1. Understand the nature of the companies you own and the specific reasons for holding the stock.
A lot of people buy stocks with the mentality – “This stock is really going up!”
This reasoning of buying stocks has never worked in the long run. You might buy a stock that is going up in price, and you might make some money in the short run. But in the long run, this basis of buying stocks is going to suck you into a never ending whirlpool of losses.
A stock is just a share in a business. So it’s important to understand what is the kind of “business” that you are getting into. And then you must have specific reasons to buy and hold the stock (again, reasons that have less to do with how the stock price is doing and more to do with how the business is doing).
2. Consider the size of a company if you expect it to profit from a specific product. You might say, “I love Maggi! In fact, everyone loves Maggi. So Nestle must be a very good stock!”
Let me ask you, “Great! But what if Maggi is just 1% of Nestle’s total sales, and the products that contribute the remaining 99% aren’t that great? Does Nestle still sound like a great investment just on the basis of one great product that contributes just 1% of its sales?”
Now what do you say?
See, companies selling products or services that everyone love or is talking about is worthy of “considering” as a potential investment.
But, as an investor, the greater task for you is to know how much of that great product or service means to the company. If it does not contribute meaningfully to the company’s sales and profits, it can’t be the core reason for buying that stock.
3. Be suspicious of companies with growth rates of 50-100% a year. “Growth for the sake of growth is the ideology of the cancer cell,” goes a famous saying. In the same way, companies that are growing at rates of 50-100% annually must be looked at with suspicion.
One reason for this is that such growth cannot continue for long (for reasons like higher competition that might want to take a pie of this growth opportunity). The second reason is that if such a company still wants to push for higher growth for a few more years, it might have to infuse more capital in the business.
This could either mean stretching the balance sheet (by taking on debt) or diluting equity (by issuing new shares). Both these are bad omens for existing shareholders.
What is more, one year of slowdown in growth can come as a shock to the stock market, and might lead to a sharp fall in the stock price.
4. Distrust diversifications, which usually turn out to be diworsefications. Experience suggests that most diversifications (acquisitions of companies in the same area or a different one altogether) are done to satisfy the egos of promoters, and not for real business reasons. And most of the diversifications end up as diworseifications.
So watch out for companies that are blazing guns in this space.
5. People get incredibly valuable fundamental information from their jobs that may not reach the professionals for months or even years. Not many small investors appreciate this, but it is one of the best ways they can pick great stocks.
If I’m a banker, I know what makes up a bank’s balance sheet and I also know which banks are worth banking upon as investments.
Considering this, I would be a fool eyeing biotechnology or IT stocks, especially when I don’t understand the ABCs of these industries, but just go by what my broker or friend advises me.
Of course I might enhance my circle of competence and learn about these industries, but my first hunting ground must be ‘banking’.
6. Separate all stock tips from the tipper, even if the tipper is very smart, very rich and his or her last tip went up. Even if I love my fund manager for his stellar track record in managing my money, toeing all his stock ideas without doing my own research would be fraught with extreme risks.
The stock he is recommending on CNBC might form just 0.001% of his total portfolio. I might be so enamored by his story on the stock, that I may buy it in bulk and it forms around 10% of my small portfolio.
Now when this stock crashes, the fund manager would appear smart for taking a very small risk with it. I might lose my shirt.
So the idea is to always do an independent research on a stock before you even think of buying it.
7. Invest in simple companies that appear dull, mundane, out of favour, and haven’t caught the street. Such a company is rarely covered by stock analysts and bought by fund managers. So there is a great chance that the stock could be available at a great bargain.
8. Companies that have no debt can’t go bankrupt. This is the most important lesson that you would remember (or forget) when it comes to identifying the right businesses for investment.
Companies that borrow money to grow their businesses might appear good (because they are ‘growing’).
But more often than not, such companies get so much intoxicated by the growth that they end up making a mess of their balance sheets, and in the process, destroying whatever shareholder wealth they created during “growth” years.
Look at realty and construction companies, and you won’t have to look anywhere else for such examples.
9. Devote at least an hour a week to investment research. Adding up your dividends and figuring your gains and losses doesn’t count. I have been shouting this from the rooftop of Safal Niveshak all this time, but not many seem to hear. So now, let me tell you how much Peter Lynch believes in the power of “independent investment research” in the success of an investor.
Lynch suggests that you must invest at least as much time and effort in choosing a new stock as you would in choosing a new refrigerator.
10. When in doubt, tune in later. Now this is where the emotional part about investing comes into play.
I have spent ten days researching a stock, and thankfully on the eleventh day, I find that it’s a great business and even available at a good discount to the intrinsic value. So it seems like a perfect “buy”.
Now, what in the world should stop me from buying this stock?
Well, here are some questions that must stop me from buying that stock (call it XYZ) instantly:
Am I biased towards XYZ just because I’ve spent ten days researching it?
Am I getting over-confident with my analysis?
Am I impressed by just the company’s recent performance?
Do I like the stock just because it has fallen in price?
Do I like it just because my friend advised it to me in the first place?
If the answer to any of these questions makes me uncomfortable, it’s an indication that I must sleep on the stock idea instead of buying the stock then.
There have been numerous instances where I have waited weeks or even months before committing money to a stock idea I liked.
As Peter Lynch says, “The key organ for investing is the stomach, not the brain.”
The 15-20 days after I complete my analysis on a stock help me know whether my stomach is ready to digest the stock even when the mind answers in the affirmative.