Investing 101: Don't Pick Stocks, Pick Companies

NEW YORK (TheStreet) -- Warren Buffett once said, "If a business does well, the stock eventually follows."

If you have been reading my articles over the years, you would know by now that I quote Buffett quite a bit. The reason is simple: It's hard to argue with his brand of logic. Being in opposition to "The Oracle" has made fools of many people while costing them quite a bit of money.

When I was asked to contribute to this "Investing 101" package, explaining some of the "do's and don'ts" to newbie investors, I jumped at the chance. After studying so many companies and digging through hoards of buried information, there's no question that (in my opinion) successful "stock picking" is a myth.

Investors, especially those who are new to the game, believe they can come into Wall Street's house, pick a few stocks and leave with the house's money. It doesn't work.

The way to beat the market is to pick great companies. It seems simple enough, right? But how is it that so many smart people lose their retirements every year doing exactly the opposite? You have to know how to spot a great company. It first requires two things: never taking anything for granted and constantly doing your homework.

Take, for instance, the dot-com era. While I'm not old enough to remember the Woodstock music festival of the 1960s, from stories I've heard I think of the dot-com era as the high-tech version of Woodstock -- plenty of great memories that you wished never happened. Likewise, investor due diligence and personal responsibility were non-existent during the dot-com era.

Contrary to Buffett's quote above, greedy investors bid up shares of any company with a ".com" attached to its name. This went on even though these companies literally had "no business being in business." Still, their stocks performed exceptionally well. Why? Investors -- if you can call them that -- were more than willing to mortgage their future on the likes of Pets.com, Webvan.com and eToys.com, betting they would grow into their valuation and make tons of money. Well, we know how that turned out.

In the late 1990s, I was a young investor. I wasn't foolish enough to participate in all of the hoopla. Truth be told, had I any money at all, chances are, as with everyone else, I would have been toasting the Internet's arrival. Fast-forward almost two decades later. What sparked the Internet bubble is still a hotly debated topic today -- picking stocks. Young investors are unsure of what method works the best. Is it active investing or taking a more passive approach, also known as buy and hold?

This is where both your values and investing objectives have to be considered. I don't believe that one method is necessarily better than the other. I'm sure there will be those who disagree with me. But investors shouldn't make the mistake and believe there is anyone sophisticated and well informed enough to consistently make the right decisions on any given information -- at least not legally. The market is too inefficient. This is another lesson that investors much learn quickly.

What I do know, though, is the market makes winners and losers out of everyone. More often than not, the only thing that separates a winner from a loser is time.

To that end, what a young investor needs to focus on more than anything is the earnings that his/her companies are able to produce. There's really no point in investing without first understanding how earnings work. To put it into simplest of terms, a company's earnings are its profits.

Essentially, you take a company's revenue, whether it comes from goods or services, subtract all the costs to produce that product or the service, and what's left over are the earnings. The earnings are then divided into the share amount outstanding, which results is the metric called earnings per share, which is essentially what every company's credibility is based on.

As noted, during the dot-com era, stocks outperformed the earnings companies were able to produce. Buffett's quote, if you recall, was in the inverse order -- the business should do well first and then the stock, not the other way around. As everyone got burned, Buffett was protected. Young investors need to realize that if there are no earnings, which is another way to say profit, there's no point in investing. I can't make it any clearer.

Investors should also become extremely critical of the companies in which they're interested. Don't take anything for granted. Profitability, I believe, is the single most important indicator of a company's financial health. The more money a company continues to make (rising earnings), the higher the stock price typically goes. If the company is making money, it makes it easy to ignore the noise that are being spewed, even from people like me.

Logic suggests that if the company is growing profits, it's hard to argue that the business is on the right path of producing the returns investors expect. But getting there and finding these sort of companies is a process - one that is more sophisticated than simply looking at a chart and a daily moving average, which is typically the method of picking stocks.

New investors must also realize that there are no signals for spotting good companies. Just because you hear a company's name get mentioned 24/7 in the media it doesn't mean the company is worthy of investment. It requires you to be thorough and conduct sound due diligence, while paying strict attention to detail.

Along those lines, it goes a long way to find companies where management values shareholders -- something that you can witness by the manner in which they communicate information. It seems trite to say, but there are a host of companies that go out of their way to bury bad information. If not deliberately, they certainly make it hard to find. Accordingly, you'll know that you have become a true student of investing when you figure out the right questions to ask. Again, don't take anything for granted.

I've said this before and it's worth a reminder: It also helps to have a standard of performance for your companies, a set of guidelines from which you never waver -- preferably one that is hinged on logic and based on realistic expectations. If you remember these simple yet complex tips, you will then agree that your stock is doing well for no other reason than because the business is leading the charge.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

Richard Saintvilus is a co-founder of StockSaints.com where he serves as CEO and editor-in-chief. After 20 years in the IT industry, including 5 years as a high school computer teacher, Saintvilus decided his second act would be as a stock analyst - bringing logic from an investor's point of view. His goal is to remove the complicated aspect of investing and present it to readers in a way that makes sense.

His background in engineering has provided him with strong analytical skills. That, along with 15 years of trading and investing, has given him the tools needed to assess equities and appraise value. Richard is a Warren Buffett disciple who bases investment decisions on the quality of a company's management, growth aspects, return on equity, and price-to-earnings ratio.

His work has been featured on CNBC, Yahoo! Finance, MSN Money, Forbes, Motley Fool and numerous other outlets.

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