City Builders

You are now well on your way to becoming a city builder! You are really moving up in the world! If you have been with us for the whole ride, hopefully you have learned a thing or two about stocks, business, economics, and maybe even psychological biases. This is our last leg; by the end of it you should be able to analyze stocks and have a solid foundation so you can beat the market! Let’s waste no time…

By this point you are probably wondering where you can buy these things called stocks. Our recommendation is to open up a Robinhood account because it has a nice user interface and it offers commission-free buying and selling. Robinhood is a brokerage, a platform for buying and selling stock, and by clicking here you can also get a free stock to start! Just make an account, link your bank account, wait until you get approved and then fund the account with an amount you would be comfortable losing 50% on. We say this because you should not invest your mortgage payment or your tuition for next semester. 

This is important: you should only invest money you would be comfortable losing 50% of. This is certainly not to say you will lose 50% but that is the mindset you need to have. Typically, brokerages charge $3-7 per trade. This can really add up if you don’t have a whole lot to invest. So that is why we suggest Robinhood. There are other brokerages that are solid too like Schwab, TD Ameritrade, and Interactive Brokers. 

The next natural question is: what stocks should I buy? There it is…what we have all been waiting for…

Before we get into the stocks you should buy, we need to clarify a few more things. Too often, investors focus on either quickly growing companies or “cheap” companies. It’s either growth or value, rarely both. But both groups of investors are the same in that they want a greater value than the price they are paying. So we say don’t focus too much on growth or value; focus on your edge. This idea of edge is very important. 

For instance, an IT professional will probably have an edge in technology companies that are naturally growing more quickly. But does that mean she should not know anything about “value” companies or cash cows? No. She will just have an edge in the growth-style. So don’t associate with one style, growth or value; instead, find your edge and work backwards. 

Are you more patient than the average person? Leverage that. Are you better with numbers than the average person? Leverage it. Do you know a specific industry really well? Leverage. Are you extremely analytical? You know what to do. This is what we mean by edge. Once you think about your edge, and everyone has one, you can work towards finding companies that fit it. Warren Buffett calls this edge a circle of competence (usually he is talking about specific businesses and industries). 

Invest within your circle of competence. The thing about this concept is that you have to know what you don’t know as well as what you do know. Are you fooling yourself into thinking you know a lot about technology? Are you really not as patient as you think you are? Good investing takes a lot of self-awareness. Once you have an idea of what your edge is then you can tailor your search to find companies to invest in. This edge might coincide with growth or value and that’s ok but don’t start by saying “I’m only a growth investor” or “I’m only a value investor”, that’s limiting! 

Moreover, we encourage you to continuously expand your edge. The wider your edge, the wider your circle. And who doesn’t want to expand their edge on the competition? So now that you’ve found your edge, we’re almost there!...

So what stocks should you buy? This is a question that requires a very detailed answer because it is nuanced. If you are just looking for stock tips, buy our Business Breakdowns subscription.

But investing is so much more than stock tips. It’s like that phrase, “Catch a man a fish, feed him for a day, but teach him how to fish and feed him for a lifetime.” Stock recommendations may help you catch fish but we are here to teach you how to fish. 

Once you catch that fish, are you going to know what to do with it if you have never been taught how to gut it or prepare it? So stock tips are the tip of the iceberg, one piece of the puzzle, but we believe you can find good stocks on your own. How? Well, let’s get into it…

To the point, the best place to start looking for investment ideas is companies you are already familiar with. Do you work in healthcare and is there a fancy new drug or robot that does surgeries? Where do you get your groceries? What websites do you use the most often? What brand of shoes do you love? What subscriptions do you enjoy? This can be part of your edge.

There is a book named “One Up on Wall Street,” by one of the greatest stock-pickers of all time named Peter Lynch. This was his whole premise; that everyone has a leg-up on Wall Street because we can see the trends before they can. And it’s pretty true. It just takes some intentional observation. Notice the world around you. Which companies seem to be doing well? Take note of those and then start researching them with some of the skills you have learned. We will go much more in-depth on fostering those skills in just a moment but go ahead, observe the world!

Another method is getting stock tips from some sort of service and then doing your own research. There is also a third method called “screening.” Screening is a tactic for finding stocks by the process of elimination. If you click here, you will find yourself at a stock screener called FINVIZ.

When you “screen” for stocks, you put in criteria that you would like in the potential list of stocks. For instance, let’s say you want to find some quickly growing companies so you put in “over 20%” for sales growth qtr over qtr (quarter). But you also want the companies to be profitable so you toggle net profit margin to “Positive > 0%.” Then the screener will spit out a list of companies that fit those criteria. You can play around with it and find companies that fit your edge. 

So once you find a potential investment, what are the next steps to see if it is a good company?...

Good investors must be voracious readers. There’s no way around it. So let’s talk about some of the documents you need to be familiar with and how to analyze them. We’ll go in order of importance as well. It will also help if you pull up the documents while we go through it just so you can see how to do it for yourself.

1. Annual Reports (10-K)

Every publicly traded company is required by the SEC (Securities Exchange Commission) to file a 10-K, or annual report. This essentially has all the information you need to know on the company. But 10-Ks are usually around 100 pages so you need to be strategic to make the best use of your time.

Let’s all be on the same page, so click here. Then click on the 02/02/18 10-K for Amazon under the “Form” column. Open it up and locate the table of contents on page 2. You’ll see a group of blue hyperlinked sections. The first section will be “Business.” This is always a good section to read because it is important to know the background of the business, especially how the company makes money. You might think it is obvious how Amazon or Google makes money, but it might surprise you.

Under the general section in “Business,” you’ll see that Amazon operates in three sections: North America, International, and Amazon Web Services (AWS). So these are the three ways it makes money; the two retail segments including Alexa, Kindle, and everything in between and then AWS.

Under the “Business” section, is the Risk Factors. Our advice is to read through the first five to seven risk factors. If they seem uber-general for the lawyers to cover their bases, then move on. However, risk factors can be of utmost importance. If a company notes that one customer accounts for 70% of revenue that is pretty darn important because if that relationship ends, the stock will be destroyed. So make sure you give the risk factors a chance because there could be some crucial information.

The next and in our opinion, last section you need to read is the Management’s Discussion and Analysis of Financial Condition and Results of Operations. You need to read most of this section because it will give you the run-down on the operational and financial health of the company. In this case, it is pages 19-32. At the least, read the “Overview” and the “Results from Operations” subsections. So those are pages 19-20, 25-31.

Remember how we said you want to find out how the company makes money? Well we find out more specifically on page 25. We can see that AWS accounted for over $17 billion in revenue in 2017, almost 10% of the total revenue. We can also see that AWS as a section grew the fastest in 2017, at 43%.

Moving down to page 26, we see the Operating Income section. AWS made over $4.3 billion in operating income for Amazon. This accounted for 105% of operating income. How can that be? AWS is only 10% of revenue but it made up more than all of Amazon’s operating income? It is because AWS is extremely profitable for Amazon. $4.3 billion as a percentage of $17 billion is 25%. That is AWS’s operating margin, meaning for every dollar of AWS sales, Amazon makes 25 cents in operating profit. To put it in perspective look at the North American section. $106 billion in sales and $2.8 in operating income. 2.6% margin. So AWS is nearly 10 times more profitable than the North American retail segment.

The numbers might be a bit confusing right now, but trust us, the more you look at this stuff, the quicker you will figure it out. It might not make sense now, but struggle through it; it will eventually click. The more you look at it, the easier it becomes. Just like in anything else.

Moving down to page 27, we see the operating expenses for Amazon. You can see the operating expenses have been increasing pretty rapidly. If you do the calculation from 2016 to 2017 (173 billion – 131 billion)/131 billion)), operating expenses grew about 32%. If you look back at the consolidated revenues on page 25, the growth was 31%. So operating expenses grew slightly faster than revenues, meaning the company is less profitable this year. However, you have to look at this in context. Everything needs to be put in business context. Amazon has a huge market opportunity in front of it as it has entered many industries. So as an investor, you want to see them invest for the future. Because of this though, the company is not “cheap” based on valuation metrics.

Valuation Interjection

Many investors value companies based off of P/E ratios (or price-to-earnings ratios). This is the price of the stock divided by the earnings. So a stock that trades for $100 per share and has $10 of EPS (earnings per share), will have a P/E ratio of 10. Plus, the historical P/E of the market indexes is around 16, meaning investors are willing to pay 16 times one year of earnings for stocks. This means that, theoretically, it will take 16 years for the investor to receive those earnings.  So why would an investor pay that much for the earnings of a company? Because it could be a good value actually. If our company grows its $10 earnings by 25% for 5 years and the price of the stock stays the same, the earnings will be $30.5 and the resulting P/E ratio will be 3.3. Incredibly cheap. Of course, the stock price wouldn’t stay the same if the business was performing that well.

Here’s the thing, valuation really depends on the industry. Software companies with no earnings will be valued much differently from airlines or blue-chip healthcare businesses. But at the end of the day, all investors are trying to find good value; it’s just that sometimes it looks different and unconventional. For instance, Amazon’s P/E ratio, at the time of writing this, is around 250. So it would take a quarter millennium to receive back the earnings! What on Earth!? Investors are basically saying that they think there is some serious growth to come. But if it doesn’t, then the value might not be great. That is valuation: finding a good value based on what you think a company can achieve. Most investors use “multiples” methods to value companies. The P/E ratio is a multiple, a multiple of earnings. So investors compare companies based on their P/E ratios to see if certain companies are cheaper than others.

That, in our opinion, is overly simplistic and offers no real edge. Valuation is much more nuanced since there are factors like brand, management, future growth, and competitive advantages that cannot be found in a backward-looking P/E ratio. Investing is about the future. If a company is deteriorating, it might be trading for cheaper than it is worth and it could be a good investment. However, would you rather own a bad, cheap business or a fantastic but more expensive business? Over the long term, our bet is that the fantastic businesses will outperform the bad businesses, even if they may be cheap. After all, opportunity costs still exist. Each dollar you put into a bad business, is a dollar you can’t put towards the best businesses in the world.

Back to Amazon’s 10-K

Speaking of best businesses in the world, moving down to page 30, let’s take a look at Amazon’s cash flow. Free cash flow reads nearly $8.4 billion. This is about double operating income and as a percentage of revenue, this is almost 5%. So the company is free cash flow positive, which is important (remember the accounting block?).

So now that you know a little bit more about Amazon and reading a 10-K, we’ll move onto the second thing you should read for a company you are interested in putting some money towards.

1. Quarterly Earnings Transcript

Every public company is also required to hold quarterly earnings conference calls to update investors about the progress of the businesses. These conference calls are transcribed and it is easier to read through them than listen to the actual call. SeekingAlpha is a great resource for earnings transcripts. Google’s Q1 2018 earnings transcript can be read here. Read through the whole thing. Sometimes the analyst questions at the end are pretty confusing and so narrow that they aren’t entirely useful. However, it is a good idea to read through everything. If you have the time, read back through the last two or three earnings transcripts to get an idea of where the business is headed. If you already own some stocks, make sure to read every earnings call transcript. Just set a reminder and then make sure to read them.

1. Proxy Statements (“DEF 14A”)

It is a good idea to skim through a proxy statement. A proxy statement is a company’s mandatory filing that goes into detail on management’s compensation. To access proxies, google “Edgar” and click the first link or click here. Then type in the name of the company you want. So type in Amazon. Make sure you then click on the WA (Washington) incorporated option under the “CIK” column. Then find a box named “Filing Type:” and punch in “DEF 14A” and press enter. This is the government code for proxies like 10-k is for annual reports. Then click the blue box, “documents” under the “Format” column. Choose the 2018 filing (2018-04-18). Now we are on the proxy document for Amazon. It’s seems too hard to find, coincidence? Hopefully.

On page 21, you can find the stock ownership for management. This is important because, as investors, we want the people running the business to be aligned with our interests. If a CEO owns a lot of stock, he probably wants to increase the value of it. It’s skin in the game. So this is key.

Down further, on page 26, you can see how much management is paid. This is important only if it is outrageously excessive. Executives also get stock options and restricted stock units which can skew the pay. Usually, the salary is not outrageous but the stock grants and options can be. If the company is doing well, management probably deserves it, but there are always limits.

Proxies are not read by many investors in our estimation so it might be a good idea to go above and beyond and solidify your edge. However, our time also has an opportunity cost so don’t get down too much in the details…unless you like that sort of thing, then by all means, go for it.

So as you may have seen, reading is pretty important. These three documents allow you, as an investor, to get a clearer picture of your investment. The stock market is a strange place after all. People will spend hours determining what dishwasher gives them the biggest bang for their buck but then they will hear a stock tip on the subway and go home and buy it, even if that stock costs multiples of the dishwasher. We don’t understand it. Give your investments the same focus in which you buy a dishwasher, or even a car, and we bet you will do pretty well. After all, you now are in the business of buying businesses. It takes time to do your homework. But what exactly should you focus on once you’ve read these three documents?...

Now that you’ve found your edge and you know which documents to start your research, what do you do next?

One of our biggest pieces of advice is: build your pattern recognition. What this means is look at a lot of companies. As you research and become familiar with more and more companies, you begin to build a mental rolodex of different company metrics and the industries they are in. It also helps to keep an excel or even a paper notebook to keep track of the financials of individual companies.

One thing that really helps is keeping track of quarterly results. If you click here, we have included the outline to an excel sheet that will simplify this process. You can get quarterly data by googling the company you want followed by “investor relations.” Then, you can navigate to the company’s press releases or quarterly data and fill in your notebook or excel sheet.

We suggest recording at least the last eight quarters of financial data. At least note the revenue per quarter and the operating income/loss. If you have the time, do free cash flow as well. It will take a while but if you are serious about making money over the long run, it is a small price to pay. This gives you a good reference point when you read the next earnings transcript to see the quarterly results. This way you have a little bit of context to see if the results your company reported are in-line, better, or worse than the past results.

The second thing to focus on is your style of portfolio management. Portfolio management is just how you determine your allocation of individual stocks. For instance, if you own equal value amounts of only two stocks, they will each have 50% allocations. There are two main camps in regards to portfolio management, though there are surely more. The first camp focuses on diversification. Diversification is spreading your bets out to lower to risk of the portfolio. If you only buy Amazon’s stock and Mr. Bezos flies to Mars and never returns and the stock plummets 80%, diversification would have helped you out. If, for instance, you owned 50 stocks, equally weighted, Amazon going down 80% would have only put a 1.6% dent in your portfolio. This is a whole lot better than an 80% dent. So this camp says you shouldn’t put all your eggs in one basket because you just never know.

The second camp is the di-worse-ifiers. This group believes that you should hold a select number of companies, know that group extremely well, and not “di-worse-ify.” Di-worse-ifying is diversifying for the sake of diversifying rather than strategically limiting your risk. In other words, would you rather put money in your 100th best stock idea for the sake of diversity or more money into your best idea? This method would argue that you might put your eggs in a few baskets and then watch those baskets very carefully.

Both sides have valid arguments but different priorities. The first group values risk management and the second group values return. Here is the thing though. If you are just starting out as an investor, you should probably go with diversification. As you build up your skills, you may be able to concentrate your portfolio. The great thing about commission-free brokerages is that it allows investors with a little bit of money to diversify because the fees don’t cut into the value. At the same time, when starting out, it is tough to follow a whole bunch of companies.

Based on the amount of time you have to follow companies based on work, school, child-care, or other responsibilities, you can build your portfolio management style. The more time you have, the fewer companies you can hold. This is not to say you should just buy subpar companies if you are diversifying more, you just don’t need to know them as well versus concentrated portfolio.

What we have found is that even 15 companies is a lot to follow closely for one person. And if you hold more than 50, you might as well buy an index fund. But also, holding fewer than 5-7 requires incredible analytical skills and foresight. Here is a makeshift outline to follow. See where you would fall. As you learn and grow and have different priorities, you can always switch styles.

# of stocks

1-4 – stock genius or investing with under $1000, playing with fire

5-10 – concentrated, need a lot of time and effort to know companies

11-19 - fairly concentrated, in the middle of both camps

20-25– difficult to keep up with but gives more diversity

26-50 – prioritizes risk management and likes to learn about different businesses

51+ -- buy an index fund

So now we have a better idea of how to track the financials for our stocks. Plus, we know the criteria for how many stocks we should hold. Now we will move on to what we, as investors, should do on a daily basis…

It is important to learn what to do as an investor on a daily basis because it might help with the practicality of it all.

Lesson #1:

Good Idea: Learn more about your companies.

Bad Idea: Look only at the stock prices of your companies.

Looking only at the price of your stocks as they fluctuate up and down is not good investing. Warren Buffett’s mentor, Benjamin Graham, said, “in the short term, the market is a voting machine, but in the long term, it is a weighing machine.” What that means is that the daily price movements of your stocks are influenced by how investors feel about a company at that given time. However, in the long run, the price of stocks will be weighed by business results. So this is an incredibly important lesson: only focus on business results.

Sometimes the market goes down, in fact it will go down. Your job is to focus on the business results of your investments. If there seems to be nothing wrong, the market might be offering you stocks at discounted prices.

To take the other side of the argument, if one of your stocks is down a whole bunch, it would serve you well to find out why. This is one of the only reasons why it can be good to check the price of your stocks. Because sometimes the market can be right. If you blindly buy into a stock because it is down from your cost basis, you might be doing yourself some harm. The principle still remains; focus on the business results rather than the stock price.

Lesson #2:

Good idea: Check your brokerage once a day

Bad idea: Watch your brokerage all day

Same idea here. Investing is about businesses, not stock prices. Your stocks aren’t going to go up more because you spend more time watching their prices oscillate up and down tenths of a percent. The stock market, PST time, is open 6:30 am – 1 pm. Don’t spend that whole time watching your stocks. We know it can be fun. But it will hurt your returns.

Again, on the flip side, it can be good to at least check your stocks because sometimes the stock price can implicitly tell you something. If one of your companies reports terrible earnings and your stock is falling off a cliff, read the transcript! If you think the reaction is overblown, maybe you buy more. But don’t just make a decision based on the stock price. That is dangerous. Sometimes you might get lucky, but it is unsustainable.

This is very common with investors though. For instance, let’s say you own a company who reports really bad earnings; revenues are declining, margins shrinking, and it is burning cash. So naturally the stock plummets 20%. Should you buy more? Let’s say prior to the earnings call, the stock price was $100. If you liked it at $100, shouldn’t you love it at $80? A 20% discount, right? Well, here’s the thing; you have to look at the situation in context.

What we mean is that you have to determine if the facts have changed. In other words, is this earnings miss just a short term blip for a healthy company or is it the start of a deteriorating business? If you think the business is deteriorating, the facts have changed. If you liked it at $100 with the information you had then, you now have different information; you should change your mind. This is looking at the situation in context.

With that said, quarterly results can sometimes be taken with a grain of salt. If you are truly a long term investor, one 3 month period for a company likely won’t tell you much. We advise that you keep track of the numbers to give you context, but it probably isn’t a good idea to make decisions based on one quarterly report.

So those were two lessons about how to best spend your time daily as an investor. The more time you spend reading 10Ks, financial statements, industry reports, and other company news, the better. You will react more rationally and be more confident in your decisions. It will also be more difficult. Who doesn’t love staring at stock prices? But the market, as we established, can be very emotional. Evidence and research is the antidote to that emotionalism. Remember: focus on business results, not stock prices. Now that we’ve sufficiently hammered that home, we will move on to *sniffle*, the last topic…

Wow, well, we’re here. The last topic on this journey. Before you become a full-on city builder, there are a few helpful ways to think to become a great investor. After all, investing is the business of making decisions. So we have to think about thinking (so meta, we know…).

Key #1: Second Level Thinking

Second level thinking was popularized by Daniel Khaneman, a famous Israeli behavioral economist. He wrote the book "Thinking Fast and Slow," and in it there is a section on second level, or second order thinking. The premise is that a lot of people only think in one level. For instance, let’s say you are looking at investing in a company with pristine financials. Everyone knows the company is fantastic. But the company is valued so richly that it would basically be impossible for the company to deliver.

The first-level thinker says, “Let’s buy it, it is a great business.” The second-level thinker says, “Everyone knows it is a great business so it might actually not be a great investment.” The third-level thinker might even say, “I’ll still buy it though because I am going to hold it for so long that the business will eventually outperform these expectations.” 

Being a second-level thinker (or higher) enables you to see the complexity of the world. Looking at the world simplistically works well if you know why it works well. You are then on the other side of complexity. For example, the third level thinker knew why she believed what she did. Had she just said, “I am going to hold companies for the long term,” she may be discouraged when it looks like it isn’t working out.

In other words, don’t be complex just to be complex; think things through to really understand why you are making the decisions you are. Don’t follow our advice blindly; test it and figure out your edge. This brings us to the second key…

Key #2: Know Your “Why”

If we don’t know why we are doing something, we won’t have any velocity. That’s why all the way at Block 1, we started with why. Velocity is the measurement of speed and direction. You can be going really fast but if it is in the wrong direction, it’s useless. Knowing your why gives you direction. It gives you clarity and purpose.

For example, if you know why you are invested in a particular company, you can check the current circumstances against that “why.” This is called forming an investing thesis. It is important so you can hold your companies through the ups and the downs. If the facts change though, so should your mind, just like famous British economist John Maynard Keynes said.

Without knowing our “why” we have no basis for making decisions. But we can always improve…

Key #3: Growth Mindset

Carol Dweck, renowned Stanford psychologist, wrote a book called MindSet. The premise was that our mindsets influence our ability to grow and learn. Sounds obvious right? 

But the truth in those words is weighty. If you are thinking, “I’m just not good with numbers or I am a poor investor,” there is so much hope for you. The more you practice and take hold of this “growth mindset,” the better you will become over time. It’s the fundamental principle: practice makes perfect. 

But begin to notice your thoughts. If you start thinking you aren’t good at something, don’t focus on the negative; begin improving. It’s not necessarily a mind-blowing concept, but it can change your outlook. And it will help you in investing as well as, more importantly, in life…

Woo-hoo! You are amazing! It’s been a long journey hasn’t it? But we’ve made it and we couldn’t have done it without each other! Thank you for your time and your interest in stock market investing. We believe you now have the building blocks to be a successful stock market investor.

But don’t stop here. Continue learning. Investing is an unending journey of improvement. Click the 'Next Steps' button below to find out what's next...