What is your process for buying shares?
There’s certainly a plethora of things a diligent investor can investigate before they pull the trigger, but not all will offer much value and some can be a downright waste of time. You need to be smart about where you focus your efforts.
So it’s useful to have a clear agenda when approaching a potential investment. You’ll find it instills rigour and discipline to your investing, helping to avoid mistakes and minimise your susceptibility to a variety of grievous behavorial biases.
The value of such an approach is well established in a variety of fields, especially where lives are on the line. Both surgeons and pilots, for example, go through a series of checklists before most procedures to mitigate against our various human flaws.
Investing may not be life or death, but sensibly shepherding your precious capital is extremely important.
So, what are the things investors should check-off before buying a shares? Below are some suggestions that will help get you started.
Do you understand the business?
This is a broad question, but one of paramount importance. If you can’t genuinely understand the nature of the business model you shouldn’t be buying shares in the company.
And there’s no shame in admitting you don’t get it. There’s a lot of esoteric industries and businesses that are very difficult for an outsider to thoroughly comprehend.
As Warren Buffet says, there’s no extra points for degree of difficulty in investing. And, fortunately, there are plenty of other fish in the sea.
Ask yourself, how does the company make money? Who are the customers and what are the key factors that influence their decisions? How are the products or services different from that of competitors? What are the key industry dynamics at play? What are the major profit drivers for the business? Does the business have any competitive advantages (moats)? And so on.
Do you trust management?
Who, exactly, is steering the ship? What experience do they have? What are their incentives? Do they have skin in the game? Have past promises proven reliable? Are they clear communicators? Do they take ownership of missteps and challenges, or do they just offer excuses?
Management capability is hard to quantify, but it is of immense importance. Reading back through past annual reports and annual presentations can be extremely valuable, as can attending results calls and the annual shareholder meeting.
What are the risks?
Investors spend a lot of time thinking about what can go right for a business, but less time thinking about what could go wrong. But, as they say, if you look after the downside, the upside will take care of itself.
Here it is important to distinguish between inevitable risks that relate only to short-term factors, and longer-term structural factors. A disappointing quarter for sales against a weak economic backdrop is not great, for example, but probably says little about the enduring earnings power of the business.
Is the balance sheet in good shape?
Investors tend to focus heavily on sales and profits — and rightly so — but the balance sheet is also of key importance.
A business with strong cash reserves and modest debt represents a much lower risk proposition. Not only can they endure extended periods of difficulty, they often emerge much stronger as competitors are forced to the wall, or acquired for cents in the dollar.
What price is fair?
No business, no matter how wonderful, is worth an infinite amount. At too high a price investors can still suffer big losses, even if the underlying business continues to perform well.
Attempting to fairly value a business is an extremely valuable exercise. Not only does it help determine whether the market is presently offering good value or not, but the very process helps us better understand the nature of the business itself.
Final thoughts
If the above sounds like a lot of work, you’re right!
But if you’re not prepared to put the effort in you are trusting to hope — and hope is a very poor investment strategy. Indeed, you are essentially gambling, and you should expect the same outcome.
Those that do follow a process, though, and adapt and enhance it as they continue to learn, will find they have an immense edge on the average investors.
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