If you’ve been investing very long, you no doubt understand the importance of having a solid system in place.
By “system” I’m not referring to a secret black box or to technical trading rules, though both can be valid approaches in the right hands. I am speaking far more broadly. Whether you are a value investor, a technician or a data-crunching quant, consistently making good returns in the market depends on having basic investment guidelines in place.
Today, I’ll share with you the basic characteristics I like to see in place when buying a stock.
1. Is the stock on the right side of a durable macro trend?
This is the very core of my investment process and, naturally, what I spend the most time writing about. A durable macro trend is an economic inevitability driven by forces too powerful to stop. Demographic trends, such as the aging of the Baby Boomers or the family formation of the Millennials, fall into this category.
Why do macro trends matter? Because, to borrow an old expression, a rising tide lifts all boats. If you are on the right side of a macro trend, the rest of the investing process becomes much easier and you have a much higher probability of success.
2. Is the stock attractively priced?
That sounds good. But how do you define value?
My methods here will vary slightly from stock to stock. Often, I will take an income statement approach, comparing the stock’s current price to its historical or expected earnings, cash flows, or sales. This might mean looking at the current P/E ratio or looking at a longer-term indicator such as the cyclically adjusted P/E ratio, or “CAPE.” Sometimes, rather than focusing on the income statement, I’ll focus on the balance sheet, looking for assets that are undervalued on the books. In this kind of deep value investing, you can often find companies whose individual parts are collectively worth far more than the current value of the stock.
3. Is management shareholder friendly?
We want to own companies with management teams that know their place. They are employed for one—and only one—reason: To make money for you, the shareholder.
One of the best signs that management takes its obligation to shareholders seriously is the payment and consistent raising of a regular dividend. But well-timed stock buybacks can also be an excellent way to reward shareholders and without the tax complications of dividends. But the key here is that buybacks must actually reduce the number of shares outstanding and must not be used to “mop up” new shares issued via executive or employee stock options.
4. Is insider trading/ownership favorable?
In an ideal stock investment, you are on the same side of the trade as the key personnel running the company. A “perfect stock” will have both high insider ownership, possibly by the company’s founder, and consistent new purchases by insiders.
The key here is “skin in the game.” You want a management team of shareholders with their interest aligned with your own. If a CEO has a large share of his or her personal net worth in the company they are managing, they are more likely to run it prudently and with a long-term horizon.
As I said, a “perfect stock” will have both high current ownership by insiders and regular open-market purchases, but “perfect” insider stocks are rare gems. For the most part, I can tolerate a benign insider picture in which insiders are neither aggressive sellers nor buyers. I’m happy if I see either favorable ownership or favorable new buying, and I am downright thrilled if I see both.
DISCLAIMER: The information in this material is not intended to be personalized financial advice and should not be solely relied on for making financial decisions. All investments involve risk, the amount of which may vary significantly. Past performance is no guarantee of future results.