How exactly do you go about finding stocks to buy?

And after I read it, I really began to think about how my investing process works. How do I go about identifying, researching and ultimately buying a stock?

For many investors the process has evolved so much for them that it’s tough to tell what their exact methodology or framework is anymore. So after reading that question, I decided to pull out my yellow legal pad and literally write down my investing methodology…and here it is (the abridged version):

1. Stock Screen & Filter

This part of the process isn’t set in stone but it’s what I find myself doing when I’m searching for stocks that aren’t on my radar yet. But many times I’ll simply find companies due to overall macro trends that I’m following (e.g. wireless, China, etc.) and then I’ll just skip this first step.

But in the event that I am looking for new companies, what I’ll typically do is use one of the free stock screeners out there (Yahoo! Finance has a great Java app for screening stocks). Here are some of the criteria I’ll use:

• Market Cap: Depending on which types of stocks I’m looking for (large-cap, small-cap, etc.) I’ll tweak this setting accordingly.
  
• Return on Equity (ROE): This is an extremely important metric in determining the overall health of a business and how competent management is. Anything above 15% is a healthy ROE number.
  
• Earnings Yield: This is a number many people don’t look at but it’s very helpful in quickly screening for potential investments. The Earnings Yield is basically the inverse of the P/E ratio, so it’s Earnings divided by Price.

Think about it this way, if you could get a 5% yield on a government bond (a risk free investment), then wouldn’t you want more out of a company you’re investing in?

I’ll typically look for companies with earnings yields north of 6%, but the higher the better.

• Look Out For Debt: While I’d ideally like a company with zero long-term debt, some debt is ok as long as it’s not breaking the company’s back. So make sure the company is able to comfortably meet interest payments (interest coverage ratio) and that long-term debt doesn’t make up the majority of its capital structure.

2. It’s All Business

After you get your list of stocks, the next step is to filter it down further but this time you’ll need to look a bit deeper than the numbers.

For me, I’ll only invest in a stock if I really understand the business behind it. I’ll want to know exactly how the company makes money and what makes it a better company than its competitors, etc.

So you would never see me invest in a chemical company because I just don’t know enough about the industry to say which company has a real advantage over another.

So make sure the business you’re investing in is one you’re familiar with and understand.

3. What’s It Worth and Is the Price Right?

OK, so now we’re back to the numbers — and here’s where it gets tricky…

Let’s say we’re looking at a stock with a $500 million market cap.

How do we know it’s not really worth $100 million?

How do we know it’s not worth $5 billion?

The answer is tricky in that there is no single “correct” way to determine the value of a business. Everybody uses their own metrics and equations.

But what I can tell you is that nobody will ever come up with the exact value of a company. It’s impossible to be right about something as dynamic as a business. There’s just too many different variables and moving parts.

So what is an investor to do?

For this topic I’ll default to the kings of value investing: Benjamin Graham and Warren Buffett. To be clear, Graham was the one who came up with the concept I’m about to discuss, but Buffett’s success in applying it makes it worth including his name here as well.

And the concept I’m referring to is, “Margin of Safety.”

For example, if you think a stock is worth $1 billion, then you should only buy it when it’s trading for $500 million. Meaning, you should require a Margin of Safety of 50% or more on every investment you make.

This way you eliminate a lot of the uncertainty and the risk involved in trying to accurately value a company. If you get nothing else out of this article, then I hope that the concept of Margin of Safety really sticks and you use it in all of your investing operations.

Here’s the process in a nutshell:

First, find a list of companies with strong financial characteristics and make sure you really study the industry and who else is operating in it. Finally, figure out what the business is worth and make sure you don’t overpay for it.

I’m obviously oversimplifying here, but I know if you stick to a regimented system, whether you’re buying a large cap tech stock or small cap alternative energy company, you’ll consistently outperform the market.

If you’d like to read about how other investors pick stocks or submit your own ideas then click here now.

Regards,

Wayne Mulligan
July 1, 2008

P.S.: Investing is often viewed as a gamble. With the ever-changing market trends and vulnerability of today’s market, it truly takes a lot of research and time to choose stocks with a profitable return.

Stock Picking Made Easy was originally featured in the Penny Sleuth.