How to pick your investments

The research you can do to become a better stock picker.
February 17, 2021

“Do your own research” is common advice in the investment field (and the conspiracy theory field — please don’t draw any conclusions!).

It basically means, “don’t take my word for it, I’m not on the hook, you need to take responsibility and come to your own conclusions.”

That’s good advice and good ass-covering.

And it does sound very reasonable. But one issue swiftly appears when you put it into practice — where do you start?

You’ve already gone to the effort of opening your investment account and now you have to do research. And more research on what constitutes good research.

This seems suspiciously like work!

Well, it is a bit. But some upfront research is probably the most efficient way to improve your investing skills and unlike most work, what and how much you do is totally up to you.

It could be a week of meticulous analysis, or a couple of sense checks on Google.

Here are some good places to begin.

Dealing in data

There are two big sets of data associated with stock prices:

  • Trading and pricing statistics from markets
  • The underlying financial data from the company, sector and economy

The first set is highly relevant for technical analysis — an approach that focuses on trying to read and predict market behaviour from pricing trends.

We won’t get into technical analysis because (regardless of its efficacy) it’s arguably more suited to short-term trading than long-term investing.

The second provides the basis for fundamental analysis.

 

Fundamentals

Fundamental metrics can’t tell you everything about a stock, but they’re a good place to start. It’s like if you’re buying a car, you check that the doors open and it is actually a real car and not, say, a very realistic painting of a car.

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Anyone could have made this mistake

Anyway, some common metrics you might encounter:

  • Price to earnings ratio (the ratio of share price to yearly profit and a key metric of value)
  • Profit margin
  • Revenue and profit growth
  • Dividend yield (if dividends are paid)
  • How much debt the company carries
  • Free cash flow

You can usually find these metrics on stock analytics sites, but for most info look to the company’s financials first. These are usually found on an investor relations website. Companies can define these terms differently, so it’s worth checking exactly what a company you’re interested in means by these metrics.

 

Company financials

All publicly listed companies issue annual reports and shareholder letters each year to communicate their performance. These are dense documents but there is some seriously useful material in there — it’s like x-raying a company. It’s just very time-intensive and requires a huge amount of discipline.

With professional analysts poring over this stuff, it will be hard to spot something they haven’t already. However, there will still be cases where diligent, cool-headed independents can find something very powerful in the data.

A good example would be fund manager Terry Smith, who foresaw a big downfall of Tesco shares in 2014. Tesco had been the dominant figure in UK retail for years, but Smith noticed that the return on capital presented a very different picture.

 

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Return on capital employed is a metric designating profit divided by the capital you needed to generate it. It’s not a universally consistent data point — there are a few ways you can calculate employed capital — but it’s a powerful tool.

In the context of ROCE, a company’s capital is all its fixed assets — properties, equipment etc — plus its working capital — the cash it needs to operate day-to-day. The ROCE shows you how well that capital is being used to generate a return.

Effectively it can show you how efficiently a company makes a profit and let you compare that to its peers regardless of their relative sizes.

So, in this case, Tesco was growing but only by borrowing to swell capital spending even more — opening more and more stores with more and more debt. (That’s not sustainable.)

 

News and analysis

Have a look at what journalists, analysts and investors are saying about a company or a sector, but always be careful to gather diverse perspectives and view them all with a sceptical eye.

That’s ok though: your goal here isn’t to find a side to take but to look at the lay of the land.

Consumers and public opinion

Company forums and communities are a good place to track sentiment in aggregate. Obviously, you have to take the views of a company’s biggest fans with a pinch of salt.

However, a brand with 1000s of hardcore fans has both an interesting asset and a body of research ready and waiting for you to uncover.

Likewise, if reviews website are full of customer complaints about a company and its products, then this might give you a sense of the company’s overall health. 

In both cases, though, this sort of anecdotal evidence needs to be treated alongside a whole body of evidence and shouldn’t be used on its own to form an opinion about a company.

Your own knowledge

You might not be able to read a balance sheet like Buffett but it’s likely you have an understanding and expertise in your own industry that might be a serious edge.

If you’re a software engineer, you’ll have an advantage discerning good tech companies; if you’re in advertising you could be better placed than the average investor to work out whether WPP is now sunk or about to fly.

One important note: don’t focus too much on what you know. No matter how good your perspective, it’s always possible for a whole sector to run into trouble. Diversify!

While it should be obvious, if you’re investing in an industry that you know really well, it’s also important to be clear that you should not make an investment based on what’s called “material non-public information”. 

That’s referred to as insider trading and it can get you in a lot of trouble!

Discussion and debate

You shouldn’t defer your investing decisions to others but defending and debating them is a great way to test their durability.

We have an excellent forum full of novice investors, hardened veterans and in-betweens — come discuss your investment ideas.

 

Your own analysis

Gathering information is only one side of the coin. Once you’ve got it, you need to make sense of it.

In investment firms, prospects are often referred to as ‘stories’. Seems unlikely for high-powered fund managers but what many really want are compelling stories: businesses as simple, testable narratives.

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This is what the investing stories of 2008 look like.

Snapchat’s story could be ‘social media has to be constantly re-iterating and hyper-authentic’. Glencore’s might be ‘with cheap leverage, one company can capture most of the world’s commodity trade’. Note these are just some random examples and not an endorsement of those stories.

And once you have a story, you can test whether or not that story works out in reality.

A simple model to use is ‘if… then…’ analysis. Try to come up with some likely scenarios and model what will happen if they come true. Here’s how it works.

Say you’re thinking of buying shares in a huge incumbent UK grocer. It doesn’t have any obvious glaring financial weaknesses and the valuation isn’t already overly high for a mature company i.e. the PE ratio isn’t ridiculously high and there’s feasible room for growth. So it’s cleared the lowest bar.

Then you work out if there’s an investment story there: why will this company grow your money?

The story might be ‘everyone needs to eat and people are lazy when it comes to food.’

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Yep, that’s cheese.

Then look at the factors that influence the company and the story’s success. What happens:

  • If the country it does most of its business in has an economic downturn?
  • If energy or food prices rise?
  • If competitors start muscling them on price?
  • If culture or political policy around food changes?
  • If everyone starts ordering food from meal box startups or Amazon?
  • If you misread or misinterpreted the financials?

Assign a rough probability to any of these scenarios and try to decide whether your story would survive one or more of these possibilities.

As you build your portfolio, you’ll usually settle into the research style that suits you. More research is often a good thing, but don’t get so bogged down it saps your motivation.

Hopefully you’ll find your forays into research highly rewarding. Any investment gain is a wonderful thing, but a gain that comes from your ideas is a great feeling. You’ve effectively outwitted the world.


This should not be read as personal investment advice and individual investors should make their own decisions or seek independent advice. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication.

When you invest, your capital is at risk. The value of your portfolio can go down as well as up and you may get back less than you invest. Past performance is not a reliable indicator of future results.

Freetrade is a trading name of Freetrade Limited, which is a member firm of the London Stock Exchange and is authorised and regulated by the Financial Conduct Authority. Registered in England and Wales (no. 09797821).

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