There is some pretty good advice that says people shouldn’t bother with individual stock picking. Instead, they should just accept the fact that they cannot outperform the markets and buy well-diversified mutual funds and try to come as close to the returns of the markets as they can by keeping fees low. It is probably true that most people shouldn’t buy individual stocks, because most people buy (and sell) individual stocks for the wrong reason.
Some people buy stock in companies that they know (think McDonald’s). Others buy individual stocks because they see they have record earnings. Still, others buy into a stock because think that their business will do well (for example, everyone uses Google, so I should buy stock in Google). Sometimes people follow the price of a stock and buy because the stock has fallen significantly in price, increased significantly in price, or follows some price pattern. Some people buy stock in the company for which they work. Some people even buy stocks because they like the name or the ticker symbol.
None of these are good reasons to buy stocks and you’d be much better off just putting your money away in low-cost index funds and getting another hobby if these are your reasons. You will be buying too high, buying too late, selling too soon, and maybe putting your money into stocks that will just do nothing for the next few decades. You might have some great stories about the stock you bought that did well, but you’ll earn 2-3% returns when the markets provide 10-15% returns over the same period. In other words, you’ll retire with $500,000 when you would have had $50M if you’d just invested in index funds.
So why would you buy individual stocks? Well, think about the restaurants that are in your neighborhood. If you were to invest $10,000 and buy a 0.5% stake in all of the restaurants, over a long period of time you’d probably make a decent return on your money. Some restaurants wouldn’t make it, but some would do spectacularly well. Overall, because people need to eat and because inflation will cause the price of the restaurants to increase over time (the value actually stays the same), the price of your investment would increase. In 30 or 40 years, you might be able to sell your stake for a few million dollars. This is assuming something like a tornado doesn’t come through and destroy everything – but you could deal with that risk by buying stakes in restaurants across the whole state. This is like buying mutual funds – you get a small stake in a lot of companies and overall you get a decent return.
But I’ll bet there are a couple of restaurants in your area that are better run than others. When you go in the door, they’re always crowded yet people don’t mind waiting. The food is fantastic. The servers are consistent and generally make the experience fun and pleasurable. You can tell that they have every aspect of the experience down to a science. They are even located on just the right corner.
Looking at how things are run, you can expect this restaurant to earn more money than the others. Even more important, you think they might expand the dining room to serve even more people each night or open a second restaurant across town. While something could happen such as a divorce of the owners, a fire, or a change in management, in general, you can reasonably predict that this restaurant will do better than the others, so you would want to have a bigger stake in this restaurant than the others.
Now things do happen, even to great restaurants. You therefore don’t want to put all of your money into one restaurant. But maybe you find the best restaurant in your neighborhood, then find the best one in the neighboring town. Maybe you find the best five or ten restaurants, one or two in each town or city, and buy stakes. Maybe you invest a quarter or half of your money this way, then invest the rest in a small stake in the rest of the restaurants, just in case your picks don’t work out.
This is the same way you choose and invest in individual stocks. You find the great companies – the ones that are well run and have a consistent record of performance. You find companies that have room to grow since the stock price increases roughly at the same rate as earnings growth. You buy larger stakes in these companies, perhaps even just starting with one company when you only have a couple of thousand dollars to invest. As your portfolio increases in size through regular investment, you then start to diversify out into mutual funds to protect your gains and hedge against bad stock choices.
So in looking for stocks, I try to find the best stocks in each sector and buy into those. I look at management, through the history of earnings growth and factors like return on equity. I look at debt and try to find companies that are able to fund growth without needing to borrow a lot of money. I look for companies that still have a lot of room to expand and grow. I look for the companies who are the best at what they do, both in how they treat their customers and how they treat their employees. That is how you choose individual stocks.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.
