

1. Start with companies whose products you like
You’re as qualified a consumer as anyone else! If you like a company’s products better than those of its competitors, that’s important. Talk to friends to see if they concur. Think about where the company may be able to take its products in future releases and if it can build on its advantages.

2. Make sure you understand how the company makes money
Inexplicably, well-known (mostly Internet) companies are able to go public — making their shares available for our purchase by the broad investing public — before anyone knows how they’ll make money. The idea is that if they are very popular and have lots of visitors, they’ll eventually figure out how to monetize the business (ie, make money from their visitors).

But it’s not so simple and making a leap-of-faith can cost investors dearly. Look at the history of Groupon and Zynga since they went public. Groupon in particular has a strange business model that seems to victimize its vendors as much as it helps them. It requires that its customers make a tremendously discounted offer. Next, the company subtracts a significant portion of the Groupon that consumers buy, leaving the vendor with very little.

What about Zynga? It offers free games that people tire of quickly. Not surprisingly, Zynga continues to lose money and its stock remains at depressed levels.

3. Go with strength
There’s little room in investing for rooting for the underdog! It’s a romantic notion that plays out well in the movies but not so much in real life when it’s your money at risk! For example, McDonald’s has dominated the fast food business for decades. During this whole time, Burger King has flailed away as a weak competitor. Just now you read about how Burger King is coming out with the double bacon cheese mushroom avocado fire grilled cilantro burger that is so tasty, it will finally overtake McDonalds! Please.

Consider that some markets can only support a leader and a strong runner-up. For example, Starbucks and Dunkin’ Donuts are the leading coffee shop chains. Can you name the third leading company? The point here is that if the corporation you are considering investing in is not a leader in its markets, it will have a difficult time sustaining itself over time.

4. Look for rising sales and profits
As investors, we win when stock prices go up. They go up when profits go up. The best method for raising profits is to raise sales! Rising sales means that consumers want more and more of what the company produces. Therefore, it is critical that the company have a track record for increasing both sales and profits. You can check sales and profits by clicking the Financials tab at any good investment site.

5. Look for industries that have a high barrier to entry
Some industries require massive amounts of resources to enter. For example, to create a new commercial airplane manufacturing business will require billions of dollars and as much as a decade to get off the ground. If you invest in Boeing or Airbus, you have the comfort of knowing that there is unlikely to be a new competitor entering the industry. We say that the airplane manufacturing business has a high barrier to entry. FYI, analysts refer to a well-protected company as having a “moat” (yes, like around a castle).

Now, consider what it takes to develop a cell phone app: A computer, some technical skill and hours dedicated to programming the app. Because an app can be created with minimal investment, we say that app development has a low barrier to entry. This explains why there are so many apps and why it’s so difficult for app developers to get any attention for their creations.

6. Look for companies that have a sustainable advantage
Apple has iCloud, where its users store all types of media and documents. Google has Drive. People thinking about leaving these “ecosystems” have to consider how much of their digital stuff they’ll lose.

Sustainable advantage can also come in the form of patents on new products that keep copycats at bay and products, like complex software, that would be very costly for big businesses to remove and replace. This concept has also been put in terms of how “sticky” the company’s offering are, which is referring to how difficult it is to leave the company and its products behind.

7. Avoid the long shots
“Did you hear about NXD Corp? They’re developing a drug that’s going to cure cancer….” Maybe, but probably not. A small bio-technology company may have one drug in development. Its stock may climb as hopes rise that its drug will prove effective in medical trials. It will surely plunge if the government declines to approve the drug because it didn’t show positive results. The word “plunge” is thrown around a lot these days to describe stocks that fall as little as 3% or 5% in a day. When we say plunge with biotechs, we’re talking about a 50% or 75% loss in a single day. After all, if a company is developing one drug and it proves to be useless, what does the company have left?

8. Avoid heavily indebted companies
Some corporations borrow a lot of money to acquire the equipment and other assets they need (instead of purchasing it with money acquired by selling stock to investors). Two problems with having debt are that it comes with interest payments and it eventually has to be paid back. When the amount of the interest payments a company must make each year starts approaching the amount of profit the company is achieving, there’s a real problem developing. The ratio which compares these two figures is called Times Interest Earned (ie: Earnings Before Interest and Taxes / Interest Expense).

9. Get up to speed on the company
If there’s a company that has passed the above tests, scan several months’ worth of its news headlines. It’s amazing what you’ll learn. There might be a new product on the horizon, an expansion into a new geographic region, a buyout of a competitor or a lawsuit filed against the company.

Just as important, you are bound to come across articles written by experienced writers that give you a free ride, so to speak. The writer analyzes the company and you get to read what the numbers show and if the writer thinks the company is a good investment.

What can be frustrating, of course, is reading conflicting articles. One writer see the glass as half full. Another, half empty.  It’s up to you to decide whose arguments are more persuasive.

10. Find companies whose executives put their money where their mouths are
Top executives who own a significant number of shares in the corporations they run are invested alongside us. When they win, we win. It’s a little suspicious when the upper executives of a corporation make a lot of money year-in and year-out but own few to no shares. It’s as if they’re just working for a paycheck.

When executives buy and sell shares of the corporation, they must notify the SEC that they have done so by completing Form 4. A little research in this area may be worth your while.

11. Get a sense for the “expensiveness” of the company
When we say that a stock is expensive, we mean that its price is high compared to the profits it is earning on our behalf. With the average company, for each dollar in profit it makes, its stock price is about 15 times greater. For example, the average company earning $2 in profit per share would have a share price of about $30. Notice the ratio, called the P/E (ie: Share Price to Earnings per share) is $30 / $2 = 15. Sometimes investors get overexcited about the future of a company and push its stock to levels higher than the underlying business justifies.

Let’s say that GHI Corp’s stock is reasonably priced now at $100 per share. The company announces that in the coming year a new product will allow it to boost profits 50%. That would support the price rising from $100 to $150 (50% more than $100) over the course of the next year. Now let’s say that you discover this company in the middle of the following year and its stock price has just blown past $250 per share. The company is doing well, no doubt. Actually, it’s doing amazingly well. Investors love it, but too much to justify sending the price all the way up to $250. We can say that the stock price has gotten ahead of itself and that it is overpriced.

The reason we advise getting a sense for “expensiveness” and not making any hard and fast decisions is that this is a complex issue. The rate at which corporations are growing their profit has a big effect on what a fair P/E ratio for the company is. There are companies with very high P/E ratios, like Amazon, that investors continue to love. Instead of racking up big profits, it reinvests to dominate the future of commerce. In the other extreme, there are those whose low P/E ratios seem like a good value but are not because the companies themselves are losing ground and investors are losing faith in them. They may be on their way to bankruptcy.

Bonus: Bounce your ideas off an experienced investor
If you know such a person, make a case to him or her on why it’s wise to invest in the company. You’ll be clued in to any holes in your analysis and learn a lot in the process.

Riddle me this:

  1. Identify at least two products or services you should consider yourself an expert on because you know so much about them.
  2. Choose one of the two products or services you just identified above and then explain how the company that offers it is able to charge money and make a profit.
  3. Using a financial web site, bring up a quote for a corporation you like. Find its financials tab or section, then choose its Income Statement. Finally, make sure you are looking at Annual data. Complete the table below, and then answer the question: Has the corporation’s Sales (aka Revenues) and Profits (aka Net Income) gone up from year to year?
    Most recent completed year: 20_____            Year before: 20_____    Two years before: 20_____   

    Sales (aka Revenues)

    Profits (aka Net Income)
  4. Identify a corporation whose product or service dominates its market. Identify a second corporation whose product is struggling in that same market.
  5. Explain why analysts say that a well-protected corporation has a formidable “moat”. Or, explain the issues consumers have to deal with when switching from an Apple to an Android phone, or vice versa.
  6. Identify an epic problem that we as humans as a race have had a problem solving. If you heard about a new company that promised a solution, what would be your first reaction, and why?
  7. What is the benefit of bouncing your ideas off an experienced investor?
  8. Finally, what have you learned as a result of this activity that will make you a better investor?