Some people in the market boast about being good at picking stocks. When the market performs exceptionally well, like it did in 2013, the rising tide lifts all the boats and all stocks perform well, making stock-picking almost irrelevant. Most of the time, however, the market will not perform exceptionally well, and stock-picking will play an important role in whether someone will earn or lose money in their stock investments.
Buying a stock is a lot like buying a business. The only difference is that stocks are a lot more liquid and the buyer of stocks will not be responsible from making day-to-day operational decisions of a company, unlike someone who buys an entire company. You can buy and sell stocks within minutes, while it takes a lot of paperwork, time and effort to buy and sell businesses.
It is still fair to compare buying stocks to buying a business though. First and most importantly, whether you are buying a business or shares of a company, you are actually buying a company either in entirety or in pieces. This also brings up additional considerations. For example, when buying a business or stock of a company, the price and value both matter. Price is how much you pay and value is what you get in return. Would you buy a company that makes about $50,000 in annual net income with no growth prospects for $1,000,000? It might be a tough sell. This is like buying a stock with a P/E of 20 with no growth. Whether you are buying pieces of a company (i.e., stocks) or a business altogether, valuation matters.
So picking stocks is similar to picking a business to buy. Let's say you moved to a new town and you want to own a local business to make a living or see your money grow. After all, everyone has different goals when investing their money. In this new town, you might have several business opportunities, including a barber shop, a bakery, a franchise of a well-known restaurant chain, gas station, motel and you even have the option to buy some residential property and rent it out for a sale. When picking which business to buy, two things come to mind: 1) which type of business fits your skill-set better, 2) which type of business have the most likelihood of safely accomplishing your long-term goals. When buying stocks, you don't have to worry about the first option (i.e., you will not have to know anything about how to cut hair to buy stocks in a company that specializes in hair services) but you will definitely have to worry about the second option.
So, what are some common mistakes investors do when they are picking stocks and how can you avoid these mistakes?
1. Investors often forget about the underlying companies and focus too much on stocks: You did your research and finally found the stock of your dreams. It seems like this one stock keeps going nowhere but up no matter what happens. Investors really like the stock and all the indicators are extremely bullish. On the other hand, you (and many investors) forget the most basic rule of investment: stocks in the market represent the companies and their underlying businesses. If a company's business model is not healthy and it is not likely to survive or prosper anytime soon, and if a company has limited growth ahead, then it may not be a good buy. What goes up always comes down, especially if it went up for no substantial reason in the first place. This is also true for companies whose stock seems to be on a downtrend. Just because a stock went down so much in the previous year does not mean it will go up in the next year to compensate for this. Reverting to the mean only happens when circumstances are ordinary. Many times, when a company's stock price keeps plunging for a long time, there is an extraordinary situation going on and this company might be actually going out of business.
2. Investors often use diversification the wrong way: Diversifying your portfolio is a great way to limit some of the downside in case one or more of the companies in your portfolio perform really badly. The overall market usually outperforms most of the mutual funds or ETFs because it is well-diversified and well-protected from bad performance of one or a few companies. Many times, investors see diversifying simply as "buying more stocks" but that's not what diversifying is. Diversifying is a form of risk management and this should be kept in mind. One of the common mistakes investors do is they pick stocks in a way that doesn't warrant diversification. For example, if I have 10 stocks in my portfolio and 9 of them are biotech stocks, I am not really diversifying. If I buy 10 stocks 9 of which are based in one particular geographical location (e.g., Spain), again, I am not diversifying enough. Picking 10 random stocks from 10 different industries or countries does not constitute diversifying either. Every stock you buy has to fit with your long-term goals and they should all have good fundamentals and low chance of failure. If you have a portfolio of 10 stocks, you can pick 5 industries and 2 companies from each industry, one being American, one being international. Make sure that each of these 10 companies have strong fundamentals and they fit your overall theme though. For example, if your overall theme is growth, your portfolio should have more growth stocks than someone whose overall theme is dividends. Of course, you can also have a diversification between dividend and growth stocks, but you might need to have more than 10 stocks for sufficient diversification of this kind.
3. Hot industries don't always result in best investments: In 1910s car companies (i.e., the companies that produced car, car parts, car supplies and anything related to cars) were seen as the hottest investments because this was a growing industry with tremendous demand and future potential. Next, 1940s came and airline industries became hot. Many investors thought you could not go wrong with an airline company because there was so much demand for flying. In 1990s, the same happened with internet companies where many people thought they could get rich by putting their money in these companies. How did it all work out? Well, most car companies that were founded between 1910 and 1960 went out of business and most investors of car companies lost most if not all of their money. Airliners and internet stocks did not yield better results either. Every time one of these industries became hot, people thought that we were experiencing a paradigm shift and that the traditional fundamentals would not work anymore, yet, every time, the classic fundamentals prevailed at the end. It's ok to make a couple bets in a "hot industry" but betting the farm on it might bring more harm than good. Even when an investor is putting their money in a "hot industry," he or she should research the company well enough and make sure the company in question has a sound business plan. Remember, businesses exist to make money and if a company doesn't know how to make money, other metrics don't matter.
4. Not understanding business model of a company can be damaging to your portfolio: When an investor puts his or her money in a company, it makes absolute sense to conduct sufficient research and figure out what that company's business model is. This is not to say that you should understand every single detail about a company's product. For example, if you are investing in a biotech company, you shouldn't have to learn how a chemical compound works; but you should have an understanding of what this company's chances of success are. If a biotech company is producing a drug in a heavily saturated market, this might be a red flag. If a biotech company has multiple products in its pipeline and these products are meeting some unmet demand, the company has a higher chance of success. Having a basic understanding of a company's business model and its management always helps investors.
5. Past success is great, but the market is future-oriented: Just because a company has a low trailing P/E or high trailing dividend yield does not mean it is a good investment. Just to give an example, a couple years ago, RadioShack (NYSE:RSH) and BlackBerry (NASDAQ:BBRY) both had single-digit P/Es and many investors thought that these companies were undervalued. I've witnessed times when people claimed that a company's 5% dividend yield is great, just to see the dividend get cancelled the very next year because it was unsustainable. If a company is seeing revenue shrinkage and its future profitability is in question, there is little sense in focusing on its trailing fundamentals. The trailing fundamentals only make sense if a company is well-established, its future performance can be highly predictable based on its past performance and things are not deteriorating for the company. Also, as another exception, if a company has a long history of raising its dividends year-after-year, that will be a good indicator about the company's future dividends.
6. There is no room for emotions in investment: Just because you met your true-love in a particular coffee shop does not mean that coffee shop is a great investment, and just because you drive a particular brand of car does not mean it is a good investment. There are many brands that are in our lives every day and everyone has their favorite brands. It is said that many great investors like Warren Buffett prefer to invest their money in companies that offer products they personally like (e.g., Coca-Cola), but liking a company's products should not be a reason alone to invest in a company. If a lot of people like a company's products, chances are high that the company will prosper; however, there is no reason to fall in love with a stock or hate a stock apart from its fundamentals. Also, investing should not be a form of making a political statement. If you avoid a fundamentally great company for disagreeing with its management politically or if you invest in a fundamentally weak company for agreeing with its management politically, you may put yourself in a financially difficult situation.
7. Picking a stock based on share price is a bad practice: This mistake is usually seen in people who are new to investing. Some people look at share price of a company to determine whether that company is cheap or expensive without paying attention to what those numbers actually represent. To an uneducated eye, a stock with a share price of $50 appears to be 10 times as cheap as a stock with a share price of $500. A company's share price depends on the number of outstanding shares as well as the value of the overall company. Even these two metrics don't tell us much if we don't have other relevant metrics such as earnings, revenues and dividends to compare them to. By itself, share price means pretty much nothing. There is one exception to this rule: if you plan on buying 100 shares of a stock in order to sell covered calls, you should make sure that buying those shares will not burden your portfolio. For example, if your portfolio is at $50,000, it makes little sense to put it all in one stock that's $500, so that you can own 100 shares and write covered calls, because this eliminates diversification.
8. There is no substitute to doing your own homework: In order to feel comfortable about your stock holdings and make sure that your stocks actually align with your personal goals, it is imperative for you to conduct your own research. Don't buy a stock because someone on TV, on the newspaper, in a website…etc. told you it's a good stock. They say "one's man trash is another man's treasure" because not all stocks are created equal and not all stocks are suitable for all goals. There are as many investment goals as there are investors and each investor should do their own homework. This is not to say that other people's opinions and advice should be ignored. It is always a good practice to take advice from others, as long as you follow it up with your own research.
Now that we covered the basics, it's time to look at some examples. What are some good stocks that are worth an examination? Notice that I didn't say "what are some good stocks that are worth buying" because every investor has their own goals and not all stocks meet all goals. This is why investors should create shortlists with stocks that are worth studying in order to determine which stocks they will be buying. Next, I will provide three examples that fit most of what I am looking for in a high-quality stock.
My first example is Boeing (NYSE:BA). This company meets many criteria of a "good stock" and it fits goals of many different types of investors. The underlying company is highly profitable, it has a long history of dividend raises and the company's growth has visibility through its huge backlog. Boeing offers value to dividend investors, growth investors and those that want a nice mix of both. The company's low price to earnings multiple of 23 might seem high at first; however, the company's huge backlog of $441 billion offers a lot of visibility for the next decade and deserves a premium. Boeing's dividend yield of 2.20% is better than the S&P 500's average yield of 1.88% and it has room to improve based on the company's low payout ratio of 38%. When we look under the hood of Boeing stock, the underlying company and its fundamentals look very strong.
My second example is Disney (NYSE:DIS). This is one of those stocks I would feel comfortable holding forever. In the last 30 years, Disney posted revenue growth 26 times, and the only exceptions for this company were recession times. In other words, if past performance tells us anything, as long as there is no recession we can always count on Disney for growing its revenues year after year. What makes Disney so special is that the company is well-diversified in its wide range of products, services and offerings around the world. It makes movies, operates theme parks and cruise ships, owns many TV channels around the world and it has a great diversification both in terms of business type and geographical location. As mentioned above, it usually takes a global recession to hurt Disney's revenue growth, and even then the company stays highly profitable. Disney's business model offers huge visibility and this is one of the aspects to love in stocks.
My last example is Microsoft (NASDAQ:MSFT). In number 6, I mentioned how emotion has no place in investment. This is where Microsoft comes in play. I personally don't like Microsoft's consumer products and you would not catch me using one of these products; however, I like it as an investment. Microsoft is one of the most profitable companies in the world that delivers consistent revenue and earnings growth coupled with dividend raises, and it manages to stay cheap year after year. What else could an investor ask for? After reaching a near-bubble status in 1999, Microsoft has been in a penalty-box for more than a decade and investors started to appreciate this company again in the last year or so.
In summary, some of the pitfalls investors fall in when picking stocks include forgetting to look at the underlying fundamentals and focusing too much on the stock independent of the company, diversifying their portfolio wrongly, relying too much on "hot industries," not making an effort to understand business model of a company before buying its stocks, focusing too much on past successes and forgetting future potential/threats, allowing emotions to take the driver's seat and not doing their homework. Avoiding these pitfalls will help you get better results from your investments.
Disclosure: I am long BA, MSFT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.