When you’re buying just about anything, you study it. If it’s a restaurant menu, you look over all the options. If it’s a purchase in the supermarket, you check out the nutritional facts. For cars, you might check the Kelley blue book, you might watch youtube videos, whatever. Houses come with their own checklist of things to go over.

A stock should be no different. Once we’ve decided that a stock is worth researching, we need to put it through its paces to see whether we want to ride it in our portfolio.

I don’t have a specific checklist I follow each time I study a stock, but there are several categories or topics I want to drill into. We’ll start with evaluating a stock’s basics and understanding how the underlying company’s business works.

Figuring out how a company makes money

Before anything else, you need to understand why the business exists. What value does it bring to the world? How does it profit off that value such that it’s a worthwhile investment?

Netflix is a streaming video business that sells subscriptions to people around the world. It buys the rights to TV shows and movies, or it pays to develop those shows/movies, so it can show it on its platform. Netflix operates globally and can produce or license content in one country and then air it in many others.

With each business model there are certain questions that come next. What will happen to Netflix’s production costs? There’s a writer’s strike going on, which will affect both near-term production and what the company’s long-term economics look like. How good a job does Netflix do acquiring new users? How good a job does it do keeping them? Will its new advertising tier work, both in bringing in new users and being profitable in a new way? There will be specific metrics we can track for each of these questions. First you need to find the right questions to ask.

A company like Nike can seem simpler. Nike sells shoes and clothing. They make money by selling those items for more than it costs to make, whether through their own stores or via clothing stores. But even that statement opens up questions – is it better for Nike to sell direct or via a partner? How much of a margin are they able to earn? Will that change over time?

No matter which company you are studying, you need to understand what their business model is. You then need to understand what will affect the company’s business in the months and years ahead. The stock price will change based on how much money the company is expected to make in those months and years. Your focus needs to start with understanding how a company’s business works and how its prospects might change.

Understanding the industry

Once you understand the company’s business model, you need to understand the industry for context.

Is the industry an emerging industry? That can be an exciting time to invest, but also tricky because often only a few companies win. Is the industry more cyclical and up and down? Or slow-growing or flat, where you are looking to squeeze out cash?

Industry Example: Online Advertising

Take online advertising. In the 2000s and 2010s, this was an emerging, exciting industry. For all that, the big winners were mostly Google and Facebook*, which sucked up all of the revenue, while a lot of “digital advertising” companies or stocks stagnated or died out.

*Both Google and Facebook officially belong to parent companies, Alphabet and Meta Platforms, respectively. Both parent companies make money beyond digital advertising, especially in Alphabet’s case. But, digital advertising is still each company’s dominant business.

The industry context is relevant for understanding a company’s performance. In a secular boom time like the 2010s, the question is whether Google and Facebook can maintain their growth rates, and whether they can turn that into money.

Then there can be an event like 2020 and 2021. As we are all spending way too much time on our phones and devices, advertising booms. Facebook’s parent, Meta Platforms, grows 37% in 2021, faster than it had in three years. This is super impressive since it had $117B in sales that year.

Super impressive, except Google’s parent, Alphabet, grew 41% in 2021, its fastest rate in over a decade. Alphabet had $257B in sales in 2021. Eat my dust, Zuckerberg, right?

This was all great, except in 2022 things slowed down a lot. Meta’s sales actually dropped that year, while Alphabet’s growth rate dropped to under 10%, its second slowest in its public history after 2009. It is expected to drop to 5.9% this year. And Alphabet made less money in 2022 than in 2021.

From a purely business perspective, both companies are impressive. But we need context. Grading their performance in 2023 is different from grading it in 2021 or 2015. The context of the pandemic boom and post-COVID hangover affects how investors think about these companies.

Understanding the competitive position: introducing moats

Building on both of these topics – the company’s business model and their industry – is the company’s competitive position. How strong is their position? Or to use a popular concept: how wide is their moat?

A moat around a castle is meant to keep invaders out, or at least at bay until the castle can start pelting the intruders with hot melting metal and that sort of thing.

A business moat is what allows the company to maintain its profitability, its growth rate, or other advantage. I love Jif peanut butter, it’s far and away the best peanut butter out there. I don’t know what makes them better – is it a secret formula? Their manufacturing process? Their brand? – but I know I would pay more for Jif than other types of peanut butter. If there are a lot of people out there like me, that’s a sign of Jif’s moat.

As Warren Buffett says*: “When our long-term competitive position improves as a result of (delighting customers, eliminating unnecessary costs, and improving our products and services), we describe the phenomenon as ‘widening the moat.’ And doing that is essential if we are to have the kind of business we want a decade or two from now.”

*From his 2005 shareholder letter.

Moat examples

Look at each of the mentioned businesses:

Alphabet’s moat is pretty obvious: Google is a verb, and Youtube is a dominant online video platform*. On the flipside, part of the ChatGPT hype is that AI might finally erode Google’s moat.

*And probably a verb.

Meta’s moat is fairly strong, even as legacy Facebook becomes a hangout for older folks and crazy people*. Instagram is pretty dominant, whatsapp is like blue messages for the globe, and who knows, maybe Meta’s VR stuff will pay off.

*Sometimes both.

Netflix’s moat seemed tenuous with all the competition in streaming. But their dedication to the subscription, online model may help them outlast competitors who are struggling, like Warner Bros Discover – the owner of HBO and CNN, among other things – or Disney. Netflix is also a verb, as in Netflix and chill, which is always a decent clue about a moat*.

*Being a verb can be both good and bad – if we genuinely use Google to search for things, then a verb is a sign of a moat. If we watch 5 different streaming channels and lump them all together as Netflix without knowing which is which, it’s a sign of a weak moat.

And Nike’s brand power remains strong, in the sports world and beyond. Their marketing and branding have resonated with multiple generations by now, and their sales continue to grow. I don’t know Nike’s business as well, but I would suspect they have supply chain advantages as well*.

*Nike has been criticized over the years for sweatshop labor. I am not up to date on where that is, but also much of the apparel and footwear industry has moved operations to South and Southeast Asia for cost reasons. So their ‘edge’ may be slimmer than before.

The full business picture

Before you make a purchase, you want to know what you’re buying. With a stock, we have to remember that we are buying a piece of a business, and not just a piece of paper. We need to understand that business to know whether we want to own it.

That starts with the basics covered here. How does the company make money? What is its industry like? And how strong is its competitive position?

2023 is a fascinating time to address these questions. Just about any company, including all of the ones covered here, has seen dramatic short-term changes in multiple directions through the course of the pandemic and its aftermath. The new normal is probably not quite here. That doesn’t make understanding a business impossible, but it throws in an extra variable.

In our next video, we’ll go beyond the conceptual understanding to the data. We need to validate a company’s moat, or an industry’s direction, or a company’s success. We can do that by looking at its business fundamentals, as borne out in its financials.