Investing need not be complicated. You don't need tenure on Wall Street or an MBA to succeed. In fact, sticking to a few key principles can go a long way toward helping you build your wealth.
Just ask the sixth grade "Math Minions" of Oak Grove Lutheran School in North Dakota. Back in 2014, they outperformed all of the competition in a nationwide investing contest. Their process was exceedingly simple: "[It] centered on companies the students knew about with good track records."
That's it: familiarity with a company and solid past performance.
The result: a 22% return over the course of less than a year!
Image source: Getty Images.
It's worth noting, however, that one-year returns aren't the best measuring stick. Successful stock investing requires taking the long-term view. That means aiming to meaningfully increase your wealth over a decades-long time frame.
That being said, the strategy that the students used was sound, and it can help to guide you as you build your own portfolio.
Don't start investing yet!
But before we dive into the stock market, it's important to make sure your financial house is in order. For the purposes of this article, that means three things:
- Make sure you've paid off all high-interest debt, especially credit card balances.
- Build up an emergency fund that could cover your expenses for a minimum of three months if you lose all sources of income.
- Don't put any money in the stock market that you think you might need to spend in the next three years. Instead, put that money in safer investments like CDs or money market accounts.
If you can cross those three criteria off the list, then you're ready to buy your first stock. If not, be patient: Over the long run, investing isn't worthwhile if it puts your financial safety at risk.
Setting your account up
When you're setting up your portfolio, you'll have lots of choices to make. The first step is picking out a brokerage to place your trades. The Motley Fool has a page that compares brokerages for you to choose from.
You'll also need to choose how you want to classify your brokerage account. I strongly suggest that you consider making it a traditional or Roth IRA. These accounts offer you tax advantages that help you grow your nest egg much faster.
What to look for in "beginner stocks"
There are two key qualities to look for in your first few stocks.
By far the most important criterion is that you're familiar with the company. While it's commonplace to think that investing in an obscure, underappreciated stock trading for pennies has the potential to make you quick money, that's often a recipe for disaster.
Since you aren't an industry insider, and you're not spending hours each day reading trade magazines, it's important not to get too complicated with your first investment. That's why you should put your hard-earned capital into companies you know and understand. This approach yields an important advantage: Because you use the company's goods or services on a regular basis, you're likely to know whether the company is gaining favor or falling on hard times. Perhaps, for instance, you invest in Walmart, but over time, you realize store traffic is dwindling, and the selection is getting worse by the week. That's an important data point to inform your decision to buy or sell more of the stock.
The second quality to look for is a competitive moat. No, we're not talking about the spike-filled waterway that surrounds a castle, though it's a helpful analogy. In investing, a moat is what protects a company from the competition; it is the sustainable competitive advantage that keeps customers coming back year after year, while holding the competition at bay for decades.
Moats can take four different forms, and I'll explain them by picking stocks based on those moats below.
Brands with staying power
The first moat a company can have comes from its intangible assets. These can include things like patents, which, for example, give big drug companies a major advantage by prohibiting competitors from selling the same drug compound for years. Intangible assets can also include government protection. For example, large power companies require so much up-front investment, and provide such a vital service, that the government will only allow a few providers within a locality. In other words, regulations keep competition at bay.
But for the purposes of this stock pick, we're focusing on the power of a brand -- that is, the way a company and its products are perceived around the world.
Few companies have the type of brand strength that Disney (NYSE: DIS) enjoys. Consider that all of the following popular characters and franchises are part of the Disney universe:
- Mickey Mouse and all of his friends.
- Star Wars and Lucasfilms.
- Pixar and its stable of blockbuster movies, including Finding Nemo, Toy Story, Cars,and many others.
- TV properties like ESPN and ABC, which boasts hit shows like Modern Family, Scandal, Grey's Anatomy, and the newly resurgent Roseanne.
- Marvel, which has spawned films like Iron Man, Spiderman, and the recent megablockbuster Black Panther.
You may have heard that Disney is having trouble in the age of cord-cutting. And to an extent, those are legitimate concerns. ESPN accounts for a big portion of the company's bottom line, and consumers are abandoning cable TV in droves.
At the same time, however, Disney is on the verge of releasing its own streaming option to rival the likes of Hulu and Netflix. With the stable of intellectual property mentioned above, Disney is one of the few companies that could become a streaming leader over time. Subscribe to the service once it becomes available, and you'll not only contribute to your own investment, but get some critical research done in the process.
When switching costs are high, customers stay put
Sometimes a service or product becomes so important to you that parting ways with it would be painful. Other times, it's not so much your love for the product, but your your reluctance to go through the hassle of switching, that keeps you put.
Either way, the company providing you with that service has a powerful moat around it: high switching costs. Perhaps the most salient example of this is American banks. I've personally vowed for over six months to leave Wells Fargo after all of the scandals that surfaced over the past two years. While I still plan to do so, I haven't yet followed through: There's more paperwork, relinking of payments, redirection of direct deposits, and so forth than I can handle right now. I'll eventually get to it, but for now, Wells Fargo is protected by high switching costs.
However, my stock pick in the high-switching-costs category is not a bank, though it's involved in financial services. I believe Intuit (NASDAQ: INTU) offers particularly "sticky" services. If the name doesn't ring a bell, perhaps its two biggest products do: TurboTax and QuickBooks.
The QuickBooks segment provides software -- increasingly over the cloud -- that helps small and medium-sized businesses (SMBs) track their accounting. Business is booming in the segment, buoyed by the trend toward self-employment. Once an SMB has started keeping its books on one platform, there's some monetary and logistical pain that comes with migrating all that data. That keeps customers around for the long haul.
TurboTax, on the other hand, makes doing your taxes easy, especially because it stores all the data from previous years. Often, half of your data is already pre-populated by the software before you even begin your tax return. This makes the once-harrowing process of filing your taxes much more stress-free. The move toward offering real-time customer service via TurboTax Live only makes the service more valuable.
But the bottom line with both products is this: You have better things to do with your time -- either as a taxpaying citizen or as a small-business owner -- than migrating all of your financial records from one service to another. It's an expensive, time-consuming task that comes with the risk of losing critical data. That's why I think Intuit is a solid pick.
The most powerful network effect in America?
The network effect is a powerful moat for an investor. A company enjoys the network effect when every additional user of its service makes that service more valuable, creating a snowball effect whereby each additional user begets even more users. The perfect example is Facebook (NASDAQ: FB).
Think about it: What would the value of Facebook be if your friends and family weren't already part of the network? When you join, it incentivizes your friends to join, which incentivizes still more people to join. It's a virtuous cycle that has led the company to reach 2.13 billion monthly active users. While the service itself is free, Facebook uses the gobs of data that it collects to serve targeted ads on its platform, and merchants pay handsomely for those ads.
Of course, that data collection is now under intense scrutiny following the Cambridge Analytica scandal. But that's why investing in companies that you know is so important as a beginner: As a (probably) regular user of Facebook, you are as close to the action as is possible. If you and your friends are truly leaving the platform en masse, then you know the company isn't for you. And it's important to note that Instagram and WhatsApp are also parts of the Facebook universe -- so if you leave one for the other, then you haven't really left the parent company at all.
I, however, believe that Facebook will be just fine. The company will need to rethink how it protects user data, and the service will change over time. But my own use of the company's platforms hasn't changed, and the stock itself still makes up over 6% of my real-life holdings.
These companies have a low-cost advantage
My final two picks are exemplars in low-cost production -- though the services they produce at such low costs are very different.
The first is Alphabet (NASDAQ: GOOG) (NASDAQ: GOOGL), the parent company of Google. Google has seven different products with over 1 billion users: search, Maps, GMail, YouTube, Android, Chrome, and Google Play Store. As with Facebook, all of these services are offered for free. Alphabet monetizes it all by using the data it collects to sell targeted ads. This helps explain why the company -- along with Facebook -- is part of the online advertising duopoly that is raking in cash.
Once these seven properties are set up -- and more are likely to come -- it doesn't cost Alphabet an exorbitant amount to maintain them. The data it gains from the services, however, is today's version of gold -- and Alphabet can mine that data at a lower cost than just about anyone else. Because there are so many users of these services, Google has been able to capture enormous market-share of digital advertising. Its ability to collect consumer data is rivaled only by Facebook's.
My other recommendation is Amazon (NASDAQ: AMZN). Perhaps the most important part of the company's rise to e-commerce dominance is Amazon Prime. As we recently found out, the program has over 100 million users. And while the program has many benefits, free two-day shipping remains the real draw.
Amazon is able to offer that perk because of its enormous network of fulfillment centers, estimated at 130 locations in North America and another 145 spread out throughout the world. These multibillion-dollar centers help ensure that the company can deliver packages faster than any competitor. Fast delivery is the low-cost service that Amazon offers -- and it is the linchpin of Prime. Because of its success here, the company has been able to take cash from its e-commerce division and reinvest in lucrative opportunities like original streaming video content Amazon Web Services, one of the world's leading cloud computing platforms.
There are lots of simple ways for you -- the beginning individual investor -- to monitor how well Amazon is doing. Walking down the street, I can often see many Amazon cardboard boxes waiting the be brought inside. As a Prime member myself, I'm constantly delighted when my the benefits of my Prime membership grow (my daughter loves some of the original kids' programming), and I have no problem paying up when membership dues rise.
If those things change, that's an important indicator that I might need to go back and reevaluate my reasoning behind owning the stock.
When the time comes to buy your first stock
In the interest of 100% transparency, you should know that I'm not personally invested in Disney or Intuit, though I have given both outperform calls on my All-Star CAPS profile. On the other hand, Alphabet, Amazon, and Facebook combine to account for a whopping 40% of my family's real-life stock holdings.
In the end, you have to decide what works best for you. Remember to ease yourself into stocks, focus on what you're familiar with, and make your decisions with the long term in mind. Your future self will thank you for it -- profusely.
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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Brian Stoffel owns shares of Alphabet (A shares), Alphabet (C shares), Amazon, Facebook, NFLX, SHOP, and VEEV. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Amazon, Facebook, Intuit, NFLX, SHOP, VEEV, and Walt Disney. The Motley Fool has a disclosure policy.