Got your cursor hovering over the “buy” button? Please hold your fire. Before putting your cash on the line to buy a stock, take the time to answer these key questions about the opportunities, risks and your expectations.
Start with a background check
Here are seven questions to guide your research and uncover what makes a company tick.
What does the company do? Or, more precisely, how does it make money? The answer may seem straightforward at first — “It makes widgets!” But digging a little deeper could reveal that, actually, the main drivers of the business are the servicing contracts it sells or that its financing arm is the most profitable part of its operations.
Does this company have a competitive advantage? Ideally, there’s something that makes it a standout in its industry — something about the business that’s hard for the competition to copy and potentially eclipse. That could be size (dominance in the industry), reputation, superior research, manufacturing or distribution capabilities, patents or some other special sauce. Speaking of the competition …
Who are its competitors? What are they up to? Compare the important operational metrics of your company to its rivals and sector averages. Who knows, you may find a better contender for your cash or decide to buy shares in a few of the competitors to spread your risk.
Is the company profitable? Investors use a number of metrics, ratios and analytical styles to assess a company’s health. Look at the data from as many angles as possible, including historical results, sector indexes and how other businesses in the same industry measure up. (For a detailed how-to, see NerdWallet’s guide to how to research stocks.)
Who’s running the show? Buying a stock is the equivalent of going into business with the folks who run the company. Do a background check on management. Read transcripts of what they say during company conference calls to get a sense of their style. Look into how they managed the company during good times and bad and make sure you’re comfortable putting your money in their hands.
How do company leaders feel about the business’s prospects? You don’t have to call and ask. A telling sign of management’s take on the business is insider activity: Have they been buying or selling shares? Buying significant amounts — $500,000 worth of stock or more for senior management — is generally a good indicator that they’re bullish on the business. But also keep in mind that people buy and sell stock based on their own financial needs and interests. You’ll find a list of major stockholders and insider activity when you call up a stock quote on any major financial website. Some also will provide a sense of the size of each insider’s position.
Will this company be around in 20 years? Once you’ve gone through all of the above, you’ll have a better sense of the company’s long-term prospects. If you’re a buy-and-hold investor, owning a stock for decades isn’t out of the question. Consider investors who bought shares of Amazon stock when it went public in 1997. Those who stayed committed to the company in good times and bad are now — two decades later — sitting on a 49,000% gain. No, that’s not a typo.
Figure out what’s in it for you
When it comes to picking stocks, you’ve got choices. Roughly 4,300 of them. Of all those companies trading on U.S. stock exchanges, what makes this one special? To help set expectations and find out if this is a relationship worth pursuing, reflect on these three questions.
What exactly do you like about the company? It’s time to start your “why I’m buying” list. Some of the items unearthed during your competitive advantages research will make this list, as well as answers to the following questions.
What are your expectations? What needs to happen for the company to succeed? What are the key metrics you’ll use to judge its progress and during what time frame? While past performance is no guarantee of future returns, it can provide insights into the business’s trajectory.
What role will this stock play in your portfolio? Stock purchases shouldn’t happen in a vacuum, whether you’ve got a fleshed-out portfolio or are getting ready to buy your first stock. Consider how this company fits into the portfolio of businesses you already — or are planning to — own. For example, will it fill a hole (offer new exposure to international stocks), augment current investments (add weight to your health care holdings) or replace an underperforming stock? Also consider how big of a commitment you’re going to make — the percentage of your overall portfolio you plan to devote to the stock (aka asset allocation). Deciding that percentage figure upfront makes it easier to rebalance your portfolio down the road.
Consider what could go wrong
What could go wrong? Famous last words, right? It’s time to play a game of “Let’s Catastrophize!”
What are the biggest threats to the industry? After your competitive research, you’ll get some idea about what makes everyone in the same industry nervous. List those challenges — changing laws and regulations, perhaps, or demographic shifts — and consider how well your company is equipped to respond.
What are the biggest threats to the company? Explore the company-specific weak spots. What would prevent your stock from reaching its full potential? For example, does the company have a stronghold on its competitive advantages, or could it easily lose ground? Consider both near- and long-term challenges. And look at how the company has performed under pressure in the past.
What fundamental business changes would drive you to sell your shares? You have your “why I’m buying” list. Now it’s time to write the companion “why I’d sell” list. This is less about share-price changes — especially short-term price movements — and more about things that would affect its ability to grow over the long term. Reasons could include the company’s loss of a major customer, the emergence of a viable competitor or a new CEO’s shift in the business focus.
Any time you feel pressure to make a spur-of-the-moment investing decision, whether it’s to sell a stock you own or to buy a stock that’s on fire, this Q&A will serve as a reminder of your investing intentions from calmer times.