Investing: 5 Characteristics to Look for in a Great Stock

The NASDAQ keeps track of stock prices for over 3,300 companies, some that you have heard of like Apple, Tesla, and Disney and others that you haven’t such as Fonar, Unify, and Knology (don’t worry, I haven’t heard of these either). With so many companies, how are we supposed to know which ones to invest in? The big companies can seem safe because they are familiar but many times they may not return the yield that is desired out of pure name recognition. On the other hand, it can feel like a shot in the dark investing money into a company that you have never heard of before. These are the 5 main characteristics Baba uses to find great stocks.

These 5 stock characteristics will give you a decent idea of a company. You should do your full due diligence prior to purchasing a stock. This article is meant to be an intro. There are a lot of deeper components that go into each of these characteristics.

Investor’s Risk Appetite

Before we continue any further. YOU should only be choosing stocks based on YOUR risk appetite. This will decide what type of investments you are looking for. Based on YOUR risk appetite. For me, I don’t have a family or kids that I need to support, I can be a little bit riskier with my investments. The one thing I keep in mind when putting money into my brokerage account, I only put money I can afford to lose.

This will allow me to remove any emotions, which helps with long term investing. It will let me ride out the ups and downs of the wild market in the short term. This helps me focus on the long term fundamentals of the business. When I mention money I can afford to lose, what I mean is: if I lost this money today, my lifestyle would not change. I don’t have any upcoming bills that would require me to sell stock in order to pay them.

People do not understand that concept. Let’s say you had an upcoming medical bill of $1,000, and all your cash was tied up in a random stock because you assumed you’d be able to turn the $1,000 into $1,200 before your bill was due. Guess what, poor economic news was published and the whole market tanked – your $1,000 is now $800 (a $200 loss for those of us who aren’t good at math) You are forced to sell at a loss because you have a bill due. If you really believed in that random stock, and it checked all your boxes, over the long term you would have probably been okay, but since you had an immediate bill due, you had to sell at a loss.

There is always going to be a risk when it comes to investing. If there were no risk, everyone would do it. Investing is a patience game. If you are into day trading, you might as well throw darts to choose your next stock. Just because your buddy told you about this great stock at the bar, does not mean you should buy it without doing your homework. We want to minimize risk when it comes to investments. So how do we do that?

1. Liquidity

Prior to the coronavirus, this was not on the top of my list. Given the Black Swan event we just experienced, liquidity is the first thing I look at in a company. If a company doesn’t have enough cash to pay its “bills” it may have to file bankruptcy soon.

During the corona crisis, businesses came to a halt. Let’s take gyms for example. Revenue came to a halt, but companies still had overhead expenses they needed to pay (rent, salaries, and other stuff). If you don’t have a cushion of cash on the Balance Sheet or availability on your line of credit to get you through those few tough months of closures, you will be in bad shape.

In addition to overhead expenses, companies still have debt-related obligations (interest payments, mandatory debt repayments). Debt maturities also came due for a lot of companies during the coronavirus pandemic, and since their businesses came to a halt, and the debt markets also came to a halt, they were not able to refinance their debt and had to file bankruptcy.

The cheesy saying is right. Cash is always king.

This begs the question, “Where can I find this ‘liquidity’?” Great question. You want to check the company’s SEC filings (10Q – Quarterly, 10k – Annual). There are different ratios you can find online for liquidity, but for the purposes of this article, I will not go that deep.

Check the balance sheet. See if they have a lot of debt in the “Current Liabilities” line, these are due within 1 year. See if they have enough cash and short term investments in the “Current Asset” section to pay off any current debt coming due.

Look at the “Cash Flow from Operations” in the Cash Flow statement and see how much cash they are making from their core business.

Assume their business was shut down and they still had to pay their overhead (SG&A), how many months could they last with the cash and short term investments on their balance sheet?

These are some of the questions and analyses you should be performing. One other piece of information that a lot of people forget to dig into, debt covenants. Think of these as rules, and if the company breaches these rules, all their debt can become due at once (mature).

2. Earnings Growth

This one seems obvious. Any company that has shown sustained growth over multiple years especially from an earnings standpoint is a company that you certainly want to consider. Company growth is never purely linear, but there are certainly positive trends that anyone can quite clearly see.

Earnings traditionally mean Net Income. I personally don’t like Net Income because it includes non-cash expenses. It is not a true indication of how much the business actually “earned” on a cash basis.

I like to see EBITDA growth, and I also like to see Levered Free Cash Flow growth. Levered Free Cash Flow is how much cash is available after paying all mandatory payments. The cash that is left over can be paid out in dividends to shareholders or can be reinvested back into the business for future growth.

LFCF:

3. Fad Risk

Whether you fell victim to the fashion fad of frosted tips or the investing fad of putting money into a company that is trending on Robinhood, either way, you probably ended up regretting it. The best investments are the ones that you found at Goodwill. You looked through every aisle, you did your research, and you found the true value at the lowest price. 

For example, maybe you’re hearing a lot about a company and they have decent earnings growth, enough to make it attractive. That company may look pretty on the outside but we have yet to do any research on the financials, the leadership, and the industry that the company is in. It’s like online dating. That girl looks great on her Tinder profile but just remember you have yet to hear her voice, get to know her personality, and make sure she isn’t crazy. Fads can push stocks to wild valuations.

I bet you’ll question yourself, “What if I listened to my friend and bought the stock that every single person is talking about?” That feeling of missing out on crazy returns is painful, but you have to stay disciplined and grounded.

The three types of fad risks that I think of when it comes to stocks are:

1. Pump and Dumps: Though P&Ds are illegal, they work primarily on smaller cap companies. Basically, a group of investors buys the stock at a cheap price and then hypes the stock through misinformation/misrepresentation. After people have bought into the hype and the stock has risen, the investor group dumps their shares.
2. Robinhood Bump: This is a recent phenomenon. It also only works on smaller cap companies. Flocks of new retail investors trying to make a quick dollar in the market have been purchasing all companies that have been severely affected by coronavirus, anticipating that they would quickly recover to their pre-corona levels. All I have to say to this is, bankrupt companies don’t go back to their pre-corona level (Hertz).
3. One Hit Wonders: This is the true definition of fad risk. Do you guys remember GoPro ($GPRO)? That was the hottest item. Everyone wanted one until people realized they aren’t athletic enough to do anything worth recording (joking). That stock hit a peak of $86 dollars before falling off the cliff. I believe it trades around $5 dollars now.

The most important thing to remember here is to do our research on the company and feel confident about it long term. Fads will come and go.

4. Qualitative Assessment

There are many qualitative factors. I usually ask myself:

1. Do you like the company?
2. Do you use the company?
3. Does it solve a problem? Does it solve a problem long term?
4. What kind of competition is this company taking on? 
5. What’s their competitive advantage?
6. How’s the CEO and management?

In our opinion, you should only invest in companies that you like and fully understand.

For example, there are plenty of health-related companies, but during the coronavirus pandemic companies like Teladoc Health were addressing the problem of not being able to physically go to the doctor and solving that with telehealth options, something that we may see with increasing popularity in the near future.

5. Regulatory Risk

Regulatory risks are important in almost every industry, especially those that come under large amounts of political scrutiny. This is where understanding the political climate and what policies are changing is important. Policies passed by legislators can directly affect how a business operates and what it costs to operate, which in turn affects stockholders as a whole. 

Look what happened to JUUL, it was the hottest product, every high schooler, college student, and adult had one in their mouth, but it was a health concern. The company started getting negative publicity for making “Juuling” sexy, leading the FDA to ban flavored cartridges. This killed JUUL’s earning growth and destroyed the valuation overnight. Ask Altria how that $4.1B write-down felt.

Conclusion

I know this can seem like a lot but taking these factors into consideration can allow for long-term success. Remember the next time you’re thinking of which companies to invest in, just think, what would Baba do?

Here are some great resources. These books will help refine your investor mindset and further develop your own investing framework.

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