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How to Start Investing in Stocks

There's a lot happening in the capital markets. While I spend most of my time writing investment ideas, reviewing the fundamentals is an essential part of my checklist process. Every investor has some type of checklist. Some are qualitative, some quantitative, some both.

However you slice, everyone has their own methodology. So I thought it would be a good idea to publish my own research process over time.

Below you will find a breakdown of how I analyze stocks, my thinking process and valuation methods. This process is constantly evolving, so feel free to revisit this post in the future.

The Summary Introduction

I've always found writing a snapshot of any investment is the best way to get started. Whether I'm reading the thesis or someone else, everyone needs a refresher. I write a lot of investment updates so it is easy to get different posts confused.

The most common investment updates are quarterly earnings. Sometimes a product or acquisition announcement. These tend to be catalytic events that move the stock price. Making it simple to identify when something happened parallel to a price chart.

So I'll begin a summary with 'In Q3 2024 investors expected the following,' which tells me this is a prediction post. Then I'll explain my thesis on how the stock price will react afterwards.

Most investors track earnings, which is great, but other catalysts you want to identify when writing an investment update. Examples can include mergers & acquisitions, insider transactions, product announcements or some other press release event.

Next is the Valuation Process

Now I use several tools to help with stock valuations. Most of it is for retrieving financials from different sources like the SEC Edgar. Capedge is one free resource I use often to track changes.

Before I would build my own financial models but I ran into two errors overtime: 1) Buffett doesn't build models; and 2) I would never update the models.

Unless you are doing a buyout, building financial models to value stock prices becomes obsolete very fast. The problem is so much of the public markets is based on the psychology of investors, or even earnings estimates. You don't want to spend hours building models to price a stock down the penny. You need a better macro picture idea.

The preferred method for many investors are valuation comparables. It's way simpler to compare price-to-earnings or price-to-cash flow than to spend hours building models. Plus computers do spreadsheet work better than humans now.

Similar to Buffett, I look at the earnings power of a business. If you can read financial statements, then you will look for the net income/free cash flows (earnings) and the owner's equity. If the return on equity (earnings/equity) is greater than 15%, you have a good business. Buffett prefers a 20% ROE for multiple years.

I use this methodology, combined with other valuation methods, to understand the health of a business. Then I'll add some projection estimates and look at the price plus investor position to determine a valuation. I'll need to expand on this exact process in a longer post.

Every Investment has Risks

There are too many times I've ignored even the most basic risk factors when making a simple investment earlier in my career. When you are too optimistic about the future, that's the exact moment you need to price the downside. Yes, price it.

I've worked in risk management departments, built fancy financial models and priced different option instruments. There are ways to price risk. If you haven't done it or don't do it, now's your time to get started.

Outside of buying an index, you can and need to price individual stock risk factors. In fact, every annual report has this section laid for individual companies. Read it.

At first, these risk factors come off as boring and repetitive. However, you need to drill the downside in your mind. Only the paranoid survive. If you don't track or price the downside, then the market will do it for you.

I suggest writing down the three or four key risks in your investment. If you can identify and price them, then you can build a portfolio position accordingly.

Find the Catalyst

I think this is the missing element from many investment ideas. Every so often you'll find investors talk about their 'gut' or that the stock price was too good. Ignore these intuition-based investors. If you are not a trader, you need a more precise investment methodology.

Now I've mentioned a few typical catalysts such as product releases and earnings announcements. These are good to identify but not specific enough. Similar to the 3-4 key risk factors, you need to find 1-2 catalysts for your investment thesis. You need to know what will move the stock price, up or down.

If you're like me, I look for the rate of change in a stock. I look for the 2-3 operating drivers that will push the stock price higher. Examples might include a business going from low net profit margins to a higher net profit margin.

This increase in margins will attract a lot of new investors. First, investors love a comeback story and to invest in great companies. Second, a higher profit margin will show up on everyone's screener.

Summary

In this post, I've shared the key elements of my stock investment process. Remember, there's no one-size-fits-all approach, but having a structured framework is crucial.

We covered the importance of starting with a clear investment thesis, conducting a thorough valuation, understanding and pricing risks, and identifying potential catalysts that could move the stock price. I've learned these lessons through experience, often the hard way, by making mistakes and refining my approach over time.

The key is to move beyond gut feelings and develop a system that relies on data, analysis, and a clear understanding of your own investment goals.

My investment process is a living document, constantly being updated and refined as I learn more and the market changes. I encourage you to use this as a starting point to develop your own personalized investment checklist.

Don't be afraid to experiment, track your results, and adapt your approach as needed. The journey of investing is a marathon, not a sprint, and a well-defined process will be your trusted guide along the way. What are the key elements of your investment process?