An index-tracking ETF can provide investors with average market returns, which, incidentally, will still outperform 90% of investors. The next step for an investor can be the world of purchasing individual stocks. This requires greater attention; however, it does not demand daily focus and worry as many people think—we do not need to live under the daily spell of stock prices. It is best if we completely ignore checking our portfolio’s value for longer periods of time. Think about it: if we were to start a business, such as a restaurant, would we check its valuation on a daily basis? Obviously not. Just because a company’s shares are publicly traded on a stock exchange does not mean that we have to constantly monitor its momentary value. Company growth is slow (it is worth thinking in terms of at least a multi-year horizon), so the value of their shares follows their underlying value slowly as well. However, in the short term, prices can produce strange swings depending on market sentiment, which does not mean that a stock’s momentary price behaves in tandem with the actual value of the company. To ensure that investing in individual stocks is not speculation and gambling, but rather a well-thought-out business decision, it is worth considering a few factors.
Understanding the business model
Warren Buffett, one of the world’s most renowned value investors, always emphasizes in his writings: “Never invest in a business you cannot understand!” The main question is: how does the company generate its revenue? What kind of customers does it have? Who is the target buyer group for its product? What value does its product or service hold? How intense is the competition in the industry where it operates? How easily could competitors copy the given product or service?
The company’s competitive advantage
The finest companies possess some form of competitive advantage that sets them apart from the pool of competitors. Experts call this an economic moat (a metaphor from Warren Buffett). In practice, this moat ensures high profit margins for the advantaged company over many years. This can be, for example, brand equity (Coca-Cola, Apple), a quasi-monopoly position regarding certain services—see card networks (Visa, Mastercard)—or a cost advantage, meaning that due to something, its production costs are significantly lower than those of its competitors.
Key financial indicators
It is worth considering these financial indicators during the preliminary analysis of a company. They can ensure buying at the right valuation, provide a margin of safety—which is particularly important in value investing—and secure an adequate (hopefully above-market) return for us in the long run. A simple, free, but highly usable website for quick financial data searches is www.financecharts.com.
Of course, it is even better if we dig into the annual financial statements of companies, as we can access far more information there. A company’s operations cannot be properly judged solely from financial metrics alone.
- P/E Ratio (price-to-earnings): The P/E shows how many times the company’s current stock price is relative to its earnings per share (EPS) over the last 12 months. For example, if the current P/E is 15, then at the current earnings level, the invested amount would pay off in 15 years, provided earnings remain unchanged. Obviously, this is not realistic; in a good company, earnings grow over the long term, meaning the payback period can shorten, while earnings can also decrease, extending the payback period. Of course, P/E alone does not say much; it is worth comparing it with the company’s industry average and looking at how values have evolved over a longer timeframe. Average P/E values can vary greatly by industry; for instance, utility providers typically have higher values because the market considers them fundamentally safe businesses with rare major bankruptcies or collapses, and their services will always be needed.
- P/B ratio (price-to-book value): This compares the current stock price with the company’s book value. Generally speaking, if the value is below 1, it is worth examining the company, as the current stock price may be undervalued. Naturally, here too, it is necessary to compare with industry averages over a longer period, as values may differ. A company with a P/B value between 1 and 1.5 can easily be a good buy as well. Above these values, our return level will most likely decrease, so it is rarely a good deal. Typically, companies requiring a lot of intellectual capital trade above a P/B of 1.5, and technology and software development companies also rarely drop below this value. Incidentally, companies involved in such activities generally have a higher P/E value as well.
- ROE (return on equity): Measures the return relative to shareholders’ equity. This is also industry-dependent, but 15–20% is already considered an excellent figure.
In addition to these, it is naturally worth observing the ratio of net profit to revenue and its trend, as well as the asset-to-liability ratio and the evolution of free cash flow.
How does the CEO communicate in annual reports, and how do they treat shareholders? Do they consider them business partners, or do they ignore their interests? Does management own a large quantity of shares? The more management acts as owners, the more it is in their interest to increase shareholder value, which also benefits minority shareholders. A long dividend payment history and gradual, sustained dividend growth can be an important indicator. Simple logic dictates that if a company has been paying dividends for a long time and continuously increasing the dividend amount, it must have the means to do so—meaning its operations are sustainably profitable and the business model is viable. Based on this, the key is not a high dividend payout ratio, but rather dividend growth. Another sign pointing toward increasing owner value is the regular use of share buybacks.
Investing in individual stocks and building a portfolio can be an interesting endeavor, but here too, it is worth keeping diversification in mind to somewhat reduce the impact of our mistakes. There will certainly be deals that turn out unsuccessful—since even the best make mistakes—yet even with this possibility, good returns can be achieved. However, excessive diversification is also dangerous because a person’s attention gets scattered, and they may not be able to sufficiently understand a company’s business activities. Research shows that beyond 30 companies, diversification no longer yields demonstrable benefits, so I believe it is worth targeting around 20 companies—though certainly not at all costs. If you understand a business and have properly researched a company, it is unnecessary to own shares in additional companies you do not know well simply for the sake of diversification.