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What Makes Good Stocks Good?

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If you want to make money buying and holding stocks, you need to buy good stocks at good prices. What makes a stock good? How do you know the right price to pay? The answers depend in the underlying businesses.

A Good Stock Represents a Good Company

Every stock represents a business. Some businesses grow. Some fail. Some become diverse empires. Some find a comfortable niche.

A good stock belongs to a growing business. This company has a purpose; it has a plan and it's executing that plan. Perhaps it imports genuine maple syrup from Canada or it builds everything from home heating systems to hydroelectric turbines and replacement parts for the International Space Station. Whatever the plan is, it should make sense. You don't have to understand all of the details, but if you read a quarterly report or an analyst report, it should make sense.

If the business plan doesn't make sense to you, don't invest. There are plenty of other good opportunities.

If you peruse useful investing literature, you'll see people from Benjamin Graham to Peter Lynch to Warren Buffett refer to the concept of an economic moat: any competitive advantage which reduces competition. It may be Coca-Cola's secret recipe or Facebook's network of existing users. As long as that moat is present, the business has a tremendous advantage into its market.

Finally, a good business has stable leadership and management. The CEO, CTO, and CFO can't by themselves make a company great, but they do set strategic directions, drive tactical decisions, and influence company culture. This contributes to success. An ill-advised acquisition can burden the business with debt. Layoffs can reduce morale. Paranoia and recklessness can bring questionable decisions which result in lawsuits and investigations and prosecution. (If you're still not convinced, consider Carly Fiorina's not-brief-enough tenure at HP, which still haunts the company after a decade, or the influence of Steve Ballmer at Microsoft, which struggled to take advantage of new markets.)

Good management and leadership plans for the future and helps keep the good parts of the company stable.

A Good Stock Represents a Successful Business

A successful business is worth owning. A stock representing a successful business is worth owning. Success is far more than just "made a lot of money last year" or "reported great earnings" or "beat analyst estimates". It's a lot of criteria, some of which depend on the nature of the business. What makes a relatively young company like Salesforce different from a well-established company like GE is important to figuring out whether it's worth buying either of them.

You can get a pretty good picture of the success of a business by perusing its financial statements. Multiple varied ratios and calculations attempt to summarize financial performance into comparable numbers (P/E ratio, current ratio, and free cash flow are three examples). You don't have to understand all of these, but you ought to be able to see a story behind the numbers.

Good financial numbers represent coherent and sustainable growth. They show a company with low debt (or debt used intelligently). They often show a company with a growing amount of cash on hand.

Great financial numbers (and calculated ratios) demonstrate that a company knows how to invest its profits well—that its return on invested income is not only positive but also better than investing in bonds or Treasury notes.

You don't have to understand all of the numbers in a financial statement. (Unless you have an accounting degree or work in corporate finance, you probably won't.) Yet the numbers should make sense to you. Otherwise, you may be seeing accounting shenanigans, in which case run the other way.

A Great Stock is Available at a Good Price

A company may be good—trustworthy, safe, growing—but the stock is not worth buying right now. Why? Because it's too expensive.

If you're investing (not trading), the right price for a stock depends on the money the company can generate for its owners. It makes no sense to pay $10 for a share that'll return $1 over the next ten years. You're losing money on that investment. If you're paying $10 to make $20 over the next year, that's a different story.

There are various calculations and ratios to estimate what a stock is worth. This is more of an art than a science; you have to do some work to predict what may happen in the future. Though with a good company, you can look at its past performance and give yourself a margin of error to miscalculate. A good company will have a good price if that price reflects the real money it can generate for its owners (owner earnings), if its dividend rate is realistic, and if your margin of safety is reasonable.

To figure those out, you have to look at the numbers.

What Makes a Good Stock Worth Buying?

After you've done your research, you must be able to tell yourself a story about the business. What does the company make? What does it sell? Who are its customers? How do those fit the business's performance? Given the company and its performance so far, will its business continue to produce profit for its investors? Can it grow?

Once you've answered that, then you can look into the price and figure out what you're willing to pay for each share of stock. If the company is good and the price is fair, congratulations! You've found a good stock to buy!