What Does A Good Stock Look Like?
Updated: Sep 17, 2021
In these days of covid savings versus the loss of gambling venues (casinos), it seems like everyone with a spare dollar, access to a bit of cash or credit, and/or a reddit and Robinhood account is throwing money to the wind in hopes of generating a windfall? This is about the longest shot at making money one could take, and as I think I’ve mentioned in the past. Some may make big gains while others will take enormous losses. I keep using Gamestop as an prime example, as people keep pouring money into this company, without getting any value back. They only get the value of other people’s money as it accumulates or decumulates from the market cap. It feels like a modern day version of “The Wolf of Wall Street”, where Leonardo Decaprio portrays a shady broker who takes big commissions from unwary investors buying into long shot penny stocks. Investors in Gamestop can only hope others continue to prop this company up with more and more investment and never take their money out, or somehow the company makes something out of this obviously struggling brand. Either way, it will be a painful exercise for all involved.
Stocks (shares) and dividends are not that complicated. When companies enter the stock market, they basically issue a number of shares for a price in an IPO (initial public offering) equivalent to the imputed value of their company, and then they are off to the races. The money that comes from the IPO is available to the company to use. Of course, there is a much more complicated procedure to moving a company from a private company, where the company owns it outright, to a public company, where investors own it. A company needs to pass several financial stress tests to qualify and be able to apply to any stock exchange to be listed publicly, and if they fail to meet those qualifications later, they may also be delisted from the stock market. There is a lot of due diligence applied by stock exchanges to companies registering to become publicly traded.
The value of any given stock (share) in a company on any given day is based on the market cap of that company divided by the number of outstanding shares. The market cap is soley determined by the overall value investors place into that company, through the purchase of it’s stocks. The stock price rises with the value investors place into the company on a whole daily, and inversely falls when money is removed visavis stocks being cashed in (e.g. money is removed from the market cap). The value can also be diluted by more shares being added in, which usually occurs to generate more capital for the company, but also sometimes as a stock split. Dividends are sometimes a good indicator that a company is performing well and making more money then it spends. This is especially true if they are paid on a consistent, multi-year, and slowly-increasing basis. Dividends usually mean a company is generating more profits than it can spend, but not always. Large cap companies have deep pockets, and even when these companies suffer temporary financial setbacks, they have enough cash in reserve or access to money through various means to continue to support their dividend programs, rather then fall out of grace with investors.
Dividends alone do not make a good company, and a deeper dive into the company’s financial statements may reveal that the appearance of financial health through paying dividends may just be a smokescreen for underlying money issues. Companies who do not generate annual net revenues on a consistent basis but still pay dividends may not have their budgets or their priorities in order. Revenues may be significantly down and not recovering, or costs may be significantly up and mismanaged, and a savvy investor needs to watch for all the red flags in a failing company. Companies may cut or even stop paying dividends if their financial stresses get too high, but sometimes this is a prudent thing to do. Companies may sell off assets to generate cash-flow, or cut operating costs beyond the factors of safety which may lead to worsening outcomes. Should these red flags wave for too long, it will cause investors to lose confidence and divest. When this happens, the mass exodus of investors will cause a significant drop in the companies stocks value/price, as value is withdrawn from the market cap.
Again, this is why low cost, index-tracking ETFs work so well. They have already done the homework for you, and have built a large portfolio of well-diversified, performing stocks that are meant to mirror the stock market index. You can purchase these ETFs in different markets and asset classes, or now, you can also buy all-in-ones that hold interests in all the world markets (Canadian, USA, Foreign, Emerging markets) and asset classes (stocks and bonds). I like the all-in-ones because you can pick your mix preferences and the balancing happens automatically, but they will have slightly higher MERs (management expense ratios) than the single market ETFs.
If you are going to play with individual stocks, you should understand the risk and basic fundamentals of stocks. You may also not want to put all your eggs in this one basket? You may want to initially assign a percentage (5-10%?) of your savings towards this effort and stick to your guns. I think playing a little bit in individual stocks will help you learn very quickly how stocks work, and if this is something you want to continue, but don’t learn with all your money! It’s a bit of a risky space for people emotion-wise too. For example, if you have any success with a bad stock, it tends to make you want to try to repeat that success, which could net a more negative result the next time. Be wary of your own emotions and hubris. They can work against you and make you overconfident in really bad situations.
Another easier way to play individual stocks is to have a look at how the index-tracking ETFs are structured. The top 10 stocks in these ETFs are very reliable, large-cap, high-performing stocks, and these top 10 stocks will usually form 40-50% of the funds total holdings. So when there is a crash in the markets, picking up any one of these stocks at a discount will usually turn out favorably, unless the crash severely cripples them from recovering, which is unlikely.
Back to the original question, “What does a good stock look like?”. A good stock is very resilient in the stock market. It offers a goods, service, or product that is a staple in the economy, and not easily cast aside during hard times. It has a history and reputation of good fiscal performance and growth, and it’s financial transparency is trusted. Good companies and their stocks consistently shows positive net revenues (earnings after costs), and will typically reward their investors with dividends they can afford. They use their capital wisely, turning out more profits than the capital they spend towards generating them. They manage their debt loads wisely, and do not spend outside their means so they can service their operating expenses, including debt. In essence, they don’t lose money or investors, particularly when times are difficult.
The market pundits will throw all kinds of fancy metrics, predictions, and verbage at you to describe good stocks or stock opportunities, but as I mentioned before, you can pick any index-tracking ETF and find really good stocks in the top 10-15 holdings. To me, that is an easier way to learn and see what moves the markets, and these are the stocks you may want to grab if they are ever severely discounted, like they were in the March 2020 Covid crash. Since then, these stocks have all recovered 30-50% and many have even doubled or more.