Whether it’s Tesla, GameStop, AMC, Bitcoin, or even Dogecoin, it seems like millionaires are being minted every day. You can read countless stories about people buying into meme stocks or cryptocurrencies, and making a huge profit. Unfortunately, getting rich quick by hitting that lucky jackpot only sounds easy. Most people end up losing their shirts trying. The good news is that there’s a better way of building wealth. It’s not as sexy, but plenty of savvy people have built a fabulous life around stock market investing for the long haul. If you’re willing to put in the effort to do some due diligence, riches can be had. So what exactly is stock market due diligence? Simply put, it’s a closer look at the finances of any company you’re considering investing in. Here are some questions to ask and general tips to get you started.
Understand How the Company Makes Money
You may think that Forest Gump buying Apple stock because he thought they sold Apples only happens in movies. However, the reality is that many people buy a stock without really knowing what the company does. I have a friend who made a ton of money in the pandemic, betting on technology stocks. When I pressed him on a specific stock he recently bought, he froze up. All he could tell me was some vague answer related to cybersecurity. He didn’t even know! I was a bit surprised, since I consider this friend to be quite intelligent. Instead, he basically took a shot in the dark on some stock that he heard about on the internet. He might as well go to the casino and bet it all on black. It would’ve been a faster way to get rich!
Analyze the Competitive Advantage
Simply put, why is this company better than its competition? If a previous customer were to choose all over again, would they still be a customer? Warren Buffet calls this the economic moat. Amazon, for example, is a company with moat. People can shop for similar products all over the internet, but most go back to Amazon again and again. They have the largest selection, hassle-less customer service, blazing fast shipping speeds, all at a competitive price. How much moat does the company you want to invest in have? If you believe the company you want to invest in has a competitive advantage over their rivals, that’s obviously a good sign.
Is the Barrier of Entry High?
This is similar to having an competitive advantage. Companies are better able to protect their cash flows and profitability if it’s hard for new competitors to crop up. Whether it’s due to a huge financial burden or a proprietary technology, can someone easily mimic their products or offer the same service? Sometimes, a company can be in a market that has a high barrier of entry even if the product is easily replicated. This is when knowing the company (and product) inside out really helps.
Apple, for instance, makes electronics that are easily copied. Yet, none of its competition comes close to their market reach and profit margins. Why? Apple has not only built a solid reputation and loyal following, it’s also taken massive care to integrate its products. The convenience of using their products isn’t easily replicated by competing brands.
When you use an iPhone for example, everything is more intuitive. There may be more features on a competitor’s device. Android loyalists will (correctly) scream that many of the best iPhone features actually existed on their OS first. However, Apple has a reputation for better integrating those features into their software. For the millions of users who aren’t tech-nerds, an iPhone just works. Customers value that.
Is The Company Growing?
Stock prices, once you average out short-term volatility, ultimately measure how much cash flow the business generates over the long haul. The faster the growth rate, the more it will be worth to investors. That’s why a company with accelerating growth prospects is worth more than a company that’s not really growing anymore. Factor this into your due diligence.
For example, look into whether the company is branching out into new potential markets. Are they expanding nationally? Or even internationally? Or is your potential investment content to just be consistent player in a pre-existing, stable market? These market trends can really spark a rally in the stock, so don’t underestimate these factors.
Are There Any Catalysts?
Stock prices are set by supply and demand. At the end of the day, prices only go up because there is a reason for buyers to buy the stock. The growth trends I talked about are some examples of catalysts. After all, why wouldn’t you buy stock in a company that’s about to expand nationally?
Netflix is a stock that’s done extremely well in the past decade. They started as a DVD-by-mail company, but quickly pivoted into streaming. They were the first major player in the streaming market. Then they started offering their own original programming instead of just licensing movies and show you could have seen elsewhere. Best of all, all that content only cost 10% of what most people were already paying for cable. Then it expanded to hundreds of countries around the world, with equal success.
While hindsight is always 20/20, anyone who performed some due diligence on Netflix would have seen the potential catalysts for growth. It’s been one of the best performing stocks over the last decade.
Does the Market Cycle Favor the Stock’s Industry?
Economies go through cycles. When the economy is in recession, consumers typically tighten their belts. That means less spending on discretionary goods. Credit is also harder to come by, which favors larger, established companies. They generally have deeper pockets to weather the economic storm.
The reverse in true when you come out of a recession. Consumers are tired of being frugal. The pent-up demand will favor companies that make money from discretionary spending — that could mean things like travel, entertainment, or consumer electronics. Small companies also benefit more when the economy is accelerating, since credit is flowing more freely again. They can be more financially nimble to capitalize on the latest trends.
Factor the greater market conditions into your due diligence. When you are investing in the stocks that have favorable market dynamics, it’s like sailing with the wind at your back. Conversely, you could pick the best stock but still lose. If every stock in a particular space is going down due to market cycles, it won’t do you much good.
How is the Market Doing as a Whole?
Similar to the economic cycle, the entire market also has its ups and downs. When the market is doing well, everyone feels like they are a genius. Stocks just keep going up! On the other hand, it doesn’t matter what you buy when the market is crashing, since everything is going down. Many people need to raise cash to satisfy margin calls. Take the onset of the pandemic in 2020, for instance. The value of almost everything went down, causing plenty of people to lose money (if they sold, that is). While it’s impossible to predict the market, try to take its overall state into account when doing your stock market due diligence.
Decide Whether You Are Trading or Investing
Everyone is ultimately trying to make money when they buy stocks. However, there is a subtle difference between trading and investing. Traders only really care about the short term performance, since they like to bounce in and out of various markets all the time. On the other hand, investors are thinking long term.
Stocks values track the performance of the company. That means the information that helps a trader will help an investor. Still, there are indicators that are much more important to investors than traders — and vice versa.
Competitive advantage, for instance, is more important for a long-term investor. On the other hand, a short-term catalyst can help a trader reach his short-term price target. When it works, traders can make a quick buck. However, those short term blips may not be all that important in the long run.
You’ll probably see a ton of investment tips online for any individual stock you’re interested in. Try to decipher whether that advice is geared towards the trader or the investor — and which of those two approaches you prefer.
Figure Out the Risks of Ruin
Most people dream about their stocks shooting up in price. However, really successful investors also protect themselves against the risks of their stocks falling.
When I first started investing more than a decade ago, I lost quite a bit of money buying Etrade stock during the financial crisis. I thought how there was no way a profitable company like Etrade could lose so much in market cap. The stock price would eventually go back up — I was sure of it. As a result, I kept buying more as the price went down. Eventually, I sold it at a substantial loss as more and more bad news about its loan portfolio surfaced. Back then, I simply didn’t think hard enough about the potential risks of that one trade. I paid dearly for that mistake.
Successful investors know that as long as they protect the downside, the upside will take care of itself. Even if one stock tanks, there will be plenty of investments that pan out. Luckily for me, I kept invested in the stock market. The other investments I had at the time more than made up for the Etrade mistake.
If I kept being stubborn and continued to plow money into that losing bet, then my financial position wouldn’t nearly be as solid now. I would have been too financially traumatized by that lost, and would have likely missed my chances to earn from the strong stock market decade that followed. When doing your due diligence on any potential investment, make sure you calculate the possibility of losing. Then make sure that loss won’t ruin you.
What is the Company’s Cash (or Debt) Position?
Sometimes it can seem like public companies can borrow money forever. Yes, even if they keep losing money year after year. However, those that can’t generate free cash flow eventually have those debts catch up to them. They will inevitably buckle under the debt load.
Companies that have their own cash reserves have other advantages. They can pay a dividend, buy back stock, or even invest their cash and make money on those investments. They can also buy smaller companies to expand their product offering or to improve their product lineup. The latest mantra on the street is that cash is trash, but I’d take cash any day of the week. There’s a reason that Apple often brags about their ample war chest of almost $200 billion in cash.
Do You Have Enough Capital to Ride Out Volatility?
Even the best (or luckiest) investors shouldn’t expect that every stock they buy will go up immediately. That’s why it’s important to make sure you won’t actually need the money you’re investing immediately. This issue becomes especially sensitive if you are borrowing money to invest, since your lenders will still expect to be paid on time. They don’t care that your “can’t miss” stock market tip isn’t performing as expected.
Almost every intelligent investor will strongly caution you against using borrowed money to buy stocks. Margin calls are the single most destructive force to wealth in the investment space. You need to be able to weather any potential downturn, without having it default on debts. Before you invest, make sure you are well capitalized! Even then, don’t overextend yourself by making more investments than you can feasibly pay for.
Are There Better Alternatives for Your Money?
Watching a stock you own go up is an awesome feeling. However, that doesn’t mean buying it was the right move. Could you have made even more money invested in something else, while taking less risks? At the very least, your investment should outperform passive investments, like an index fund. After all, a passive investor doesn’t need to be glued to the markets, will pay less taxes over time, and is taking on less risks than a trader who is betting on individual stocks.
Before you click the buy button, make sure you conduct your due diligence. Research the company, their products, and their financial figures. Make sure you think long and hard about the best ways to use your money. If your due diligence points to a winning stock, then go ahead and press that “buy” button. Then pay attention to your results. If your due diligence keeps picking losers, it’s time to reevaluate what criteria you’re using.