Questions to ask yourself before making any stock purchase

caveat-emptorAlong with the modest success I have had in stock market investing, there have been numerous experiences that have taught me a few basic questions that I need to address before buying any stock. For the benefit of the readers, I am going to share these all important qualitative aspects that you must consider before venturing into any stock (apart from the detailed financial analysis which you will do).

What is the big picture?

Here you need to understand how the industry (in which that particular stock is operating) currently doing. If there are any headwinds/ tailwinds? In addition, you must try to analyse from a layman’s point of view as to how the industry is supposed to do in the next 10 years and why? You may say that several industries are so complicated that you cannot understand them yourself. In such cases, I prefer to stay away. Take for example the pharmaceutical industry, wherein I do not understand how patents (which are the most important asset of a pharmaceutical company) can affect the earnings of the company in the long run, so I stay away from companies in this industry. It is better to miss investing in companies you do not understand than invest in them hoping that they will do well because some x-y-z person said so. I prefer not to live in hope. If I can understand the industry and thus be confident about it I will look further, else it is a no go for me.

Are the company’s operations scalable? Is there a moat/ durable competitive advantage?

Well, this is pretty straightforward. If the industry has potential for growth and the company you are analysing has a durable competitive advantage because of its size, cost structure, entry to barriers in the industry, brand value etc. it is time to analyse the company in detail. A durable competitive advantage will ensure that the company is growing earnings for the next many years.

Am I investing because the stock price has come down?

Do not fall in the trap of averaging a bad investment. Sometimes, market does offer a great company at bargain price at which time you may add more to your holdings. However, if the fundamentals have deteriorated because of certain developments recently or you made a mistake when you bought the stock in the first place, you are better off booking your losses and investing the proceeds in a better stock investment. When markets have fallen substantially because of some macro event, it is the best time to correct your mistakes by reshuffling your portfolio and getting rid of those poor investments. A quote from Warren Buffett comes to mind, “The most important thing to do if you find yourself in a hole is to stop digging.” Get out when you know what you have done is wrong.

Am I trying to time the market?

It is well proven, even by research, that one cannot time the market to perfection. Devote more time to buy stocks much below their intrinsic value (sufficient margin of safety) than to predicting what the market will do next.

Has the company been squandering excess cash it had accumulated in good times on acquisitions?

Mergers and acquisitions rarely add value. Beware of companies which have are addicted to acquisitions. Especially if there is a combination of debt and acquisitions, you need to be extra cautious.

Is the management capable, enthusiastic and honest?

Do investigate the promoter’s credentials before analysing the stock in detail.

Is management remuneration reasonable?

It is helpful to compare management compensation with peers in the industry. Also, has the remuneration increased in line with growth in earnings?

Has the company been diversifying in unrelated businesses?

This is a red flag especially if the company’s core business has been doing well and there is still a lot of room the scale the operations in the existing line of business.

What is the extent of related party transactions?

If related party transactions are material as compared with sales the company is making, this is a big concern. While these may be absolutely legitimate, it is better to cautious of such transactions as the company may be overstating revenue/ understating costs by virtue of such transactions.

Is the company/ industry being touted as the next big thing?

Again, you cannot invest on hope. If there is sufficient operating history for the company via which one can analyse the business and take informed decisions, only then should one look further. Howard Marks puts it so well in his book “The Most Important Thing: Uncommon Sense for the Thoughtful Investor”,

All bubbles start with some nugget of truth:

  • Tulips are beautiful and rare (in seventeenth-century Holland).
  • The Internet is going to change the world.
  • Real estate can keep up with inflation, and you can always live in a house.

Caveat Emptor!

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