• Brett Schafer

How I Research a Stock

If you want to be a successful stock picker, you need a consistent research process. This will not only help you find the right companies for your portfolio but make it easier and more efficient to sift through the thousands of publicly trading businesses on the market.

And just as there is no one-size-fits-all investing strategy, there are no cookie-cutter approaches to investment research. What matters is whether the process works for you to be able to find quality companies that you are comfortable owning. Everything else is irrelevant.

I’m going to go through my research process, from finding a ticker to eventually adding the company to my portfolio. This is by no means a foolproof strategy. I’m also certain that in 10 years, after continually learning about investing, I will have added or subtracted criteria from my checklist.

After reading this, I hope you will either a.) understand the basics of investment research (if you’re a novice), or b.) have found something to add to your established process. I know I could have used something like this when I started investing.

Here are the basic steps I follow:

  1. Financials/What they do

  2. Can (or do I want) to understand the business?

  3. Do they have any competitive advantages?

  4. What their industry is like

  5. Vetting of management

  6. Is there a plausible scenario where they beat the market?

Each of these six steps is done in a specific order so as to minimize time-wasting. How it works is, if a company doesn’t make the cut on any step of the process, I stop research and either put it on my watchlist or forget about it. For example, if the basic financials or business model don’t check out, I don’t even bother going through any other of the steps. Who cares how great management is if the valuation is bonkers?

Let’s go through what I look at on each step and how I identify red flags within the company.

The Financials and Business Model

Financials and how the business makes (or, in today’s world, probably doesn’t make) money are the first things I look at. Rarely, unless something is just totally out-of-whack, will I discard a stock at this step. For example, sometimes (but not all the time!) it can be a good thing for a company to lose money.

Here are a few times I have stopped researching at this step:

  1. Absurd Valuation. There are rare instances where a sales ratio above 40 is justifiable. Shopify and Beyond Meat are not one of those instances.

  2. Unit Economics. Unit economics do not scale. In other terms, if you sell a dollar for 90 cents, there is no way to make it up in volume (looking at you, Uber).

  3. Exploiting Customers. I invest for the long-term, ideally holding a company for a decade-plus. If you exploit your customer base, your business is not going to succeed over the long-term.

Most stocks make it out of this first tier. The reason being, every company is in different stages of its lifecycle and needs to be evaluated on its industry, competitors, management, growth prospects, and moat potential. This is what the next steps are for.

Do I Understand the Business?

If you don’t understand how a company fits into its respective industry, it’s inconceivable that you can know more than the market consensus. And if you don’t know more than the market consensus, how can you expect to beat it?

That is why it is imperative you own companies you understand. But don’t think this means you can only invest in what you’re an expert in now. Given enough time you can learn about almost anything.

However, even if you have the ability to learn about a company, that doesn’t mean it is the most efficient way to go about it. Which is why a stock has to pass these two questions before it can move onto the next step:

  1. Is the company too hard to understand? If the answer is yes, then I don’t invest. A good example of this is DataDog. I loved the financials when their S-1 came out, but it would have taken me months of meticulous work to become an expert in what they do.

  2. Do I get the industry/is it cyclical? This one is very basic. If a company is in energy, industrials, or one of the many cyclical sectors, I likely won’t invest. The reason being is, at least right now, I am not comfortable putting my money there, no matter how attractive the valuation. That’s not saying I never will though.

Competitive Advantages

Competitive advantages are enormous for sustained growth. Here is the dictionary definition of what it is:

“a condition or circumstance that puts a company in a favorable or superior business position.”

These conditions and circumstances can come in a ton of different ways. Here are a few that I look for, and what can springboard a company to the next step of the process:

  1. Two-sided marketplace (i.e. classic network effect): Mainly coming into play with consumer software apps, a network effect is when every incremental user makes the experience better for every other one. The classic examples of this are Facebook and Twitter. Spotify, a company I own, has a strong network effect of creators and users.

  2. Economies of Scale: This is a classic piece of moats companies can build. A modern example of this is Netflix. Say what you want about the stock (I have no position), the business is creating a content barrier that very few can compete with. Visa and Mastercard fit in here as well.

  3. Brand: One of the toughest ones to decipher as an investor and build as a company, but one that can lead to phenomenal returns. Apple, Ferrari, and Disney come to mind when I think of brands that are tough to compete with.

There are plenty of other ways companies can build moats. For a company to pass this leg of the checklist, I need to identify at least one way the business has an advantage over other players in the industry. If a company has zero or even some disadvantages (think Comcast) they will be fighting an uphill battle.

Industry and Competitors

Competition matters greatly for investors, especially in today’s world with Amazon, Microsoft, and other tech companies investing in seemingly every industry imaginable. That is why it is important to understand the broad market dynamics for any stock you’ve invested in.

Here are two topics I focus on:

  1. Industry Tailwinds. Does the company I am looking at benefit from industry tailwinds (i.e. a growing market)? An easy way to check this is by looking up some consensus market statistics on Statista or IBISWorld. For example, if you were invested in Roku, it would be pertinent to check the growth in connected TV’s and what the estimates are for future years.

  2. Main Competitors. For this part, and it can get a little nuanced here, I try to identify whether they are beating competitors in relevant growth/profitability metrics. For example, if a social media company has better user growth and operating/gross margins than its two largest competitors, you’d probably say they are the best in the industry (or at least the most efficient). Conversely, if all the relevant financial/company statistics are worse than the competition, you probably need to investigate why that is.

The beautiful scenarios are when a stock you own has little to no competition. This is rare, and usually only happens with smaller market opportunities, but can lead to fantastic results. It’s just one less thing to worry about when analyzing a company. Two names that come to mind with no relevant competitors are Axon Enterprises and Ferrari.

Is Management up to Par?

A very important question is whether management and the executive team are up to the task of turning the business they manage into a serial compounder.

I have no ways to communicate directly with executive teams on any of the stocks I own. Neither do you. Well maybe you do, but probably not. The best way to gain confidence in a CEO/founder is to consume what they produce and see what others think of them. This can be done through:

  1. Reading Glassdoor ratings

  2. Reading/listening to earnings letters, conference calls, and speeches at conferences

  3. Watching anything the executive team does in the media

You obviously can’t know for sure if a CEO is just faking it or truly believes in his company’s mission. The best we can do as individual investors is to research as much we can and come up with a conclusion from there.

In order for a stock to pass through to the final step, I need to be confident the management team is doing what is best for the long-term success of the company. Anything less and it will be tough to get me invested.

Can They Beat the Market?

Lastly, we have an important, but impossible to answer question. Nobody knows for certain whether a company will beat the indices (if they did, the stock would move higher immediately, and that arbitrage would be lost).

However, what I do want to answer with this last question is whether I believe the stock will beat the market and how likely it is for them do to so. Again, a hard question, but one that can be reasonably answered with all the research I did above. We didn’t do all that work for nothing guys. Well, maybe we did, but we won’t know for five years.

I’m not a discounted cash flow (DCF) person, so don’t expect me to come up with some magical 2025 “price target” for every stock I own. All I’m doing here is using a few conservative predictions for revenue growth, operating/cash flow margins, buybacks/dividends, and any other future valuation metrics to estimate whether a company could beat the market. This typically boils down to high cash flow growth and returning capital to shareholders (or just not diluting them) to drive sustained earnings growth that outpaces the market.

Just know though, that there are no guarantees in investing. The market owes you nothing. But there is a reason millions of us continue to put our capital at risk. Because it has been damn foolish to bet against the progress of capital markets and human ingenuity over the long-term.

Disclosure: the author is not a financial advisor, and may have an interest in the companies discussed.


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