Don't Buy That Stock… Until You Answer These Three Questions

 
Legendary investor Peter Lynch once said you should spend as much time figuring out which stock to buy as you do picking out a new refrigerator.
 
The thing is, few people spend that much time thinking about their stock purchases.
 
We recently talked about three questions you should ask yourself before you buy an asset – whether it's a refrigerator, a beach house, or a stock. Those questions are a good place to start.
 
But when you're buying a stock, there are a few more questions to ask before you begin to dig more deeply. The wrong answer to any one of these questions is a sign you should look elsewhere…
 
1) How does this company make money?
 
Lots of companies make a lot of money doing very complicated things. And that's good for them. But if you can't explain what a company does – and how it makes money doing it – in a way that a child could understand, then you should probably look elsewhere.
 
There's a very good reason for this. Simple businesses are more difficult for bad managers to mess up. The more "idiot proof" the business, the lower the execution risk. (That's the danger of management not being able to do its job.)
 
And as an investor, if you can understand how the company works, you'll have a better sense of what's really going on at the company.
 
Of course, what is "simple" to you might not be "simple" to others. If you're a biochemist, you might understand what a pharmaceutical company does in a way that most people can't. If you're a financial analyst, reading a bank's balance sheet might be easier for you than boiling water. You should use that special insight and expertise to your advantage.
 
But whether you're a rocket scientist or a truck driver, use your edge – and stick to what you know.
 
2) Is the stock already "done"?
 
A few hints that the stock you're looking at has already enjoyed its day in the sun:
 
•   If your great idea is on the "Focus List" of the big brokerage house where you trade, don't buy it.
   
•   If your broker sends you a thick research report on a stock, with "Buy" stamped on the front, don't buy it. (I used to write this sort of report for hedge funds and mutual-fund investors. They're 95% worthless to most people.)
   
•   If you discovered your great stock idea on the cover of Forbes or Fortune magazine, it's already over. Don't buy it.
You don't want to buy the stock that everyone has already picked over – a stock that most other investors have already digested and acted on. Remember, a stock will only go up if there are more buyers than sellers.
 
If your broker's largest clients have already bought the stock, there's not much left for you. If it's an idea big enough to make the cover of a magazine, then it has already been acted on by countless others. And those earlier buyers will be selling to you. Being the "last buyer" of a stock is a bad place to be because there won't be anyone else for you to sell to.
 
One exception here is if you're wrong about a stock being "done." You might have some unique insight on an industry that you think everyone else knows – but in fact few people at all know.
 
So treat your own ideas with more respect (than you might otherwise) if they're from direct professional experience. And in this special case, don't assume everyone else knows what you know.
 
3) Is management on your side?
 
There's a big difference between just earning a salary – and owning the company you're working for. If a lot of your personal wealth is tied up in the success of your enterprise, you're going to work a lot harder than if you just collected a salary.
 
Few investors see it this way – but when you buy shares, you're actually buying a small portion of a company. You're not collecting a salary. You make money only if the company does well and the share price increases.
 
What you want is a management team that also has a lot of reasons – and financial incentives – to make the company grow and the share price rise. The senior management of the company should own a lot of shares of the company and should buy more all the time. If they don't, you should look elsewhere.
 
These questions are just the first steps in figuring out whether a stock is worth adding to your portfolio. But if you don't completely understand how a company makes money… if the stock already has all the exposure that it's going to get and is "done"… and if management isn't laser-focused on making the share price go up… then you should move on.
 
Regards,
 
Kim Iskyan
 
Editor's note: Recently, Kim and his colleagues at Truewealth Asian Investment Daily put together a special report to show investors what to watch for in order to protect their hard-earned money from the dangers of the market. Find out how you can receive the report right here. And if you're interested in receiving their free daily e-letter, click here.
 

Source: DailyWealth

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