5 Things To Check When Choosing Good Stocks – How To Pick The Best Companies

“Wide diversification is only required when investors do not understand what they are doing.” – Warren Buffett

Other People’s Money: Common Sense vs. Expert Advice

I remember watching Danny Devito’s movie, Other People’s Money as a kid and I imagined trading in stocks to be glamorous and badass. I thought stockbrokers had the opportunity to be the richest guys around and often wondered why they were not. Years later I read about a comparison that was done between stock portfolios managed by “experts” and those managed by everyday people like me. Apparently regular people were just as good as (if not better than) expert traders when it came to choosing good stocks.

This motivated me to start my journey to building my own stock portfolio. But first I had to learn what made a good stock. The following are the 5 key traits of a winning stock. These traits are the criteria that I use in deciding which stocks to invest in out of the myriad of options in the stock market. A good company should have all these characteristics. That way you can “set and forget” once you’ve bought the shares. I will also be linking to my best online resources for tracking and managing your investments in the stock market. So, let’s get into it.

Criteria #1 – Size

The first characteristic of a good company to invest in is its size. I know a lot of people like to target “penny stocks” (i.e. cheap stocks that can be sold when their prices go up) but I’m not referring to the price of the company here. I’m referring to its assets.

You’ll notice the Nigerian banking sector was one of the few to survive the 2016 recession and actually turn profit that year. This is largely due to the recapitalization exercise that happened in that sector 10 years earlier, that forced them to beef up their capital base.

When choosing a company to invest in, you need to make sure it’s strong enough to withstand the inevitable upheavals that every economy goes through. To do this, check for the company’s asset base. As a rule, I usually buy shares in companies with Total Assets worth at least $250 million (about 90 billion Naira at current rates) or with Annual Revenue or Turnover of $500 million (180 billion Naira). This helps weed out a lot of options and reduces your choice to companies that we are 80% sure will still be existing in another 10 years.

Criteria #2 – Working Capital

The 2nd characteristic to look out for is a company’s Working Capital. You know the saying that cash is king? Well Working Capital is an indication of a company having sufficient funds or cash flow to stay in business for the short term. Usually this is the difference between the company’s current assets (e.g. money in the bank) and it’s current liabilities (e.g. debts owed to its suppliers). Some big corporations have poor working capital but continue to stay in business based on their reputation or the willingness of vendors to allow them to continue to owe. This is a risky position and a shakeup in the economy can put such a company out of business (Ahem Etisalat Nigeria). To confirm a company’s liquidity position, you need to see its financials.

Criteria #3 – Profit

This is where things get interesting. The first 2 criteria were about the sustainability of the business. The next 2 are about the sustainability of its profits and backing by investors.

The 3rd criteria for a good stock is Profit. There are 2 questions to ask here.

  1. Has the company consistently made profit over the past 5 years?
  2. Has the profit been growing over the past 5 years?

A good company will not only have made profit consistently every year, it would have increased the profit at an average annual growth rate of at least 3% over a 5-year period. Lots of companies on the Nigerian Stock Market have grown profits higher than this. Some companies are however inconsistent with their profits. Others have declining profits. Smart investors avoid such companies. There are lots of other companies to choose from.

Criteria #4 – Dividends

The 4th criteria for good stocks is dividend payments. A good company would pay dividends consistently to its share holders over a 5-year period. While it follows that a company would pay dividends when it makes profit, this is not always the case. Some companies retain all their profits and reinvest in the business. That may sound nice but I like my investments to pay dividends. On the other hand, you shouldn’t assume that a company that pays dividends has been consistently making profits either. Some companies pay dividends even when they make losses. I don’t consider those good investments either. Again, we need to check the financials.

Criteria #5 – Price

The final criteria is the price. A company that satisfies the first 4 conditions is usually a great option. However, it may be overpriced on the market. What you want is to find good companies that are currently under-priced. Why? Because usually, over time, the market will catch up to the fair price of every stock on the exchange. This means if a company is already overpriced, the likelihood of the price dropping in the future is high. Even if it is a great company. While if a company is under-priced, the value of your investment is likely to grow over time. You can comfortably ignore any temporary fluctuations in the price.

There are 2 ways I usually use to determine if the company is fairly priced.

Number 1 is something called the Price to Book Value. You get this when you compare the stock price to the company’s net assets, per share. In other words, we are comparing the price people are willing to pay for a company’s stock with the actual value of the company if it were to be sold off. Ideally this should not exceed 1.5 to 1 i.e. a good company is priced lower than 1.5 times its book value.

Number 2 is the Price to Earnings ratio. This compares the stock price to the company’s earnings, per share – i.e. how much profit the company made in the last financial year compared to how much it’s being sold on the stock market per share. Ideally the stock price should be less than 15 times its profit per share. Otherwise it’s overpriced.

A true penny stock is one that satisfies the earlier-mentioned conditions and still remains under-priced. Most under-priced companies do not satisfy the first criteria of size though so… check the financials.

Bonus Resources

You are probably wondering, Where do I get the financials? How do I check for all these criteria? How do I even get started at all?

That’s why we are here.

Stock prices are relatively easy to find but how about the company’s assets, profits, working capital and all the other ratios? For the Nigerian Stock Market, my first resource is the CSCS website where you can check the latest stock prices and also register and track your stock portfolio performance online. The other resource is the Nigerian Stock Exchange website where you can check specific stock ratios or search for each company’s latest audited financial results. There are also some stockbrokers that provide a 5 year summary of each company’s performance on there website. I no longer use this as I prefer to read through the financials myself but this was a useful resource when I was just starting out.

What To Do Next

While I’ll recommend you always check with a professional before making any moves with your money, you can start by opening an account with a stockbroker today. But remember, don’t just buy anything. Buy stocks in the right companies. To watch me carry out an analysis of one of the most popular stocks on the Nigerian Stock Exchange live and decide if it is a good buy, check out this live walk-through video on YouTube. You’ll also find a Sample Template for Analyzing Stocks in the video description.

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