $6B but their cap is $5B, that means they’re trading at a 20% discount. As soon as something triggers people to look at that stock, maybe an increase in earnings or a new product, it may correct itself.

You don’t necessarily have to do a value estimate yourself, but there are a few metrics I really like to look at myself.

  1. P/E: Price to earnings ratio. If a stock has a $50 p/e, that means they make $1 in earnings for every $50 in price. If the company paid all of its earnings to stockholders, and price didn’t fluctuate, stockholders would get a 2% ROI. A stock with high p/e may be overvalued while a stock with low p/e may be undervalued.
  2. P/FCF: Price to free-cash-flow. I like looking at this metric because free cash flow tells a more precise picture than earnings. If you make $2000 a month but pay $1000 in debt payments, you aren’t doing near as well as someone making $2000 a month with no debt payment.
  3. Book/Market: Book-to-market ratio. It is more difficult to calculate book-market-ratio than the other metrics, because it can be difficult to determine book value. But public companies generally publish their financial records, so if you can go in and subtract assets – liabilities it should give you the book value. If a company has a lot of patents or brand equity, your results will be skewed because intangible assets are often not treated the same as physical assets. Then divide book value by market cap, and that’s the book/market ratio.

The quick and dirty method I use to check a stock’s value is to look at the Zacks Value Style-Score. Stocks are graded A-F where undervalued stocks will fall within A or B and overvalued stocks will be D or F.

The standard I use is a Zacks value style score of A or B because I want to buy stocks at a discount.

What are the Growth Prospects of the Stock?

A stock can be completely bought at a discount with value investing, but if the stock later declines in value the discount is worthless. If the stock increases in value and you bought at a discount, that means your investment grew.

That’s why I like to look at growth estimates on top of value estimates. You can buy into a major huge company if you’d like, but if they are projected to grow at like 2% next year, there is no reason to expect to gain much value out of that investment.

One indicator that a stock will grow is looking at what amount they are increasing their investment in their operations. For instance, if the company spent $10 million last year on their factories and stuff, but this year are spending $12 million, you may assume that they’re growing at 20%.

This isn’t always true, sometimes it just means that things are more expensive in the market and therefore they spent more, but usually it is an indicator that they are increasing in size.

I don’t spend the time assessing these metrics myself on each stock, I use Zacks Growth Style Score and my standard is that the stock should have an A or B in growth, but can have a C if all other indicators are perfect.

What are the Earnings Surprise Prospects for a Stock?

By the end of this article you’ll notice I use Zacks for most of my analysis when tracking individual stocks. But the reason I got started using them is this one metric for measuring stocks, and that is Earnings Surprise.

A positive earnings surprise occurs when a company releases earnings that were higher than previous estimates. If they projected 10% growth in earnings and they hit 10% growth in earnings, that would be a 0% earnings surprise. However, if they projected 10% growth in earnings and hit 12% growth in earnings, that would be a 20% earnings surprise.

Zacks Rank is a 1-5 rank of stocks based on their predictions on whether a stock will issue a surprise or not. Their exact formula is under wraps, but essentially they put the 5% of stocks with the greatest estimated earnings surprise as a 1 ranking, and the 5% with the worst earnings surprise (could be negative) in the 5 ranking.

Right now my strategy is to only buy 1s, and definitely sell if a stock hits a 3. I’ll only keep a 2 ranked stock if all of the other metrics look fantastic.

How to Track All of These Stock Questions in One Place

Zacks has a lot of features that are only available for paying subscribers, but one of their features for free members that I use almost daily is portfolios. You can build a “portfolio” of stocks you own or are interested in and it will show you a stock’s industry rank, Zacks Rank, and style scores.

It would be very difficult to keep checking each stock in your portfolio to see if it still meets your criteria. Instead you should just have all of the relevant things you care about in one place so you can easily see if a stock falls below one of your quality indicators.

Now I’m not a professional stock picker by any means, but I am a strong believer in using these fundamental metrics to pick stocks. If you stick to a measurable strategy, you will achieve much better results than the average investor.

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