Oftentimes we will buy a stock after we hear a compelling story from some analyst or from an executive from the company. They make it seem as if you are guaranteed to make money when you buy a stock. But this simply isn’t so. At best, we can try to put the odds in our favor and even then, it takes a lot of hard work that requires you check your emotions at the door. So before you decide to pull the trigger, ask yourself the following three questions.
1. Who’s selling and why?
One thing that people forget when they are buying a stock is that there is always somebody on the other side of the trade — somebody is selling the stock to you. We often forget this point, and by extension we forget that the person on the other side of the trade has a reason of his/her own for selling. This reason may have nothing to do with the fundamentals of the underlying company.
For instance, the stock may have risen a lot and the investor wants to rebalance his or her portfolio. He or she may also need the cash. But it is also possible that the owner of the stock bought the stock at a lower price in anticipation of the same story that is now prompting you to buy it at a higher price. It may also be a seasoned short-seller who is borrowing stock from his or her broker as a result of extensive research into the aggressive accounting strategies that management relies upon to sucker new investors in at an irrationally high price. While we can never know for sure we should at least take a guess, and more importantly, understand the bear case.
2. How low can the stock go?
Investors buy a stock because they think it is cheap. But what is a “cheap stock”? This question is difficult to answer, especially considering that historically, stocks in the aggregate have traded with a price-to-earnings multiple as low as 5 or 6 and as high as 40. So 12 times earnings may seem cheap, but in the right environment, your stock could have 50 percent downside even if earnings don’t decline. While we can never know for sure how low a stock can go, we can take a reasonable guess.
One thing to do is to take a look at the historic price-to-earnings multiples that have been paid for a stock. S&P reports this data in its research, which is available through many reputable brokers: the firm provides each year’s high P/E and low P/E for the past 10 years. So if a stock currently trades near the low of that range, you might reason that it has limited downside. But if your 12-multiple stock traded at 6 times earnings in the past few years, you need to be prepared for a reoccurrence.
3. Who else owns the stock?
Buying a stock is in some ways like joining a club or a community of the people who own the stock. You should know who these people are, and by “people,” I mean institutions (e.g., funds, holding companies, etc.) and insiders. Generally you want to gravitate toward companies that have large institutional ownership basis because institutions typically have more resources with which to do research than individuals, and their decisions are generally more authoritative.
However, the key thing to look for, especially with smaller companies, is insider ownership. Insiders have a unique view of the company that we as “outsiders” simply cannot gain. If insiders own a lot of the stock, that means they see a lot of promise in the company’s future from a unique viewpoint. It also gives them motivation to work harder in order to improve shareholder value.