👑 Reasons to buy a stock

It’s not hard to find quality companies.

But when should you buy them?

In today’s article, we’ll cover 5 reasons to buy a stock.

Value versus growth

All intelligent investing is value investing.

You try to buy stocks for less than what they’re worth.

The intrinsic value of a company can always be calculated as follows:

Intrinsic value = The discounted value of the cash that can be taken out of a business during its remaining life

This also means that growth is always a component of value as it will increase future cash flows.

Here’s what Warren Buffett has to say about the value versus growth debate:

So in theory, investing is very easy: buy stocks below their intrinsic value.

It’s so easy in theory, but it can be very hard in practice.

As a way to help you, I am covering 5 potential triggers to buy a stock in today’s article.

“Investing is simple, but not easy.” - Warren Buffett

5 Reasons to buy a stock

Here are 5 reasons to buy a stock:

1. The stock is undervalued

2. Fundamentals are improving

3. The moat is strengthening

4. The future looks bright

5. Insiders are heavily buying

1. The stock is undervalued

In the short term, stock prices fluctuate way more than the intrinsic value. As Benjamin Graham beautifully stated: “In the short run, the market is a voting machine but in the long run, it is a weighing machine.”

Most stocks fluctuate with more than 50% every single year.

As a result, volatility can offer a lot of opportunities for rational investors.

But how can you know whether a stock is undervalued?

A good starting point is to look at the current valuation level of a company compared to its historical valuation.

You can easily do this via free websites such as Morningstar.

Let’s take Arista Networks as an example.

Via the Valuation tab on Morningstar’s website, you see that Arista Networks currently trades at a forward PE of 28. Over the past 5 years, the stock traded at an average forward PE of 29.1.

This indicates that Arista Networks is reasonably valued compared to its own historical average.

Source: Morningstar

Obviously, looking solely at the current valuation level of a company compared to the historical valuation isn’t enough to determine whether a stock is undervalued.

You can take a look at these 2 articles if you want to learn more:

• Everything you need to know about valuation

• How to value stocks like a professional

2. Fundamentals are improving

Over time, stock prices always follow the evolution of the intrinsic value.

That’s why the fundamentals are by far THE most important thing to track as an investor.

Let’s say that a company called Quality Inc. has the following characteristics:

• Profit margin 10%

• Earnings per share (EPS): $10

• P/E ratio: 15x

• Stock price = EPS * P/E ratio: $150

Now assume that over the next 3 years Quality Inc. is able to double its profit margin from 10% to 20%.

Due to the fact that Quality Inc. doubled its profit margin (and as a result its earnings), investors are also willing to pay more for the company. As a result, the price-to-earnings ratio increases from 15x to 25x.

Can you guess how much Quality Inc.’s stock price would have increased in this example?

Here’s the performance of Quality Inc:

Stock price = EPS * P/E Ratio
Stock price Quality Inc. = $20 million * 25 = $500

As you can see, Quality Inc’s stock price more than tripled thanks to the profit margin increase from 10% to 20%!

This example beautifully shows why your return as an investor can be very satisfactory if you invest in companies which can improve their fundamentals.

When you are looking for companies which are improving their fundamentals, look at these metrics:

• The balance sheet is strengthening (look at Net Debt / FCFF)

• Capital intensity decreases (look at CAPEX/Sales)

• Capital allocation improves (look at ROIC)

• Profitability improves (look at profit and/or FCF margin)

3. Moat is strengthening

For quality investors, a moat is essential.

Determining the existence and durability of a competitive advantage is key to make good investment decisions.

When you invest in companies which can widen their moat, your results will be very satisfactory.

Very recently, Michael Mauboussin has written a new paper about this topic. You can read it here.

I’ll summarize the paper of 30 pages in 2 bullet points for you:

1. Companies with a high ROIC outperform companies with a low ROIC

2. Companies which manage to increase their ROIC significantly outperform all other companies

You can also see this in the table below.

Companies which managed to go from the lowest ROIC quintile to the highest ROIC quintile outperform all other companies by a wide margin.

Source: paper Michael Mauboussin

Take a look at these articles if you want to learn more:

• What you need to know about moats

• What you need to know about ROIC

4. The future looks bright

In the long term, earnings growth is the main driver for stock prices.

This also means that the longer your companies can grow their earnings at attractive rates, the better.

Via the formula below, you can calculate your expected return as an investor.

Expected return = EPS Growth + Shareholder Yield (Dividend yield + Buyback yield) +/- Multiple expansion (contraction)

This means that if you pay a fair price for a stock that can grow its earnings per share with 10% per year and pays a dividend of 2% per year, your expected return is equal to 12%.

Here’s a great practical example from François Rochon:

As you can see in the table above, the companies within Rochon’s portfolio have grown their value (EPS growth + dividend yield) by 2474% while his portfolio has achieved a total return of 2817%.

5. Insiders are heavily buying

When an insider sells its own stock, there can be multiple reasons. The person might need money to finance the wedding of his daughter, he wants to buy a second house, …

However, there is only 1 possible reason why an insider buys its own stock: he thinks the stock is undervalued.

And guess what… there is no person who can determine the intrinsic value of a company better than an insider.

There are multiple studies about this topic and the consensus states that companies in which insiders are heavily buying their own stock outperform the market over the next 12 months with 3-6% per year on average.

Via Dataroma you can see which insiders recently bought back their own shares:

Take a look at this article if you want to learn more:

• Skin in the game matters

Conclusion

That’s it for the 100th article of Compounding Quality. I am really looking forward to the next 100 and hope you are too.

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To summarize this article:

• All intelligent investing is value investing. You try to buy things for less than what they’re worth.

• In general there are 5 reasons to buy a stock:

  • The stock is undervalued

  • Fundamentals are improving

  • The moat is strengthening

  • The future looks bright

  • Insiders are heavily buying

Next week we’ll discuss reasons to sell a stock. Stay tuned!

The end

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About the author

Compounding Quality is a professional investor which manages a worldwide equity fund with more than $150 million in Assets Under Management. I’ve read over 500 investment books and spend more than 50 hours per week researching stocks.