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I have excellent news: Fundamental investing is arguably one of the easiest ways to invest.
Investing is stressful and hard when you worry about the stock price. Because the price keeps moving up and down, you can literally see the value of your investment every minute, and that's extremely taxing. If the stock price goes up, you want to save yourself from future regrets and lock in that gain as fast as possible. If the stock price goes down, you want to save yourself again from the pain of losing more money by selling the stock now. But, there is also the possibility that you make a mistake and sell something just before it goes up another 10% or sell a falling stock just before it recovers and goes back up.
If your investment decision is based on price and price predictions, you always have something to worry about. Moreover, every time there is a piece of news about the companies you invested in, you worry about the impact on their prices.
In contrast, in fundamental investing, you don't stress about price fluctuations or what the news says about the company today, this week, or this month. Because in fundamental investing, you are not picking stocks, you are investing in the company behind the stock, which differs from its stock price. Buffett says it the best:
"Charlie and I are not stock-pickers, we are business-pickers."
When you pick a business, the company's situation rarely changes daily or based on news articles. The price can fly to the moon or crash to the ground, but the business behind it is still the same. You can research the company once without worrying about it for at least a few quarters, if not longer.
That's the good news. If you invest fundamentally, you can invest slowly and steadily without the stress of the market and build wealth.
Now that we know fundamental investing is about the business behind the stock, we should ask ourselves what makes a company strong. In this video, I give you a 6-part research process anyone can use to assess the strength of a business and use it to pick stocks for the long term.
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 a series I started a few weeks ago to fundamentally research companies to manage my real-money portfolio. I've already researched Canopy Growth (CGC), Fastly (FSLY), Snap (SNAP) , Shopify (SHOP), Airbnb (ABNB), Unity (U), JD.com (JD), NVIDIA (NVDA) and several others. I'll continue with this series for a few more weeks.
Remember, this content is for education and sharing ideas and not advice to buy or sell any securities.
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Now, what makes a company a good one? Think about it intuitively:
You may come up with some other points. Coming up with the characteristics of a strong company isn't too difficult. What's important is to learn how to use the company's financial statements and publicly available information to assess the company.
Criteria One: How Does It Make Money
A business is a for-profit entity. At its core, it has to be able to make money. So the first thing we must do is to understand how the company on our radar actually makes money. I can't tell you how many people I have spoken with that invested in a stock and had no idea how it actually makes money. Does it sell something, get paid for its services, charge a fee or a subscription, or something else? It is the foundation question you must answer.
How to find them?
The best way to start your research is to read the business description. All companies share a brief business description on their annual and quarterly reports. Review a company's annual report and look for the business description section. On Stock Card, you can read the description in the introduction section.
This may seem to be an extra step. However, if you want to understand a company, you have to know how it makes money. Some business models are better than others. For example, digital subscriptions or SaaS business models are recurring and are more profitable than a physical retailer. You can see that in Amazon's business. It makes money in two primary ways: 1) Selling products on Amazon and 2) Delivering its cloud services through AWS. Selling products is very expensive and low margin. Delivering cloud services is highly profitable because you build the infrastructure once and sell it several times. You may feel I'm simplifying things, but that's the point. You want to find companies with simple, recurring, easy ways of making money.
Some companies don't make money yet. Think of research-phase pharmaceutical companies or SPACs (special purpose acquisition companies) that became quite popular in 2021. They were fundamentally difficult businesses to research or pick because they weren't making money yet. So investing in them was stressful because there was no money-making foundation behind the stock. I don't say you shouldn't invest in companies that don't make money. Some are worth it, but understand that you are taking the risk of "no business model," which is a very big risk in most cases.
Criteria Two: Topline and Bottom Lines
The top line is the figure that tells you how much money a company makes, and the bottom line is the figure showing how much money is left at the end of the month, considering every single expense the company has to incur to make money and keeps the lights on. Knowing those figures are important. However, the more important thing is the direction of the top and bottom lines. You'd want to know whether the company is growing or shrinking its revenue and profits if it has any.
How to find them?
Those figures come directly from companies' income statements. You can visit any publicly traded company's website and look for the investor section. In the investor section, there is a portion for SEC filings. There are typically the annual and quarterly earnings reports the companies file with the SEC. Those reports show how the top and bottom lines have moved in the last few quarters or years. You can also get that information on Stock Card. Look up any company's Stock Card, and you can see the Revenue and Profit sections as the top 2 pieces of information contributing to a company's financial strength. Make sure you know how much money a company makes and then how it has increased or decreased in the last quarter over quarter, year over year, and three years.
The important factor is understanding why the company's top and bottom lines have increased or declined. If the revenue is up, ask yourself why? For example, in Q1 2023, Unity's revenue was up by more than 50%. At first glance, it's good. But, if you read through the company's quarterly earnings, you realize it is due to a recent acquisition and not organic growth.
The difference between a robot and you looking at such information is that you can see the growth or decline rate and ask yourself why? If this were an algorithmic trading bot, it would have considered the revenue growth a good thing and moved on.
You, with your organic intelligence, can look at the information and ask yourself why this happened and whether it shows the company is better and stronger than a year ago.
The last thing about assessing a company's top and bottom line is identifying how it can grow over the years. There are many factors contributing to the answer. Some common factors are:
For example, a company like Nvidia is developing computer chips, and the market for those chips is rapidly growing. In contrast, a company like Coca-Cola is in the soft drinks market that is much slower in growth.
A company like Unity is one of the two companies that enable others to make high-quality digital experiences and games and has a higher potential to grow than a company such as Target, which is one of the many retail stores in the U.S.
And lastly, a company that is run by its original founder may be able to grow faster because the founder's personal and financial success is tied to the future of the company.
You may come up with, hear, or read about many other factors on the web. At their core, they are all different ways to assess whether the company can grow its revenue and profit faster and far longer than others.
Criteria Three: Cash Generation
The next important factor in researching a company is understanding whether it has money to allocate to its future growth and invest in itself. Where does this money come from? Either the company's operations generate cash, or it has saved up or raised capital in the past and has kept it accessible to invest in its future.
Naturally, everyone jumps on profitability. However, you need to understand profit is an engineered number. Profit at the end of a company's profit and loss statement is not equal to the cash it made in that period. Accounting departments engineer profit. You can remove non-cash expenses such as stock-based compensation or depreciation of your assets from your income and report a very different number than what amount of cash your business actually generated.
A better way to understand a company's cash generation strength is to look at free cash flow. Free cash flow takes the cash from the operations, adds back non-cash expenses, and removes capital expenditures that are not shown in the profit and loss statement. A company with strong finances can generate free cash flow.
That's why Stock Card has a full section allocated to free cash flow, just like revenue and profit. You can also get the free cash flow figure from financial statements. Just open any financial statement a company has filed with the SEC, and search for the term free cash flow, and you'll get the figure.
Sometimes, companies do not yet generate free cash flow. This is quite common in early-stage growth companies. In those cases, you'd want to see how much cash or cash equivalents the company has available on its balance sheet, compare it with short-term liabilities the company holds, and make sure it has the resources to invest in its future, even though the operations don't generate free cash flow.
As a matter of fact, it's always a good idea to look at the cash vs. liabilities of a company to make sure a significantly large amount of liabilities does not burden it. Just be mindful that some companies, such as banks, hold a lot of liabilities, but that's not bad. They are in the business of lending and borrowing money. That's why we discussed the importance of knowing how a company makes money because you can make these subjective judgments about high liabilities in the context of its business model.
How to find them?
Like the other few data points, there is a section on every company's Stock Card about its cash vs debt that you can use to assess its balance sheet strengths and weaknesses. Or, simply go to the latest SEC filings by the company and look for its balance sheet.
One More Criteria: Stock Valuation
Many fundamental investors don't agree with me that valuation matters. However, my experience tells me, and most likely, your experience in life would agree that it's better to buy things we like at a lower price whenever it's possible, or at least avoid paying significantly higher prices than what's reasonable.
Before digging into how to use valuation information in our investment research, let's discuss why many long-term investors do not pay attention to stocks' valuations.
There are two ways you value a company:
The problem with the first methodology is that it is backward-looking. But, you invest in companies that you expect to have tremendous success in the future. Their past performance should be only a fraction of their future success. Therefore using valuation ratios is irrelevant.
The problem with the second methodology is that it is forecasting the future. No one really knows what will happen in the future. As they say, there are two kinds of forecasters: those who don't know and those who don't know they don't know. That's an exaggerated way of saying that forecasting the future is impossible, therefore, trying to value a company based on it is irrelevant.
While I agree with the shortcomings of both methodologies, looking at the valuation ratios can be a very useful exercise. You can use the valuation ratios to decide how feasible it is for the company to grow into its valuation. Let's take an example:
Take Zoom (ZM) as an example. In May 2023, Zoom's price-to-sales ratio is about five times. In simple terms, this means investors expect the company to at least grow its sales five times its current revenue, all other factors such as profit and free cash flow being equal. To grow sales by five times in ten years, the company has to be able to grow its revenue by almost 18% per year. Is that possible? Zoom has grown its sales by roughly the same amount compounded annually between 2021 and 2023. It also operates in the web conference software market, which is expected to grow globally by 14.30% annually between 2020 and 2027. Therefore, the five times price-to-sales ratio for an investor willing to hold Zoom for ten years is reasonable. This math doesn't guarantee the valuation, but it gives us some sense that the market is not overexcited about Zoom, and we won't be paying too high of a price if we invest today.
How to Find them:
The good news is that you can find the most common valuation ratios on each companies' Stock Card. Click on the valuation, get the list, and even compare the valuation ratios with each company's peers.
For the second methodology. there are tools out there that help you calculate the valuation of a company using the discounted cash flow method. I don't use them myself because I agree with the critics that no one can predict the future, especially when investing in companies that are expected to bring significant growth to our portfolios. Typically, such companies get better and are flexible with the direction they take, and it is very difficult to say what new products or services they will launch in the future that impacts their future cash generation power. But mind you, if you are investing in more stable companies, let's say Coca-Cola, then a DCF methodology can be used because it is pretty clear what that company will be doing 5 to 10 years from now.
Step-By-Step Fundamental Analysis Recap
Let's recap a 6-part process to research stocks fundamentally to find such companies:
I hope you find this helpful. The only way you can master fundamental analysis is to practice it. So go ahead, pick one company now, and research it fundamentally.
There are several examples of such detailed analysis on our YouTube channel. There is a link to it in the notes section. Make sure to continue your education.
See you next time!