I am extremely selective when I decide to buy the stock of an individual company because as I mentioned in this article, I have two components to my portfolio: Index Funds and Individual Stocks. Over the past 9 years, the index funds have provided about 13% annual returns for me, which is outstanding. So, if I decide to buy any individual stock, it has to exceed this threshold. There are about 6,000 companies listed on NYSE and NASDAQ combined. I don’t invest in penny stocks or other Over-the-Counter (OTC) companies that are not listed on these two stock exchanges.
Even if I exclude 99% of those 6,000 companies, I will be left with 60 companies which is too many for me. For me, the ideal portfolio is about 15-20 companies. I run a concentrated portfolio where the top half of my portfolio makes up about 60-70% of my portfolio. So, I can be highly selective about which companies I will include in my portfolio. In this article, I describe my process on how I pick a company to invest in. This process has evolved over time and I have learned from many mistakes along the way. Below, I list six factors that I look for in an investment. It is very difficult to get all six factors in one stock so if I can get as close as possible to these six factors, I am happy with that. So what factors do I look for in an investment?
- Newsletter Pick: I subscribe to many newsletters (Motley Fool, Seeking Alpha) and they release about 10-15 new picks per month. So, this process narrows down the pool from 6,000 companies to about 300 companies. Usually, my investment will come from one of the companies that is written in one of these newsletters. But I cannot invest in all of the companies recommended by these newsletters. If I did that, my portfolio would look like an index fund and mimic the returns of an index fund. So, I have to be highly selective about which companies I will include in my portfolio. This is usually the starting point of my research.
- Low Capital Intensive Industry: I generally avoid companies in a high-capital intensive industry such as construction, mining, cell phone towers, restaurants, infrastructure, airlines, cruise companies, etc. Over time, the returns from these sectors will be similar to index funds so I generally stay away, because I am already invested in index funds. I am more interested in companies from an industry that is low capital intensive, is growing and has unlimited potential. You will see this referred to as TAM (Total Addressable Market) in the financial media. Think software, advertising, fintech, e-commerce, etc.
- Revenue Growth and High Gross Margins: This is important. I will never invest in a company that has no existing revenue. For example, an early stage biotech company that has a drug in pipeline but waiting on FDA approval before they can generate revenue. That is an investment strategy based on “hope”. I stay away from these investments. I only invest in a company that has stable revenue that is recurring, preferably on a subscription basis and growing at a minimum of 20% per year. Think Netflix, Zoom where the revenue is flowing in like clockwork and they are focused on bringing in more subscribers to grow the revenue base every quarter. Low-capital intensive industry and high gross margin usually go hand-in-hand. You will notice that companies in high-capital intensive industries will have gross margin in the neighborhood of 20% or even lower, whereas some of the companies in the software industry will have gross margin in the range of 80% or more. Crowdstrike, a cyber security company, has a gross margin of more than 80%. Usually, high-revenue growth, recurrent revenue, and a high gross margin is a sign that the company has a moat and a strong competitive position and usually is trying to disrupt an existing company in an industry.
- Founder-Led: This is a nice-to-have and not a must-have feature. If the company is led by one of the founders, that is an extra motivation for me to look further. I have found that founders are extra motivated to see their companies succeed and grow. On top of that, if a founder owns a substantial stake in the company, that’s extra points because they have skin in the game and my interests are aligned with them. Think companies like Atlassian, Amazon, MongoDB, Twilio, and Zoom where the founders are still there and own a huge stake in the company.
- Net Retention Rate: There is a new breed of companies available on the public markets over the last five years or so that have a Net Retention Rate (NRR) above 100%. Don’t get confused with the name. Basically, NRR provides a metric of how much money the existing customers spent with the company. For example, MongoDB has a NRR in the neighborhood of 120%. This means that their existing customers who spent $1 in the previous year have spent $1.20 in the current year. Think about that. That is a growth of 20% without adding a single new customer. What if they can add new customers on top of that. MongoDB is actually adding loads of new customers every quarter.
- Strong Past Price Appreciation: If the stock price of the company that I am looking into has doubled in the previous year, that gets me very interested. Surprised? You are not alone. This is something which took me the longest time to learn. In the past, if you gave me a list of companies to invest, I would look at which of the companies are trading near their 52- week lows and pick those. In my mind, that used to be like a bargain in a discount store. However, later I figured out that those companies are trading near their low price for a reason. I now look for companies that are trading near their 52-weeks high in combination with the previous factors I mentioned. Think about this. Companies that do well over long periods of time will have strong price appreciation and will always look expensive. Netflix went public around $1 per share (the price was never around $1 per share, it’s because their stock split many times). Does it matter if you bought Netflix at $2 or $5 per share? At $5, that would have been 400% return. In the past, this would have scared me, that it has already gone up 400%, how much higher can it go. But if you bought at $5, you would be sitting at almost 11,500% return today. I actually bought Netflix in the neighborhood of $11-$12 per share in 2012 when it was already up 1,000% from its IPO price.
Once I identify a stock that meets most, if not all, of my criteria, I start buying with a small amount (usually around 0.5% of my portfolio) and learn more about the company by reading quarterly earning call transcripts (you can get these at the investor relations website of the company), watch YouTube videos of founders and company management. This process takes anywhere from six months to a year and if I like what I find, I will increase my position in stages. If I find something that I don’t like or a huge red flag, I exit the position. I don’t wait for the price to recover my original price or anything. I spend a lot of time in this process doing research before buying an initial position.
But if I decide to buy I would usually give at least 2-3 years to see if the thesis holds. Sometimes, these companies will have hiccups along the way and miss quarterly estimates and that would provide opportunities to add to your position. When I do decide to buy a stock, my conviction level in the company is about 60%. That is, there is a 60% chance that it will beat the market returns. Over time, as I get to know more about the company, their management team, their culture, my conviction level usually increases and then I add to my position. Like I mentioned earlier, I want to keep the number of my holdings less than 20 (usually around 15), that way I can spend time on reading earnings call transcripts every quarter and watch their presentations. In my next post, I will talk about how I build my portfolio and other portfolio management strategies that I use.
If you read along so far, how do you select a company? Feel free to share your thoughts below.