Beginner’s Guide Part 6. Picking the right stock/Asset

You do not buy a stock because the company looks cool.

You do not buy a stock because you like their products.

In other words, you buy a stock because it is a good stock based on factual and rational information, not your emotions.

I must also add, in the words of Warren Buffet, “Money moves from the impatient to the patient.”

Your holding period, as an investor, should not be measured in days, weeks or months but in years.

Picking the right stock depends on your intention. I must warn you here. No one can time the market. No one!

However, the question to ask yourself here is: Are you a trader or an investor and what are the things that you must look for in stock for you to satisfy yourself that it is a good stock as an investor?

For a long term investor, I have come to understand that the best way to look for a stock is to look for stocks that have a competitive advantage over their competition. Warren Buffet would say, concerning this very same thing, “look for companies with an economic moat.”

What is a moat? According to Wikipedia, a moat is a deep, broad ditch, either dry or filled with water, that is dug and surrounds a castle, fortification, building or town, historically to provide it with a preliminary line of defence. The primary purpose of a moat is to provide a form of defence to the castle.

Concerning companies, a company with an “economic moat” has a competitive advantage that is some sort of defence against competition. This is important because such companies tend to enjoy some form of dominance before competition enters the market. Value is lost for companies that do not have an economic moat as soon as the competition enters the market. This can happen overnight or over a period of time.

You want to look for these companies because you want to be able to enjoy the economic benefits that arise from them for a long period before competition can figure out how to get into that market.

The longer the period the company has an economic moat, the longer you will enjoy the economic benefits that arise out of it. In other words, the longer the company enjoys a competitive advantage, the longer the period you enjoy good returns on your invested capital.

What should be my entry point?

Entry points are important in the stock market. However, this may also depend on your intention, are you a trader or a long term investor. For long term investors, they can enter the market at any point as long as they keep adding to their position at the same time each month or at whatever interval they decide on. This is called the dollar average method.

Investopedia defines this concept as follows: “Dollar-cost averaging (DCA) is an investment strategy in which an investor divides up the total amount to be invested across periodic purchases of a target asset to reduce the impact of volatility on the overall purchase. The purchases occur regardless of the asset’s price and at regular intervals. In effect, this strategy removes much of the detailed work of attempting to time the market to make purchases of equities at the best prices.”

As you can see, with this method, you can reduce the costs of purchasing stock over time. But, it is important to keep in mind that you can only do this in a good company, that one we said should have an economic moat. Otherwise, you will lose money over time if you buy at higher prices and the company/stock performs badly and does not recover.

If you are trading, however, charting (study of charts) becomes very critical for you to determine your entry points.

A simple way to look at it is to first look at the 5 or 10-year chart of a stock to determine the direction the stock price is moving. You want to pick a stock whose 5/10 year chart is showing an upwards trend.

From here you want to look at the monthly or weekly chart to determine the moving average price of the stock. You want to buy when the price is close to or just below the moving averages.

Another way to look at the charts is by looking at some indicators and getting in when they are in your favour. We will discuss some of these indicators like the RSI, and MACD at a later stage in this series. For now, these are just the basics. Go and study indicators of your choice and remember that one indicator alone may not be very useful for trade. For example, you may need to use the MACD together with the RSI and the Bolinger bands or you might want to use the RSI and Ichimoku indicators. Remember, if you are beginning, you may need to stay away from trading.

What else should you be looking at before taking a position in a stock?

1. Does the company have organic growth?
2. Does the company have a diversified portfolio of customers?
3. Does the company have expanding margins?
4. Does the company have free cash flow?
5. How does the company apply the free cash flow? Do they use it to pay dividends or to expand the business?
6. How does the company treat its employees? Does it have a great place to work?
7. Are the founders involved in the running of the business? Founders of the business often stick to the true vision of the business.
8. Is the company a market-beater?
9. Is the company profitable or does it have the potential to become highly profitable in the future?
10. Is the business recession-proof and can it transform to survive the storm? We saw how important this is during the various economic crushes and the Covid-19 Pandemic.

1. We already discussed this one in some detail. But, does the company have a widening moat? In other words, can it withstand competition for a considerable period?
2. Does the company have recurring/subscription income?

We could go on, but the essence of this is:

1. You are not buying a stock because the company looks cool.
2. You are not buying a stock because you like their products.
3. In other words, you are buying a stock because it is a good stock based on factual and rational information, not your emotions.

So what is the process of buying a stock as an investor (forget the trader for now?)

1. Identify a business that has an economic moat and that can generate good profits (in other words, a company that beats the market or generates above-average profits) for a considerable amount of time.
2. Be patient and buy the stock when the share price is below the true value of the business.
3. Be patient and hold these shares until the underlying business is no longer good.

This leads us to the last part of this discussion, when do you sell? You sell when:

1. The business has deteriorated, is no longer a good business or is now poorly run.
2. You have now found a better investment.
3. The share price is now overvalued compared to the true value of the business.
4. Your portfolio is now “out of balance.) In other words, you carry more risk in one class of asset/stock…

You may have noticed I used the word “patient” a few times. This is because I learned this the hard way. I bought shares that I exited too quickly but that went on to make good returns. Why? I panicked. But, In the words of Warren Buffet, “Money moves from the impatient to the patient.”

Therefore, your holding period, as an investor, should not be measured in weeks or months but in years.

Are you learning anything from this series? Do you want to share any pointers or experiences? Please leave a comment and remember to share.