Weighing up the pros and cons of a stock We take a closer look at how to determine whether a company is worthy of a place in your investment portfolio.
oneof the most important points of investing is how we get to that final decision about whether to buy a stock for inclusion in our investment portfolio. It is vital that we do not just act on a whim or a single piece of news or data. Sure, maybe the man in the nice shiny suit on TV rates it a buy, or the know-it-all on some chat forum says it’s going to be a 10-bagger. Certainly these opinions can be used as starting points, but we need to build a body of evidence to support the purchase decision.
I call it my preponderance of evidence. Generally, there is one thing that will initially attract me to a share: it may be a great dividend yield or a historically low price-toearnings ratio (P/E), great results or maybe even the shiny suit on TV – but whatever it may be, that is merely the first step. Now that we have a starting point, we need to do more digging into the share and its investment potential. I typically start my digging with just a blank piece of paper.
Listing pros and cons
On the left side of my pro/con list, I write down the good points for investing in the stock and on the right I write down the risks – the reasons for not investing in the stock. As I go along doing my research into the company, I write down more information in these columns.
When I run out of paper, or run out of stuff to dig through, I stop and examine the evidence before me. There will always be reasons not to invest (the risks) because in order for there to be reward there has to be risk. But what is very important is that the good bits significantly outweigh the bad bits. I want a preponderance of evidence that this is a good company to invest in.
If my list is dominated by bad news and risk with very little good stuff, then the investment is simply far too risky and I will walk away. But if the good stuff dominates, then I’ve found something worth buying.
What makes a stock attractive?
The next step in the process is to highlight the top two or three good points for making the investment. These then act as my exit strategy. They were the key reasons for entering the investment and hence if they change for the worse, they become my reasons for exiting – in trader speak, my stop-loss on the investment, although it is based on the fundamentals of the stock rather than the price. So for example, if one of the main attractions was a great margin and this margin starts slipping, I have to consider exiting. I am never quick to exit, and one reporting period of reduced margins will not worry me, but repeated slipping margins would concern me.
Update your findings regularly
Lastly, when I am finished with the process, I file the piece of paper away, I don’t toss it. On it is my research and my exit strategy – I need to keep it as the investment may run for years or even decades, and as the years pass I may not remember what drove me to invest in that particular stock in the first place.
An important point is that I will revisit the list every time there are results or other important news coming out of the company. When there is news, I update my list, adding pros and cons. If the negative aspects increase and start to outweigh the positive ones, this would be a reason to exit, but if the good continues to dominate then I will keep holding the stock.
On the left of my pro/con list, I write down the good points for investing in the stock and on the right I write down the risks – the reasons for not investing in the stock.