Warren Buffett once famously said that he does not invest in a business that he does not understand. Although, he used the statement in reference to technology stocks, I believe it can be used as a rule of thumb while investing in the stock market in general. A majority of investors have been known to take positions in stocks based on tips alone. I have come across a few such people who hold stakes in many a company without knowing who manages them. Well, maybe one can get away not knowing those details, but I sure do expect them to know the current health and future plans of that company.
Ideally, investment in stocks should follow an approach similar to that of buying a used car. If you do not want to end up with a lemon sitting in your garage you need to not just kick the tires before buying, but also check everything under the hood. Simply put, you need to do a thorough analysis of a stock before buying it. So if you believe in the story of a particular stock check the following before investing -
1. comparative price to earning (PE) ratio - indicates the premium that people are willing to pay for future earnings of the company compared with others in
the same industry. In simple words it tells you how cheap or expensive a stock is.
Note: A lower PE can be indicative of a struggling business or an as yet undiscovered gem with the potential of making a turn around.
2. volume of trade (buy vs sell) - indicates a general trend in the direction of the stock. More buyers indicate a bullish sentiment and vice versa.
Note: A stock that trades in low volumes may present difficulty when selling in urgency.
3. future growth plans - find out what will drive future growth of the company (expansion/acquisition plans, stake sale etc.)
Note: Businesses such as utilities companies (water, electricity, gas etc) may have reached the threshold of growth through expansions, however they may have
avenues to improve on operational efficiency.
4. exit plan - always set your exit strategy at the outset. A good plan is to set a stop loss to limit your losses and a target price at which to sell and book profit.
Note: A good harvest provides the seeds for next sowing.
There are several other things one should check, however they will find their way here some other day.
Happy investing!
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