The decision to invest in individual stocks can be driven by multiple factors. Maybe you feel secure enough in your other retirement investing and want to dip your toe in the water of individual stock ownership. Maybe you’ve heard about the great market returns of the shares of companies that you use and love every day, and have decided to earn some return on your investment into the products. Whatever your reason, you might find it hard to finally push that “Buy” button and own your first shares of individual stock. This post will aim to help you with that decision, and also try to illustrate when it’s time to walk away from an investment as well.
I personally believe that any investment should be an active decision; that is, not only should you be able to justify purchasing shares of a company, but you should also have a goal for the investment. Though I am generally a long-term, buy-and-hold investor, there have been times in the past where I’ve dabbled with buying something in the short-term based on looming news that might boost my short-term gains. For example, I purchased shares in Blockbuster and American Airlines’ former parent AMR Corp. shortly before both trouble companies declared bankruptcy, risking only a few hundred dollars in the process.
The thought was should either company somehow avoid bankruptcy – the chances were slim and I was expecting both to declare at some point – their stock prices would rebound and I could walk away with a sizable profit in a short amount of time. I went into both investments planning on holding both for less than 45 days, and after bad earnings releases for each but before the actual filing for bankruptcy protection, I sold both positions at a small loss before watching them both go to zero not long after. Do I do this style of “investing” often? Not really, but I was doing well enough with some of my other long-term holdings and wanted to try something new. I entered both investments with a definite exit strategy, and even though I lost money, it helped reinforce that a goal is necessary for any investment decision.
This goes for any long-term investment as well. In a perfect world, we could simply make a choice and just say that it’s forever. But even the strongest conviction buy should have an exit strategy. One of my favorite companies is Berkshire Hathaway (NYSE: BRK-A; NYSE: BRK-B), primarily because of Warren Buffett, but also because the company is so well run. It tends to be the first stock I buy whenever I venture into individual stock ownership, and I only loosely follow what they do on a regular basis. They really can’t do any wrong in my opinion, and Buffett doesn’t seem to be slowing down, though he does less of the day-to-day investing these days.
However, I do have an exit in mind for this stock, though I would prefer to simply hold it forever. When Warren Buffett eventually hands over the reins completely – whether it’s after he dies or simply decides to walk away – I will have to reexamine whether or not I want to stay invested. It’s not an immediate sell trigger when Buffett is no longer leading the company that made him famous, and I will most likely give his hand-picked successor the benefit of the doubt, but it would be an event that would lead me to at least look at what I think the prospect of the company will be going forward. This is a philosophy I take any time that I decide to invest, and I could provide similar outs for every investment in the portfolio I manage.
When it comes to actually choosing which company to invest in, I tend to follow this simple Buffett philosophy:
- A business that I understand
- With favorable long-term prospects
- Operated by honest and competent people
- Available at a sensible price
The first is reflected in Peter Lynch’s philosophy of “invest in what you know.” If you have a hard time understanding what a company does to make money, then you will have a hard time identifying when things start to go south for the company. This philosophy also led Buffett to miss out on some of the greatest performing companies of the past 30 years – he mostly avoided technology companies like Microsoft (Nasdaq: MSFT) or Alphabet (Nasdaq: GOOG) despite their outsized returns – but it’s hard to say that he or the investors of Berkshire Hathaway are terribly upset with his market-beating performance over the past 40+ years.
Figuring out if a company has “favorable long-term prospects” can sometimes be difficult, but there are ways to do it. You can build complicated models projecting the future prospects of the company, even predicting the price in the future so you can measure your upside. Or it could be as simple as identifying which companies have an “enduring moat,” or something that differentiates it from its competitors. This could be a strong brand – like Buffett favorite Coca-Cola (NYSE: KO) – or a low-cost producer with customer loyalty – like Berkshire Hathaway holding Costco (Nasdaq: COST). That’s not to say that these companies do not have viable competitors, but that both have the resources and stature to withstand any assault on “their castle” because of their sizable moat.
Identifying honest and competent leadership can sometimes be a bit more difficult, but it’s just as important and also helps with understanding the long-term prospects of the company. I personally like companies that are run by founders – my affinity for Under Armour (NYSE: UA; NYSE: UAA) and Kevin Plank reflect this – but also leadership that is invested in the long-term prospect of the company. If a senior leadership team is rewarded for performance of the company – not the stock price – and they are given shares or options as part of their compensation package, they are invested along with everybody else that owns shares.
Figuring out a sensible price may be a bit more involved, and could come from various sources. Similar to the second step, you can model where you think the company might be going in the future to determine what a sensible price actually is. The intent is to pay less than what it might be worth in the future, and then deciding how much upside you need in order to make the investment. Some people want to see a huge upside before deciding to purchase shares; others just want it to be trading at below its intrinsic value. The bigger this margin of safety is, the easier it will be to justify making the purchase.
There is no magic formula that helps find the best investments. If there was, somebody would have figured it out long ago and made billions. But there are many successful investors that use their own methods in choosing their investments, so it is ultimately up to you how you decide to invest your hard-earned money. My only advice is that you should have some conviction about why you chose the investment, and also have an end goal in mind with that conviction.
Until next time…
Note: My mother owns shares in Berkshire Hathaway that I purchased on her behalf. Read my entire disclosure statement.