Investing in the stock market is not an easy task. Let’s be clear about that. And beating the market is even harder. Especially in the short term. What makes a winning strategy (at least in the long term)?
This is a condensed, clear, and easy-to-understand guide on how I invest in the stock market for people who are just starting out or who still have trouble coming up with their own strategies.
This is something that I was personally struggling with (since I had zero previous experience in stock market investing just a few years ago). I did this in a Q&A format so that it’s easier to digest.
What you'll learn:
⓵ How do I know which company to buy when investing in the stock market?
Put simply, you should always try to identify the best business when investing in the stock market. Well, how do you tell which company is better than the other? To start with, a company’s sole purpose is to turn a profit.
Whether they make a product or offer a service, the end goal is to become profitable. Now whether a company actually turns profitable or not is another matter.
The point is that they should move in that direction without sacrificing growth potential. Meaning that they shouldn’t stop investing in their Sales and Marketing (S&M) or Research and Development (R&D) in order to reduce costs dramatically and appear profitable instantly.
❖ This is what makes a company better than others:
◆ 1. High (and even accelerating) YoY revenue growth of at least 50%+
A company is a live thing. It is different to let’s say a commodity like gold which doesn’t actually produce something itself. So, gold’s value is simply determined not by what it produces but by what people are willing to bid it up to.
Unlike the greater fool theory, investing in companies is different as the value changes according to the intrinsic value of a company. If a company is growing revenues at 50% per year, then in 4 years its intrinsic value could be worth 5 times as much (1.5⁴=5).
◆ 2. A competitive advantage over the competition
A moat or a competitive advantage would make sure that other companies will have difficulty taking market share from our company. Competitive advantage could be something simple (like a better interface or a sexier and more simplistic design) or something advanced (like AI and data that take years and knowledge to replicate).
3. High recurring revenue (as close to 100% as possible)
The higher the recurring revenue the better. This applies to all Software-as-a-Service (SaaS) companies. This is similar to what we pay to our internet provider, mobile phone, electricity, water bill, etc.
Some companies charge according to usage/consumption (SNOW) and some others offer a fixed fee (MNDY). This gives better visibility into a company’s revenue as it is much easier to come up with an estimate.
This is important to us investors as we can predict where the company is going in a much smoother way than companies with lumpy revenues.
Another important thing for looking for high recurring revenue is the fact that these services are usually much stickier and locked in for years. This makes growing revenues easier for software companies as they don’t need to do all the sales from scratch again. They simply build on top of the existing ones.
◆ 4. High gross margins (at least 75%+)
A company with 90% gross margins (GM) will keep twice as much in profit (all other things being equal) than a company with 45% gross margins. If company A brings in 100 million in revenues, then it will keep 90 million whereas company B will keep only 45 million.
◆ 5. Improving operating metrics
Let’s say a company is spending a great deal of money on S&M to push growth and try to catch as many customers as possible early on. Remember that this is a SaaS model which pretty much locks in customers for many years.
So, it makes sense for a company to spend a lot of money to land clients at the expense of short-term profit.
However, this and other operating metrics should show improvement and move in the right direction. Examples include improving gross margins, improving customer acquisition, improving cash flow, improving profit, or dropping losses if unprofitable.
◆ 6. High dollar-based net retention rate (DBNRR) of 120%+
This is how much your total clients spend this year compared to the previous year. A DBNRR of 120% means that clients are spending 20% more this year. So, if they spent $100K last year, this year they increase their spend to $120K. This metric is net, meaning that it includes churn.
◆ 7. Improving free cash flow (FCF)
Free cash flow shows how efficient a company is at generating cash. The more cash a company has the easier it is to pay down debt and pursue growth opportunities. If a company is not yet FCF-positive, then it should move in that direction and show improvement every quarter.
◆ 8. Lots of cash and little to no debt
Debt will kill more companies than anything else. If a company carries zero debt, then the risk of going bankrupt is much closer to zero than a company carrying lots of debt.
◆ 9. Substantial insider ownership and founder-led
Companies that are still run by founders/co-founders have a much better chance of success than those that aren’t. insiders should have skin in the game by owning a decent amount of their own stock so that their goals are aligned with ours (10%+ is generally a good sign).
◆ 10. Low customer concentration (no client should account for 10% of the revenue)
If a company is heavily dependent on a single customer, then if that client goes away then you instantly drop revenues significantly and this is not a good risk to have. Ideally, you don’t want any specific customer significantly accounting for more than others.
⓶ When do I buy and when do I sell when investing in the stock market?
When buying, the intention is to hold for as long as the above-mentioned criteria are met and only sell when they change for the worse. Sometimes, we make mistakes, and we sell our positions.
Never sell on price appreciation alone. Just trim it if it grows too much that it makes you uncomfortable. This could mean 10% for you or 20%+ depending on your appetite.
Never wait for too long to start a position if you like the company in hopes that you would get it for cheaper. Good companies usually go up more than they go down. If you are worried, then simply buy a starter position and then either let it grow organically, add to it while it goes up (average up), or simply add whenever you have extra cash.
Don’t get too attached to the price of a stock. The stock has no memory. It doesn’t remember the price you bought it at. Simply focus on the company and if it keeps executing as planned then don’t be afraid to buy more at a higher price. Remember that as a company grows, it deserves a higher price (higher market cap).
Also, don’t just buy something to make a quick buck (trade). Only buy good companies that you think can triple in the long term. This is not momentum trading where we simply try to catch a wave. This means that our stocks will go up and down so stay with it (can you stomach it?).
Don’t try to time the market by hopping on and off as the jump usually happens quickly and it is almost impossible to predict the exact timing of getting off and on every single time.
If new evidence comes along that changes the story significantly then get out asap. This means you need to have access to a broker that allows trades outside regular trading hours (RTH) as most earning reports are either before the market opens or after the market closes.
Once you decide that a company is not worth being part of your portfolio anymore and you sell, forget about that stock, and focus on the ones that are still in your portfolio. These are the ones that matter now. Remember that you made the right decision based on the fundamentals of the company and not on the price action alone.
⓷ How many stocks should I own?
If you are just starting out and you have a small base you can concentrate on just 4–5 stocks. As you gain experience and grow your portfolio you can start adding a few more (7–8 seems ideal).
This is not a buy, hold and pray approach. This approach requires active learning of what the companies you are buying are doing.
This means you need to pay attention to news/press releases, read the earning reports, listen to the earning calls, and generally do your best at learning what the company behind the ticker is doing and not the other way around.
Price eventually follows fundamentals. If the company underperforms the price action will do just that. And vice versa.
⓸ I love this company shall I buy its stock?
It’s ok to love a company/product/service and not invest in its stock. Our job as investors is to maximize returns by focusing on the numbers (as mentioned above) and trying to take emotion out of the equation.
The greatest asset, an investor can have, is the ability to admit his/her own mistakes. At the end of the day, nobody is keeping score so just think about the good of your own portfolio.
If an investment has turned out to be a bad one, then just take the loss and get out. The longer you stay in a losing company the more losses you will endure and the greatest the opportunity cost.
Of course, you can wait for years until the company figures it out and maybe eventually comes around but think of all that lost opportunity if you had just taken the money and invested it elsewhere.
⓹ Is the stock market ever efficient?
The market might agree or disagree with your choices in both the short term and the long term. But if the market was efficient, we would never see prices rise or fall. Everything would be already priced in.
Sometimes the market would take in a piece of news in the wrong direction or simply overreact or just be too slow to react. All this creates opportunities for us. But instead of losing our minds over the market’s reaction, we should simply focus on the performance of our companies.
⓺ Shall I pay attention to guidance and analysts’ estimates?
Analysts give their estimates as to what they expect from a company during its earnings release. You will often see misleading headlines that don’t take into account what the company is actually doing. They would simply focus on the wrong thing.
If for example, a company grew earnings by 99% and the analysts were expecting 100% growth they would simply say that the company missed the consensus and fell below expectations.
Now of course a company that is growing earnings at 99% is doing incredibly fine. But that alone could drive the stock price down.
Nevertheless, companies try to sandbag their guidance so they have more room to beat their own guidance but if they guide too low then the market might react negatively as well since they’ll say that the guidance is too weak.
You can estimate how a company behaves by monitoring how much they beat or miss their own estimates and adding that to your calculations, so you know what to expect.
⓻ Should I add foreign stocks to my portfolio?
This is up to you and depends on where you are located. But foreign companies are much harder to follow. And the fraud risk is even greater. With so many options in the US market, there is no need to look elsewhere (even for non-US investors).
By doing so, you eliminate unnecessary risk. There are many fraud reports recently (Luckin Coffee).
⓼ How do I start evaluating a stock?
When investing in the stock market and you see a company that you would like to go over, simply go to their investor relations site and take all the info from there.
Don’t just trust any other source for info besides the site of the company. Sometimes other sites will pull out the wrong info. So, it’s better to avoid them.
Once you go to the investor relation you need to go over their latest earning report. Listen to their latest earnings call. And try to understand what the company does, how well they do it, how many customers they have, an how fast they grow.
Compare all this and the other metrics explained above to other companies and see if they fit into the criteria.
Start with writing down the revenues for the past 8 quarters so you have a better visual. This way you can see sequential (QoQ) and year-over-year (YoY) changes, identify any seasonality and get an understanding of where the company is headed.
You can do this for other metrics too like gross margin, free cash flow, operating expenses, etc.
⓽ How do I manage my own stock portfolio?
As mentioned earlier, you can start with a smaller number of stocks (4–5) if you are just starting out with a smaller base and adding to it as you go. Usually, 8–10 is the maximum number of stocks that you can properly follow as the earnings season will give you a busy time.
However, there are a number of things that affect the number of stocks in my portfolio. First, the conviction in current holdings. If the conviction is strong then simply add funds to the existing positions.
If the conviction is low or the existing positions become too large, you might try out new starter positions in several companies which will drive the number of stocks in the portfolio up.
On the contrary, if there is a market correction, trim/sell the ones that haven’t fallen much and add to the ones that dropped the most since this will give them a chance to bounce faster. This will drive the number of stocks in the portfolio down.
In addition, in a market correction, you might try opening new positions, although I’d keep it small since it’s difficult to put money in unfamiliar stocks when there is panic all around.
I prefer to have a much more concentrated portfolio as this makes it easier to follow and easier to maximize returns as it takes 1 stock that doubles to have a 100% return on your entire portfolio or 100 stocks that double to have a 100% return on your portfolio. Nevertheless, having too much concentration is very risky and thus 7–8 seems ideal to keep a balance between risk/reward.
❖ When do I sell winners and how much cash do I keep?
Sell a little of your winners if:
- They have grown very fast compared to the other stocks you own
- You feel they can’t warrant their high valuation and hence they are riskier
- You want to raise funds to buy a new stock
Having a few years’ worth of living expenses in cash can provide safety and peace of mind so that you don’t need to sell your stocks if/when the need arises.
⓾ What is the difference between GAAP and Non-GAAP?
GAAP stands for Generally Accepted Accounting Principles and lays down a uniform set of rules and formats that companies need to follow in their method of accounting.
Non-GAAP (also called adjusted earnings) is any method of accounting followed by companies other than GAAP where non-prescribed standards are followed.
Pay attention only to Non-GAAP results as this is what shows the true picture of the company. GAAP earnings only distort the picture. Pay no attention to it. Focus only on adjusted earnings instead.
⑪ Shall I care about insider trading and lockup expiration?
When investing in the stock market, investors tend to focus too much on what insiders are doing. But insiders can sell for all sorts of reasons.
Generally, try to avoid making decisions based on insider selling unless it is heavy, out of the expected, selling with some confirmatory evidence and info that changes the story/thesis of your investment.
Lockup expiration usually is a self-fulfilling prophecy. The stock price goes down before the actual expiry. Don’t pay too much attention to it. If it does go down just buy a few more shares if you have the extra cash. It rarely does though.
⑫ Are ethical values important when it comes to investing in the stock market?
Some might argue that as long as the company is growing rapidly and rewards handsomely its investors then it shouldn’t matter what the actual product/service is. I tend to disagree and choose not to invest in unethical companies.
I simply choose to invest in what I want to see more in the world instead of feeding the companies that do bad (not badly though as an investment). Everyone is responsible for their own choices, so this is up to you. Investing in the stock market is personal.
So whatever you do, make sure you understand the risks involved and take ownership of your choices.
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