While investors have a responsibility to research the companies they are interested in, knowing how to research sets apart the good investors from bad ones. Think about when you were in high school. What separated good students from bad students? It often comes down to their studying habits, right? Student who struggle with grades and can't study well -- whether because they don't know how or lack the time -- can't survive without a tutor, or in some instances, summer school.
Similarly, investors who don't know how to research or lack the time to do so effectively must come to terms with this by knowing their strengths and weaknesses. How would someone know what to research if he or she doesn't first know what they don't know? By and large, sound research is where so many investors consistently struggle. The easiest way to compensate is to limit your research to only a handful of companies. Here's why...
Research Rule No. 1: You Can't Follow Everything
As of the most recent quarter, the New York Stock Exchange traded stocks for some 2,800 companies, while the Nasdaq has listed somewhere in the neighborhood of 3,100 others. Combined, this comes out to almost 6,000 companies that are actively traded in a wide range of industries and sectors. And when you factor in the number of new companies that file for IPOs (initial public offerings) and enter the market each year, the number of companies can grow dramatically.
For example, if you work in the technology industry, you're more than likely to already have above-average knowledge of what an investment in, say, Microsoft (Nasdaq: MSFT) or Apple (Nasdaq: AAPL) might mean. While you might not yet have full understanding of the financial components that drive MSFT or AAPL stock, your current knowledge of the tech industry gives you a sizable advantage over an investor who might not know how important a new release of Windows or an iOS update could be to the success of these companies.
In that vein, your existing industry knowledge can reduce the stress level of research because, as you're reading press releases or other company disclosures, you're already familiar with certain technical terms and phrases that would be meaningless jargon to a less educated investor. This would also be the case if you worked in the financial or medical sector and focused on stocks in those areas. In short, there is some truth to the axiom, "Invest in what you know."
Research Rule No. 2: Understand Company Relationships
Once you've picked a company or stock that you're interested in, you can maximize your time by understanding the important industry relationships that drive the company's revenue and profits. In our Microsoft or Apple example above, it would also serve the investor well to know who Apple's and Microsoft's customers are. Likewise, who are their main competitors and why are their supply chains so important?
Once these questions (among others) are answered, the investor should also seek to learn who the company's suppliers are. In this case, it is okay to cast the net a little wider and consider devoting extra time and add a few other companies to assist with the research. This is not the same as casting the research net so wide that you struggle to decide on what companies to invest in. But in this case, as you're researching Apple, for example, it makes sense to research its component makers such as Qualcomm Incorporated (Nasdaq: QCOM) and Intel Corporation (Nasdaq: INTC), which provide the wireless chips that make computers and iPhones work.
And while you're at it, why not seek to understand Taiwanese electronics manufacturing giant Foxconn Technology Co., Ltd. (2354.TW), a major supplier to Apple? In recent years Foxconn has come under fire for what some perceive to be poverty-level salary of its workers in mainland China. As such, Apple -- by virtue of its relationship with Foxconn -- has been accused enabling poor ethical working conditions for the sake of profits.
While Apple has addressed the issue and has taken steps to ensure its suppliers comply with labor and human rights, Apple's brand has nonetheless suffered some PR damage. To be fair, with Apple's suppliers employing some 1.6 million people, it's a lot to ask for Apple to police independent contractors, which is what its suppliers are, especially when its suppliers reside in 20 different countries with different labor laws.
Nevertheless, Apple's customers spoke up and demanded change. And the company was forced to take a stance. This reinforces the importance of researching the partners of the companies you're interested in. Likewise, if you see that Qualcomm or Intel has a bad quarter, it might change your opinion on whether or not Apple will hit its earnings estimates.
Finally, what if an accident occurred at one of Foxconn's manufacturing facilities? Would this affect Apple's holiday-quarter inventory? Maybe, maybe not. But having this information can be valuable to understanding how an investment in AAPL will fare.
I'll have three more research tips for you in an upcoming article...