When you buy a stock, it should be because your work has lined up. You understand the company’s business model and how its results might change depending on different variables – its competition, its newest product line, the market conditions, whatever.

You can see something in the financials that suggests good things ahead for the company, and you know that it’s stable.

And you understand the current price and valuation, and think it’s reasonable.

The last thing to do is to see whether there’s enough of an opportunity here to be worth your time. How wide is the disconnect between the price and what you think the value should be? What will change the market’s mind? What happens if you’re wrong?

Let’s talk about putting the story together to have a reason to buy a stock.

Types of general investment theses

You get ‘paid’ as a shareholder in a few ways, but I’d distill them to 4, which overlap

1. The company returns capital to you as a shareholder to make your full return on your investment. This is unlikely to be the case – it’s rare for a company to return that much to shareholders. But it’s feasible, especially in what we call special situations.
2. The company’s earnings accelerate, so even though the market doesn’t change the multiple it applies to the earnings, since they have grown faster, the stock goes higher
3. The market re-rates how it values the earnings, i.e. the P/E multiple goes higher. You buy at 9x earnings, and then the multiple goes to 18x; if earnings stay the same, your stock has doubled, all things equal.
4. The company agrees to a buyout by another company.

It’s hard to predict buyouts. The full capital return situation is not common. Most stories are somewhere on a spectrum between 2 and 3.

Multiple expansion vs. earnings growth

What does that look like? Let’s imagine there’s a company that is on sale for 9x its earnings. The stock market multiple is somewhere between 16-20, so on the surface, company A is cheap. It’s probably the case because the market doesn’t believe its earnings will grow, or that they are sustainable. It could be a cyclical company whose earnings go up and down every few years, for example.

If the company grows earnings consistently for a few years, it might convince the market that its earnings are more consistent, and worth more. You buy the company at $9, for $1/share in earnings. Those earnings grow steadily to $1.5/share in three years. Convinced this is now a ‘secular’ growth story, the market pays 15x those earnings. Earnings increased 50%, and the multiple increased 66%. Your shares are worth $22.5, a 150% return, or 35% a year, on 14% a year earnings growth.

That’s an illustration. Let’s take a real example. TJX, the business that owns TJ Maxx and Marshalls, sold for about 18x earnings in early 2013, adjusted for a split. They have grown their earnings just under 10% in the decade since, let’s round to 10%. Their shares are up a little less than 14% since, and they’ve paid a dividend through that time. The S&P is up about 11% a year in the same time.

TJX outperformed the S&P and grew more than their earnings growth. And as we might expect, its multiple has grown; it now trades at almost 26x earnings.

What does that mean for finding a stock?

When you are reading about and studying a stock, you need to find either that case where things are good now and you’re ok with them staying good, or you need a reason why things will be better than the market expects. (Even the ok with them staying good, you’re implying that the market doesn’t think things will stay good).

This is hard to do, but it’s also something that you don’t have to go crazy thinking about. A few examples from my recent investing, and just giving them as examples and not advice to follow:

Charles Schwab: the temporarily wounded giant case

I’ve mentioned Charles Schwab, as it’s one of my most recent buys. I think it meets the definition of “a very strong company goes on sale for a temporary issue.” The banking crisis this March highlighted a real problem. Investors realized Charles Schwab will make less money this year than expected. The shares dropped as much as 48% this year, for a larger than $100B company. Shares are still down 33%. My basic thesis is that this is a temporary issue, Schwab will remain profitable for now, and its earnings will be higher 2-3 years from now, which will send the stock price back up.  

Photo by Alexander Shatov on Unsplash

Spotify – the sexy (but not that sexy) growth company finally becomes cheap

I bought Spotify shares last fall. I’ve followed Spotify for a long time. I understand its business model – subscriptions for music, ads for podcasts and free users, a few bonus things. The shares are often expensive – Spotify is treated like a tech company. But at the end of the day, it’s recreating the radio and maybe the recorded music business. It’s not that hard to imagine what it could be worth as a leader in its field.

At the price I was paying last fall, between 1-1.3x enterprise value to sales, between $75-95/share, I didn’t need a lot to go right. Spotify surviving and cutting costs would probably be enough. Growth and holding their own as a focused company against more diversified competitors like Apple and Amazon would result in meaningful upside. I didn’t expect the shares to more than double in 6 months, but that’s the sort of year 2023 has been. (I have sold some of my shares, for the record).

Market cliches to unite these ideas

Mr. Market

Mr. Market was Benjamin Graham’s creation. The metaphor stands in for the wider market as a whole. Mr. Market is not the most stable character, and may offer you $20 for a stock today and $10 tomorrow, and $30 next Friday. You don’t have to accept his offer as either a buyer or seller at any point. Instead, you can listen and wait until he gets to extremes, and buy only at those extremes.

The Mr. Market metaphor is a little hokey, but it is still a valuable way to think about the ups and downs of the market.

Risk/reward

Buying a stock is risky. Above all, your biggest risk is that your analysis is wrong. I think Schwab’s issue is temporary, but I could totally misunderstand it. I think Spotify will outcompete Apple and Amazon, but maybe it won’t. Whatever.

Accepting that all your work may be wrong, you should still try to think through what could happen to the business in question in a bad case scenario. Say there’s a recession, and it affects how many people add money to their Schwab accounts. And say interest rates are cut, so Schwab can’t make as much money on that money; or that interest rates stay high, but Schwab has to raise the interest rate they pay on that money, affecting their business. How much money would Schwab make? Would the company be in trouble? What would the market likely pay for that?

You want to think through the bad case scenario, and then compare it to the upside scenario. What happens if Schwab goes back to pre-March in terms of both earnings potential and multiple? What if Schwab does even better, because higher interest rates give it more room to make money?

You can create a ‘bull-case’ scenario and a ‘bear-case’ scenario, and see how the risk/reward is. You want to invest in stocks where the potential reward is meaningfully more than the risk. I’ll talk about what I look for later, but asymmetric risk/reward, where you have something close to a “heads I win, tails I don’t lose” scenario, is the goal.

There is a Graham concept that also helps frame risk/reward, but we’ll save that for a later post.

Regardless, when we make a case to buy a stock, we should factor in the risk vs. reward equation.

Waiting for fat pitches

As you’re getting started as an investor, it’s ok to make small investments and experiment. See what it feels like to invest in a company that is really strong and keeps beating market expectations. What it feels like to invest in a temporarily on sale giant. Or in a turnaround story. This is where you learn what your investing style is, and what types of strategies you can stick to.

As you get more experience though, it’s worth keeping a Buffett concept in mind: there are no called strikes in investing. You will miss out on thousands of great investments in your career, if not millions. That’s ok. It doesn’t count against you.

You can wait for a fat pitch. Something that you understand, that seems to be available for an attractive price, and that you don’t think will hurt you very much even if you’re wrong. Not only can you wait for fat pitches, but the more you can train yourself to do so, the more success you are likely to have.

Of course, you have to recognize what a fat pitch is. That’s where taking swings now makes sense – it means more when you have money on the line, skin in the game. Just be aware, it doesn’t take many winners to change your fortunes. Patience is important in the holding of stocks and staying in the market, but also in the buying.

What’s to come

We’ve gone over four steps in evaluating a stock to buy. We know how to make the case to buy the stock. That doesn’t make every stock a buy, but it gives us the process to decide.

I’ll do one more post on a few smaller items that I didn’t get to here, but we’ve covered most of what we want to know before we buy a stock. After the next post, I’ll go over where you can find materials to do the evaluating of stock, so you can answer all the questions we’ve raised. That’ll be a couple more videos. Then I’ll share my personal approach to looking for stocks as an example, and we’ll go into actual examples of stocks I or other investors have bought, why they did it, and whether it worked out.

Check out the full roadmap, or just the how to buy stocks course to see what’s coming ahead, and stay tuned!