Today’s episode is from the archive, Andrew and I hope you enjoyed your holiday weekend and everyone is safe. Please enjoy this episode redux concerning stock picking and some of the pitfalls to avoid.
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Welcome to the Investing for Beginners Podcast. This is Episode 100 Tonight, Andrew and I are going to talk about stock picking for dummies. So we have some stories we’d like to pass along to you guys, and we have some ideas that might help you along the way with picking out some stocks. So, Andrew, would you like to talk first, or would you like me to talk first?
I think your story is the better one. So maybe it’s such a perfect illustration of how, when you’re picking stocks, it’s really easy to get caught up in the numbers or get caught up in a narrative or get caught up in your biases, tore the stock. And sometimes depending on what price you’re paying with for the stock, it’s creating these expectations that you don’t realize might be unreasonable. So tell your story first.
Okay. All right. We’ll do so. A lot of you know that I have been watching the videos that Professor Aswath Damodaran does on YouTube.
And I’ve been studying valuation with his MBA classes as well as his undergrad classes. And it’s very interesting and very enlightening. And he was telling a story on one of his lectures the other day that I thought was kind of fascinating. And I shared it with Andrew a while ago, and we thought this would be a perfect illustration of what we’re going to talk about tonight. So what the professor related to all of us was that he had a student that part of their project is to do a valuation of a company at the end of the semester. And so one of his students presented his findings at the end of the semester, and everything was really good except for one small detail. So he called the student in and had him come in and talk to him about his, his work and everything.
And the professor went over everything and said, there was a lot of great stuff in there. And he asked him why he chose the company, and the company he chose was Tesla. And so without talking about any of our biases about the stock, the young man said told the professor that he liked Tesla. I thought it was a great company, really like the Elon Musk, and had a lot of respect for him and, and those kinds of things. But the professor was like, you know, okay, great. And he talked about his numbers and all the things. And he asked him if he ever really checked himself for the numbers that he was relaying and his spreadsheets and the students said no why? And he said, well, he said, the valuation you came up with is probably not a horrible one. And he said a lot of the numbers are great.
The growth rates are great. The discount rates are great. He said, there’s one small problem. He said the growth rate that you’ve put on this company to grow for the rest of eternity is a little bit out of line. And he said, and the students said, why? I think it’s a great company. I think it’s going to grow for far into the future. And he said, well, he said, the professor said, well the growth, the growth rate, you assigned it at in 10 years, it’s going to be worth about as much as the GDP of the United States and the student just kind of blinked. And then he said in 20 years; it’s going to be worth the GDP of probably North America. And the students just kind of blinked. And he said in the third year earth, after 30 years, the growth rate is going to make it larger than the GDP of the entire world.
So if you want to buy toothpaste, it’s going to come from Tesla. If you want, car insurance is going to come from Tesla. If you need to go to the doctor, you’re going to have to call Tesla and get an appointment to see a doctor. You said Tesla would govern everything. And he said he looked at the student. He said so the growth rate that you assigned to the company is unrealistic. And I said, I think you meet, I want to go back and check your numbers. And the student was, of course, appropriately chagrin and went back and adjusted his numbers. But I thought that that was kind of a perfect symbolism of when you’re in glove with a company, and you try to rationalize the great things that you expect from the company because you’ve fallen in love with the company. So you’re kind of encompassing all your biases in that one particular example, one particular company. So I thought that was kind of interesting. And Andrew and I thought that that would be a perfect way for us to start.
Yeah, I think it’s, it’s, it’s great because depending on where stocks are priced, that generally tells you how much wall street expects a certain company to grow. So, Peter Lynch, we mentioned him last week. He’s a, you know, one of the best fund managers Fidelity’s ever had and one of the best fund managers we’ve ever seen just in general. And he’s written a couple of great books that are great reads, really good for beginners. And one of the concepts that he talks about frequently is the peg ratio. So, you know, the price-earnings ratio is a ratio that can relate how much a company is earning versus how much it’s priced. So if the price-earnings ratio is high, that means the stock is very expensive compared to how much it’s earning and vice versa. So he relates this PE ratio to the growth rate.
And so basically he tries to look for a company that has a peg greater than one. And so the thought process is if the company is growing more than its price-earnings ratio, then that’s a good thing. And if it’s growing less than this price to earnings ratio, then it’s not very likely that you’re going to get good returns off of it. So just to give an example here, I pulled up a spreadsheet. So let’s say we have a company that’s growing earnings at 15%, and let’s say, it’s also priced at a price to earnings of 15. So that would be a price, a peg of around, or, in this case, it would be one. So for basically what, that’s pricing in. So if you were to take earnings and grow them for 15 years, I’m sorry, for 15% year after year after year, it would take nine years for all of those earnings to catch up to the price.
So, as an example, let’s say the stock market cap was $1,500. And if the earnings were at a hundred, that would be a price to earnings of 15. So if those earnings grow 15%, you know, the next year they’re at 115, then they go to the one 32, it compounds from there. By the time you get to the ninth year, earnings will be at about three Oh five, which is three times more than where they started nine years ago. So that’s, that’s a pretty good deal. And it’s at that price where you have a breakeven. So if you were to add up all the earnings until that ninth year, then you’d get around $1,500, which is the price you paid originally. Now, of course, as investors, we don’t have, you know, you don’t get all the earnings paid to you. Our company, its user needs to grow the business and, and make those profits grow for shareholders.
And they do things like share buybacks and things like that, but it kind of illustrates. Okay. So as a typical example, if a stock has a PE and their growth rates about the same, it still takes nine years until that investment, that price you paid for, it pays off in earnings over the life of that investment. To me, that sounds like a long time; nine years sounds pretty long. Now, if you imagine the discrepancy when the price of earnings is at 30 or 50 or 100, you know, I could bore you with the numbers I’m going to choose not to this time. It’s, it’s way, way worse. And so, you know, when you’re talking about a basic valuation, something like Tesla or some other company where the price-earnings ratio is so high, they need to have that, that much growth for these investments to pan out.
And, and, you know, you, you do see the price, earnings ratios stay very high for very long periods. But eventually, if that growth isn’t keeping up with the high evaluations, you know, you hear all the success stories, you don’t hear the failure stories. And so these growth types of investments work great until they don’t. And so you’ll see them at the end of really long bull markets, like the.com bubble, where all these huge PEs were the ones who got crushed the most, and that’s happened time and time again. So my kind of example of trying to take some common sense and use that in a stock-picking approach. It’s not as, like the gray of an example, I would say, but it’s something recently that I’ve taken into consideration. So, you know, I read in a book recently where they talked about basically how much a company has grown up to now, doesn’t correlate with how much it’s going to grow in the future.
So, you know, it’s, it’s nice. And I think it makes sense in general, to try to find companies that have grown in the past, and you hope that growth continues, but it’s never a guarantee. And if you ask anybody who’s been in the market longer than let’s say four or five years, they’ll tell you that. Yeah. Like many companies that continue their high growth rates, a lot of them don’t. And so, you know, I think it helps too when you’re looking at a stock, and you’re looking at its history, you can look and see what it’s done so far, but it also makes sense to look at what’s the future possibly hold. So I don’t want to single out this company because I think it’s a great company and it’s a smaller company. I think it could maybe be a great investment, but, you know, I’m pretty picky.
And so it’s not something that I’m leaning towards anymore, but, what they manufacturers, they manufacture snow equipment. And so they’re doing a very good job of sticking to their niche. You can’t sell snow equipment in Hawaii. That’s not going to really work out too well. So they have their area of the Northeast in the United States where they sell an overwhelming majority of their, of their products, you know, that snowbell up there. And I think they do a little bit in Canada too, but, you know, that’s, that’s where they get the principal, majority of their revenues. And so I liked a lot of things about this company over the past ten years, it’s grown revenue close to double digits, pretty, you know, if you average it out year after year after year, it’s getting close to 10 digits grow, double-digit growth for revenue earnings.
It’s done even better. It’s, it’s over double-digit growth, for earnings per share. And, you know, they claim to be the number one in their market, which is all good things, all things you’d like to hear. There’s been a growing dividend for many years, and you know, the top of all of the price-earnings is decent. The price of books, reasonable prices, sales, decent things look good, and they have a lot of free cash flow. However, if you think about what the future of the Northeast holds, and then you look at some other interesting data. So something that I wanted to look at was population trends. You know, something as simple as, you know, if a state is growing, then I think that’s a good place for investment. And if it’s not, then it’s probably not. So I went and, you know, Wikipedia has a great little chart where they bring to the States, and they showed the percentage of growth and everything.
And so they took from 2010, 2019. And you know, some of the biggest States with growth were Texas, Florida, California is not as hot as it probably was in the nineties, but it’s still got decent growth. And as I looked at all of the different population, growth trends, you know, it seemed everybody was moving West or extremely South with Texas and Florida. And the bottom 10 when it came to population trends were all almost, almost all in the Northeast of the United States—so looking at a company where snow equipment doesn’t have much of a growth potential kind of as it is because you’re not going to increase more demand unless you can somehow make it snow more. It’s a; it’s a pretty consistent kind of thing. You would probably look at it as a more defensive type of investment. But when you’re looking at something five years, ten years out, you want to try to put everything and kind of ride all, all these waves congruently. If you can find as many good trends and ride on top of those. And so, you know, I look at a situation like that, and the population demographics don’t look great. And so it’s hard to imagine. I mean, yes, there will be hope, you know, you would hope to see GDP growth, population growth. But if, if it’s lagging some of the other parts of the country and the country population growth
It is already showing that it’s just in my mind, you know, if if you have an industry that’s just not going to grow sure you can grow your earnings and your revenues by taking market share. But eventually, once you’ve taken all the market share, if there’s no more growth in that market, then your options for growing the company as a whole are limited. So, you know, when it comes to this particular investment, I could be completely wrong. They could have plenty of market share they still take. And, you know, I hope they do very, very well, but it’s just one of those examples where I think you can look at a company. I got super excited about this one, but I think if you look at a company and you try to put it where your goals are. So for me, I want something five, 10, 15 years. I feel good about holding. And you know, if it’s, if it’s not, if it’s, if it doesn’t sound as great of an investment, because there are huge factors that are kind of out of their control, then maybe you’re best served looking elsewhere.
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I love that idea Of looking at, beyond just the numbers and what the company is doing, but thinking about the population trends in the area and thinking about in essence, their, their niche, and how they operate within that niche. That’s a that was kind of brilliant. I’m I’m impressed. That was, that was a that’s a great example. And I got 1 million ideas per month. That’s more than most of us, so that’s good. So I guess something that I guess I would like to share as far as, when you’re thinking about picking stocks and some of the examples that Andrew was, was sharing with those four great ones. I think along the same lines of what I was talking about when you’re thinking about weighing out any sort of numbers and spreadsheet and trying to anticipate where you think the company is going some great anchoring tips, if you will, is looking at how other companies have done in your industry.
So, for example, if you’re looking at somebody like, I don’t know, Verizon, and you want to see their revenue grow by 10% over the next ten years, first, you have to think about, have they done it in the past? And if they have, okay, then it’s possible that they could do this again. But then you often also have to extrapolate and think in their industry, how many more people can they get to get a new phone or to sign up with service for them is their service that much better than AT&T, T-mobile, and anybody that’s out there. And if it is, then there’s a possibility that they can do some of those things, or they can do things like Andrew was referring to and take market share away from somebody like at and T. Now that’s a very competitive market. It’s a very competitive field that they’re in.
So you have to ask yourself, are those things logical? And I’m not trying to be Debbie downer and Mr negative. But when we’re thinking about putting our money out there as an investment, we have to sometimes think beyond just the numbers of the company and seeing that, Hey, the PE ratio is great and the price to book is great. And the revenue growth is great. And they’ve got all this free cash flow, and all these things are fantastic, and the price is going up, or maybe it’s kind of flat and you think it should go up. Those are all things to take into consideration obviously, but you also have to think about what are the business prospects for this company beyond when I lay my money into the market to borrow, for example, where do I think it’s going to be in 10 years? And where do I think it’s going to be in 20 years?
And is that company, do I, do I envision that that company is still going to be here at that time. And those are all things that you have to take into consideration and thinking about the market cap of the company; it’s this big now, can I logically grow to 10, 10 to 15, 20% more kind of like with the example I was explaining before, we’re at a certain point, it grows so much that it can’t grow any faster. And the law of economics says that at some point, the company can’t grow faster or bigger than the economy that it operates in because then by logic, it has to become the economy. Now, some could argue that Amazon will become the economy of the United States at some point, and you know, who knows, but at some point logically, something like that has to stop.
And I’m not trying to, again, I’m not trying to be negative. Still, you just, you have to think about some of those things and try to make sure that you put all those reasons in comparison to what is what you see going on and how logical you think that is—so doing some of the things that like Andrew was doing, going beyond just looking at the numbers of the company, looking at industry averages, looking at other companies in the industry. One of the things that I love about Warren Buffet is because he is so well-read, he’s become a walking encyclopedia, and he knows everything that he needs to know about this company, that company, this company, that company, so that when he’s presented with an opportunity to buy something, he instantly knows because of his experience and because of his knowledge, how that company stacks up against his competitors.
And let’s not kid ourselves when we’re buying a company. And when we’re buying a stock, we’re buying a company, and we’re buying that company. It’s competing against other companies for money. Whether it’s a restaurant, whether it’s a cell phone, whether it pans out, it doesn’t matter what it is. They’re all competing against somebody else. They’re very rare cases as they’re going to be somebody that got the complete market leader and has zero competition, it just really doesn’t happen. And generally, the better something does, the more competition is attracted to that because people want to try to take a piece of that pie. And so when we’re, when we’re sitting down and picking through stocks and as part of your checklist, one of the things that you should put on there, I encourage you to do this is to think like Warren Buffett doesn’t and research the other companies and understand how those other companies balance out with the competitor.
So, for example, I’ve, I’m trying to learn more about the telecom business. And so I’m reading annual reports for Verizon for at and T and for T-Mobile and then another sort of businesses that are associated with those so that I can try to learn as much about the industry as I possibly can so that if I ever decide to make it an investment in those industries, I have some sort of basis of knowledge. I’m not just picking at and T because it’s the shiny thing. I’m trying to make a, I guess, an informed decision and part of making that informed decision is having the knowledge, but also trying to ask those questions is this logical, is this reasonable? Do I, is this something that I think they can achieve? Or is it in an industry that’s older and it’s been around for a while and to expect Walmart to grow at 27%, Amazon has been, is probably unrealistic. So those are all questions that you need to ask yourself when you’re thinking about these things.
Yeah. I love the idea of reading the annual reports of competitors. I’ve noticed that some companies will be more Frank about, Hey, here’s a list of all of our competitors and others will just be like, yeah, you know, we’re in a competitive industry. And so sometimes it is kind of like putting pieces together in a puzzle. If you’re trying to get a complete industry picture, sometimes earnings reports like the presentations that can come with earnings calls, where they’ll have the slides and kind of layout the industry that can give you some clarity a little bit, depending, depending on the company. So, you know, it makes it tough because the financial data is nice. We have, at least in the States, we have the sec, which mandates everybody’s 10 Ks need to all report the same financials. There’s, there are different parts of that that companies can interpret and maybe focus more on Disclose some of this disclose some of that,
But there is a standard where everybody has to report, at least These numbers, earnings, revenues, assets, liabilities. When it comes to gathering kind of big picture data, common sense data industry data, there is not a uniform standard for that. And so sometimes you do have to kind of do a little bit of Sherlock homie, and then really just find information as you can. And I would say, you know, in the scale of like importance, Oh though maybe I shouldn’t make a judgment like that, but you know, it is, I think it is important to bring some common sense to the numbers. Warren Buffett talks about how just to have a circle of competence and to know it very well. It’s great to hear him talk about his Coca-Cola investment because he just makes it sound so simple. And I guess in a way it kind of is, you know, he says it’s the most popular drink in the world for the longest time people associated a cheeseburger and a Coke.
And those were like, just like a one, two combos. It was like a cheeseburger Coke and good times. And then, you know, I was watching this documentary on Netflix, it’s called history one Oh one. And they talked about the very first episode was talking about fast food in the United States. And they talked about how McDonald’s was United States’ major export through the eighties and nineties. And, you know, probably the decade after that, to what, so the is pretty much every McDonald’s, and you can find that was Coca-Cola. So it was interesting for me to see how first off, I guess, the other countries got excited for McDonald’s like they, they looked at it the same way. I would look at all. You can eat Brazilian steakhouse kind of mail, but it was a major export. And there was a huge, huge win for, for, you know, not only McDonald’s, but Coca-Cola, and some of the other restaurants that I followed suit from that.
And when Buffett talks about that, he talks about Coke. He talks about how it brings that emotional attachment. And he also talked about very simply he, he said, you know, I don’t know what the number was, but he said something like 20 billion let’s, let’s, let’s call it 20 billion Cokes are sold throughout the world. And so I don’t know if he said like per day, per week, whatever it was. And then, so he said, even if you raise the price of a Coke by a penny, that’s still, you know, however, many 50 million, 50 billion, whatever the number comes out to. So, you know, he, he knew those numbers very easily. They weren’t super hard numbers to comprehend. He’s just stating the facts. Coca Cola is, is one of, you know, was one of America’s most favorite drinks, and it sold a lot of it. And so they had a lot of pricing power because they were a leader.
And then they had a lot of kind of wiggle room to work with. They had lower costs through having bottlers do all the manufacturing and, and they just had a lot of competitive advantages. You could see very easily how they can increase profits just through their sheer size and from the loyalty of the brand. So, you know if investing was a hundred percent that easy, we would all be billionaires because we could just kind of look around us and see the things that we like and invest in those. It’s not that simple because I guess a lot of wall street seems to price things that way. Anyways, if you look at some of the most expensive stocks right now, you know, the Fang stocks, those are all products and services that most, everybody uses pretty much every day, but that’s not to say that stocks like that won’t become cheap one day.
And so it’s really about keeping your eye out, knowing where you want, you know, what price is, is a good price for you. So that’s where the financials come in and, and, you know, knowing how much you want to pay for earnings, knowing how much you want to pay for sales, having an idea of what that range looks like. And then once a company is there, then, you know, what’s the, what’s the longterm narrative here? What, what, what are the chances that they can continue to grow if they’ve grown already? And, you know, does that sound like a practical idea? And I think combining those two, I think amazingly isn’t done enough. I think kind of talked before how people kind of fall into two camps, but there can just be a lot of opportunity with that. And hopefully, our discussion has inspired at least one, maybe one kind of extra step for somebody who’s out there doing some research. We have Google these days. So there’s no excuse for getting data and information. And so it’s really up to us if we want to take on that kind of journey and try to be a little bit creative, be a little bit intuitive and try to find the right balance.
All right, folks, we’ll that is going to wrap up our discussion for this evening. Thank you, guys, for taking the time to listen. I hope you enjoyed our conversation about stock-picking for dummies, and You guys will find a few nuggets in there that can help you guys along your way. Go ahead and sign us off—emphasis on the safety. Have a great week, and we’ll talk to you all next week.
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