Performing Due Diligence on a Stock
Portfolio management is a complex beast. Everyone hopes that whatever they’re holding is only going in one direction: up. However, no one really knows what’s coming next. Even top fund managers call it wrong sometimes. If you’re reading this, you’re probably not a proprietary trader ¾ but that doesn’t mean you can’t learn to keep track of a stock or two!
Check Out the Fundamentals
The first thing you should do when evaluating companies for investment purposes is to learn about “fundamental analysis.” Fundamental analysis involves learning to interpret a company’s financial statements (balance sheets, income statements and cash flow statements) to determine the company’s “fundamental value.” There are a number of different approaches to financially assessing a company, and you should be familiar with as many of them as possible.
Once you know the basics about financial statements, a good “first model” to learn is the dividend discount model (DDM). The DDM allows an investor to determine a theoretical price for a company using future expected cash flows, as if it were a bond. Remember, this is just a starting point, and the price you calculate with the DDM will probably be very much theoretical.
Comparative Position in Industry Sector
Analyze how you believe the company could grow. For example, an operation that mines lithium might strike you as undervalued if you believe production of electric cars and large rechargeable batteries will see enormous expansion in the coming years. Who are the company’s competitors? What are its comparative advantages? Does it have a stronger management team or access to better technology than its competitors? These are all good questions to ask yourself in order to start building an idea of how you think a company should be valued.
Keep an Eye On SEC Filings and the News
All exchange-traded companies are required to file quarterly and annual reports with the Securities and Exchange Commission. Check out the company’s last few 10Qs and 10Ks to get a handle on where it’s been and where it might be going. You can find these documents through EDGAR, the Electronic Data Gathering, Analysis and Retrieval system. Once you’ve been through the SEC filings, watch the news for mentions not just of the company, but anything that might significantly impact its business.
Check Out Sentiment
While you shouldn’t rely on blogs and forums for concrete research, they’re useful for taking the temperature of other investors’ opinions. Research has shown that sentiment can predict a stock’s price movement more accurately than professionals! There are hedge funds that make trades based directly on Twitter-scanning algorithms.
However, without some serious experience designing algorithms, Twitter consensus will only do you so much good. Sometimes rumors and opinions build up into a major bubble that just can’t be sustained by reality. In the end, you should always rely on your own research.
Don’t Get Carried Away
Remember, you’re not a professional. Even if you feel extremely confident in an equity, you shouldn’t put up more money than you’re willing to lose. Picking stocks isn’t quite gambling, but if you’re an amateur, it’s pretty close. So, make sure the main portion of your retirement and savings is always in a risk-balanced, diversified portfolio. It’s up to you to choose between index funds or employing a fiduciary advisor with low fees.
That said, if you like to stay abreast of market news, actively managing a small portion of your wealth (2–5 percent, perhaps) can be an educational and rewarding experience!