People buy stocks for different reasons. Some investors buy a stock strictly on “technical” reasons based on chart patterns and trends, some buy a stock because they read an article or saw an interview where some “expert” recommended a stock, others buy a stock because I talked about it on 20s Money.
All of the above reasons can be good reasons at different times (especially the 20s Money reason); however, this post will provide you with a checklist for you to walk through whenever you are considering purchasing a stock. Hopefully this will help you eliminate buying stocks for wrong reasons and help you make more money!
If you think you found a stock that you want to buy, do a quick run through the following check points. Does your stock pass the test?
#1 – Does your stock pass the owning a company vs. owning a stock test?
If you had a friend that offered you a stake in a company (the stock of the company you are considering buying), would you purchase an ownership stake? It is important to recognize that by purchasing stock you are buying ownership in a company. How would you research a company you were considering becoming an owner of? You’d probably research the management, its products or services that it sells, its capital structure, etc. You should do the same with a stock.
#2 – Do you understand the services or products the company sells?
For me, I don’t understand banks very well. Derivatives, securities, other financial instruments, blah, blah, blah. I prefer a company like Philip Morris; they sell cigarettes and do a great job doing it. Or Apple, I use almost all of their products, in fact, I’m an indirect salesman of Apple products. I am always selling my friends on why they need the latest Apple product. Clearly, I understand them. Buy stocks of companies that you understand.
#3 – Do you understand the basics of the company’s financial state?
Learn how to read a basic balance sheet and income statement, then analyze them for this company. Is the company heavily in debt? Does the company finance its growth through cash flow from operations?
#4 – Is the corresponding sector poised to outperform?
The company can have great leadership and great market share, but if the overall market they are a part of is poised to drastically shrink, you’d better steer clear. For example, would you invest in a leading company that produces VCRs? Of course not.
#5 – Is their market domestic or global?
Who are the customers for the company? If they are limited to American companies or individuals, you may want to reconsider as economic conditions domestically are fairly ugly. I like companies that sell their products and services globally.
#6 – How would your react if your stock goes down after you purchase the stock?
Would you panic and sell? If so, you obviously did not have much conviction in your initial buy. If you would buy more, then obviously you’re a believer in the long term value of the stock. I frequently will purchase only a chunk of my overall position that I want to accumulate in my first buy so that if over the short term, the stock goes down, I can purchase more.
#7 – Why do you think this company will make you money?
Can you explain to someone in 30 seconds why you are buying this stock. Here’s a hint: to make money. Do you expect growing dividend payouts over the years or are you counting on share price appreciation? Why will the share price appreciate?
#8 – Are you investing in this company for the sake of diversification or because you like the company?
Would you buy this stock if you could only buy one stock? Buying a bank because you aren’t exposed to the financial sector is not a good reason. Don’t buy a stock simply to help you diversify; buy a stock because they are going to outperform and make you money.
#9 – Would you recommend the stock to a family member?
This is a great test to see how much conviction you have in buying this stock. If you recommend a stock to your father and it loses value, you’ll regret the recommendation. Can you recommend this stock? Would you recommend to buy more if the stock goes down in the near term?
#10 – What is your exit strategy?
This is often overlooked. Profits on paper are meaningless. Do you have a targeted share price you want to reach before selling all or part of your position? If you reach your target share price, stick to your initial plan and cash out at least some of your position.
Do you plan to hold this stock indefinitely to collect dividend payouts? Will you reinvest the dividends or take the cash and deploy elsewhere?
Implement this checklist
While this checklist is by no means exhaustive, it will certainly help you begin your thought process when making a decision to buy a specific stock or not.
Are there any points on your mental checklist when you buy a stock that are not listed here? Add them to the list by adding a comment!
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Chris | 20-Jun-08 at 3:22 pm | Permalink
I really like your list, it is very buffet-esque. I also like looking for strong insider ownership or insider purchases…like PM. I also don’t want to be late to the party so i am more likely to feel I am too late for the Agriculture run. I would prefer to pick the best companies that are in a short term decline, but with a positive future. Financials will turn around and I may start trying to buy the best in breed (WFC, GS) in the next few months. I am young so I can wait for a turn-around and accumulate at low prices. I also really like a history of dividend growth. Great list though.
theWild1 | 20-Jun-08 at 6:24 pm | Permalink
These are all great points. Pinpoints lot of the common mistakes people commit when dealing with stocks.
Tom | 21-Jun-08 at 1:37 am | Permalink
Sorry to burst your bubble, but you’re WAY off in your list.
Here’s a quick rundown:
1) You only own a piece of paper. If you owned K-Mart before they went broke, what do you have left? The company never closed its doors, the CEO didn’t lose his job, but you were left with nothing.
2) Unless you’re employed by a company, you have no way of ever having enough information as to what they’re doing. You know Phillip Morris? What else do they do? You’re aware of every product in Apple’s pipeline (knowing what they sell now is useless information).
3) Are you a CPA? Do you understand GAAP? How does the company show sales? Every company cooks their books….legally! Can you spot the frauds?
4) Who cares if a “sector” (I think you mean industry) is poised to outperform? The only thing that matters is money flow into and out of sectors and industries. Nuclear power is going to be much stronger over the next 15 years. That means GE should “outperform”. But they’re at a 4 year low!!!
5) So you wouldn’t invest in any of the domestic oil companies? Any of the domestic utilities?
6) This is tied into #10….and they both should be #1!
7) Sure you want the company to make money, but the only reason you buy a stock is to sell it…..hopefully at a profit!
9) Who cares? If you’re interested in making money, you’ll tell everyone. The goal is not to make money with every stock. No one has ever done it or ever will do it. Your goal is to make money over the long run consistently.
10) The mistake that most every investor makes is they spend a ton of time trying to pick out the right stock, but spend almost no time figuring out how to sell the stock once they’ve bought it. ALWAYS go in with your exit strategy set, including how much of a loss you’re willing to take. This should be your first rule!
Best of luck investing!!
kevin duffey | 21-Jun-08 at 8:42 am | Permalink
Tom, thanks for the comments.. very thorough!
Sure you own a piece of paper, but I think the mental check of viewing it as owning a company can help people make better decisions on where to put their money. (That ticker symbol they see on a website is more than just a name, it is a living, breathing company).
Sure, I don’t know every detail of all the new products in Apple’s pipeline, but I sure understand their direction, and I sure have a pretty good idea of where their pipeline is heading. I understand their products much more than Goldman Sachs! Better investment that GS? maybe not, but a good exercise nonetheless.
Saying that nuclear is poised to have a strong 15 years is exactly my point in looking at the potential future sector performance. However, GE worries me because of its financial component.
Energy companies are pretty much the only domestic companies i like. I love Chesapeake Energy (CHK).
Sure who cares about telling others about a stock. My point is that if you can get your dad into a stock, you should be pretty confident in doing your homework. It’s a mental check. Whether you do it or not doesn’t matter.
Exit strategy is huge, I agree. Know what you want to make or have an estimate, then stick to it! That’s why I’ve been unloading Chesapeake Energy as it’s gotten into the 60’s even though most people on here are telling me I’m nuts!
Thanks!
wheresmyhouse | 22-Jun-08 at 4:06 pm | Permalink
But I was told VCRs are the wave of the future.
Dave | 22-Jun-08 at 4:51 pm | Permalink
Thank you, thank you and thanks.
Small Business Income Center | 19-Nov-08 at 1:45 pm | Permalink
Unless you know what stock to buy, when to buy, and why you are buying it, one is doomed to mere gambling.
Tom implied it is necessary to be a CPA or have an understanding of GAAP. Although I don’t believe that is mandatory as an investor, merely suggesting to someone, without a basic understanding of accounting, to “learn to read a financial statement” – is pretty shallow and unrealistic to the average person. Perhaps companies do manipulate their books, to believe anything else would be naive. But, if if you feel that threatened by a company’s financial reporting, don’t be an investor then!
When targeting certain sectors, it is true that a rising tide elevates all ships, but one must still be able to “pluck the prettiest flower” amongst the bunch. How can you do that?
Investing requires more than speculating on the market’s direction, it requires proficiency in accounting, economics, finance, etc.
This will not happen to anyone overnight though.
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Please visit the Small Business Income Center fo other articles relevant articles: http://www.smallbusinessincomecenter.com
Mark | 12-Dec-08 at 11:06 pm | Permalink
I like the list. You must have a fundamental thesis for investing especially in this market.
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[...] The Ten Point Checklist For Buying Stocks (10,771 hits) [...]
Ray | 14-Jan-09 at 4:18 pm | Permalink
I don’t miss trading individual stocks. I had my best year on record in 2008 just trading the trends using Index ETF’s [mostly SDS,BGZ]and crude oil ETF’s [DTO and DXO]. It is really simple but shhhhh…..you are not supposed to know that.
Great post!
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[...] in check. I wish you the best and happy investing!Other articles written by Kevin includes: The Ten Point Checklist For Buying StocksI’m In A Good Position Financially, What Can I Do To Take My Personal Finances To The Next [...]
Alex Stewart | 20-Apr-09 at 8:35 pm | Permalink
Good points if you think that the market is wrong in its pricing. Now, if you think the market actually knows more than the investors, try out some technical analysis.