10 Things To Look For When Buying A Stock By Mark Riddix

#1: A Wide Economic Moat

Investing in the stock market can be a confusing journey. People often wonder what to look for when buying a stock. Over the course reading this e-book, you will learn all of the components of investing. Warren Buffett absolutely loves companies with wide moats. What is a moat? If you have ever seen a movie set during medieval times then you have probably seen a moat. Moats are those giant ditches filled with water that surround a castle. Drawbridges would have to be lowered so that visitors and entrants could cross over the moat. Moats are the first line of defense. They are great for protecting castles from enemy attacks. Economic Moats An economic moat works exactly the same way. It is a defensive component. Economic moats are major competitive advantages that protect companies from competitors and potential competitors. Companies with wide economic moats have a better chance of long term survival. Economic moats help to protect revenue streams, profitability, and market share. Always invest in companies with wide economic moats that are sustainable for a long period of time. Types of Economic Moats Strong Brand Name A strong brand name is an example of an economic moat. You cannot put a price on brand name recognition. The names Nikes, Coca Cola, and McDonalds are worth billions of dollars to each of these companies. Customers will often by these products on brand name recognition alone. It may take new entrant years to build up a name that can compete against these corporate juggernauts. Large Capital Requirements A large capital requirement can also be an economic moat for a company. Have you ever wondered why there are so few companies in the telecommunications industry? It is because the industry is extremely capital intensive. There are huge upfront costs that keep new companies from competing against companies like Verizon and AT&T. It costs millions of dollars to establish networks, attract customers, and become a legitimate player in the telecommunications market. High Customer Switching Costs

High switching costs may not be good for customers but they are great for companies. High switching costs act as a deterrent to switching providers. It is more likely that a customer will stick with a particular brand or service if switching providers would cost a significant amount of money, time, and energy. This is exactly why cable companies and cell phone companies charge cancellation fees to customers. Businesses will often remain clients of device makers and document storage firms due to the high switching costs. Intellectual Property Patents, copyrights, and trademarks can guarantee a companys revenue stream for years into the future. Drug makers rely on patents to protect their creations and keep clients from selling similar products until expiration. Copyrights can help boost the revenue streams of movie studios, music labels, and book publishers. A trademark gives a company a way to distinguish itself from its competitors. Final Thoughts These are just a few of the types of economic moats that exist. A business model, unique product, and pricing structure can all be economic moats for a company. Be sure to distinguish companies with true economic moats from companies with fake economic moats. For example, a company like CVS may appear to have a wide economic moat because you recognize the name but truly it does not. There is nothing that differentiates a company like CVS from Walgreens, Rite Aid, or Albertsons. Picking the winner in the competitive drugstore industry can be like throwing darts at a dartboard. A lack of an economic moat is the reason that I sold Gamestop back in 2008. Ask yourself the following questions before investing. - Does this company have an economic moat? - Is the companys moat wide, narrow, or non existent? - What is this companys competitive advantage? - Is there a competitor that is rapidly taking market share from the company? - Can this competitive advantage sustain the company over the next 10 to 20 years?

#2: Easy To Understand How They Make Money

Warren Buffett loves to invest in companies with an easy to understand business model. He often jokes about the fact that he isnt smart enough to understand the business models of many companies. Buffetts three largest investments are Coca Cola, Wells Fargo, and American Express. He shies away from many technology companies with complicated business models. If the worlds greatest investor avoids companies that are too complex to understand them so should you. You should only invest in businesses in which you can quickly identify exactly how they make money. Take Best Buy and Walmart for example. Its very easy to see how both companies generate revenue. These large retailers have a simple and straightforward business model. They make money by buying products at a lower price and selling them to consumers at a higher price. Investors can easily judge their results by looking at the companies margins and same store sales(comps). Complicated Business Models Conversely, General Electric participated in so many different business segments that it became increasingly difficult to understand how the company actually made money. The companys financing arm GE Capital became a larger component of GE than its industrial division. It took a decade but the company is finally selling off many of its divisions and getting back to basics. A company should derive the bulk of its revenue from its main business. Area of Expertise Always stick to your area of expertise. If you understand how a company makes its money then you can be on the lookout for future growth opportunities. It also helps you to watch out for future impediments to growth. I always use my investing experience with Krispy Kreme as an example of investing in an area that I did not understand. I thought the company was a good buy because of its doughnuts and did not look at the companys business model. The companys same store sales were horrible and they only made money by getting royalty fees from new store owners. Once Krispy Kreme stopped opening new stores, the companys sales plummeted. If you cannot understand the business model then you will not be able to recognize if a companys stock is a good or bad investment. Companies with extremely complex business models may actually represent a good

investment opportunity but I would rather not take the chance. Its easier to just invest in businesses that you understand.

#3: No False Profits

You never want to invest in any stock that does not have this component. It is absolutely the number 1 thing to look for when investing. Buffett himself considers this component essential to his investing strategy. So, what is number 3 on our list of the 10 Things To Look For When Buying A Stock? The answer is earnings, earnings, earnings. A lot of factors may impact a stocks market price but nothing has the effect on a stocks price like earnings. Wall Street firms, mutual fund companies, and ordinary investors are all looking for the next great growth story. Stocks with earnings growth have absolutely no problem attracting money from potential investors. Companies like Apple (AAPL), Amazon (AMZN), and Netflix (NFLX) are the darlings of Wall Street because of their strong earnings. It doesnt matter what a companys management says, the earnings report tells the story. Companies can inflate net income by cutting expenses but they can not fake top line revenue growth. If a companys revenue is dropping, the demand for the companys products may be falling. Dell (DELL) is a perfect example where the company has seen revenues dip for three straight years. So, how can you measure a companys earnings? Start with the income statement. Earnings in their simplest form are revenue minus expenses. Look for companies that have been able to increase revenue and net income for at least five consecutive years. Five to ten years of net income growth shows earnings stability. One bad year of earnings over a 5 to 10 year history is likely an outlier whereas 3 or 4 bad earnings years demonstrate a trend. Quarterly earnings and annual reports are a great way to gauge a companys earnings progress. Next, take a look at a companys earnings per share (EPS). Earnings per share is your share of a companys profit. Every share that you own is equivalent to that share of the companys profits. Find companys that are growing earnings above the industry average. For example, Apple has done an excellent job of crushing industry averages. Conversely, Dell has failed to meet the industry average. The company is projected to grow earnings at a 7% clip over the next five years whereas the industry average is twice that at 14%. The key to investing is to try to find great growth stories early. These are the companies that Peter Lynch referred to as multibaggers. Companies that have the potential to see their earnings double or triple over the next

few years. If you can find these companies early, you will be smiling all the way to the bank. Would you ever invest in a company with negative earnings?

#4: A Strong Captain At The Helm

The sports playing field is very relatable to the business world. A basketball team is only as good as the point guard running the show. Look how bad the Hornets were last season without Chris Paul. A football team is only as good as its starting quarterback. Think of the Colts without Peyton Manning. Likewise, a company is only as strong as the management team that guides it. Warren Buffett always believed that you can tell a lot about a company by looking at the members of the management team. Great leaders like Steve Jobs at Apple (AAPL) and Jack Welch at General Electric (GE) can take a company to heights that were previously unknown. Great CEOs can end up becoming icons whose careful stewardship makes money for all involved. Worst CEOs Poor CEOs can have the opposite effect and turn a blue chip company into a dog of the Dow. Stay away from companies with management teams that are solely focused on quarterly earnings. These management teams are short sighted and may take extreme risk just to beat quarterly expectations. They are more motivated by their own bonuses and stock options than making sure that the company is in good financial shape. If you want to know exactly how a CEO can destroy a company, see Angelo Mozilo of Countrywide, Kenneth Lay of Enron and Bernard Ebbers of Worldcom. These men singlehandedly ran their companies into the ground and put their own self interests ahead of the companys. These CEOs made a fortune despite their companies being dogs. Here are 4 things that you should look for when evaluating a management team. 1. Invest in companies that have a strong management team that is devoted to creating value for shareholders. I like to invest in companies that are focused on growing earnings over the next decade or two. One of my favorite CEOs is Jim Sinegal of Costco. He has done a great job promoting the Costco brand and delivering value to shareholders. He is the rare customer friendly CEO and has helped Costco deliver an impressive 88% return (excluding dividends) to shareholders.

2. Invest in companies with an honest, accountable management team. You want company management to tell you the truth when they have a bad quarter. I like executives that admit that they just plain blew it last quarter and will focus on improving results next quarter. Watch out for CEOs that make a bunch of excuses and blame things like cyclical trends or the weather for their porous results. Companies with accounting scandals who fudge their numbers are a no-no. 3. Invest in companies with CEOs whose pay matches their performance. CEO pay has been a hot topic over the past two years. Corporate executives have been in the crosshairs due to their lofty salaries. I have no issue with company management teams making millions of dollars annually as long as their performance merits it. CEOs like Reed Hastings of Netflix (NFLX) and Jeff Bezos of Amazon (AMZN) have done a great job of growing their companys market share and deserve every dime that they have coming to them. Avoid management teams that are just about bankrupting the company with extremely high salaries despite the poor performance of the stock. There are too many CEOs that treat the companys bank account as if it were their own piggybank. 4. Invest in companies that outperform their competitors. Stats do matter when investing. Find companies whose management metrics are better than their peers. A good place to start is by looking at ROE and ROA. Return on equity (ROE) measures the rate of return on capital provided by shareholders. Basically it demonstrates how effectively company management is using your money. Return on assets (ROA) is another useful metric because it judges how efficiently a company is managing its assets. Other useful statistics are return on investment (ROI) and return on invested capital (ROIC). What CEOs do you think have done a great job of managing their companies?

#5: Little To No Debt

Debt can not only sink the finances of an individual but can sink a corporation as well. Washington Mutual, General Motors, Blockbuster, Kmart, and Lehman Brothers were all forced to file bankruptcy because of too much debt. What do Apple (AAPL), Research in Motion (RIMM), and Buffalo Wild Wings (BWLD) have in common? All of these companies have no debt on their balance sheets. Warren Buffett loves investing in companies that have little to no debt. Buffett favors companies whose ability to generate cash dwarfs their outstanding debt. Why does debt matter? Debt matters because it can reduce shareholder returns and deplete the cash reserves of a company. Also, you can get a good snapshot of a company by looking at the amount of debt on the balance sheet. Cash Flow to Debt Ratio Compare the total debt to the cash flows that are generated by the company. This is known as the cash flow to debt ratio. Its expressed in the formula below. Cash Flow to Debt Ratio = Operating Cash Flow/Total Debt The higher the percentage is, the more likely it is that a company can make its debt payments. A high cash flow to debt ratio decreases the risk of a company defaulting on bond and loan payments. Debt to Equity Ratio Another way to judge a companys level of indebtedness is by looking at its debt to equity ratio. This ratio helps you identify exactly how much leverage a company is relying upon. The formula is as follows. Debt to Equity Ratio = Total Liabilities/Shareholders Equity

A high debt to equity ratio illustrates that a company is relying heavily on debt to finance growth. Companies with high debt to equity ratios are more likely to fall prey to financial difficulties and bankruptcy. That is because they may find it difficult to service their debt load during economic slowdowns.

Follow Buffetts lead Look for companies that have a debt to equity ratio below 0.50. Buffett is even more conservative preferring to invest in companies that have a debt to equity ratio that is below 0.30. Buffett likes to see companies that can grow earning using equity and not large amounts of debt. Its important to note that some industries require using debt to finance expansion because they are very capital intensive. In these situations look for companies whose debt ratios are lower than competitors. You have to be careful about investing in companies whose debt to equity ratio is much higher than industry peers.

#6: Manage Your Money Well

Return on equity is important because it helps you to see how effectively a company is using your investment. Return on Equity measures how fast a company can grow earnings. This is the amount of net income that is returned as a percentage of shareholders equity. ROE measures the rate of return on your ownership interest. The formula for Return on Equity is expressed as follows: Return on Equity = Net Income/Shareholders Equity This is a useful metric for comparing the profitability of one company to another. Buffett looks for companies whose return on equity percentage is greater than that of its competitors. For example, Buffett has been a long time shareholder of Coca Cola Inc. (NYSE: KO). One of the things that Buffett has loved about Coca Cola is the companys high return on earnings. Coke has a 29% return on earnings which is significantly higher than most industry competitors. The minimum ROE that Buffett likes to see in a stock is 15%. While ROE is an important statistic, it should not be used by itself. Companies with large amounts of debt can have above average ROEs because of their use of leverage. For example, banks were able to generate high ROEs by loading their balance sheets up with debt instruments. It is best to avoid these risky type of investments with high ROEs and high debt ratios. Companies with low debt levels and high returns on equity are often the perfect combination for value investors. Here are 5 companies in distinctly different industries with above average ROEs: Netflix (NASDAQ: NFLX) Colgate Palmolive (NYSE: CL) Campbell Soup (NYSE: CPB) Starbucks (NASDAQ: SBUX) 3M (NYSE: MMM)

#7: Generate High Profit Margins

Everyone knows that a stocks price is often based upon a companys earnings. While earnings are important, they are not the sole factor to look at in valuing a company. There are other factors that you have to take into account before investing. Buffett loves companies that are able to consistently generate high profit margins. Profit margin is a simply a measure of a companys profitability. Profit margin will tell you how much net income a company has for every dollar of sales. This is how much money a company is actually able to hold onto. The formula is expressed as follows: Profit Margin = Net Income/Revenue The higher a companys profit margin, the higher the margin of safety. A company with a high profit margin is doing a good job of controlling costs and is typically in better shape than a company that has lower margins. Its important to note that you should only compare profit margins of companies that participate in the same operating sectors. For example it would be useless to compare the margins of Kroger to Apple. Grocery store chains have very slim profit margins and rely heavily upon operating efficiency. Technology companies have much higher profit margins due to greater pricing power. Look for companies that have profit margins that are higher than industry peers. You want to invest in companies with profit margins that are either increasing or stable. Declining profit margins are a sign of potential trouble. An earnings increase does not mean much unless profit margins are rising as well.

#8: Attractively Priced

Warren Buffett is a big believer of investing in companies with consistent operating results. You wont find Buffett chasing after many startups and new IPOs. Buffett likes to see 5 years or more of consecutive earnings growth and strong cash flow growth. Lets take a look at three stats that Buffett finds useful for valuing stocks. He values stocks based on their book value, price to sales and price to cash flow. Book Value Value investors know all about book value. Book Value is the value of an asset on a balance sheet. It is the difference between total assets minus total liabilities, preferred stock, and goodwill. This is a useful statistic because it tells you exactly what a companys shares are worth. This is the amount of money that you would receive for your stock if the company were sold or liquidated. Buffett never likes to pay more than 1.5 times tangible book value. Price To Sales Ratio The price to sales ratio is as simple as it sounds. It is simply a stocks price divided by its sales. The lower the price to sales ratio is the better for a value investor. Buffett likes to see a price to sales ratio less than 2. This means that an investor is only paying $2 for every $1 dollar of sales. The ideal situation would be to find a company trading at a 1 to 1 basis. This would mean that you are only paying $1 for every dollar of sales. Price To Cash Flow Ratio Buffett also relies on the price to cash flow ratio. Price to cash flow is a good gauge for judging the future health of a company. Price to cash flow ratios can differ significantly depending upon the industry that a company operates in. Generally speaking, Buffett looks for a price to cash flow that is under 12. The lower a companys price to cash flow ratio compared with its competitors, the more likely that the firm may be undervalued. This may explain why Buffett is such a big buyer of insurance companies. He loves the huge float because it costs him practically nothing and he uses the cash to generate significant investment income.

#9: Put Safety First

Value investors like Benjamin Graham and David Dodd invented the phrase margin of safety. Those value investing masters classified a stocks margin of safety as the difference between a stocks market price and its true value. Value investors like Warren Buffett love to buy stocks that are selling at a discount to their true value. How do you find a stocks true value? A stocks true value is based on a number of factors including current earnings, cash flows, earnings potential, P/E ratio, and more. Investing in stocks with a margin of safety gives an investor the ability to survive market corrections and short sales. If a stock has no margin of safety then you allow yourself no room for error. You could lose a sizeable sum by chasing a stock trading over its true value. Every investor should aim to only buy shares of a stock when it is trading below its true intrinsic value. The price that you pay for an investment matters because it determines whether you made a wise investment decision or a poor one Why price matters? Two investors can own the exact same stock and it could be a great investment for one investor and a terrible investment for the other one. For example, lets say you bought shares of Apple at $100 in 2008. The stock could be one of your greatest investing wins since shares are now valued at well over $300.00. Conversely, lets say you bought shares of Apple a few weeks ago when it was trading above $320. The stock is currently trading below where you bought it at and you are actually in the red on your investment. Your purchase of Apple has not been such a great deal. Where can you find value stocks? Look for companies that participate in industries that are often overlooked and neglected by Wall Street. Wall Street brokerage firms love tech stocks because they participate in an exciting industry. The same firms may not pay as much attention to a garbage company, paper producer, or a bottle maker. You have the advantage over these firms in industries like these.

Look for companies with low Price to Earnings ratios, low Price to Book Value ratios, and a low Price to Sales number.

#10: A Long Term Track Record

Trust is not only essential to personal relationships but to investing decisions as well. A company should not receive one dime of your money if you cant trust their financial statements. So, how do you find companies that you can trust with your money? Look for companies with a history of consistent operating performance. Companies that have a minimum of 5 years of consistent operating results. You want companies that have integrity and are not plagued by scandals. Stay away from companies that have to restate earnings or have paid fines to the SEC for misleading investors. Insider trading and financial malfeasance should not be tolerated. Companies that have had accounting scandals or have fudged their numbers in the past are not worth your time. A recent example of this is Dell Inc. Dell has had numerous accounting scandals and fraud charges levied against the company over the years. The company continually pays hundreds of millions of dollars in fines to settle these cases. How can an investor have any confidence in the earnings numbers that Dell reports? The answer is that they cannot. Bed Bath & Beyond is the exact opposite of Dell Inc. The company has a history of being transparent with its financial transactions. The company has been squeaky clean in regards to all of its financial dealings. Investors that want to know what companies are the best at handling their financial business should take a look at Audit Integritys reports. Audit Integrity does a good job of ranking companies based on their transparency. The company assesses the quality of corporate accounting and management practices. According to Forbes magazine Audit Integritys rankings signaled problems at both AIG and Lehman Brothers. This will help you steer clear of companies facing potential lawsuits or worse yet insolvency. Its hard enough just trying to trust the ethical companies. Stay away from the unethical ones.

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Mark Riddix is the founder of Buylikebuffett.com and MarkRiddix.com. He has also published the book, Your Financial Playbook. Visit us on the web at http://buylikebuffett.com. If you would like to sign up for my monthly stock picks newsletter and private investor forum, you can by registering online here.