Invest in this: How I pick stocks

I've been doing what I call “investment banking” for a friend's company (I say it that way because the work I do is almost definitely not what you probably think of when you hear the term), and I get this question almost every day:

“So, I guess you know a lot about investing!”

Well, I know more than perhaps most people about investing. But, again, it's not what you think; I'm not doing any research into public companies, and I'm never, ever picking stocks professionally. Most of the work I do is with deals that have closed long before or deals that are only imaginary.

People ask me, often, “So, you're an investment banker? What should I invest in?” My response isn't what they're expecting, even though I think it's the best advice:

“Invest in companies you like.”

I'm going to make the usual disclaimers here: most people should be Sharebuilder. (Basically, you pick a dollar amount to invest each month — say, $50 — and it gets put into the stock of your choice, on the same day each month, in fractional quantities based on the stock price that day.)

So I have a list of things I look for in a stock. And the first one is that I like the company and most importantly the CEO.

“The CEO is the main character of a stock's story.”

It's not a coincidence, I don't think, that I'm both a writer of stories and a lover of investment banking. I think of companies in much the same way I think of literature: driven, essentially, by the main character of the story. CEOs are interesting; of the companies whose CEOs I've either met or gotten to know by obsessively studying their interviews and public statements, I never once remember seeing a company whose long-term performance differed greatly from the personality of the CEO. That's not extremely clear so I'll give you a few examples.

1. Hospital management company number one. When I was a young investment banker, I had two hospital management companies whose deals occupied a lot of my time. In both cases I got to know the management teams fairly well. In both cases, I watched their performance for several years. Number one was run by a very ego-driven doctor whose tan was nearly orange and who often made startling pronouncements in bank meetings — predictions not supported by his financial team, say, or exaggerations of performance when we had the real numbers in our handouts. His employees seemed a little frightened of him. Hospital company number one bought too many urban hospitals outside of its management scope, got too deeply in debt and ended up having to liquidate a few hospitals, losing money.

2. Hospital management company number two. The second company's management team was boring, boring, boring. The CEO was also a doctor, but he wore unremarkable suits and worked too much to spend any time tanning. He was careful and kind, and his management team followed him loyally. His VP of finance would call me in the middle of the night sweating over a small detail in the financial sheets. He did not, that I know of, drive a flashy car. This company made smart investments, slowly, and was ultimately purchased by a larger company for a good price.

No matter what sort of company it is, a CEO will set the tone. Many organizations are held together entirely by the force of the management team's personality, and the CEO usually hires the rest of the team. If you think the CEO is stupid, ego-driven, mistake-prone, too likely to take risks, cripplingly risk-averse, unethical, or tending to make decisions on a whim; well, you might (as with, say, Enron) make money in the short term, but in the long term the company's story will hew more closely to the CEO's story than to any of the bit characters.

“Invest in sustainable market trends.”

Quick distinction: there is a difference between trends and fads. One is the way the sentiment of a large group or force is moving. For instance, our country is trending toward greater acceptance of gay marriage. The other is something that could be extremely popular today and a complete dud tomorrow. Silly Bandz were a fad. Invest in trends and not in fads.

One of the client companies I've been following is an end-of-life transition company. In other words, they own funeral homes and cemeteries. There is a sustainable market trend for you; death rates are increasing — any reversal of such would be slow and obvious — and we have not seen a major cultural shift away from funerals or burials. It's sustainable, because we keep growing people, and they'll have to die eventually.

It's also relatively “sustainable” in another meaning of the word; it is not a company whose product uses very finite resources (or whose byproduct damages finite resources) that might disappear, increase greatly in price, or become heavily restricted in the near future. For instance, many human rights watchers have begun to voice concerns about some of the metals used in the components of most mobile phones, digital cameras, tablets and laptop computers. They are mined under dangerous conditions, they can provide funds for combatants in conflicts, and their disposal is tricky.

But you could see “sustainability” in a number of ways; maybe you wish to invest in companies engineering crops for drought tolerance and higher yield, or maybe you believe that such companies are forsaking economically sustainable practices (seed saving and soil preservation, for example) in order to obtain a higher price for their goods (the seeds). It's important to remember that you still have to make your own judgment. A claim of sustainability is just that, a claim, and you have to determine how well you believe in it (return to the first point, likability and trustworthiness).

“Invest in companies whose future prospects are rosy.”

You don't want the companies whose projections show 20 percent growth for the next five years. Those numbers may be impressive and awesome, but they're expensive. Investment advisers say that a company's future growth is “priced in”; in other words, you'll be paying for the stock as if the company had already achieved the analyst-consensus growth rate. But that's just a guess based on current market conditions and current information. You're paying for a guess.

You're better off not with companies whose futures are so bright (you gotta wear shades), but with companies whose future are just a little blush of pink. You want a company whose growth prospects are possible. Take McDonald's, if you believe that fast-and-cheap-and-corn-fed model has a long future — I don't — but we can all agree the company is pretty widely distributed. Even its international growth has been a part of pop culture for decades. Remember the “Royale with Cheese”? Anyway, it's a crap shoot; there might be a big future for fast food, but then again, there might not. Better off with something small enough to leave room for growth but not so small as to be unproven. Rosy.

I like companies who are taking advantage of growing market trends in sustainable products, like Seventh Generation. (The company isn't public, but if it was, I'd be a buyer!) Maybe you believe in the future of sub sandwiches. Maybe you believe in the future of Med-alert devices. Whatever it is, take a look at the future, and make sure you can see it — glowing but not blinding.

What stocks do you think make sense in these qualifications: likeability, following a sustainable market trend, and with a rosy future? Is there anything else you really focus on when picking a stock?

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JS Daly
JS Daly
7 years ago

Why oh why is LEGO not public ?!

My Financial Independence Journey
My Financial Independence Journey
7 years ago

My stock choices are based predominantly on value. I look at things like dividend stream, PE ratio, Graham number, discount model, payout ratio, and dividend growth to name a few. I also look for long term business sustainability. I disagree with the author’s examples of “rosy” companies. McDonald’s would be a great investment (disclosure: I own it). The company has a tremendous share of the fast food market in the US and is expanding overseas as well. Furthermore, it’s even a hedge against recessions. In the last recession, people traded in Olive Garden for McDonald’s. Solar panels, while they are… Read more »

Matt Becker
Matt Becker
7 years ago

Thanks for the tips, but I think the key part of this article has to be your quote that “only about 5 percent to 10 percent of larger retirement portfolios should be invested in individual stocks”. Most people should not be trying to invest in individual stocks. If you are, you should understand that the individual stock part of your portfolio is akin to gambling. How much of your portfolio would you like to gamble with? That’s up to you. There’s nothing inherently wrong with it, but it’s not a likely way to build long-term wealth. Personally, I don’t spend… Read more »

Mom of five
Mom of five
7 years ago
Reply to  Matt Becker

Well, I like to invest in individual stocks because it’s fun. We make a few hundred dollars a year in dividends, which is much more than we’d be making in the bank. We own some good, stable stocks which are likely to crash and burn only in a zombie apocolypse type scenario – and if that happens, the few thousand we have invested in them will likely be the least of our worries. And then we’ve got some individual stocks that I picked for their fun factor – more like gambling. Right now, they’re paying off in spades, but I… Read more »

TheGreedMachine
TheGreedMachine
7 years ago

I completely agree that buying individual stocks is essentially gambling. In my opinion, while the markets are far from efficient, there are much better minds than my own dedicating more time than I ever could to spotting the inefficiencies.

To me this doesn’t mean that index funds are the only way to go. There are loads of great mutual funds out there that consistently beat the markets. My philosophy is simply to allow the professionals to try to beat the markets instead of thinking I can do it myself.

TB at BlueCollarWorkman
TB at BlueCollarWorkman
7 years ago

I like the idea of investing in companies that I believe in or like. Seems like that’s what everyone should do since when you buy stock you’re buying partial ownership of the company, right?

Here’s a GRS article idea — explain the difference between a stock, bond, and index fund. What the heck is an index fund?

Buy & Hold Blog
Buy & Hold Blog
7 years ago

In case you want reading, I’ve explained the difference between an index fund and actively managed fund on my blog.

http://www.buyandholdblog.com/actively-manged-funds-vs-index-funds/

I’ve also talked about ETFs and why they are bad for long-term passive investors.

http://www.buyandholdblog.com/why-etfs-are-bad-for-buy-hold-passive-investors/

Random Hangers
Random Hangers
7 years ago

Here are two basic articles on index funds: https://www.getrichslowly.org/investing-101-an-introduction-to-index-funds-and-passive-investing/

Here’s the definition of bond: https://www.getrichslowly.org/saving-and-investing-what-is-a-bond/

And here’s stock: https://www.getrichslowly.org/saving-and-investing-what-is-a-stock/

There’s probably more, if you’re interested. Try poking around in some of the older stuff, doing searches, etc.

John
John
7 years ago

Investing in stocks based on these criteria is like choosing a puppy in a pet store because it looks cute.

This is terrible advice, sorry.

Anon
Anon
7 years ago
Reply to  John

Not true, Warren Buffett has been quoted saying he picks stocks that he simply likes and understands…

So yes it is like picking a cute puppy in the pet store. Would you pick the ugly one?

numbacruncha
numbacruncha
7 years ago
Reply to  Anon

not true. buffet uses a fundamental analysis style of business valuation based on graham’s style. there’s more to valuation than, “i like the CEO, the product and the industry.” this article is very superficial, and that was the point of the above poster’s response.

anyone that understands business valuation knows the level of research involved, which this article does not cover at all. it’s shallow fluff. if you don’t realize that, you shouldn’t be investing in individual stocks.

Mr.Bonner@bonnersbillions
7 years ago

This is going to be an interesting comment list. Everyone has various reasons to pick stocks. I’ve only bought one stock in the past year. In the past few years I have picked up and am sitting on GE, a REIT ETF, CTL, BAC, and C. All are doing very well simply because I got lucky with timing. I also picked up AA, which is down since I bought, but I’ll still hold it for a long time. Most of my investment money, however, is in SPY, an S&P500 ETF. Oh yeah, and the one I bought in the past… Read more »

The Norwegian Girl
The Norwegian Girl
7 years ago

investing in the company you like.. hm,an interesting thought! But I guess it has a lot to do with what your guts are telling you. Sometimes certain things just feel right.

Lincoln
Lincoln
7 years ago

Like it or not, all retirement planning is gambling. Just because you put money in index funds doesn’t mean it’s not a gamble. It’s just a bet that the whole market is less likely to collapse than a smaller selection of stocks. I like Bogle’s philosophy as much as the next guy, and I like conservative financial planning, but don’t assume that it’s not a gamble. Unless you can accurately see the future, it’s all a gamble. As long as we are being honest, life insurance and health insurance are also gambles.

Matt Becker
Matt Becker
7 years ago
Reply to  Lincoln

This is true in the sense that there are no guarantees no matter which route you take. But there are significant probabilities in your favor if you take the tried and true approach of buying and holding index funds. If you get into individual stock picking, the probability is significantly higher that you will lose/underpreform in the long term.

Anyone getting into investing absolutely needs to understand that nothing is guaranteed. But you also need to understand how to tilt things in your favor. For most people, that will not involve trying to pick stocks.

T
T
7 years ago

Great timing on this article. I finished Joel Greenblatt’s “The Little Book that Beats the Market” this weekend. Though I have very little experience with the stock market (and the world – I’m 23), the factors of his “magic formula” and the approach to using it make sense to me. Sarah’s ideas seem somewhat related (though Greenblatt says nothing about companies you know vs. those you don’t), and I know there are many approaches you can take to investing, but does anyone have any thoughts on his method?

Jacq
Jacq
7 years ago
Reply to  T

T – the book is a good one. Wes Gray and Tobias Carlisle wrote Quantitative Value and did some backtests comparing their selection method to Greenblatt’s and theirs was somewhat better. Greenblatt’s method is still pretty good though.
Their website is greenbackd.com

T
T
7 years ago
Reply to  Jacq

Thanks!

sarah
sarah
7 years ago

First you say you don’t know that much about investing in stocks, then you say we shouldn’t invest in stocks, then you have a whole article about how to invest in stocks. And none of it is backed up by any data.

Buy & Hold Blog
Buy & Hold Blog
7 years ago

The advice presented in this article sounds fine, but looks impractical for the common everyday investors. Except for the top few companies and media-friendly CEOs, for majority of the companies, there are hardly any characters of the CEOs on display. For thousands and thousands of companies, it is hard to know their CEOs’ characters. Even if you come across an interview or two, it is hard to judge them based on what is put online. This is why I advocate only buying high quality index fund as you are not relying on one person to hold your financial future. Your… Read more »

Mom of five
Mom of five
7 years ago

But the small investor doesn’t need to know thousands and thousands of CEO’s, just he ones he’s investing in. If you go by the Peter Lynch theory of investing in what you know, you can be successful. Say, for instance, you enjoy shopping at Target. You like their product lines and you enjoy the experience. So you go to a few different Targets and make sure your good local experience isn’t a fluke. Once you’re sure it isn’t, you have some initial faith in the management team so you start investigating the P/E, the debt load, the cash on hand,… Read more »

Katie
Katie
7 years ago
Reply to  Mom of five

Eh, I liked shopping at Borders; I don’t really know how this approach is going to help the average consumer. Also, coming to a random price point in your head isn’t particularly reliable either.

Mom of five
Mom of five
7 years ago
Reply to  Katie

Well, you should set the price point in your head AFTER investigating the P/E, the debt load, the cash on hand, etc. And no matter how much you liked Borders, if you were researching the company, you would have known they were drowning in debt.

Buy & Hold Blog
Buy & Hold Blog
7 years ago
Reply to  Katie

@Mom of five. I still think it is hard to spot problems with companies until they become much obvious to the general public. I was reading Kiplinger’s this morning. Here are some of the darling companies from a decade ago. Their stock is essentially flat over a decade. Microsoft – Was one of the hottest stocks in 1990s. The company may have grown, but the stock is essentially flat. Nokia – Was one of the top 5 tech companies in the world with a market cap of $200 billion, now the market cap is only $13 billion, declining by the… Read more »

AverageJoe
AverageJoe
7 years ago

Good advice for creating your watch list….but from there you’ve still got work to do. Peter Lynch gave this advice many years ago (“buy what you know”) but he mentioned it as step one. Step two is to dig into the company’s financial picture and find out as much as possible. Sure, it’s going to be a gut call no matter what…but I like my gut call to have as much information as possible before I press that BUY button.

Mom of five
Mom of five
7 years ago
Reply to  AverageJoe

Hah! I was going to post exactly this thought (including Peter Lynch!) in reply to John up at comment #7 – this advice isn’t so much terrible as really, really incomplete.

But the fact that Sarah needs to diss corporate giant McDonald’s, give a thumbs up to a crunchy delisted private company with no IPO in sight, and mention that the country is trending toward gay marriage all in an article on stockpicking is just tiresome.

Darnell Jackson
Darnell Jackson
7 years ago

People need to remember we are in command control economy not a free market so the real reason why stocks go up or down is really due to the BUYER more than ever.

The problem is that BUYER these days is only a hand full of people.

NO Jim Cramer isn’t that lucky he’s TOLD about more stuff than you or I will ever know.

David Stein
David Stein
7 years ago

I spent years as an investment advisor researching and meeting on site with stock managers, hedge funds, growth firms, value shops,etc.

I found there is no right way to research stocks. Everyone has their secret sauce.

The key question to answer before investing in any company is what informational edge do you have over the hundreds of other professionals who are on the other side of the trade & gladly sold you the stock you just bought.

Having said that, there is no better, more humbling way to learn to invest than buying a few individual stocks.

Troy
Troy
7 years ago

This is wonderful advice. At OTA we often tell students to invest in a company, not a stock. It is valuable to do the research and really get to know the ins and outs of company culture. Ask – do you respect what they do and how they’re run? That’s often a better indicator of long term success than whether or not a financial adviser recommends a stock as “buy”.

Jake
Jake
7 years ago

Investing based on companies you “like” the look of may be a great idea, or it may be terrible. It depends on the reasons of why you like them in the first place. I think you’re reasoning is a decent place to start, but you need to do some more research to decide if it’s actually a good buy or not.

As many (including the article) have mentioned single stocks are a complete crapshoot and should only be used in conjunction with other, more stable, investment vehicles.

Jason
Jason
7 years ago

I have to say that honestly I am a little sceptical about stockbrokers in general.

It is a business that is so close to the money that you can’t help wondering why they don’t invest in their own tips if they are so clever?

Clearly some people make it work, but let’s face it, not that many that I can see.

It seems a little closer to casinos then investing half the time.

You might select the right color (black or red) and double your money, but then again you might not…

Carol
Carol
7 years ago

“Well, I know more than perhaps most people about investing.”

I’m sorry. Is this a joke or were you being serious?

jessica
jessica
7 years ago

This is bad advice as are most of sarah’s articles.

Aaron
Aaron
7 years ago

Sarah, this is one of the better posts I’ve seen on GRS. I’m an avid reader of GRS but haven’t commented until now (I can partially thank the scotch for that this evening). Very sound advice around diversification and giving consideration to the personality of management teams. Also amused by your friends/acquaintances’ misunderstanding of your role as an investment banker. Keep writing and thanks for treating us like adults.

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