Don’t buy that stock! Until you answer these 3 questions

Figuring out a stock to buy – according to legendary investor Peter Lynch – should take at least as much time as you’d take to decide what refrigerator you should buy. The thing is, few people do.

Last week, we talked about three questions you should ask yourself before you buy an asset – whether it’s a stock or a beach house or a fridge. Those questions are a good place to start.

But when you’re buying a stock, there are a few more questions to ask before you begin to dig more deeply. The wrong answer to any one of these questions is a sign you should look elsewhere.

1. Do I understand how this company makes money?

Lots of companies make a lot of money doing very complicated things. And that’s good for them. But if you can’t explain what a company does, and how it makes money doing it, in a way that a child could understand – then you should probably look elsewhere.

There’s a very good reason for this. Simple businesses are more difficult for bad managers to mess up. The more “idiot proof” the business, the lower the execution risk (that’s the danger of management not being able to do their jobs). And as an investor, if you can understand how the company works, you’ll be able to have a better sense of what’s really going on at the company.

Of course, what is “simple” to you might not be “simple” to others. If you’re a biochemist, you might understand what a pharmaceutical company does in a way that most people can’t. If you’re a financial analyst, reading a bank’s balance sheet might be easier to you than boiling water. You should use that special insight and expertise to your advantage.

But whether you’re a rocket scientist or a truck driver, use your edge – and stick to what you know.

2. Is the stock already “done?”

A few hints that the stock you’re looking at has already enjoyed its day in the sun:

If your great idea is on the “Focus List” of the big brokerage house where you trade, don’t buy it. If your broker sends you a thick research report on a stock, with “Buy” stamped on the front, don’t buy it. (I used to write those sorts of reports for hedge funds and mutual fund investors. They’re 95 percent worthless to most people.)

If you discovered your great stock idea on the cover of Forbes or Fortune magazine, it’s already over. Don’t buy it. You don’t want to buy the stock that everyone has already picked over – a stock that most other investors have already digested and acted on. Remember, a stock will only go up if there are more buyers than sellers. If your broker’s big clients have already bought the stock, and if it’s a big enough idea to make the cover of a magazine, then it’s already been bought – and those earlier buyers will be selling to you. Being the “last buyer” of a stock is a bad place to be, because there won’t be anyone else for you to sell to.

One exception here is if you’re wrong about a stock being “done” (seehere about how I made this mistake). You might have some unique insight on an industry that you think everyone else knows – but in fact few people at all know. So treat your own ideas with more respect (than you might otherwise) if they’re from direct professional experience. And in this special case, don’t assume everyone else knows what you know.

3. Is management on my side?

There’s a big difference between just earning a salary – and owning the company you’re working for. If a lot of your personal wealth is tied up in the success of your enterprise, you’re going to work a lot harder than if you just collected a salary.

Few investors see it this way – but when you buy shares in a company, you’re actually buying a small portion of a company. You’re not collecting a salary. You make money only if the company does well, and the share price increases.

What you want is a management that also has a lot of reasons – and financial incentives – to make the company grow, and the share price to rise. The senior management of the company should own a lot of shares of the company, and should be buying more all the time. If they don’t, you should look elsewhere.

These questions are just the first steps in figuring out whether a stock is worth adding to your portfolio. But if you don’t completely understand how a company makes money; if the stock already has all the exposure that it’s going to get and is “done”; and if management isn’t laser focused on making the share price go up – then you should move on.

Kim Iskyan is a former research director for an emerging market investment bank and hedge fund manager, and has spent the past 25 years exploring and analyzing global markets. Kim has been quoted in the Economist, The New York Times, the Wall Street Journal, Barron’s, and Bloomberg. He’s appeared on Fox Business News, China Central Television, Bloomberg TV, and elsewhere. Kim is also the founder of Truewealth Publishing where he writes and shares his investment insights regularly.

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