Consult this checklist before you buy a stock

 

Since even a drunk monkey could get rich in the market today, and you are almost certainly a sober human, let's assume that you are flush with your most recent market win and looking to re-invest while the bull is still running. You may not realize it, but that little hint of a grin, that swagger in your step, that sparkle in your eye all reveal a great deal about you. What they reveal is that through your success, you have grown bold, and that through your boldness, you have grown yet more successful. They reveal that you have realized, at long last, how good you are at this and how easy it all is.

I won't say that you have grown careless, because I don't know that you have. I won't say that you are taking short cuts, because you may not be. But can we agree that human nature causes most gamblers, consciously or unconsciously, to bet a lot more freely when they are gambling with “the house's” money? And can we agree that it might not be a bad idea to put a quick safeguard in place to make sure you are not falling into this trap?

I wouldn't blame you for being eager to get fully invested, times being what they are. Here then, is a list of what I believe to be essential questions to ask yourself before buying a stock. Think of this as a sort of pre-flight checklist: if you can't check any one of these, it’s a deal breaker; if you can check them all—off you go!

Do I know this company's growth plan?

A good growth company always needs a good plan. Companies don't continue to make more and more money unless they expand, and they don't expand unless they have prepared to expand well in advance. If you are buying a company for growth, be sure you know exactly why the company will make more money in the future than it is making today. This information should be easy to find, as the company’s CEO should never leave the market in doubt on this point.

Half measures or a lack of vision can kill a company, and in this, you can know CEOs very well from their track records. Few go to bed at night as go-along, get-along types and wake up in the morning as inspiring leaders. Look for companies with solid plans. Consider Tesla (TSLA). The world knows Tesla not merely for what it is, a company that sold 6,900 cars last quarter, but for what it plans to be, a company that will build a new kind of factory and sell 500,000 mid-priced cars in 2016. You may not think Tesla can do that, but the price of TSLA stock demonstrates that a lot of people do. Note, it is better to have a bad plan than no plan at all.


Chart courtesy of stockcharts.com

Are those at the top honest, law-abiding, and ethical?

In an oft repeated anecdote, dating all the way back to the 19th Century, a U.S. president describes a despot saying, “He may be an S.O.B., but he's our S.O.B.” The president and dictator vary with the telling, but the point is that our human nature allows us to see those who break the rules to our benefit in a different light from those who break the rules to our detriment. Don't ever engage in this kind of thinking when deciding on an investment.

Consider Zynga (ZNGA), who's co-founder Mark Pincus once boasted “I did every horrible thing in the book, too, just to get revenues right away.” Pincus may have seemed just tricky enough to make investors rich, but it turned out that ZNGA stock was as damaging to investors as its first games were to computer owners. A person who can't be trusted simply can't be trusted. Don Mattrick took over as CEO of Zynga in July of 2013, and as you can see, things have been better since then.


Chart courtesy of stockcharts.com

Is there a history of revenue and earnings growth?

Nothing demonstrates an effective business plan like a consistent growth rate, and nothing creates cause for concern so much as wildly fluctuating numbers. A great deal has happened in the last ten years—companies have been tested by rapid technological change and wildly different economic conditions. Any company that has increased its revenue and earnings in at least nine of the last ten years has got deep roots. Grab onto these while you can and gain the strength to endure the storm.

One such company is CVS Caremark (CVS). It was nearly a year ago that I named CVS the best stock in the whole market, and I remain every bit as impressed today.


Chart courtesy of stockcharts.com

Is the industry expanding?

This is every bit as simple as it sounds. You might know instinctively whether to have faith in a company's management and be able to spot a promising balance sheet from across a crowded in-box, but if you persist on investing in companies in industries that are contracting, you doom yourself. Of the many examples I could point to, consider Google (GOOG), which is in the information industry and Peabody Energy (BTU), which is in the coal industry.


Chart courtesy of stockcharts.com

Both companies have been working furiously to reinvent themselves, but only one has a core business that is expanding. That one (yes, Google) can use its growing business as leverage to enter new markets, whereas the other (Peabody), must contend with constant trepidation on the part of customers and suppliers who don't know whether the company is even going to be around a few years from now. For a company to successfully reinvent itself requires great strength. Strength always grows out of strength, never out of weakness.


Chart courtesy of stockcharts.com

 

If the market were going to close tomorrow for five years, would I still buy this stock at this price today?

Many readers will recognize this wisdom, as it comes directly from one of the most successful investors in the history of the world, Warren Buffet. The reason for the question is that if you have done your homework well enough, you will have a pretty good idea of the value of the company, so you will know whether you are getting the stock at a good price or not without needing the market to tell you. It is human nature to check the prices of our stocks to see if have been “right” or “wrong” in the short term, though we deceive ourselves by doing so, since short-term price fluctuations are random. If the value is there, the market's whim is irrelevant; you'll make your money eventually. Phrased another way (again, by Buffet)—be an investor, not a speculator.

This is the three-year chart of Buffet's holding company, Berkshire Hathaway (BRK.A). Yeah, he's good.


Chart courtesy of stockcharts.com

Did I get all the information I have about this stock from an objective source?

I was once a stockbroker; I charged a percentage of the total amount of each trade as a commission every time I was able to convince a client to run a trade through me. The commission varied from trade to trade, but it was always higher than my clients would have liked, as it needed to be if I were to keep ahead of the fees my employer charged me. (Long story. Also depressing and pointless.) Suffice to say that you should never make a stock trade based on the advice of someone who only gets paid if you make a stock trade. I recommended a great many trades for my clients in my time as a stockbroker, some of which were good, a few of which were great, and most of which were ill-advised.

I do recall particularly a day in 1996 when I advised all my clients to sell Intel (INTC) to buy shares of Theragenics, (First THRX, then TGX, now nothing.) Theragenics stock was trading near $16 per share at the time and was eventually bought by Juniper Investment Company for $2.20 per share. I don't recall how stock in Intel has fared since then.


Chart courtesy of stockcharts.com

Julian Close has been a business writer since the first day of the twenty-first century, having written for PRA International and the United Nations Department of Peacekeeping. He graduated from Davidson College in 1993 and received a Master of Arts in Teaching from Mary Baldwin College in 2011. He became a stockbroker in 1993, but now works for Fresh Brewed Media and uses his powers only for good. You can see closing trades for all Julian's long and short positions and track his long term performance via twitter: @JulianClose_MIC.

Julian Close

Julian Close

Julian Close became a stockbroker in 1995. In his 20 years of market experience, he has seen all market conditions and written about every aspect of investing. Julian has also written extensively on corporate best practices and even written reports for the United Nations. He graduated from Davidson College in 1993 and received a Master of Arts in Teaching from Mary Baldwin College in 2011. You can see closing trades for all Julian's long and short positions and track his long term performance via twitter: @JulianClose_MIC.

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