A Universe of Overwhelming Opportunity
When you're looking out into the sea of several thousands of individual stocks you can buy and sell with your brokerage, trying to find the right investments and to knowing when to buy a stock instead of running in the opposite direction can seem intimidating. There are hot stock picks coming at you like impossibly fast-moving bullets during a geopolitical conflict, and half of the "screaming buys" you keep hearing about are also rated "must sell" by some analyst or pundit.
It can be really hard to cut through all the noise and determine what you should do in order to build a strong portfolio, but there are some simple guidelines that can help you get a clear sense of what to buy and when. The main idea is going to be thinking about subtraction instead of addition, and inverting our thinking just a bit here, as Charlie Munger might prescribe in his Poor Charlie's Almanack.
By having certain filters in place and by using a margin of safety, the game becomes a great deal simpler almost instantly. Each of these three questions (or filters) is discussed in detail in the sections that follow.
3 Questions to Ask Yourself When Buying Stocks
- Is the stock undervalued?
- Is there a catalyst?
- What is your relative margin of safety?
1. Is the Stock Undervalued?
Since we have around 5000 stocks to choose from (give or take a few hundred depending on how you count this and precisely when), we have an overwhelming list. If we were to perform a granular analysis of every company, including projecting out future earnings with a DCF (Discounted Cash Flow) model or some other suitable valuation metric, forming a deep understanding of the company's management and industry, and determining whether the company has any sort of sustainable advantage, our analysis would outlive many of the companies we're trying to study!
Since hot stonk tips aren't reliable, we need to first eliminate as many of the 5000 stocks as possible. One really good way to do this is to consider whether the business is selling for cheap, or if it's really expensive right now. Fortunately (or unfortunately), there are often times when the number of stocks selling below their intrinsic value is very low, and the majority of years after 2000 have been exactly like this with a few notable exceptions (alas, those "shooting fish in a barrel" years are few and far between—and well worth writing home about).
Individual stock valuation is a process that demands a lot more words than would be appropriate here, but doing this for every single company without a massive team would be impossible. Instead, you can use proxies like Peter Lynch's famous numbers in order to get a quick idea of whether something might be a bargain.
In this case, it's okay to throw out the baby with the bathwater; remember that you don't have to swing at every pitch, so if one or two amazing deals get "thrown out" here, that's a small price to pay for eliminating thousands of time-wasting, overpriced stocks.
By asking yourself the question, "is the stock undervalued?" and then taking a pass on any stocks that aren't obviously in this category, you can cut your stock universe down from around 5000 to somewhere between 100 and 500.
2. Is There a Catalyst?
Getting the number of stocks you're following down to around 100 would be fantastic, but doing a deep-dive on even just 100 different companies would still be a monumental amount of work for most investors who aren't doing this full time (not yet, anyway!), and the company story tends to change over time, so continually following 100 stocks can be problematic.
Once your stock has passed through the valuation filter, ask yourself a second question—does the stock possess some kind of a catalyst for quick realization of a return on your investment? While the stock absolutely must be undervalued to even be considered a purchase, you don't necessarily have to have a catalyst in order to decide to buy, but it's highly preferable when you do have one. That's why I almost always use the valuation filter before I run a stock through the catalyst filter, since valuation alone can often disqualify a stock from being considered, and you can often do the disqualifying with a really quick glance.
Catalysts can come in many forms, but some of my favorites have been the following.
- A company's scandal hits the news and the stock price dips 30% in two days, but the underlying fundamentals are still looking fantastic.
- A short squeeze is possible since the stock has entered "meme territory" (it's not uncommon for a stock that held a lofty position last month to become a good value today).
- A completely irrational price drop occurs because other, similar stocks dropped recently, so a relatively fast correction can be expected.
The key here is to understand that the business must already be a good value, and regardless of whether the catalyst comes to fruition or not, the investment is still a decent one. This "heads I win, tails I don't lose too much" approach was best articulated by Howard Marks and Monish Pabrai.
Staying contrarian is of the utmost importance when considering whether there might be a catalyst, but the most important part of this process by far is to make sure the stock is cheap. Buying an expensive stock while hoping a catalyst comes to fruition belongs more in the realm of speculation than in investing.
3. What Is Your Relative Margin of Safety?
Perhaps you filtered down the list of 5000 stocks by first looking only at stocks that appear to be undervalued. Over a few days, you've identified some 100 businesses that meet the criteria (to be fair, there are probably a lot more out there, but these are the ones that are pretty easy for you to identify).
Next, you take your 100 or so cheap stocks, and you comb through each of them, looking to determine which of the businesses have catalysts for a faster realization of profits. This has perhaps left you with around 20 businesses that not only appear to be undervalued but also have a good chance to return to what you perceive as "fair value" in the next year or two.
First off, congratulations are due to you, since you've done a great deal more for your portfolio than the majority of investors out there, and you're well on your way to being a relatively safe and intelligent investor.
A third component can help you whittle down the list of stocks you're considering purchasing, and there's a really good reason Seth Klarman entitled his value investor's magnum opus Margin of Safety. Suppose for a moment that you work in a pharmacy, you have determined that the intrinsic value of a large pharmaceutical company to be 20% below what it's selling for, and you see a potential catalyst in the form of an upcoming merger with another company (since you work in the industry, you're confident this will be a successful merger).
Another company in your list is also 20% undervalued . . . or at least that's your best guess. This second company is an auto manufacturer you like a lot, but you're not as sure about the catalyst since you don't understand the auto industry as well as you understand pharmaceuticals. You're also a lot less confident in the 20% discount to fair value.
The answer here is simple: Demand a higher margin of safety any time you're less certain about a particular stock. Maybe 20% is a great spot for a company (and industry) you know really well, but 40% might be appropriate for an industry you don't know as well.
If the auto business is selling for 30% off, and the pharma stock is selling for 20% off, you'd want to jump on the pharma business. However, if the auto business was 50% off next week, that would be a better bargain than the pharma and the right call to make based on this concept. Having a relative (or sliding) margin of safety is a crucial step in deciding which individual stock to buy at a given time.
Munger and Buffett on Margin of Safety
The Hunt for Value
A stock purchase can be facilitated a great deal by asking three questions and creating a systematic method for determining what to buy:
- Is it cheap right now? If so, move on to question 2. If not, don't buy.
- Is there a catalyst? If so, move on to question 3. If not, you could still consider buying the stock, but a catalyst would be a great tiebreaker.
- How large of a margin of safety do you need?
By asking the first question, you often won't have to ask the second or third questions, and you can often answer the first question very quickly. Don't worry if you're not identifying 100% of the undervalued companies out there; your objective is to eliminate a bunch of junk instead so that you're only left with good values.
Next, determine which of those good values has a catalyst for a quick realization of profits, and realize that you can shift mental gears and be comfortable being a long-term holder of the stock.
Finally, you need to figure out your margin of safety and use this to determine which of the great bargains (with catalysts) to buy based on your own understanding and knowledge base. Happy value hunting!
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.
© 2021 Andrew Smith