If you’re someone who is willing to dedicate a large portion of your time and energy to choosing the right long-term stocks for yourself, you are probably eager to learn which elements are vital in your decision. The question, “how to choose a stock to buy” has probably gone through your head multiple times.
Luckily, you’ve come to the right article to answer that question. Here, we will be explaining the five elements laid out by Benjamin Graham, Warren Buffer’s mentor, and revised by Jason Zweig, that still hold importance as decisive factors upon choosing the right stock and how much you should pay for it.
Keep in mind that this article is for those who are looking to seriously invest and dedicate themselves to that practice. Trading is not investing, the elements outlined in this article will not work out for those who want to choose the perfect stock to trade, but rather the perfect stock to build an establishment of long-term wealth and growth.
Investing is not a get-rich-quick scheme, it is a seed that you plant for yourself and the generations ahead of you. In order for you to be able to appropriately plant that seed, it is important for you to shift your paradigm from short-term schemes to long-term wealth.
With all that being said, these are the five elements outlined by Benjamin Graham on how to choose a stock to buy.
The Company’s “General Long-Term Prospects”
Today, the investor looking for long-term growth should be downloading at least five years’ worth of annual reports (Form 10-K) from the individual company’s website. This can also be done from the EDGAR database at the SEC website.
Once downloaded, they should be able to skim over these financial statements and gather evidence to help answer these important questions:
- Is the Company a “Serial Acquirer”?
- Is the Company an OPM (Other People’s Money) Addict?
- Is the Company relying on one customer (or a handful) for most of its revenues?
- Is it resistant to substitution with a strong brand identity?
- Short-Term vs Long-Term Growth
Let’s see how we can answer these questions.
A company is a serial acquirer when it constantly has to buy the stock of other businesses rather than investing in its own, these purchases are known as acquisitions. Usually, an average of more than three acquisitions per year is a bad sign.
You need to ask yourself the following questions to find out what the company’s track record is in acquisitions:
- Has it only been this year that they’ve obtained these acquisitions?
- What are the particular reasons behind these acquisitions?
- How many consecutive years have they done this?
You must watch out for companies that take on big acquisitions, only to disgorge them at a loss, this proves that they overpaid for their acquisitions.
An OPM Addict is a company that is borrowing debt or selling stock to raise capital from others’ money. In an annual report, you can find these activities in the Statement of Cash Flows, titled “Operating Activities,” “Investing Activities,” and “Financing Activities.” This page outlines the company’s inflows and outflows into these sections.
These activities can make an ill company give off the appearance of growth, even if the underlying business is not generating enough cash. For example, if cash from Operating Activities is consistently negative, while cash from Financing Activities is consistently positive, then the company is in need of more cash than it can produce. Remember to always look at the positives as well as the negatives when looking at the resources of growth and profit.
You should avoid these companies, as they are proving that the operations of its own business are not sufficient to meet its capital demand.
A company is Relying on one customer (or a handful) when the prospectus reveals that one customer or a handful of customers account for 100% of the company’s revenue for a given year. Be sure to clarify that the company’s revenue is diverse and comes from its operating activities.
Next, a great example of a company that is Resistance to Substitution with a Strong Brand Identity is Coca Cola, whose secret formula has no real physical value but maintains a priceless hold on its consumers. Even though Pepsi exists, it does not fully serve as a substitute for Coca Cola. All their years of existence proves this to be true.
Following that, is a company’s growth short-term or long-term? By looking at the Income Statements, you can see whether revenues and net earnings have steadily grown over the previous ten years. An extremely high rate of growth or a sudden burst of growth in one or two years is very certain to fade. Look for earnings that are growing at a long-term rate of 10% pretax (or 6% to 7% after-tax), that may be sustainable.
Also, make sure to look at whether and how much a company is spending on R&D (Research and Development). This may not be a source of present growth, but it may be growth for tomorrow. The average budget for R&D varies across industries and companies, but in the long run, a company that spends nothing on R&D is as vulnerable as one that spends too much! Personally, I prefer anything that spends 5%-10% on R&D. R&D is another important factor for long-term growth.
Quality of Management
Read the past annual reports to see what forecasts the managers made and if they fulfilled these forecasts or consistently fell short. Responsible managers should admit their failures and take full responsibility for them, rather than blaming outside factors like “uncertainty”, “the economy” or “weak demand.” Executives should be able to consistently stick to what they forecast and be independent of what the media says about the company.
The following questions can help you determine whether those who run the company will act in their own interests or in the interests of people who own the company, such as yourself.
- Are they looking out for #1 or the company as a whole? An example of a company that only looks out for #1 is one overpaying the CEO or other executives a fat paycheck every year. Even if the company is doing well, this is NOT okay. The extra money could be going into new developments and growth for the company. This is an example of a company which is run by the managers, for the managers.
- Any potential flood of new shares from stock options? Any established company that reprices options for insiders is a potential red flag. A company with a top executive who reaps the multimillion-dollar paydays by selling their own stock options in the name of “enhancing shareholder value” is, again, a red flag. In this scenario, future earnings will have to be divided among more shares, eliminating the potential for genuine growth of your shares. “Form 4,” available through the EDGAR database on the SEC website, shows whether a firm’s senior executives and directors have been buying or selling shares. Repeated big sales are a red flag. A manager cannot be your partner if he keeps selling and repricing, while you’re buying. In this scenario, the company, again, is only looking for #1 rather than those who own the company.
- Are managers managing or promoting? Executives of a company should be spending most of their time managing their company rather than promoting it to investors. An example of this is a firm that is constantly spewing forth press releases, boasting about hypothetical opportunities. The company should be communicating candidly and fairly with its shareholders, they should be putting its shareholders’ long-term interests first and refuse to engage in practices that only make it look good for investors. Make sure that actual losses are not being cloaked by things like “pro forma” earnings or acronyms like EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). A company should be fully transparent with its financial results. It should not have a history of covering up losses with cloaks like these to make their value “look good” for investors.
To conclude this section, it is important that you ensure that the company’s management is competent, transparent, and looking out for the long-term success of the company and its shareholders. Responsible management is what will keep the company growing for the coming years.
Financial Strength & Capital Structure
As Jason Zweig puts it, “The most basic possible definition of a good business is this: It generates more cash than it consumes.” The surplus in cash should be going for further growth of the company. This establishes long-term growth for the company regardless of what the stock market does.
As an owner of the company’s shares, you should be able to see established growth in your earnings. According to Zweig, to fine-tune these earnings, you should subtract the following from reported net income:
- any costs of granting stock options, which divert earnings away from existing shareholders into the hands of new inside owners
- any “unusual”, “nonrecurring” or “extraordinary charges
- any “income” from the company’s pension fund
If after these subtractions are made, owner earnings have steadily grown at a 6% or 7% average over the preceding ten years, the company is stable and its growth prospects are positive.
Go to the company’s Balance Sheet to see how much debt it has. Generally, long-term debt should be under 50% of total capital. In the footnotes to the financial statements, make sure that the debt they have is fixed and not variable. This means that the interest they pay on debt is consistent rather than variable, as a variable interest rate could lead to more expensive debt if interest rates were to rise.
Even if the debt is fixed, you need to be careful. In the annual reports, look for the statement showing “ratio of earnings to fixed charges.” This can either show earnings falling short of covering interest costs or earnings from operations producing enough to cover them. You want the earnings to be able to cover them, otherwise, in the case of default, the company’s assets will be going to bondholders, not shareholders.
Recurrent Dividend Rate
“Research by money managers Robert Arnott and Clifford Asness found that when current dividends are low, future corporate earnings also turn out to be low. When current dividends are high, so are future earnings. Over ten-year periods, the average rate of earnings growth was 3.9 points greater when dividends were high than when they were low” – Jason Zweig (The Intelligent Investor).
Companies that raise their dividend tend to have better returns and are projected to have greater future profitability. Thus, it’s important to look at the dividends paid by a specific company. What’s the company’s dividend track record? Have they at least remained consistent with their dividend rate?
A company that has consistently outperformed the competition while also paying consistent or growing dividends has put its cash to optimal use. This is the company you want to have your money in as an investor. Inconsistent dividends along with under performance in the market is an automatic red flag.
If a company’s dividends are not consistent, pay attention to why this might be. A smart company usually pays dividends to its shareholders rather than believing that it can do more with that extra cash than its shareholders can.
As an investor, you want to put your money into investments that have a high intrinsic value. What is intrinsic value? It is simply the value of a company independent of what the stock price says. This is how you determine if a company is overpriced or underpriced in the market. The five elements listed above are what will determine the intrinsic value of a company, and if it’s worth investing in.
Remember to look for long-term growth for your money. Don’t pay attention to next year’s projections, pay more attention to what you can see taking place 10+ years from now. This ensures long-term wealth and rids you of the cynical get-rich-quick-schemes that you see advertised all over social media.
Go down into the fundamentals of the company and analyze the company well. Your hard-earned money should be worth that for you.
With all this being said, I want to restate the fact that what’s written in this article comes from the teachings of Benjamin Graham and Jason Zweig, from the book, The Intelligent Investor, The Definitive Book On Value Investing, with the updated commentary by Jason Zwieg.
I recommend this book to anyone who wants to get serious with their investments, and is ready to start value-investing. I hope this article has served you well, leave any questions or comments in the section below, I always reply to each of them!