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To become a successful and self-reliant equity investor requires the use of a proven successful stock analysis process. While there is no one ‘right’ stock analysis process, the process used should be consistent and thorough.
I developed and refined my stock analysis process over several years. The result is that our investment portfolio has allowed my wife and me to retire early.
I have received several inquiries on my stock analysis process. In this article, I share what has worked for me.
Stock Analysis Process
A probing mind is required to:
- identify companies in which to invest;
- at what price to buy and sell.
Analyzing a company is certainly a process. Rather than haphazardly invest in companies, follow a top-down strategy where you start with an industry and then identify companies worthy of further analysis. Alternatively, you can start with a particular company and then learn about the industry outlook. This is the bottom-up approach.
I prefer to use the top-down approach. There is nothing wrong, however, if you decide to use a bottom-up approach. Just choose a process and be sure to develop and follow standard operating procedures.
When I settle on industries, I then identify industry participants worthy of analysis. I typically limit my analysis to the larger industry participants and exclude:
- Special-Purpose Acquisition Companies (SPACs);
- companies that trade over-the-counter (OTC) rather than on a major U.S. stock exchange;
- other companies of a speculative nature.
I do this because I have had success with investments in well-capitalized companies. Secondly, I have a low tolerance for risk.
How to Start
I recommend you invest for the very long-term primarily in well-established companies across 5 main economic sectors (Manufacturing & Industry; Resources & Commodities; Consumer; Finance; Utilities). You should also be leery about investing in companies that are in the broker/media limelight.
Create a portfolio comprised of ‘growth’ and ‘value’ stocks. A 'growth' stock is a publicly-traded company growing at a rate higher than the market average. A 'value' stock is a company trading at a lower price than what the company's performance may otherwise indicate.
Once you identify industries that warrant further research, set multiple parameters within a stock screener to refine your list of companies for analysis. A good stock screener will generate search results that incorporate links to company websites.
Each company’s website typically has an ‘Investor’ section from which you can obtain:
- current news;
- quarterly and annual reports;
- investor presentations;
- stock information (eg. dividend and stock split history), and
- other information to help you learn about the company.
I use the online trading platforms of two major Canadian financial institutions. Each platform provides access to analyst reports from which I can obtain consensus earnings estimates from brokers; there is often a significant disparity between the low and high earnings forecasts so you need to draw your own conclusion. Use these forecasts in conjunction with earnings guidance provided by the company’s management.
Gather the information for each company so as to compare performance and understand opportunities and risks each company faces.
What I Analyze
There is a host of information to analyze to select suitable companies in which to invest. This is what I analyze.
Industry Analysis
Within a company’s annual/10-K report is a review of the company, industry, competition, risks, and business outlook. Read the annual reports of the companies within the same industry to get a better understanding of how each company is performing (eg. Visa/Mastercard/American Express or Canadian National Railway/Canadian Pacific Railway/Union Pacific Corporation).
Industry websites are also a good source of information to see the latest industry happenings.
If possible, try to obtain from a contact, or a contact’s source, information about the company being analyzed.
Business Model Analysis
You can have a strong company in a weak industry and a weak company in a strong industry. Look at a company's strengths and weaknesses. A company's strengths are often reflected in its products, customers, suppliers, and unique brand identity.
The company’s annual report often explains the company’s business model.
The investment community and quarterly earnings presentations are also excellent sources of information.
Earnings call transcripts in which senior management discusses earnings and guidance with analysts are also a great source of information. Some investors like to listen to the earnings calls but this can be time-consuming so you may prefer to read the earnings call transcripts.
Financial Analysis
Learning about the company’s industry and the business is important. To read and understand the company’s financial statements, however, is a crucial aspect of the process that must not be overlooked.
You must understand a company’s balance sheet, income statement, statement of equity, and cash flow statement. The notes to the financial statements are often quite lengthy but key pieces of information within these notes help explain the numbers reflected within the various financial statements.
Look at financial statements for a minimum of 3 – 4 years to identify a company’s performance over time. You may need to look at financial statements for longer timeframes if the business has undergone a transformational change through the completion of a major acquisition and/or divestiture.
Financial analysis is a time-consuming process but once you familiarize yourself with a company, you do not have to continually re-read historical financial statements.
Management Quality
Key executives are responsible for a company’s future so investigate whether there has been a high degree of turnover in the company’s senior ranks. Try to gather information on senior executives by doing some research on the internet.
One reason why I generally limit my investments to large-cap companies is that senior management has likely undergone a rigorous vetting process by the company’s Board of Directors.
Growth Analysis
Look at a business to determine the:
- company’s marketplace;
- gross, operating, and net profit margins;
- competition;
- total size of the market;
- company's capital allocation efficiency.
Trust a company’s fundamentals much more than its stock price. The fundamentals indicate how a business is performing. The company’s stock price, in the short-term, may not necessarily accurately reflect the company’s underlying metrics. Companies may have a sizeable market capitalization yet they have no revenue or profits and their probability of success is questionable.
Risk Assessment
Regrettably, many investors do not learn their true tolerance for risk until they face the very probable likelihood of significant permanent impairment to their investment. Be honest when assessing your risk tolerance.
A common stock investor must be aware this type of security ranks last when it comes to liquidating the assets of the company in the event of failure. I accept this risk and my low tolerance for risk is why the vast majority of my equity investments are companies that are investment grade.
Many publicly traded companies are rated by major credit rating agencies such as Moody’s, S& P Global, and Fitch. Check the ratings assigned to a company’s long-term unsecured debt to determine if the company is an investment or non-investment grade.
Dividend Policy
Some investors invest solely in companies that have a track record of having increased their dividends for a certain number of years. I do not follow this practice and invest in companies based on the total potential return (ie. dividends and capital gains).
Had I adopted a policy to invest only in companies with a track record of several consecutive years of dividend increases, I would not have invested in several companies that have generated very attractive overall returns.
I invest in companies which:
- do not pay a dividend but retain earnings to grow the business to generate attractive capital gains;
- have a very low dividend yield (sub 1%) but have the potential to generate significant capital gains;
- have an attractive dividend yield policy since we require investment income in retirement.
I recommend you do not exclude a potential investment simply because it does not distribute a dividend.
Look at a company's dividend history. Hesitate to take a position if a company has a history of dividend cuts.
If you invest in a company that distributes a dividend, look at the extent to which earnings and free cash flow cover the dividend. In the case of a cyclical business, the company may need to borrow to cover expenses and its dividend. This should only be in exceptional situations. Exxon Mobil is a company whose earnings and free cash flow have recently been insufficient to meet its needs and it has had to resort to debt to service its dividend.
On occasion, a company's dividend policy includes the distribution of a ‘special dividend’. Stock screeners do not pick up on these ‘special dividends’. CME Group has a ‘special dividend’ as part of its dividend policy. The ‘special dividend’ occasionally exceeds the total value of the year’s quarterly dividend.
Some companies retain all profits and do not distribute a dividend. They do, however, reward shareholders through share repurchases. This is attractive when the company is undervalued.
Look at the annual weighted average number of shares outstanding for the 10 most recent fiscal years. If you see an increase in the weighted average number of shares outstanding, investigate to determine the reason. A large increase may mean a company has completed a major acquisition that cannot be fully funded by debt for the risk of a credit rating downgrade.
In Warren Buffett’s Letter to Shareholders included at the beginning of Berkshire Hathaway’s 2020 Annual Report, he explains how the company rewarded shareholders by repurchasing issued and outstanding shares in 2020.
‘Last year we demonstrated our enthusiasm for Berkshire’s spread of properties by repurchasing the equivalent of 80,998 “A” shares, spending $24.7B in the process. That action increased your ownership in all of Berkshire’s businesses by 5.2% without requiring you to so much as touch your wallet.
Following the criteria Charlie and I have long recommended, we made those purchases because we believed they would both enhance the intrinsic value per share for continuing shareholders and would leave Berkshire with more than ample funds for any opportunities or problems it might encounter.
In no way do we think that Berkshire shares should be repurchased at simply any price. I emphasize that point because American CEOs have an embarrassing record of devoting more company funds to repurchases when prices have risen than when they have tanked. Our approach is exactly the reverse.’
Valuation
Some investors estimate future earnings over several years and calculate the present value of the future stream of earnings to determine a reasonable share price. I do not have the ability to foresee the future that far in advance.
I use management’s forward earnings guidance and broker estimates for the next fiscal year to determine a reasonable share price. If management is unable to provide guidance then we must rely solely on broker estimates.
Look at the current valuation and the valuation for the upcoming year relative to the company’s valuation based on low and high stock prices in prior years.
Analyze a company’s valuation using historical low and high share prices divided by free cash flow per share. Compare historical levels against the valuation based on management’s free cash flow per share guidance.
Do not adhere to a specific Price/Earnings (PE) or Price/Free Cash Flow per Share (P/FCF) for all companies you analyze. Companies and industries are different. It makes no sense to look at a Utility company and a high-quality Technology company from a similar valuation perspective. It is not, for example, logical to value Apple and Visa like we value Tyson Foods and Verizon.
Target Price
The last step of my stock analysis process is to determine a target price. Naturally, if the target price is met, we must weigh other investment opportunities. A target price is merely a guidepost.
Final Thoughts
It is difficult to generate attractive long-term returns if shares are acquired when grossly overvalued. Be patient and wait for a company’s valuation to fall to an acceptable level.
My stock analysis process is time-consuming but has proven to be highly successful. It is not the only process you can follow. I do, however, hope what I have shared will assist you if you struggle to identify companies in which to invest.
I wish you much success on your journey to financial freedom.
Thanks for reading!
Note: Please send any feedback, corrections, or questions to [email protected].
Disclaimer: I do not know your individual circumstances and am not providing individualized advice or recommendations. You should not make any investment decision without conducting your own research and due diligence.
I wrote this article myself and it expresses my own opinions. I do not receive compensation for it and have no business relationship with the company mentioned in this article.
Disclosure: I and the companies referenced in the FFJ Portfolio.
