With more than 500,000 publicly traded companies, the question of where to start is more intriguing than what stocks to buy . In this article, I will be sharing my comprehensive 5-steps stock idea generation process and free tools to use when analysing stocks. We also throw in a bonus idea of what stocks to buy today using our 5-steps process, so please read on.
Before we start, it’s worth highlight the importance of considering sectors of the stock market. The stock picking process is much more intuitive if you’re able to connect the dots between your idea and sectors of interest. The usefulness of having a sector framework will reveal itself as we proceed. Here's my list.
|Energy||Oil and gas, energy equipment and services|
|Materials||Chemical, metals & mining, construction materials|
|Industrials||Construction, equipment manufacturers and airlines|
|Consumer Discretionary||Automobiles, consumer durables/services and retailers|
|Consumer Staples||Food and staples retailing, tobacco, household & personal products|
|Healthcare||Pharmaceuticals, biotech, healthcare equipments|
|Financials||Banks, insurance, asset managers and fintech|
|Information Technology||Software services, tech hardware producers and semiconductors|
|Communication Services||Telco, media and entertainment|
|Utilities||Electric, gas and water utilities|
|Real Estate||REITs and real estatement management and development companies|
Now we're all set and good to go!
1. Building an idea from scratch
The most creative part to find what stocks to buy is to select sectors. An interest in economics and politics is always helpful, although it can be challenging at times. I follow these steps to generate better stock ideas.
Headlines scanning for ideas
First, I scan for headlines globally. This can be done easily with any news websites of your choice. I like to pick a 2-3 headlines as my starting point. I look to connect the dots between what has happened, happening and will happen.
For example, a headline of Financial Times reads “Takeaway deliveries on the rise as cooking fatigue sets in”. One thing that comes to mind is “Will there be a secular growth in demand for online food deliveries post the coronavirus?”
Questions like these help you frame a view of the economy, which can help you navigate the stock market. Our article on “How to Invest during the coronavirus crisis” illustrates the process of what stocks to buy.
Few sources I find helpful:
Selecting sectors with most potential
Secondly, we look to select a sector that can best reflect our view. From our example above, suppose you developed a view that online food delivery demand is here to stay, you can immediately narrow down to the “Consumer staples” sector.
Digging into the idea deeper, you could hypothesise that since takeaway deliveries are increasing, a few deductions could be made:
- Restaurants without delivery capabilities will suffer.
- Demand for online groceries may decrease as a result of higher demand for online takeaway services.
With just two simple observations, it sets up two interesting sectors candidates to investigate further, namely, the restaurant or the supermarket subsector. You get the idea.
Finding key drivers of the sector
Finally, finding the key drivers of the chosen sector. The answers usually lie within the question “What drives the revenue/profitability of the sector”.
Referring back to the earlier example, the key revenue drivers for online food delivery services could be food prices, disposal income of users, market share of offline to online orders etc.
I tend to list more drivers (even those that I'm unsure) at the beginning as it’s easier to remove than to add later in the process.
2. Screening what stocks to buy
Next, we screen for stocks. The goal is to narrow down the list of possible stocks that can potentially be a great investment. In short, we want to filter the list by sector, market cap and other stock fundamentals.
To do this, here are a few free (no sign ups required) online equity screeners I use
Ideally, you want to have a shortlist of ~5 candidates for further research.
3. Company research
Perhaps the most time-consuming of them all, fundamental research answers the key question of what stocks to buy. In this context, company research does not mean analysing its financial statements line-by-line. Rather, to gain a broad understanding of a company’s operating model, outlook and how it fits in your existing portfolio.
The 3 things I do when researching companies are browsing company presentations and reports, quick Google search and identifying insider ownership of companies.
By the end of this step, you should have a pretty good idea of what stocks to buy (if any).
Company presentations and reports
Usually located in the “Investors” section of its website, company presentations are a quick and efficient way to understand how companies operate. In particular, I try to find out how they make money, its outlook and track record. My aim is to gauge the sustainability of the business. If required, annual and quarterly reports can provide further insights.
Good old Google search
Keeping cost low is key to DIY investors, hence, why I chose a free source of info, the good old Google search (or any other search engine). Googling a company creates awareness of current issues faced by the company. For example, searching the term “Hiscox” (HSX.L), a UK-based specialty insurance, returns the following headlines:
- Flop of the Month: Hiscox ‘reputation’ hit by pandemic
- Hiscox share sale raises £375m
- Hundreds of UK firms join forces to sue Hiscox over lockdown insurance
I’m able to immediately gather that
- Hiscox future business growth may be hurt by its reputation as a result of the pandemic.
- Hiscox may be raising capital today for operational purposes.
- Hiscox will likely to face heightened legal costs going forward.
Pretty powerful knowledge with just one search, isn't it?
Insider ownership refers to shares owned by senior management team. It is one of the key metrics to look at before investing.
While subjective in nature, this metric demonstrates skin in the game. For this reason, this works well because the incentives of management team and shareholders are aligned.
Consequently, significant insider ownership may be a signal of confidence in executing its future business strategy. While it's not a fool proof method, it certainly has a good chance of avoiding sub-par investment decisions.
Our goal here is to determine insider ownership % in a company. Fortunately, such data are usually a Google search away. However, if you have troubles finding it, my shortcuts are:
For European stocks, this can be quite onerous if you’re not sure where to look. But I got you covered! Here’s what you need to do:
- Open the latest annual report, preferably in PDF.
- Ctrl + F to search for “shares held”, which will usually show you a table of the number of shares owned by senior management team. Calculate the total shares owned by insiders (usually given).
- Google the term “ABC company shares outstanding”. For example “Disney shares outstanding”. The first few search results should give you what you need.
- Using Step 2 & Step 3 should give you an idea of the % of insider ownership.
I’m sure you’re asking, but how much is significant? As a rule of thumb, >1% is a good starting point for companies with market cap >$5 billion say. Obviously, this is likely to be a smaller % the larger the company is. At the time of writing, 1% of Apple is around $13.5 billion.
Clearly, the higher the percentage the more incentivised the management team is in maximising shareholders’ return.
This reminds me of one of my meetings with the senior management team of a European company, where they tried to convince me that they have the right strategy and that their share price (even at that time!) was massively undervalued. In other words, the stock’s very cheap, please buy me now! Interestingly, the insider ownership was 0.0015%! Consequently, it didn’t take long for the share price to fall another 60% and the CEO to resign abruptly.
4. Defining investment objectives
Having determined what stocks to buy, we can move on to the goal setting part of the process. This is a simple process but often missed by most investors. Defining clear investment objectives not only answers the question of what stocks to buy, but also enforce effective risk management.
By now, you’ll have built up some sector and stock specific expertise that will help you address the questions below.
- Is this a trade or an investment?
- What is your time horizon?
- Are you seeking passive income, capital appreciation or a combination of both?
- What is a reasonable targeted investment return?
These questions are useful when it comes to sizing and entry point of investments, as we'll discuss in the next and final step.
5. Sizing and timing of your investments
Position sizing: How much should you invest?
For DIY investors, a good-sized portfolio should be no more than 10-15 stocks. In my view, there’s limited benefit (if any) in allocating capital to your 15th best idea relative to your top 5. For this reason, I formulate a size of 5-10% of my portfolio for each initial investment I make.
Market timing: Enhanced dollar cost-averaging method
The holy grail of investing, market timing seems to garner more attention than actually what stocks to buy!
I know it’s a cliché, but it really depends on the investment time horizon. In general, the longer term you are, the less sensitive you are to share prices (in a way).
As a long-term investor, I use an enhanced dollar-cost averaging strategy when I buy stocks. Dollar-cost averaging is a strategy that buys a fixed dollar amount of stock over a time period. In most cases, I buy stocks in 4 tranches evenly, every Monday for 4 weeks, for example.
The “enhanced” part process consist of triangulating historical P/E ratios to ascertain the current stock valuation relative to the market. This strategy has worked well because of its flexibility when stocks are trading below average valuations. For instance, I purchase stocks more aggressively when it looks cheap relative to the market index. More importantly, this strategy ensures that the investment is executed in a timely manner, even if the “enhanced” part of the process does not come into play.
Voila! That's my 5 simple (arguably) steps on what stocks to buy.
And now, as promised, the real juice of the article, an original idea we’re written about it, from beginning to the end.
Case study: Is Disney a buy?
Investment idea generation
As bored as I can be, I actually made a pie chart of daily life pre and post-lockdown. Check it out.
It was actually while plotting the pie chart that I thought of the idea. Not to mention the increased time spent watching Netflix! A big fan of Netflix’s car restoration genre, I tried to answer the question of how the streaming services landscape would change in the face of the crisis. More importantly, what does this mean for the sector with the Disney+, Apple TV+ and HBO Max entering the space?
The crisis has somewhat accelerated the trend, in particular, screen time is taking up a larger proportion of our daily lives.
In my view, the most important element of subscription is creating content. Looking at how much the industry has spent today, there's no reason to suggest that this will slow down. For this reason, my view is that streaming services will continue to enjoy exponential subscriber growth for those with substantial investments into creating original content.
With daily attention-grabbing headlines on which new series to binge watch, I decided to look into the Communication Services sector, in particular, media/streaming services subsector.
Using my experience as a Netflix user (not saying much) supplemented with ad-hoc digging online , I worked out that the key drivers are the 3Cs – convenience, content and competition.
Screening for stocks
Here's a screenshot of my screening, after filtering the companies of interest.
In the end, I narrowed my research to just Disney, Netflix and Apple given the relevance to my thesis on secular growth in subscribers.
Presentations and reports
Scrolling through the latest presentations, my summary of the companies are:
- Netflix’s strategy is to continue to invest in original content aggressively and grow subscribers.
- Disney’s media/streaming consist of 35% of its total operating revenue.
- Apple TV+ launched in Nov 2019 (similar to Disney+) is offering 1 year free subscription for Apple product owners.
From a quick Google search, I gathered and tabulated the information. Pretty insightful!
The table highlights the valuation differentials between the big three (am excluding Amazon Prime Videos here). Assumptions are highlighted in red for convenience.
A ball-park estimate, using Netflix's valuation, Disney+ alone is worth $50 billion today. Don't forget it's only launched less than 6 months ago and not fully rolled-out to key international markets.
|Company||Insider ownership %||Insider ownership $m|
(Prices are as of 14 May 2020.)
The insider percentage may vary, but these are large companies. The absolute amount of insider ownership shows a significant sum for all three companies.
Investment objectives: Targeted return and time horizon
So, did I find any investment opportunity? Fortunately yes, Disney. Given the latest subscribers number, it’s clear that the market is assigning a hefty premium on Netflix. Interestingly, I also reminded myself that Disney has decided to pull its content from Netflix since 2017, perhaps explaining why Netflix is aggressively beefing up its original content, spending as much at $15 billion in 2019.
What’s unique about Disney is its franchise. It owns Marvel, Pixar, ESPN, The Simpsons and Star Wars, just to name a few. Consequently, Disney was involved in 13 of the 20 highest grossing films of all time. That being said, I expect Disney+ subscribers to grow exponentially in the next 18-24 months.
In summary, my investment thesis in Disney is based on the underappreciated value of Disney+. Netflix’s current valuation means that Disney+ has an excellent upside. To the extent, I’m not surprised if Disney+ is worth more than the whole of Walt Disney itself.
A high growth story, I’m not paying a huge emphasis on yield at this juncture. As a long term investor, I'm looking to at a 3-5 years investment time horizon.
Position sizing and timing
Considering the likelihood of my idea playing out and the capital appreciation potential, I allocated 9% of my portfolio to Disney.
I also adhere to the dollar-cost averaging method. The bar chart below shows the relative valuation of Disney relative to S&P 500. The higher the value, the more expensive Disney is relative to S&P. As you can see, Disney has seen a short-term rebound in share price relative to the market.
(Update: Having bought a portion, I'm currently looking for a better entry point for the stock)
Stock picking is a combination of art and science and there’s rarely a perfect stock. Being able to make educated guess, connecting the dots and embracing uncertainty is part of the game. I hope this article answers what stock to buy and how to pick a stock.
We are also proud to announce that we have been recently featured in the feedspot’s Top 100 Stock Blogs. Do check them out for more stock related blogs!
How is your process different from mine? Please share in the comment below.
In the meantime, let’s take a moment to pray for Disney to succeed 🙂