Recent market activity, which saw growth leaders give back the year’s gains in a week, looks very different to different types of investors. Many growth investors saw price movement trigger stops while value investors, on the other hand, watched the market action with the same glee that an Iowa farmer experiences when he gets a late-season rain. Stocks whose prices have fallen are potential bargains, and after a period of stubbornly high P/E ratios, the heavens have finally opened and are offering opportunities for buying a stock at a discount.
One man’s meat is another man’s poison, as the proverb says.
One practical outcome of this situation is that when I’m contacted by subscribers asking whether the current dip represents an opportunity for buying a stock, I have to ask some clarifying questions first.
And that got me to thinking that there are some questions any stock investor should be prepared to answer before buying a stock. Here are the five that come quickly to mind.
1. Why are you buying a stock?
This isn’t as obvious as it sounds. Yes, you’re buying it to make money, but are you buying it as a short-term momentum play? A long-term core holding for income? A value investment for selling at a predetermined “full value”?
Some potential investors have just heard a stock’s story and think it sounds promising. Some are lifetime devotees of the firm’s products. And some have just received a hot tip from a talking head on cable TV.
But you need to be able to sum up your ruling reason for making the buy. Think of it as the stock’s elevator pitch. The more clearly you understand why you’re buying, the better.
2. Why will you sell it?
Again, this isn’t as obvious as it might seem; you know why you’re buying a stock so you should know when to sell it. A growth investor should have a clear, written down set of maximum loss limits, either the standard 15% and 20% (for negative or supportive markets, respectively) or a technical point of support that marks an explicit danger signal.
Value investors will have a target price (which may be increased on the way up) at which the stock is fully valued.
And even buy-and-hold investors should make plans for what to do if a core holding turns up its toes and heads for the basement.
3. Does the market support your choice?
A market that’s trending down puts pressure on all kinds of stocks, making it harder for any kind of stock to push higher. Growth disciplines use the direction of the market as an important red, yellow or green light signal, telling us whether the wind is at our back or in our face. We pay attention.
Value and income investors aren’t quite as concerned about the market, as their investment decisions are more influenced by fundamentals, but anyone who hopes to see a higher price in a stock should know which way the tides are running.
4. When are earnings due?
You might think that this question would only be relevant four times a year, but it’s still important to know the answer. Quarterly results can send a stock soaring or plummeting, and you should probably avoid buying a stock, or at least making a big bet on any stock that’s going to release its results in the next couple of weeks. (If there isn’t an official earnings date, look for the previous quarter’s date and pencil in the next one in three months.)
5. Is this really the right action to be taking now?
For growth investors especially, the urge to buy can be powerful, and can sometimes have you reaching for the BUY button when you shouldn’t. Sometimes the right thing to do is to sell. And sometimes the right thing is to do nothing. Look at all your options (including using options!) A quick inventory of your available courses of action can often steer you in a better direction.