6 Inviolable Rules for Analyzing Stocks

Recently, I was a member of a panel that judged a multi-school business case competition at McDaniel College in Maryland. The case was about a junior hedge fund analyst who had to choose between making a long or short recommendation on a stock, after examining all of the relevant financial information.

This case was extremely complicated. It centered on a quasi-government entity making a gigantic capital expenditure to help lower the production costs for a very dangerous and highly regulated commodity. At the conclusion of the event, my fellow judges shared our insights with the students. Below are some of my takeaways from the case for aspiring investment analysts.

1. Humility trumps brains
In the real world, this stock would have gone into my "too hard pile" very quickly. I encourage all analysts to avoid difficult problems when they can. As they say, there are no called strikes in investing. It turns out that humility is a rare, yet extremely valuable, commodity in the investment business.

2. Think before you plug and chug
Most students working on this case were unfamiliar with the actual business, yet dove right into creating a valuation model. They invested hours doing Monte Carlo simulations, and calculating the Weighted Average Cost of Capital. Most never really took the time to understand the type of company they were analyzing, and which parts of their model were most important to get right.

Always ask yourself if you're looking at a fixed- or variable-cost business. Does it have a competitive advantage? Where is value created and captured in the particular industry?

3. You must understand where value is created and captured
Always remember that a low-cost provider wins in a commodity business. However, if there's some new technology that will lower your production costs dramatically, remember that all those savings will likely be passed directly along to customers. In other words, don't buy rosy predictions of cost savings flowing to the bottom line if you operate in a commodity business.

4. Culture eats strategy for breakfast
This case was all about strategy, internal rates of return, and breakeven analysis. In the real world, culture and people are really what you're investing in. With the explosion of the Internet, there are so many non-traditional ways to measure the power of culture at an organization, yet so many schools focus solely on strategy instead.

For example, most of the great businesses of our time make as many mistakes as other companies. No one is going to be 10 for 10 in strategic decisions. Remember Netflix's disastrous "Qwikster" decision? Even Berkshire Hathaway has stumbled with the David Sokol debacle. The great businesses have dynamic leaders who build outstanding cultures. Those cultures don't always prevent mistakes, but they do allow the company to adapt more quickly and learn from failure.

The word "mistake" is the one word that you should look for in an annual report to see if you're investing in a learning culture or not. My tip is to spend more time investigating the culture than you do understanding the financial statements.

5. Intangible assets outweigh tangible ones
Most investors check the stock price first, and then go right to the financial statements. I have news for you... all those numbers represent history, and the value of the business lies in the future. No one would recommend you drive a car by looking through the rearview mirror, yet people do that in investing all the time.

Here are a few things to ponder. Where is the value of Jeff Bezos reflected on the balance sheet of Amazon? What about the value of Elon Musk for Tesla? How about the strict underwriting discipline at Berkshire Hathaway? How about the brand value of Coca-Cola? Each of these companies possesses a rare and highly valuable asset that doesn't appear on the balance sheet. Good analysts take the time to analyze and understand these competitive advantages.

6. Being conservative in your assumptions can be very costly
This last piece of advice might actually violate Warren Buffett's "rule number one," which is to never lose money. The flip side of Buffett's maxim is that the best investors in the world are wrong about 40% of the time. The analysts who use conservative assumptions when deploying their discounted cash flow models would have never bought great businesses like Amazon or eBay. If you're looking for extraordinary businesses, you'll need to be careful that you're not too conservative in your assumptions.

Against the wind
Case studies are a good way to learn. At The Motley Fool, we value a multi-disciplinary approach to company analysis. We also appreciate independent thought, and civil and open debate. When it comes to investing, we've learned that both a kite and a portfolio can rise against the wind.