Find Great Companies to Invest In

Smart investors put their money in reputable companies and investigate new companies thoroughly before committing their money. By carefully considering the qualities of the companies you invest in and incorporating your own knowledge of the market, you can make informed decisions in the hopes of choosing stocks of good quality and value. Be aware, however, this is no small task. Mutual fund companies and the like dedicate entire teams of experts whose full-time jobs are to research and understand how to invest in companies. Be sure you have the time and inclination to do this yourself, as well as the willingness to take the risks of doing so.

Steps

Buying What You Know

  1. Stay within your circle of competence. If you have a field of expertise, you may be best able to identify quality within that area. Experience can provide you with the insights you need to make more informed choices. For example, if you work in retail, you may be better positioned to determine if you should invest in companies like Walmart, Target, or Best Buy, than you are in evaluating the latest bio-tech company.
    • Having competence in a certain area doesn't have to come from workplace experience. If you're a techie who spends his time buying and reading about the latest gadgets, you can draw on the information you obtain to help you make decisions on how to invest in the technology sector.[1]
  2. Focus on a few industries or markets. These can be either your direct area of competence or other areas that you are interested in investing in. The important thing is to realize that you can't keep track of everything going on in the global economy. Large financial institutions have whole departments for doing this so don't think you can do it on your own. Instead, narrow your focus to include only a few key industries or markets.
    • This doesn't mean you should avoid focusing on individual companies. You should always investigate every company you plan to invest in individually.[1]
  3. Stay up to date on news within that industry. Examples of quality sources for this are online finance websites like Bloomberg and the Wall Street Journal. They'll give you up-to-date information on many of the goings-on in various sectors of the economy and the World. Again, focus your energy on a few key areas and become knowledgeable on the happenings in them. Look for things like trends, mergers, acquisitions, relevant legislation changes, and any global events that may affect your chosen market.
  4. Plan ahead. Identify a company that you think stands to benefit from some change or trend in the market. Look ahead for when this change will take place and move around your money to prepare to invest in the company. For example, if you think that a new product being released by your favorite tech company is going to be a huge success, you may choose to invest in the company before the rest of the world realizes this and drives up the stock price.

Investing in Companies with Competitive Advantages

  1. Understand competitive advantages. There are some companies that manage to be consistently profitable and successful in their industry over many years. These companies have succeeded in building a "moat" around them to keep their competitors away. This distance from their competitors is also known as a competitive advantage. Competitive advantages allow these companies to make money and retain customers more easily than others. In turn, these companies are able to provide greater value and return to their shareholders.[2]
    • An investment in one of these companies allows you to participate in their competitive advantage. While they may not grow as quickly as smaller companies, they often can be less likely to fail in economic downturns and can provide consistent growth throughout the years to come.
    • Blue-chip stocks are examples of large, successful companies with competitive advantages. These companies have provided consistent growth or dividends over many years and are listed on large stock indexes.[3]
  2. Invest in trusted brands. Think Harley Davidson, Coke, BMW. These are brand names etched in the public mind as the best in their class. These companies can raise their prices on the strength of their brands, resulting in deeper profits.These companies are so well-known and essential that they are unlikely to lose a significant amount of customers to competitors.
  3. Find companies with high switching costs. When was the last time you switched banks? Or cell phone providers? These services retain customers because switching between them is more time-consuming than it's worth. Companies that have high switching costs can be expected to hold on to their customers longer than companies that don't.[4]
  4. Search for economies of scale. Companies that are able to make products and sell them at much lower prices than their competition automatically attract customers -- lots of them -- as long as quality is not compromised. In a crowded market, this is generally the result of economies of scale, a phenomenon where a large company is able to experience lower production costs solely due to its size.[5] Walmart and and Dell have perfected this concept to a science.
  5. Invest in legal monopolies. Some companies are granted legal (if temporary) monopolies by the government. Large pharmaceutical companies and manufacturing companies with patents are able to bring a truly unique product to market. Companies that own copyrights, drilling rights, mining rights, and other forms of protected property are often the sole producer or service provider in their area. Thus, these companies can raise prices without fear of losing customers, resulting in higher profits.
    • Be sure to check how long the company's patent or usage rights are in effect. Some of these are temporary and when they go, there's a chance the company's profit will go with them.
  6. Look for opportunities for easy growth. Some companies are easily scalable. That is, their products or services with the potential to network or add more users over time. Adobe has become the de facto standard in publishing; Microsoft's Excel has done the same in spreadsheets. eBay is a great example of a user network. Each additional user to the network costs the company virtually nothing. The additional revenues that come in as the network expands go straight to the bottom line.
    • For a more current example, consider Netflix. As a streaming service, they make more money for each subscriber, even as their costs remain virtually the same. That way, as they gain more users they will continue to grow in profitability, assuming they don't choose to increase costs significantly.

Evaluating Company Performance and Valuation

  1. Check the quality of management. How competent is the management running the company? More importantly, how focused are they toward the company, customers, investors, and employees? In this age of rampant corporate greed, it's always a great idea to research the management of any company you're thinking of investing in. Newspaper and magazine articles are good places to get this information.
    • This doesn't just mean that management has provided good financial results recently. Rather, look for indications of other important qualities like responsiveness, adaptability, capacity for innovation, and organizational ability.[6]
  2. Watch for management changes. A good leader can successfully turn around a company that many consider to be a lost cause. Watch the news and financial reports for changes in management positions, especially CEOs. If you believe in the new CEO of a company, based on your research, you may choose to invest in that company. Here, you're essentially putting your faith in the person, not the company.
  3. Avoid overvalued stocks. Even a great company can be overvalued. Learn to interpret financial statements and Pick Stocks and Other Investments With Fundamental Analysis to find companies the market has overvalued. Know that these companies may be some of the most buzzed-about and invested in companies around, but they are still overvalued and may experience drastic declines in price once their day in the spotlight is over.
    • One way to determine if a stock is overpriced is to examine its price-earnings-ratio. The price to earnings ratio can usually be found in the company's stock summary on financial websites. Generally, PE ratios are between 20-25, but this varies by industry.[7]
    • To evaluate a company's PE ratio, search online for the average PE ratio in the company's industry. If the P/E ratio is over the industry average, the company could be overpriced in view of its earnings.
  4. Buy undervalued stocks. Undervalued stocks are those that are trading at a lower value than their financial information would indicate. These may be companies that have only started to do well recently. In these cases, the market has not yet caught up with their newfound success. To identify stocks with room to grow in value, you can also use the price-earnings ratio mentioned above and look for companies with low PE ratios compared to the industry average.
    • You can also look for companies with a price-to-book-value of less than 2. The price-to-book ratio is the price of the company divided by the total value of its assets minus its liabilities and intangible assets. A low ratio may indicate that the company is relatively cheap.[8]

Tips

  • Start thinking about everyday companies in terms of this new framework.
  • Learn the basics of reading financial statements. Check the profitability of companies you're interested in. Check their debt position. See if they have been growing steadily.
  • Visit the company’s website and other financial websites that will give you insight into the stock.
  • While it may be advantageous to invest in companies you know, do not limit yourself to just one or two sectors of the economy. Try to research companies in a variety of sectors. Doing so further diversifies your portfolio to better insulate it from a downturn in a single sector or company.

Warnings

  • Be aware of stock tips: Whether they come from someone you see on TV or someone you meet in person, these are more often not well-researched or are even based on someone's grandiose theory about getting rich quick. They may also be provided by salesmen paid to inflate a stock's price to allow a company to raise as much capital as possible.
  • Jumping into buying stocks in a company without doing thorough research can be a quick way to lose your money.
  • Investing always carries risk. Even if you do everything right, there's no guarantee that you'll make money.

Related Articles

Sources and Citations

  1. ↑ 1.0 1.1 http://www.forbes.com/2010/05/19/invest-in-what-you-know-personal-finance-investing.html
  2. ↑ http://news.morningstar.com/classroom2/course.asp?docId=80345&page=2&CN=COM
  3. ↑ http://www.investopedia.com/terms/b/bluechipstock.asp
  4. ↑ http://news.morningstar.com/classroom2/course.asp?docId=80345&page=3&CN=COM
  5. ↑ http://news.morningstar.com/classroom2/course.asp?docId=80345&page=4&CN=COM
  6. ↑ http://www.greenbiz.com/blog/2012/07/09/finding-well-managed-companies-investors-holy-grail
  7. ↑ http://www.investopedia.com/terms/p/price-earningsratio.asp
  8. ↑ http://www.investopedia.com/terms/p/price-to-bookratio.asp

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