Think Like a Stock Analyst

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Thinking like a stock analyst can help because it provides some organized ways in which to observe the world. We all have analyticl skills but the degree to which these skills are developed depends on the individual. Honing your analytical skills will help you organize some of the information that overwhelms you each day.

For example, its hard not to notice how fast food joints are clustered together. Maybe this is an obvious question, but why is that? But why do all of the fast food joints locate near each other when there are other alternatives available? After all what good does it do for all of these restaurants to be located near each other? What happens to McDonald's if Wendy's is right next door?

The answer to these questions for restaurants, and any other business, can be found by asking four general questions to kickstart the stock analyst thought process:

1. What is the goal of the business? 2. How does the business make money? 3. How well is the business actually doing? 4. How well is the business positioned relative to its competitors?

Once you start thinking in these terms, and hone your analytical skills, you will be well on your way to thinking like a stock analyst, constantly on the hunt for investment opportunities.

For example, the goal of restaurants is to feed customers. That is a pretty straightforward business, but just don't assume a business's purpose is obvious. Be sure you have a good idea of what it is really trying to achieve. Then ask does it really make sense for a business to try to achieve this objective. For example, does it really makes sesnse for a restaurant to try to entertain customers?

Once you have a good idea of what the business is trying to do, then think about how it makes money. How much does the food in the restaurant actually costs? Does the restaurant have a pleasent ambience? Is the restaurant trying to sell a lot of meals at a cheap price or is it trying to sell fewer meals at a much higher profit per meal?

Then ask yourself "how well is the business doing?" Don't worry about any financial statements just yet; concentrate on what you observe about the business. Think about where you eat. Has your favorite place been around a long time? Are there lots of locations for your favorite restaurant? Are they busy with people in line or in the parking lot? Are they in good locations? Do they seem to get a lot of repeat business? Do they seem to have a better caliber of wait staff? How fancy are the interiors? As a potential investor in this or similar business, all of this stuff counts.

When you have a pretty good uderstanding of this business and its performance, the measure it realative to its industry. In other words, assess the competition.

Is there a lot of competition in this industry? With restaurants, there seems to be a lot of choices. What about a different industry, let's say the computer industry. Are there as many types of computer companies as there are restaurants? Not by a long shot. Does that mean that the computer industry is not as competitive as the restaurant industry? Not necessarily. Instead it might mean the competition functions very differently. Since it takes a ton of money to start up a computer company, and it takes very little money to start up a restaurant, maybe there is more risk in computer manufacturing? Maybe finding new products is more difficult? Maybe the only way to compete is on price? Asking these types of questions gives you and idea of how well a specefic business is positioned to cope with the challenges it may encounter.

If we think back to our four questions we metioned earlier, we should be able to get a good handle on a business's goals and on its performance just by reading about it and studying its financail statements. Its really the last question where we might need some more help.

As we have already seen, it is important to think outside of the numbers. In your quest to find outstanding companies, you must put forth an extra amount of effort to find that "Holy Grail."

One very helpful concept is "economic moat". Economic moat is a long term competitive advantage that allows a company to earn oversized profits over the long term. Companies that reward investors over the long term have a durable competitive advantage. Assessing that advantage involves understanding what kind of defense or competitive barrier a company has been able to build for itself in its industry.

Economic moats are very important from an investment standpoint because whenever a company develops a useful product or service, it is not long before the competition develops a similar or better product or service. Basic economic theory says competition will eat up any excess profits earned by a successful business. In other words, competition makes it difficult for a company to generate strong growth and profits over a long period of time since any advantage is at risk of imitation.

The strength and sustainability of a company's economic moat will determine whether the firm will be able to take away business and eat away at its profits. Companies with wide economic moats are better positioned to keep competitors at bay over the long term.

To determine whether or not a company has an economic moat, follow these steps:

1. Evaluate the firm's historical profitability. Has the firm been able to generate a solid return on assets and stockholder's equity? This is probably the most imporotant step in idetifying whether or not a firm has an economic moat. While much of assessing a moat is qualitive, the bedrock of analzing a company still relies on solid financial metrics.

2. Assuming the firm is profitable and has solid returns, try to idetify the source of those profits. Is the source an advantage that only this company has, or is it one that other companies can easily imitate? The harder it is for a competitor to imitate the advantage, then more than likely the company has a barrier and therfore a source of economic profit.

3. Estimate how long a company will be able to keep competitors at bay. This is the company's competitive advantage period, it can be as short as several months or as long as several decacdes. The longer the competitive advantage period, the larger the economic moat.

4. Think about the industry's competitive structure. Does the industry have many profitable firms or are the firms in the industry scrapping for the last dollars? Highly competitive indusries will offer less attractive profit growth over the long haul.

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