How to research a potential stock investment opportunity
A recipe for solid due-diligence
Hey all, I hope you are having a great week.
As the old adage goes “give a man a fish and you feed him for a day; teach a man to fish and you feed him for a lifetime“. With that in mind, I wanted to make this article a bit different.
Rather than just giving you stock research as I normally do and then warning ‘‘do your own research!!” In this article I will give guidance as to how to perform solid due-diligence on an investment opportunity, things to look for and things to be wary of. That way for future opportunities, you have a recipe book of how to approach them.
The initial screen
Before assessing an opportunity in great detail, I quickly look at 3 main elements:
What is the company? what do they do? what sector are they in? how long have they been around for? how many employees do they have?
There isn’t anything specific i’m looking for at this stage, but I’m just building an understanding of the stock such that all research I do from then on has context behind it.
The technicals and charts
Look at the price history of the company, what’s the 3 month, 1 year and 5 year trends? how did the price perform during previous crashes? (2008 for example) did it recover quickly? has the price been trending downwards for a while now, if so what levels could it recover to?
For example, I use TradingView to quickly look at price history and trends, in this case for AAPL. I drew a parallel channel based on where the recent bottoms and tops have been, allowing me to see price ranges over the last 9 months. I use this as a rough guide to where the current price is at for the stock.
Price upside & analyst ratings - Analysts usually give a target price and buy rating for companies, I use this as an indicator for possible upside and overall quality. After all, these people spend all day doing this, and some of the big equity research houses can really impact a stock price based on their grading.
The main checks
If the company passes the checks above, I move on to looking at the opportunity in more detail, looking at the following:
News, coverage & sentiment
Search the opportunity online, what are people saying about it? What recent news has it had? Read through comments on Yahoo Finance, Twitter, Reddit, StockTwits. Try and read both bullish and bearish commentary so you get a good idea for both sides of the argument.
Revenue & Earnings
This is important, ultimately, every business wants to become profitable and grow that profit year on year. Have a look through income figures and growth rates, how does it compare to competitors in the same sector? How has that fared during the pandemic? If there’s been massive growth recently, will that sustain long-term? What are analyst expectations, are they low/high? Why?
Do the same for Revenue. This is slightly less important than income, but can start to inform you about cost bases, is the company growing revenue heavily but little profit growth? Is that investment for future profit? How long in the future? do they have a high profit margin?
You want to assess the health of the company’s finances and balances (good EPS ratio, cashflow, debt ratios, debt maturity, quick ratio, book value etc).
Here you are trying to assess financial red flags and signs of good capital management. Does the company have a lot of debt? is it due soon? How will this company fare during a crash? How did it manage through COVID? Does the company have enough cash to survive big losses? Does anything not add up on their balance sheet?
Build up an indication to how the stock is priced (PEG ratio, P/E ratio, P/CF, P/B etc, this article helps explain the ratios), is the company over-valued? under-valued? How does it compare to the market it’s in? How does it fare compared to sector competitors? Can you identify reasons for valuations? (some companies trade “at a discount“ because investors are not sure about the company’s future or management for example).
Competitors & Sector
Have a look at the direct competitors, how are they performing? are they priced similarly to your opportunity? if not, why? how does the company you’re assessing stack up? what is this company’s “moat”? what differentiates them from their rival? how hard is it to compete with this company? Look at the overall sector too, how will it fare long-term? What drivers could affect the sector?
Employee ownership & trading
Look at how much equity the employees of the company own, especially the executives, are they highly remunerated based on stock price? If they are equity weighted it’s in their best interest to increase the share price, some executives check their price every hour… Are they generally buying or selling the stock?
Stock liquidity & size
What’s the market cap of the company? Does it have sufficient volume traded? lower market cap/ volume companies are more volatile and sensitive to big trades, meaning you could lose more or not be able to get your money out quickly.
What’s the background of the CEO and executive board? do they have sufficient experience in the sector? What do employees think of the CEO? have a look through Glassdoor for reviews on management styles and culture.
Try to assess how the company is owned and managed, what's the share structure? How many institutions hold this company? have they recently purchased or sold a large chunk? Are there large chunks of preferential shares that could impact your position or return? What’s the history of investors? Have they invested in ‘pumps and dumps’ ?
Price history/ Technical analysis
At this point, you should have a good understanding of the company’s health, future plans, history, balance sheet and management. While all of those things could be positive, the price history of the stock could still be a blocker. Do some technical analysis on the opportunity, what’s the price history? long-term trend? RSI and stochastic indicators? MACD, bollinger bands etc.
The unconventional checks
The above covers off a lot of the foundational and straightforward checks you should perform for any investment opportunity, and should provide you with a good starting point for you to do further research if needed.
Having said that, great research into opportunities doesn’t stop here. The above might not tell the full story, especially when you are looking at opportunities with limited history or data (penny stocks or crypto for example). In that instance, it’s necessary to do some unconventional research and think outside the box.
Some of these points are inspired by a reddit post I found, which I highly recommend you read.
Look in places/ ask questions others won’t
There's always something to learn from research even if you don't end up making an investment in a company. Curiosity makes an excellent research partner.
Try to pick out holes in the company and research, what could go wrong? what are people overlooking? What have you not covered? Does anything not feel right? Why?
This will be difficult to do at first, as you are unsure what to cover and what feels right. The point here is, a lot of the research you do should be unsuccessful, but it helps develop your sense for the market, and will allow you to sniff out iffy looking investments/figures.
If they offered you a role, would you work for them?
Usually you can tell alot about the company and its likelihood for success from the management team and their approach. That’s why professional institutions spend a lot of time focussing on and meeting the upper management.
What’s their track record? How do they come across in interviews? How do they reward and talk about their employees? Would you work for them?
Try and assess the equity structure of the company. Is the company set up in a way that it's easy to benefit the CEO, Investors and Preferred shareholders and the expense of common stockholders? Do insiders get rewarded with equity, making the success of the company their personal gain too?
Model the extremes, both risk and upside
Try to gain an idea of what happens in the best and worst case scenario. How much could you lose and how much could you gain? Thinking like this sometimes gives you ideas of “asymmetric risk“. Bitcoin in the summer was a great example, where at worst case, it would drop to 0 and you would lose 100%, but in the best case scenarios you would see a much bigger than 100% upside.
Look for opportunities where the upside/downsides are unbalanced, and structure your whole portfolio that way too (don’t lump all in on risky investments, but some potentials which could really boost gains.)
Project potential, not just finances
One of the best performing funds for the last decade, Scottish Mortgages Investment Trust, was built on the thesis that “big changes in technology can provide large revolutions to lifestyle and capability, changing the way we live and operate“
The notion here is that some companies can fundamentally change the game, and with it, revenue and earnings. Try to forecast Amazon’s current revenue 20 years ago, it was unthinkable for an online store. In the same way here, try to think about the potential of the company and its sector, on horizons of decades, not quarters.
Google is your best friend here, a lot of the things you need aren’t hard to find, it’s just about knowing what words to type into the search bar!
Luckily, a few great websites exist these days that you can use:
FT Portfolio (A premium service, but well worth having for their data and news coverage)
TradingView - Great for technical analysis and ideas
Wikipedia - Useful to know the company story and history
The companies site - you’d be surprised at the number of people that have invested into a stock without having even seen their website.
Seeking Alpha - News and commentary
Investopedia - fantastic for education and understanding terms & concepts, I find myself frequently on here remembering how certain ratios are calculated.
FinViz - Financial screener & visualizer, great for spreadsheet style analysis
Marketwatch - Market & stock data
The above should hopefully provide you with a good framework of how to assess opportunities, the approach to take and types of questions you should be asking.
This will be lengthy and confusing to begin with, but the more companies you look at and assess, the quicker and easier this whole approach will become.
There are angles I haven’t covered in here, such as how to size and time opportunities, in the bigger context of how to shape up your whole portfolio. That is a whole other set of which I will leave for another time. If you are keen to read more about these, let me know!
Did you enjoy this article? want more deep dives? let me know what you think in the comments 👇
Another brilliant read, I’ll definitely be following this advice. Keep the good content coming!
Brilliant content as always. DD on point and so accessible to everyone. Keep it coming please!