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Picture this: You go to YouTube, look up your favorite YouTuber, and he gives you one or two stock picks to feel excited about. Before you close the app, YouTube recommends another video titled "Best Stock Picks This Year," you watch it, adding a few more stock picks to your list. You promise yourself you come back and research them next weekend. But before you go to bed, a quick scroll through Twitter adds a few more ideas to your list, and just about the time you think you can't handle any more stock ideas, a breaking news article on CNBC adds a new ticker to the top. At best, you research a few haphazardly and skip the rest, and at worst, you forget about the list and repeat the same process the next day.
This stock-picking dance happens to all of us more often than we care to admit it. It is quite damaging to our success as long-term investors. In today's blog post, I'll share a process that can help you take control of your stock-picking process. It's simple and effective; anyone can use it, and it puts you in control and it is based on how Warren Buffett recommends you pick stocks.
Let's talk about that!
I'm Hoda Mehr, founder, and CEO of Stock Card, and on this blog and its accompanying YouTube channel and Podcast show, I share detailed fundamental analyses and interesting investment stories.
This post is part of our educational series to help you hone your fundamental investing skills. Catch up with the other post on How to Invest Like Buffett ?.
Remember, this content is for education and sharing ideas and not advice to buy or sell any securities.
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The starting point of this template is how Warren Buffett recommends you pick stocks. After we understand how he does it, I'd share a more practical and useful template you can use to find stock picks according to his methodology but in the modern day and age.
Warren Buffett's Approach: On several occasions, investors have asked what he would do if he had a small amount of money and wanted to make lots of money in the stock market. His answer has two parts:
To pick stocks following Buffett's suggestion, I have devised a framework I call a three-legged stool with a flower vase.
Market Cap Filter
This typically refers to a company with a market cap of at least $50 Million or above but lower than $10B. Chris Myer, the author of the 100-bagger book, explains this best. Chris has looked through companies created more than 100 times in return between 1962 and 2014 and found the most common characteristics of such companies. The idea is that smaller companies can grow ten or 20 times, still be small, and have room to grow over the year. In contrast, Apple today has a roughly $1Trillion market cap. We can safely assume it won’t go up 10 or 20 times and certainly not a hundredfold. So for us long-term investors buying companies to hold for 3, 5, or 10 years and, in return, expect to get rewarded significantly, we have to focus on smaller companies.
How to find them?
It's one of the easiest criteria to screen for. You go to Stock Card's stock screener tool, and choose the market cap filter, and remove companies with less than $50M and more than $10B in market cap. Please notice this would exclude very good investments such as Airbnb or Nvidia. But, notice, here we are focusing on finding companies that don't trend, and also, we are looking for companies that truly deserve to be held for a decade. Nvidia is a great company, but we all have exposure to Nvidia, either through holding broad market indexes such as SPY or some other ETFs.
Revenue Growth Filter
We've often heard that fundamental investing is picking businesses, not stocks. This means we must have a few criteria to differentiate a good company from a crappy one. If there is only one filter we should pay attention to, we should focus on revenue growth or a company's ability to grow revenue. Without revenue growth, it is very hard to attract talent and capital, and the company starts to shrink and decline, especially if the plan is to hold the stock for 3, 5, or 10 years, this criteria becomes super important.
How to find them?
One simple way to look at it is to just look at companies who grow their revenue in the last 12 months. But businesses are like humans, they have good years and bad. You can't just judge them based on one year's performance. You want a company that has been able to grow most of the time, with some flexibility for slower growth in a quarter or two. I prefer looking at the company's annualized revenue growth in a 3-year. On Stock Card's screener, if you choose the "Solid Revenue Growth" filter, it is based on the company's revenue growth in the last quarter over quarter, year over year, and 3-year period. Looking at all three periods, Stock Card allows for flexibility in revenue growth interruptions if a company has a bad quarter.
Cash Generation Filter
What's the most important reason businesses exist? I wait a few seconds for you to think about this. If you said making money, you are spot on. Yes, businesses exist to make the world a better place, innovate to solve problems, bring a dream to reality, and so on, but at the end of the day, the ultimate goal of any business is to make money.
How to find them?
We can use net income or profit that companies report at the end of the profit and loss statement. However, net profit results from accounting rules that don't always show the company's cash generation power. Instead, free cash flow is a better indicator of a company's ability to generate cash because it excludes non-cash expenses such as stock-based compensation and includes cash expenditure on capital expenditures. It shows the true power of a company in making money.
On Stock Card's screener, if you choose the "Cash Availability" filter, it is based on the company's free cash flow and its growth in the last quarter over quarter, year over year, and 3-year period. Looking at all three periods, Stock Card allows you to filter out companies that aren't truly cash-generating.
Those three filters are foundational to your long-term stock screening. However, they are not the only screeners you have to use, but it take the universe of more than 21K stocks listed in the U.S. down to around twelve hundred stocks on the day of recording this session for you.
Now, for the next part of our discussion, let's focus on how you can further narrow down the list from 12 hundred stocks to a few. If it were young Warren Buffett, he would have started researching the full list. But let's accept that with the help of technology, we can be much more efficient than Buffett.
Two Additional Filters To Screen Stocks Like Buffett
First off, there are super easy ways to cut things out.
Now, we have a screener that gives us about 100 stocks or so that are worth researching and spending time on. It is very easy to take this screener and make it more personal to your investment strategies. For example, if you want a company to be profitable or rather invest in undervalued stocks, those are additional criteria you can add.
This is the link to the screener I created in this blog post: Click Here. You can save it to your Stock Card account and adjust it to your liking, if you are on the mission to invest like Buffett!
I'll see you next time!