Sunday, October 28, 2012

5 Questions to Ask Yourself Before Buying a Stock

1. What do I know about this stock that other investors don't? 

Every investor who has ever bought a stock believes it to be undervalued or under-appreciated by the market, but before you press the "buy" button it's absolutely critical to think about your competition and what it might know and not know. If the market agrees with your thesis, for instance, there isn't much room for outsized growth.

After all, there are myriad analysts and investors who know a given industry inside-and-out and at least a few of them probably have better access to information, management, suppliers, and customers than you do. So, what might they be missing?

If you're looking at a large-cap stock, perhaps it's that the market is thinking too short-term or is under-appreciating the company's longer-term advantages. If you're looking at a small-cap stock, maybe it's that institutional investors have yet to pick up on the opportunity. Whatever the answer might be, be sure that you have an answer to this question before buying the stock.

2. Does this company have a sustainable competitive advantage? 

A company doesn't necessarily need a sustainable competitive advantage to make it a good investment, but if you're assuming robust growth, generous profit margins, and high returns on equity in your forecast then it's imperative to be able to identify the source of the company's competitive advantage.

If you can't determine a source, then the company probably doesn't have a competitive advantage and it may be necessary to revisit your assumptions.

If you can determine the source of sustainable competitive advantage, the next question to ask is "How long do I expect this advantage to remain intact?" Eventually, competitive forces will begin to chip away at the company's defenses and very few companies can keep competitors at bay for more than five years. Be fair, but be realistic with your assumptions.

3. If the stock loses 50% of its value over the next three years, what happened? 

Some investors call this the "pre-mortem" test. The idea is to identify potential thesis-destroyers before they materialize and hopefully help you sidestep a permanent loss of capital.

Once we've become bullish (or bearish) on a stock, it's natural to place a higher value on information that affirms our thesis and overlook or dismiss important risk factors. By forcing ourselves to consider what could go wrong, we can break that dangerous positive-feedback loop and better understand the risks before investing.

4. In two minutes, can I explain to a friend how this company makes its money?

Some companies have very straightforward business models while others can be extremely complicated with half-a-dozen reporting segments, joint-ventures, or merger activity.

If you can't make a succinct elevator pitch to a friend, describing how the business works -- that is, how money flows from customers to the company and then how the company uses, reinvests, and distributes that cash to shareholders -- it's probably not a stock you should own.

5. When will I sell this stock?

Even if you're a dyed-in-the-wool buy-and-hold investor, there are still circumstances where it might behoove you to consider selling the position. For example, the stock could greatly exceed your fair value estimate, a better opportunity could present itself, or your original thesis could be broken.

The important thing is to have some type of exit strategy established so that if and when that situation presents itself, you'll be less likely to second-guess your decision.

Share your questions

What questions do you ask yourself before buying a stock? If you'd like to share, please add them in the comments below.

Thanks for reading! Hope you had a nice weekend.


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