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Many investors seem to give more thought to which television to buy than they put into buying a stock. Perhaps that is a bit harsh, however you have to wonder sometimes. Investors sometimes fail to grasp the concept that stocks are not priced like, well televisions.
If a retailer puts a 42" television on sale and attracts a bunch of buyers, you can bet that competitors will soon counter the offer with a lower price or extra features. The result of this competition is the price of televisions go down, not up with popularity.
In the stock market, the more popular a stock (more buyers), the higher price new buyers will have to pay. Unfortunately, as excitement around the stock builds, more investors want in and they often end up paying too much for the stock.
What this illustrates is the need for a plan that identifies quality stocks at great prices and ignores the hype around Dalal Street's latest darling.
If you want to buy a stock, you should be able to state, in writing, the reasons. This is known in the business as a "buy case". A buy case is a simple, to-the-point summary of why this stock makes sense for your portfolio.
It covers five important points about the company and the stock and forces you to do your homework before investing. If you follow this procedure or one similar to it, you'll avoid buying (or selling) as an emotional response.
5 Points of a Stock Buy Case
Here are the five points your buy plan should cover:
1. What does the company do? If you can't explain the major business activity of the company in two or three sentences, you shouldn't be investing in it.
2. What part of the economy does this business serve and is it growing or does the company own a large share of that market? You invest in a company anticipating long-term growth. Companies that are built on fads or outdated technology are not good prospects. The technology sector is more volatile than consumer staples, but also offers more growth potential.
3. Is the company riding a demographic or economic trend that has long-term implications? Companies that serve retirement needs of Baby Boomers have all new babies population as market. Companies that define their market too narrowly limit their potential growth.
4. How do you value the company using standard market ratios? Using many of the tools of fundamental analysis how does the company compare to its industry peers? How does is compare to the overall market? Why do you believe it is under valued?
5. What do you see that makes you believe the company has room for sustained growth? Why do you believe the company is in a good position to grow and the stock is not priced to reflect this potential? Whatever reason, you should have a reasonable answer for why the stock price is lower than it could or should be. This is your growth margin.
When you have built a convincing buy case (at a certain price), you are ready to invest.
Retain the buy case and review it at least once a year or more often if the stock takes a big hit to see if any of your assumptions or conclusions have changed.
Remember, when you build a buy case before buying a stock, you force yourself to make a rational decision.
Investing on instinct is like guessing, sometimes you'll be right and sometimes you'll be wrong - not a great way to a solid financial future.
