Legendary investor Peter Lynch famously advised investors to spend at least as much time researching a stock as they would choosing a new refrigerator.
But all too often, this doesn't happen.
For a fridge – or whatever similar household appliance – the process is often something like this: Scour lists of the top-rated fridges... read user reviews... compare energy efficiency of different options... learn the intricacies of the French door versus side-by-side doors debate... shop around for the best deal... and then finally buy.
You don't have to be a refrigerator expert to buy a fridge. But most people take time researching before getting to the "buy."
For many folks, though, it's different for stocks... even though buying shares often costs more than you'd spend on a fridge and the potential for loss is much higher. It usually works something like this: Uncle Jed's friend's colleague's neighbor said the shares of company ABC might go up... click buy!
Part of the problem – why some folks don't take Lynch's advice – is that it's difficult to know where to start when researching a stock and what questions to ask.
So what follows are three questions to begin with when you're thinking of buying a stock to start you off...
1. Do you understand how this company makes money?
Lots of companies make money by doing complicated things, which is fine for them. But if you don't understand what a company does – if it's difficult to figure out exactly what the company's product is, how it works, and how they make money selling it – then it makes sense to look elsewhere.
Think about it this way... You wouldn't buy a household appliance – a fridge, or anything else – if you weren't sure about what it will do for you... that is, the value it creates for you, whether it's keeping food cold or toasting bread. In order to feel comfortable with a stock, you need to completely understand what the company does.
Of course, what you understand about how a company makes money might not be straightforward 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.
Use whatever special insight and expertise you have to your advantage. Whether you're a rocket scientist or a truck driver, stick to what you know and what you can understand.
2. Is the stock already "done"?
A great company may not be a great stock. You don't want to buy stock that other investors have already picked over. After all, a stock will only go up if there are more buyers than sellers.
Here are a few signs that a stock has already enjoyed its day in the sun and that it might be worth looking elsewhere:
- 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 those sorts of reports 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.
- If your broker's big clients have already bought the stock, and if it's a big enough idea to make the cover of a magazine, then it's already been bought.
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 when you're ready to cash out.
3. Is management on your side?
When you buy shares in a company, you're actually buying a small slice of a company. You're becoming a part owner. You're not an employee – you're a shareholder.
And the mentality of an owner is often very different from that of an employee who collects a paycheck, regardless of the company's performance.
So you want a company's management to be owners just like you. The folks in the executive suite should have financial incentives to make the company grow and the share price rise. That means that senior management should own a lot of their own company's shares.
Of course, management that doesn't have a big financial stake in the strong performance of the company may still do a fine job. But ideally, the incentives of management should align with those of shareholders – a higher share price. If they don't, find a company with better management.
These questions are only the first steps in figuring out whether a stock is worth adding to your portfolio. If you don't completely understand how a company makes money, if the stock is "done," or if management isn't laser-focused on making the share price go up – it's better to move on.
After all... a fridge will keep your milk cold, but won't make you money. A good stock, though, could make you enough money to buy a lot more fridges.