Five questions to ask yourself before you buy a stock

2.  Do you feel rich right now? 

As Warren Buffett has said: “A fat wallet is the enemy of high investment returns.” Markets have been steadily rising for almost a decade and good opportunities are hard to find. You may have noticed your cash piling up and you’re eager to put it to work. There’s a case for staying fully invested, but acting out of boredom or a fear of missing out is a big no-no. Does the stock you’re about to buy really tick all your boxes, or do you feel you are making compromises? Would the you of five years ago have considered this stock equally undervalued or are you buying it because it’s “the best of a bad bunch”? What’s more, just because your cash is piling up doesn’t mean it’s a good idea to increase your position sizing and overly concentrate your portfolio – even the safest, most undervalued stocks rarely deserve a weighting above 10%.

3.  Can you explain to a 10-year-old what this business does and how it makes money?

If you can’t explain in simple language how a business makes money, who its suppliers and customers are, or why it has a competitive advantage, then you may be treading outside of your circle of competence. Stick to investing in companies that you understand deeply so that you can make informed predictions about their performance over the next decade. That way, you’re less likely to be caught off-guard by operational mishaps or changing industry conditions. 
 

4.  Do you know the CEO’s salary? 

A company’s chief executive is your managing partner, yet investors often buy stocks without knowing the chief’s name, let alone what the company – their company – is paying them. If you were buying a local bakery, you would want to know who the cooks are. The same goes for stocks. Look for high insider ownership, and executive compensation based on performance and earnings per share growth. Beware of companies that regularly issue shares or have overly promotional management. Anything that suggests management is being dishonest should be a deal breaker.
 

5.   Would you rather the share price go up or down tomorrow?

Would you be OK if the stock market closed for five years? You’re buying a piece of a business, not a ticker symbol, and your returns over time will be driven by two things: the performance of the business, and investor sentiment towards it. Predicting crowd psychology is impossible, so stay focused on making investment decisions based on a company’s fundamentals: its earnings, cash flow, competitive advantages, growth prospects, valuation, etc. If you’re truly buying with a business owner’s mindset, you would rather the share price go down tomorrow, so that you can add to your position at better prices or give the company a chance to buy back its own stock. If you want the share price to go up immediately after you buy, it could suggest you’re just speculating on price movements.

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Graham Witcomb is a senior analyst at InvestSMART (under AFSL 282288). This article contains general investment advice only. It has been prepared without having regarded to or taking into account any particular investor’s objectives, financial situation and/or needs. All investors should therefore consider the appropriateness of the advice, in light of their own objectives, financial situation and/or needs, before acting on the advice. This article does not reflect the views of CommSec. The article was originally published on 18 February 2019.