Picking stocks to invest in is not an easy task. There’s a lot that goes into it and it carries more risk than a well diversified ETF. But when done correctly, picking individual stocks to invest in is a great way to boost your wealth. But how do you go about picking stocks? And why do you need to be able to understand a company’s financial statements?
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Hello hello, friends! And welcome back to Girl on FIRE, the financial independence podcast for independent women.
My name is Priya, I’m a Chartered Accountant, an analyst and the creator of Paper Money Co.
I’m also a fierce financial feminist and the host of this podcast. I believe that a woman who is in control of her money, is in control of her life.
Today, we’re kicking off a 4-part series talking about how to pick individual stocks to invest in.
This is an area where a lot of beginner investors and even seasoned investors get tripped up.
It’s really easy to fall into the trap of emotional investing and speculation which we talked about in episode 27, and invest in the wrong things.
You hear someone on the internet making predictions about the next hot stock, you want a piece of the action and you invest in it as well.
And it turns out that the tip was incorrect and you end up losing a lot of money because of it.
But that’s not going to happen to you because you’re going to do your homework, right?
You’re going to do your due diligence in researching and analysing stocks of individual companies before you start investing in them.
Otherwise, you’re basically gambling. That’s a quick way to lose a lot of money and that’s not what Girl on FIRE is about.
So, we’re going to talk about how to pick individual stocks and what to look for when you’re analysing them.
This isn’t a small topic. It’s going to take a few episodes to really get through it, so this episode is part 1 where we’ll go through an overview.
And we’ll take a deeper dive into this topic in the episodes that follow. But we’re definitely covering the basics and working up from there.
Picking individual stocks is no easy task. There are whole careers and industries that make money trying to do this.
And please always remember that the vast majority of people, even the largest fund managers, have a hard time picking individually successful stocks at a rate better than pure chance.
There was even a famous “study” done at one point that showed that some of the best stock pickers in the industry were beaten by a cat throwing its toy over a grid of company names that indicated which stocks the researchers should buy.
This is why ETF’s are so widely talked about, because if it is so hard to outperform the market, then at least keep pace with it with minimal effort.
But even if you’re not going to be stock picking, this series will really help you understand more about how the stock market works because it shows you what makes a good stock and what doesn’t.
But before we get started, I want to remind you to head to my website — papermoneyco.com/startinvesting to download your free copy of my Investing Starter guide
It’s totally free, you just need to enter in your email address and I’ll send it straight to your inbox.
It gives you a step by step plan to follow to get your finances ready to start investing, including working with a budget, building an emergency fund and paying off debt.
The sooner you can get your foundation set and get those good money management practices in place, the sooner you can start investing and building your wealth.
If you’re really serious about learning to master your money, then it’s the perfect guide for you, and I’d hate for you to miss out on it.
As always, Girl on FIRE is about learning, so whip out your favourite notebook or journal and get ready to take some notes.
If you’re not into writing things out by hand, you can always find the transcript on my website — papermoneyco.com/gof32.
Okay, let’s dive in!
Why should you invest in individual stocks
I wanted to kick things off by talking about why you as an investor would invest in individual stocks.
At this point, you know, 31 episodes in, we know that over the long term, stock market returns always go up. It generates a positive return over the long term.
If I ever created a Girl on FIRE investor creed for us all to pledge allegiance to, that fact would be #1 on the list. And that also sounds like a fun little project, so I might just do that.
Investing in ETFs is the easy road to FIRE
And in episode 17 we talked all about ETFs. If you need a refresher, an ETF is like a basket of stocks from different companies.
It could be an ETF for all stocks on the S&P 500 or it could be an ETF for all technology stocks, or all financial sector companies.
They’re just a grouping or packaging of stocks that you can buy in one trade. And they’re great because you get instant diversification across hundreds of companies in hundreds of industries with one trade.
And they’re perfect for a long term buy and hold strategy. You just have to worry about picking an ETF that properly reflects the underlying index it’s trying to track.
And you’ll make money over time as all those stocks increase in value and pay dividends.
Buying and holding ETFs for the long term is often cited as the best way to invest your way to FIRE.
And it’s especially great for people who don’t have the time, or the tools to research hundreds of companies.
It’s also a good option for you if the idea of looking over the financial statements of companies gives you hives.
So, if ETFs are so great, then should you consider investing in individual companies?
Now, of course, you could invest in individual companies because you like them and want to support them or because you like the status of saying that you’re invested in Apple.
But when it comes to building your wealth, picking the right companies to invest in can be a huge boost.
An individual stock can outperform the market
Because here’s the thing: an ETF is a basket of many different stocks. And it’s going to perform in a way that reflects all of those stocks.
So, if there’s an ETF with 100 companies, and half of those companies do well and the other half don’t, your ETF is in the middle.
The losses aren’t too significant because only half the companies aren’t doing well. But that also means that gains are limited because only half the companies are doing well.
Think of it like a classroom. Individual students can do well and have a great GPA but they can also struggle and have a lower GPA.
And each students’ individual results impacts the GPA of the class as a whole. That’s what happens to your ETF.
It’s impacted by both the strong results and the weaker results.
Now, the good thing about investing in an individual company is that it’s good results aren’t watered down by losses from other companies.
So, you have the potential there to make higher returns. Because your individual stock is doing better than the general market.
You’ll hear this a lot, people say that a stock is outperforming the market. And a lot of investors try to pick stocks that will have higher returns than the general stock market.
For example, an ETF that covers the S&P 500 might grow by 9% this year. But Apple stock might grow by 12%.
Apple makes part of the S&P 500 ETF, but you would earn a higher return by being invested in Apple directly instead of through an ETF.
The Apple stock outperformed the market. And if you remember from episode 17 when we talked about ETFs, ETFs aren’t trying to outperform their underlying index. They’re trying to match it.
Now is it super important to outperform the market? In my opinion, when the market is doing well, no not really. What’s the point in competing with other investors? There’s enough pie for everyone.
And trying to outperform something that’s already growing is just wanting more pie. You’re trying to maximise your returns as much as possible, but you’re taking on more risk to do so.
More volatility in individual stocks due to lack of instant diversification
On the flip side of that though, choosing an individual stock over an ETF means that other companies aren’t there to act as a safety net for you if the company you’re invested in isn’t doing well.
You’re not being propped up by other companies if one of your holdings is performing poorly which has the potential for you to make significant losses.
And that possibility to make big gains and make big losses adds a lot of volatility to your portfolio in the short term.
Your portfolio can go up and down, up and down very wildly.
Though with ETFs, because you buy into hundreds of companies at once, you smooth out some of that volatility even if some of the individual companies within the ETF are going up and down.
At a distance they all average each other out and compensate for one another to reduce the wild tummy churning swings.
Now, we know that one of the key thing you need in your investing strategy to tame some of that volatility is diversification.
And diversification is easy when you’re investing in ETFs because a bunch of stocks all come together in a package deal.
By their nature, ETFs offer you exposure to many different companies and industries in just a few trades.
So, when you’re investing in individual companies, a diversification strategy is that much more important.
Now, if you choose to go only with individual stocks and no ETFs in your portfolio, then diversification will be a lot harder.
It’s up to you to pick stocks to invest in and you need to be invested in many companies across different industries or geographical regions, depending on what your personal investing strategy looks like.
Using a satellite portfolio strategy
Another option is using a satellite portfolio structure, which is what I’m considering for my portfolio.
At the moment, I’m exclusively investing my own money in ETFs. But I’m not closed to the idea of investing in a few good individual companies.
However, my investing strategy is to be heavily invested in ETFs with only a few investments in individual companies.
Kind of like satellites orbiting my planet. That’s why it’s called a satellite portfolio.
You have the main bulk of your portfolio invested in ETFs with a few small investments in individual companies.
So, why would I choose a satellite portfolio strategy for myself? Because I get the best of both worlds while minimising my losses and diversifying.
I’m investing in a couple of companies that I’ve researched and I think have good prospects. And when they surge and make bank, so will I.
But I’m also heavily invested in ETFs. Which means that I’m very well diversified and I have the closest thing to a set-it-and-forget-it type investment on the stock exchange.
I may buy and sell my individual company stocks as the situation changes, but I’m planning to hold on to my ETFs for the long term.
Now, do you have to invest in individual stocks? Absolutely not. Researching and analysing individual stocks properly is a lot of work and it’s time consuming.
But it’s still a valid option for you to consider when formulating your own investing strategy.
Not only that, but understanding what makes a stock a good investment choice makes you a better investor. Whether you invest in it or not.
Because the more you understand about how the stock market works, the better.
Analysing company financial statements to pick stocks
So, when you’re considering investing in individual companies, how do you actually go about picking companies to invest in?
You could always listen to market news and recommendations from stock market analysts or Joe Internet.
But I strongly encourage you to do your own research. Girl on FIRE is about taking control and making the best decisions for yourself.
It’s not about blindly following stock tips you hear on the internet or see on Twitter and Instagram. It’s about learning to figure things out for yourself.
There are a few key ways you can research and analyse companies. The main one being financial statement analysis which is what we’re going to cover in this episode and next week as well.
And then there’s non-financial analysis which we’ll talk about in part 4 of this little series.
Okay, so in the next part of this episode, we’re going to talk about analysing a company’s financial statements.
But we’re going to start with the basics, and really dive deep into it next week. I think it’s super important not to just dive straight into financial ratios.
You need to understand what financial statements are and where they come from. And most importantly, if you can trust them.
I think this is an area that a lot of people miss. Even if they try doing their own analysis, they jump straight into trying to calculate things based on numbers they don’t understand or numbers they can’t trust.
And at one point in my career, I was responsible for putting together and checking these financial statements, so I’m pretty comfortable with them.
What are financial statements and where do they come from?
So, to start off, what are financial statements and where do they come from?
Companies have to prepare a set of statements that report on how they performed financially during a certain period of time.
All companies do this monthly for internal purposes. To see how their income is growing and how much they’re spending.
It also shows how their net worth is performing and how much debt they have. And also how much cash they have. Because they need cash to keep the lights on and keep their employees happy.
So, companies do that for their own management purposes every month because it helps them make decisions about how to run the company.
And they also have to do a formal one periodically, which is usually at the end of the financial year.
Those statements are lodged with the regulatory bodies in the countries where a company operates.
And for a listed company, their reports are also made public so that shareholders and any prospective investors can take a look at them.
Remember, a listed company is one that has it’s stock listed on the stock exchange. Which means that the public can buy and sell that company’s stock.
These financial statements are how a company reports it’s financial performance to it’s shareholders, who are the owners of the company.
Listed companies usually report some details every quarter, which is also when they announce a quarterly dividend.
Then they report even more details every half year and then do the full reporting with all the bells and whistles at the end of the financial year.
You’ll often see changes in stock prices whenever those financial reports become available to the public.
Because investors look through them and that changes their investor sentiment, which we talked about in episode 27. And investor sentiment impacts the share price.
Investors either think that company is going to do great and buy up the stock. Or they think the end is nigh and they start selling.
Okay, so there are also regulatory bodies that give companies rules as to how they’re allowed to do their accounting, how they should structure their reports and what they need to report on.
So, when you see a company reporting $1bn of revenue, they arrived at that figure by following the rules that a regulatory body gave them.
These rules are designed to make sure that companies aren’t lying when they report these figures.
And the rules also make sure that all companies that fall under the jurisdiction of that regulatory body are being consistent in their reporting.
So for example, with your budget you might have a category for food expenses. And you might include eating out and coffee runs and groceries, all in that one category, right?
Well, companies have to follow rules that tell them what they can and can’t include, and also when they have to include things based on timing.
Also, those rules are more stringent for listed companies than private companies.
Because investors rely on that information very heavily and that transparency also keeps companies accountable to their investors.
Audited financial statements
Now, you don’t need to worry about the rules. That’s what CA’s like me or CPAs in the US are for. Because all listed companies need to have their financial reports audited.
That means highly trained and educated CA’s or CPAs if you’re in the US are checking those statements and issue a report on whether they’re clean or dirty, so to speak.
We take a companies financial statements and we check if they’re correct. We look for any significant mistakes the company might have made and also for instances of fraud.
Most listed companies are audited by some of the big International audit firms like EY, which is where I used to work, or PwC or KPMG or Deloitte.
And if the auditors say, we didn’t find any errors or any indications of fraud, then you’re good to go.
That’s what I used to do in a previous job at the beginning of my career, which feels like a previous life at this point. And that’s why there’s all these jokes that people in public accounting don’t sleep.
Because when it’s reporting season and all these listed companies are preparing their reports, we really don’t sleep. It’s a nightmare.
This is the job where I once worked 20 hours a day for 10 days straight. That was maybe 6 or 7 years ago now and I still have no idea how I drove home and when I showered.
All I remember is being exhausted and irritable, I was road raging a lot and the work never stopped.
Now, sometimes, we do find mistakes or fraud in a company’s financial reports. That was how I got my job satisfaction back then.
Remember what I told you a long time ago, it wasn’t the cops that got Al Capone, it was an accountant, and they got him on tax evasion.
Finding fraud in a company’s financial statements felt like catching Al Capone.
But when auditors find mistakes or fraud we’ll say, hey, we think there’s stuff wrong with this. There’s either very large or pervasive mistakes or there’s fraud going on. And that means you can’t trust those reports.
Auditors’ reports aren’t an ironclad guarantee
But here’s a super important thing to note. Those auditors’ reports are only saying they didn’t find any issues, not that the issues don’t exist.
It’s kind of like a criminal trial. If someone’s on trial for murder, the evidence needs to prove beyond a reasonable doubt that they did it or they didn’t.
It’s not definitive proof, it’s just beyond a reasonable doubt that they did it or that the evidence doesn’t show that they did it.
That’s why it’s “not guilty “instead of innocent. It’s just saying that the lawyers didn’t find anything that proves that they did it. They’re not saying that they definitively didn’t do it.
The same thing happens when auditors are checking financial reports. We’re saying that we didn’t find any evidence of significant mistakes or any fraud.
We’re not saying it doesn’t exist, we’re saying we didn’t find any evidence of it.
That’s how things like Enron fall through the cracks. The auditors are watchdogs not bloodhounds. They weren’t looking for fraud.
They just didn’t find any evidence to suggest fraud was taking place.
So, super important, if you’re looking at a set of financial reports go and check out the auditors’ report. It should be listed right there on the contents page.
It provides some comfort as to whether the reports are trustworthy or not, but it’s not an ironclad guarantee.
So, what I want to you take away from all that, is that a company’s financial reports are regulated and verified.
Regulations change from region to region
But it’s super important to remember that those regulations change from region to region.
There are international standards which almost all countries adhere to, with a few minor changes for country-specific situations. But US companies have their own set of rules.
So, most non-US companies adhere to an international set of rules and US companies have their own rules.
So, why is it important to know that? It’s important to know that because if you were comparing a US company and an Australian company as investment options, you need to know that their reports are created and audited based on different rules.
Which means that you’re not really comparing apples with apples. Now, it isn’t the end of the world or anything like that.
But It’s something to keep in mind.
How to access financial statements
For listed companies, you should be able to access their financial statements and annual reports from your brokerage account, on the stock exchange website or the company website.
In next weeks’ episode, we’re going to take a deep dive into the types of ratios and calculations you can look at when analysing financial statements.
But this week, I really wanted to start with the basics and talk about what financial statements are, where to find them and what kind of information they provide.
Understanding financial statements
So, what are financial statements? What kind of information do they include? In each set of statements there are 4 main reports and a set of explanatory notes and comments if you want more information.
The first report is the income statement, which can also be called a profit and loss statement.
It shows the income a company made and the expenses that it had throughout the period.
So, you’ll be able to see whether the company is profitable, whether their income is growing and what kinds of expenses they have.
We know that companies pay out dividends from their net profit. If they have the cash available, then a dividend is how companies distribute their profit to shareholders .
So, when you’re looking at the income statement, you can see really quickly whether the company is actually making a profit or not.
Next, we have the balance sheet which shows the company’s assets, what it owns, and its’ liabilities, what it owes. It’s a statement that shows a company’s net worth.
We talked about calculating your net worth back in episode 11 and this is kind of the same thing.
You’ll be able to see what kind of assets a company uses to generate income. And you can see what kind of debt they have.
Then you have the statement of cash flow. This one shows how cash comes in and cash goes out throughout the period.
You’ll be able to see where most of the cash is going and how much cash they have to be able to pay a dividend.
If you remember from episode 25, we were talking about dividends and I said that a company needs cash to be able to physically pay you a dividend.
So, you’ll be able to see on the cash flow statement whether they’ll have the cash available to do that.
The last statement is the statement of equity. For our purposes, that’s not super important.
It shows information about how many shares the company has and how much profit it has sitting in it’s coffers but it’s not the key report in determining a company’s health.
Company finances vs personal finances
Now, with all those reports, you can probably see that a company’s finances is a lot like a person’s finances.
There’s money coming in and money going out. They have income and expenses just like we do.
They use their income to pay their expenses. And with leftover money, they can pay off their debts or buy more income producing assets.
And, just like a person, a company can be earning tons of income but still be making a loss because they have super high expenses.
Or, they can have a high income, have a strong net worth and still be strapped for cash.
This is what I noticed really early on when I was in university getting my degree.
The biggest difference between companies and people is that companies have systems and structures so that decisions aren’t being made out of emotion.
And that realisation is what led me to create my own personal finance and budgeting system all those years ago.
FIRE & investment calculator spreadsheet
Before we move on, I want to ask my Girls on FIRE for a favour. If you’ve listened this far into the episode then you’re probably enjoying it, right?
So, here’s what I’d like you to do next. Pause this episode for a few seconds and head on over to papermoneyco.com/podcastreview.
I want you to leave a rating and review for Girl on FIRE because it helps me provide better content based on what you’re enjoying the most.
It helps other women out in the internet wilderness come and find us as well.
And it’s also a great way to support this show for free, and for that I’d love to send you a little something to say thank you.
So, once you’ve done that, take a screenshot of your submitted review and email it to me at email@example.com.
If you do that, I’ll send you a copy of my FIRE and investment calculator. Which, if I do say so myself, is pretty damn amazing.
It’s how I plan for my early retirement and my wealth. It shows me how my wealth is going to grow, when I can retire and how long my money will last.
And it also has a separate tab that takes Australia’s superannuation into account as well.
And you can use it to analyse companies and different investment options when you’re picking stocks too, which is exactly what we are talking about in this episode.
I’ve never actually seen anything like it before, so it’s pretty special. And I’m currently not offering that spreadsheet anywhere else except to my paid members.
Not in my shop, not to my email list — it’s a ghost. So, this is kind of a money-can’t-buy type deal.
The only way to get your hot little hands on that spreadsheet is by submitting a rating and a review, taking a screenshot and tagging me in it.
That URL again is papermoneyco.com/podcastreview. I’ve made it nice and easy for you.
So, go hit pause and do that right now. It’s okay, I’ll wait.
Okay, that concludes my little ad-break, so let’s get back to it.
What to look for in financial statements
Okay, so in the next part of this episode, let’s talk about what to look for now that you have your hands on these financial statements.
In part 2 and 3 of this series, we’ll talk about ratios and how to calculate them. But there’s still a lot of information you can get just by looking over the statements we just talked about.
Are you investing for growth or dividends?
First and foremost though, you need to know what you’re really looking for. And that’s going to depend on your investing strategy.
Are you looking for growth or dividends? Meaning do you want to increase your wealth by investing in assets generating strong capital gains. Or, do you want to generate an income stream using dividends?
Because depending on what you’re investing for, you’re going to be investing in different kinds of companies.
So, let’s look at this statement by statement. First up, the income statement is going to look very different between growth stock and dividend stock.
The biggest difference is that dividend stock companies are consistently making a profit, while growth stock companies could be making losses.
And I’m not just talking about one bad quarter or year in the middle of a global financial crisis. I’m talking about consistent results here.
Generally, well established and stable companies with healthy cashflow can be relied upon to pay you good dividends. Those are the blue chip companies we talked about in episode 25.
Those are usually companies that are already mature and they’re operating in mature markets. They’re growing slow and steady.
On the other hand though, companies that offer big capital gains are usually less mature or operating in less mature markets.
They’re in that growth phase where there’s a lot of speculation about their prospects and they’re not necessarily making any profit.
Which means that they’re loss making businesses which aren’t paying out dividends. Any spare cash they have is being reinvested in the business.
And they’re still growing. It takes a few years of growth before they’re breaking even and then a few more years before they’re turning a profit.
We can also see this difference between growth stock and dividend stock in the balance sheet, which is a company’s net worth.
Dividend stock companies generally have much cleaner balance sheets. They have a higher amount of assets than liabilities.
Now, it doesn’t mean they have no debts. It just means that they generally have more assets because they’ve already been through that growth phase.
They’ve already taken on the debt to grow the business. And because they’re profitable, future growth can be funded with profits.
Instead of paying you a dividend, they can reinvest that cash back into the business.
These are companies that have had that growth spurt and they’re at cruising altitude now.
Growth stock companies, on the other hand, are more likely to have high amounts of debt. And that’s because their #1 goal is to grow and expand the business.
But they’re not necessarily making a profit yet. So, how do they fund their growth? They take out loans and raise money from investors through issuing shares.
Because growth stock companies are still in that growth phase where they’re not profitable, it also means that they may not have the cash to cover their operating costs.
So, they may also have loans to cover their expenses until they can generate enough income to take care of it themselves.
Because their suppliers and employees still need to get paid. And yes, issuing shares was a way to raise some of that money, but it’s not always the best option.
Cash flow statement
And then, we can also see that playing out in the cash flow statement.
Dividend stock companies will have healthy cash flow because they need cash to physically pay out as a dividend.
So, the business needs to consistently be generating enough cash for them to be able to do that.
But growth stock companies are reinvesting every spare penny they can get their hands on back into the business.
They don’t have cash to pay you a dividend, and that’s not a priority for them right now. Their trying to grow and increase the value of the company.
When they become a mature company with consistent profits and healthy cashflow, then they’ll pay you a dividend. But for now, they don’t have the cash.
So, you can see how financial statements play a big role in determining whether an individual company is a good place for you to invest your hard earned money.
There are different things you need to look out for depending on what you’re investing for and what your investing strategy looks like.
And just at a glance, without doing any calculations you can already tell a lot about a company by looking at it’s financial performance.
I’m always telling you that your budget is like a diary. You can tell a lot about your life by seeing where your money goes. Well, it’s the same thing for a company.
Follow the money and see where it goes. That’s a nice little Hamilton reference there for you.
Next weeks’ episode
And that’s all I have for you Girls on FIRE today!
My challenge for you this week is to head to the stock exchange website, pick a company and take a look at their financial statements. What can you learn about a company by looking at their financial reports?
How do they earn their income? What do they spend it on? Do they look like a growth stock or a dividend stock company? Do they have the cash and profits to pay out dividends or not?
What about the auditor’s report? Did they find anything amiss in those financial statements?
On next weeks’ episode we’re going to take this a step further and look at the different ratios you can calculate from a set of financial statements that tell you even more about a company’s performance.
This is a really important way to analyse a company and assess whether it’s a good enough investment for your investing strategy.
It’s going to be a super interesting episode so you’re definitely not going to want to miss it.