Common ways to pick stocks

Value investors generally prefer to invest in high-quality companies with fair prices, as explained in the previous chapter.

The question is, how to identify the value of a company?

For many investors, sifting through thousands of stocks on the market is not easy. Warren Buffett is one of the world’s most successful value investors. He believes that return on equity or ROE is a very important consideration.

For one thing, ROE, a financial ratio, is used to evaluate how well a company is turning shareholders’ equity into profit, which is an indicator of a company’s operational efficiency. For another, ROE is a measure of the potential return to shareholders.

For example, let's say you bought some Apple's shares at $2 in 2006. At the end of 2020, the stock closed at $130 per share. During this period, the annualized rate of return is 33%. Interestingly, in the past 15 years, Apple's average ROE was 39%.

The approximation of two ratios shows the reference value of ROE.

In fact, many companies are showing the same trends.  Over the past decade, their annualized ROI has been similar to the average ROE of stocks such as Tencent, Microsoft, Alphabet, Disney, and JPMorgan Chase, just to name a few. This is why ROE is widely used in stock picking.

The good news is that you can easily locate this indicator on the moomoo app.

For example, search AAPL/Apple on the moomoo app, Then go to the “Quotes” page and click on the “Financial” tab. On this page, you can select the sub-tab “Indicators”.

ROE is one of the key indicators. However, historical data only represents a company’s past performance, and future performance is not guaranteed.

Therefore, ROE could help narrow down your choices, but it should not be the only gauge for identifying good stocks.

There are many other factors to consider. Business models, competitive advantages, and growth potential are the most important aspects, among other things.

The first is the business model.

When you evaluate a company, you can research three aspects: products, customers, and corporate profitability.

Again, take Apple as an example.

The smartphone maker breaks down its businesses into 5 segments: iPhone, iPad, Mac, Service, and Accessories. Most of the revenue comes from the sale of iPhones, while Accessories and Service segments are growing much faster than iPhones. Apple sells its products to customers from all over the world.

As a result, in terms of customer base, Apple is more competitive than other businesses that focus on a certain field.

Profitability is a key indicator of a company's operational efficiency.  Apple's net profit margin exceeds 20%. In other words, a revenue of $1,000 can bring a net profit of $200.

After the business model, let’s talk about competitive advantages. Competitive advantages could be embodied in brand, patent, and network effects.

Branding is like labeling a cup of syrup with the Coca-Cola brand, and then it can be sold at higher prices globally. The patent gives a company the exclusive privilege of manufacturing and selling a specific product. This is quite common in the pharmaceutical industry. If a pharmaceutical company owns a patent for a prescription drug, it could profit from it for years.

Network effects originated in the Internet era. It refers to the phenomenon that an increase in the number of users will increase the value of the platform.

For example, Facebook, which recently changed its company name to Meta, has 2.8 billion users visiting its family apps every day.  With a massive user base, the social media company is one of the most valuable companies in the world.

The journey of finding ideal firms is not over yet.

Last but not least is the growth potential.

Oftentimes, you can find more investment opportunities in rising industries than sunset industries.

For example, Amazon started as an online marketplace for books.  As the demand for e-commerce is booming, Amazon has expanded to sell electronics, apparel, furniture, food, and cloud services.  These efforts brought tremendous changes to Amazon. To some extent, they reinvented a new Amazon.

On the contrary, Kodak has been telling a whole different story.

Kodak held a dominant position in photographic film during most time of the 20th century, and its market cap once reached its peak of $30 billion. Unfortunately, as the film-based industry was destroyed by the booming of digital photography, Kodak’s photography empire eventually collapsed.

Now, we have gone through the secrets of picking a good company.

In the next chapter, let's talk about the timing of buys and sells.