5 Questions to Answer Before Investing in a Stock

 | Jul 23, 2017 | 10:00 AM EDT
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The following commentary was originally sent to subscribers of Stocks Under $10 on July 5. Click here to learn more about this dynamic portfolio and market information service.

For any new investor, or even for an experienced one, it can be tempting to buy the latest hot stock without doing much homework. As I've learned the hard way during the last 20-plus years, more often than not that only leads to trouble. How do you know how to gauge a company's business and the competitive landscape if you don't have a firm understanding of what the company does and how it makes money for itself and its shareholders?

That's why I've developed a series of questions that you should be able to answer before you decide whether or not to buy shares of stock in a particular company. These are the questions that I start with as I take a look at a new opportunities. Over the next several weeks, we'll be sharing these questions with you and the insights we gather along the way. Some of the questions may seem obvious, but as you'll see in some of the answers, what we think may not always be what is.

Here we go.

-- What does the company do?

Right out of the gate, this is a question that you must know the answer to. How else will you be able to understand everything else about a company if you don't have a grip on what it does? Digging a little deeper, this means identifying which industries it participates in and recognizing which one or ones drive a significant portion of the company's revenue stream.

This also means digging a little into the company's financial statements, either the 10-K or 10-Q -- which you can find handily at www.sec.gov. You'll want to turn to the Income Statement, and potentially the Business Segment, information that's found in the notes at the back of the filing, to identify the different business lines your company may have. Some may only have one business segment, which can make it a little easier, but you should still read the company description to understand its products and services.

Let's take a look at Apple (AAPL) . While the company's history was in personal computers, Apple today competes in the consumer electronics business -- with revenue generated by the sale of iPhones, iPads, Mac desktop computers and laptops, Apple Watches, Apple TV and other products (accessories and so on) and services (Apple Care, iTunes, Apple Music, iCloud).

-- What are its key products or services?

When I say key products, we're talking about those that drive the bulk of the company's sales and profits. Getting back to Apple, iPhone sales were responsible for 63% of revenue generated in the June 2015 quarter. That's double the revenue contribution from all of Apple's other businesses (iPad, Mac, Services and other products). In fact the next- biggest product line -- Services -- accounted for only 13% of revenue during the quarter! While we may hear about new Macs and iPads as well as its own connected speaker, the bottom line, at least in the near term, is Apple's business will remain highly dependent on the iPhone.

In other words, if someone is trying to convince you to buy Apple shares based on the Apple Watch or Apple TV, you should think twice about what they are saying.

-- At what business unit or units does the company make most of its profits?

Even after you break down the company's revenue stream, you still have to identify which business really drives the company's profits. I tend to focus on operating profit generation, because it factors in things like selling, general and administration costs, as well as research and development (R&D) spending for the company. Another way to view it is to examine a company's operating margin to determine if they are expanding, contracting or simply treading water.

In this case, let's turn to semiconductor chip company Qualcomm (QCOM) , which derived 65% of its 2016 revenue from chip sales and 33% from its licensing business. Digging into the notes found within the 10-K reveals the chip business accounted for only 21% of operating profits last year, compared to 75% for the licensing business. This tells us that at the heart of things, the real driver of Qualcomm's business and earnings is the very profitable licensing business. As such, investors in Qualcomm need to understand the dynamics of the licensing market and trends in the royalty rate.

-- Who are the key competitors and how are they affecting the market?

Looking again at Apple, the key competitors we need to watch out for will be those in the smartphone industry. Given its sizable market share, according to data from a market research firm, Samsung is the primary concern for Apple's iPhone business. We still have to keep tabs on other players such as Alphabet (GOOGL) , Samsung, Lenovo, Huawei, LG, HTC and others, as well as the once high-and-mighty Blackberry (BBRY) . There are also software players, which includes Alphabet with its market-share-leading Android operating system, as well as Microsoft (MSFT) and some other fringe players. Other competitors given the company's other businesses include Amazon (AMZN) , HP Inc. (HPQ) , and streaming services like Netflix (NFLX) and Spotify, to name a few.

Looking at Qualcomm, its competitors include chipset companies that are currently in the mobile semiconductor, like Broadcom (AVGO) , as well as those that are moving into it like Intel (INTC) . Given that the IP licensing business is heavily focused on mobile technologies, companies such as InterDigital (IDCC) , Nokia (NOK) and Ericsson (ERIC) are ones to watch.

A rule of thumb would be to read competitor press releases and financial filings to maintain a feel for how competitor products are doing. Watching new product introductions and promotional activity, as well as product pricing trends, can tell you if a competitor is aggressively targeting market share gains, which could result in profit pressure down the line. That brings us to another rule of thumb, I tend to favor companies that focus on profits first and market share second. Why? Because aggressive pricing tends to be a losing battle over the long-term and more often than not the "we'll make it up on volume" game tends not to work.

-- What is driving growth at the company?

Again, let's stick with Apple and its March 2017 quarterly results. iPhone revenue were largely unchanged, rising 1% year over year, which was more do to higher average selling prices given the 1% drop in unit volume. Year over year, the company's Mac and Services businesses were the ones that fueled the 5% revenue bump, but even on a combined basis, these two business accounted for 24% Apple's overall revenue. What this tells us is that even though Apple has some large businesses in the Mac ($5.8 billion in quarterly revenue) and Services ($7.0 billion in quarterly revenue), they are unlikely to offset what is going on at the prevailing business segment -- the iPhone. As such, Apple is likely to be trapped in a seasonal cycle, given the annual iPhone release that is increasingly tied to device upgrades over new subscription growth. Not a bad opportunity, just something to be aware of, much the way H&R Block (HRB) revenue is tied to tax season.

As you start to look at new companies in which to invest, or even as you revisit ones you already own, the answers to these first five questions should give you a much better understanding of the company you are buying. That's right, I said the company -- the products and services that drive its revenue, how it competes and how it earns its profits are the drivers behind the share price.

In the coming weeks, I'll be sharing more of these questions. Between now and then, should you have a question or comment, feel free to email them in.

-- Chris Versace and Stephen "Sarge" Guilfoyle are co-portfolio managers of the Stocks Under $10 portfolio. Click here to learn more.

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