The 10 Questions You Have to Answer Before You Buy Any Stock -- Part 1
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For any new investor, or even for an experienced one, it can be tempting to buy the latest hot stock without doing much homework. As I’ve learned the hard way during the last 22 years, more often that not that only leads to trouble. How do you know how to gauge a company’s business and the competitive landscape if you don’t have a firm understanding of what the company does and how it makes money for itself and its shareholders?
That’s why I’ve developed a series of 10 questions that you should be able to answer before you decide whether or not to buy shares of stock in a particular company. That’s right, these are the questions that I start with as I take a look at a new opportunity that I may share with subscribers to my Growth & Dividend Report newsletter.
This week, we’ll tackle the first five, and I’ll share the remaining five questions with you next week. If there’s a favorable response, the week after that, I’ll share several questions that, depending on the answer, could signal that it’s time to sell, or at least trim back, your position.
What does the company do?
Right out of the gate, this is a question that you must know the answer to. How else will you be able to understand everything else about a company if you don’t have a grip on what it does? Digging a little deeper, this means identifying which industries it participates in and recognizing which one or ones drive a significant portion of the company’s revenue stream.
This also means digging a little into the company’s financial statements, either the 10-K or 10-Q, which you can find handily at www.sec.gov. You’ll want to turn to the Income Statement, and potentially the Business Segment, information that’s found in the notes at the back of the filing, to identify the different business lines your company may have. Some may have only have one business segment, which can make it a little easier, but you should still read the company description to understand its products and services.
Let’s take a look at Apple (AAPL). While the company’s history was one of personal computers, Apple today competes in the consumer electronics business with revenues generated by the sale of iPhones, iPads, Mac desktop computers and laptops, Apple Watches, Apple TV and other products (accessories and so on) and services (Apple Care, iTunes, Apple Music, iCloud).
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What are its key products or services?
When I say key products, we’re talking about those that drive the bulk of the company’s sales and profits. Getting back to Apple, iPhone sales were responsible for 63% of revenues generated in the June 2015 quarter. That’s double the revenue contribution from all of Apple’s other businesses (iPad, Mac, services and other products). In fact the next-biggest product line -- the Mac -- accounted for only 12% of revenue during the quarter! The bottom line, at least in the near term, is Apple’s business will remain highly dependent on the iPhone.
In other words, if someone is trying to convince you to buy Apple shares based on the Apple Watch or Apple TV, you should think twice about what they are saying.
At what business unit or units does the company make most of its profits?
Even after you break down the company’s revenue stream, you still have to identify which business really drives the company’s profits. I tend to focus on operating profit generation, because it factors in things like selling, general and administration costs as well as research and development (R&D) spending for the company.
In this case, let’s turn to semiconductor chip company Qualcomm (QCOM), which derived 71% of its 2014 revenue from chip sales and 29% from its licensing business. Digging into the notes found within the 10-K reveals the chip business accounted for only 37% of operating profits last year, compared to 63% for the licensing business. This tells us that at the heart of things, the real driver of Qualcomm’s business and earnings is the very profitable licensing business. As such, investors in Qualcomm need to understand the dynamics of licensing business and trends in the royalty rate.
Who are the key competitors and how are they impacting the market?
Looking again at Apple, the key competitors we need to watch out for will be those in the smartphone industry. Given its sizable market share, according to data from a market research firm, Samsung is the primary concern for Apple’s iPhone business. We still have to keep tabs on other players such as Lenovo, Huawei, LG, HTC and others, as well as the once high-and-mighty Blackberry.
My suggestion would be to read competitor press releases and financial filings to maintain a feel for how their products are doing. Watching new product introduction and promotional activity, as well as product pricing trends, can tell you if one of the competitors is aggressively targeting market share gains, which could result in profit pressure down the line.
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What is driving growth at the company?
Again, let’s stick with Apple and its June 2015 quarterly results. iPhone revenue soared 59% year over year, which was head and shoulders ahead of the company’s overall revenue growth of 33% for the quarter compared to what it did a year ago. Generally speaking, those businesses that are growing faster than the corporate average -- in this case, that 33% revenue growth I mentioned for the June 2015 quarter -- are the ones to watch.
One thing you have to watch for, however, is a large growth figure from a very small business. We see this in Apple’s Other Products business, which houses Apple TV, Apple Watch, Beats Electronics iPods and certain accessories. During the June 2015 quarter, revenue from Other Products grew 49% year over year -- impressive! -- but the business only accounted for 5% of Apple’s overall revenues. That’s still pretty small potatoes… at least today.
The bottom line with Apple is it’s a smartphone company that is still growing faster than the industry, as its products continue to take share from Samsung and others. Despite delivering fantabulous results, the longer-term concern is: what products will overtake Apple's revenue and profit generation? Longtime investors will remember that at one point it seemed PC and mobile phone sales would never slow, let alone contract, yet we are seeing the latter happen in both of those markets today.
As you start to look at new companies in which to invest, or even as you revisit ones you already own, the answers to these first five questions should give you a much better understanding of the company you are buying. That’s right, I said the company -- the products and services that drive its revenue, how it competes and how it earns its profits are the drivers behind the share price.
I’ll be back next week with questions 6-10. See you then!
In case you missed it, I encourage you to read my e-letter column from last week about what the 'airport indicator' could mean for your investments. I also invite you to comment in the space provided below my Eagle Daily Investor commentary.
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