Investing Checklist: 10 Questions to Ask Before You Buy a Stock (Part 1)
December 20, 2021
Investing in the stock market is no rocket science, but it does require an in-depth research process before making investment decisions. Commonly, most investors buy or sell their stocks too quickly and base their purchase decisions on isolated facts, news or share price swings, without taking the necessary time to thoroughly understand the businesses that they are buying into. This could be dangerous because this decision-making process is likely to be dominated by emotions.
Hence, I’ve designed this investing checklist that marks as a guide for investors to develop a principled investment strategy. Through a structured research process, I believe that this can better help you identify quality investment opportunities that fits into your ideal investment portfolio.
Part 1 of this investing checklist focuses on the company’s business while Part 2 will cover more about the qualitative aspects of investing.
1) What is the company’s business?
This is the most important part when it comes to investing. If you do not understand how the company operates or function, it would be impossible to gauge the company’s growth potential, it’s prospects and financial strength.
Here are some of the questions that you can ask yourself when reviewing the company’s business.
- What is the company’s business model?
- What are the products or services offered by the company?
- Learn about the industry that the company is operating in and the competition, target market, market size and how long the company has been operating in the business
- What are the competitive advantages of the company in comparison with its peers?
2) How is the company’s earnings growth?
With a better understanding of the company’s business models, products and services, you will have a better apprehension on the company’s earnings growth potential. You must know that businesses that target end-consumers would be relatively different from those who rely on projects or contracts from other corporates or organisations.
By looking at the company’s earnings growth trend historically, its profit margin and other earnings aspects, investors will have a more accurate estimate on the company’s potential and risks. For example, if you look at a company’s earnings trend, you can choose to evaluate the profit margin trend of the company. Usually, a company that shows consistent growth in revenue and expanding profit margin indicates that consumers or customers are willing to spend more for the same services or products.
Here are some of the questions to ask when you are looking at the company’s earnings growth:
- What’s the revenue and earnings growth trend over the last five years?
- If the company is operating in different business segments, find out which are the main business drivers for the companies, and if there are any changes over the last five years.
- How is the company’s profit margin and what is the trend over the last five years?
- Read about the key drivers for the company’s earnings changes over the last five years. It is important to know if the company is growing due to higher margin, more interests from their customers or due to cost-cutting measures implement by the company.
- Compare the company’s earnings with its peers – growth, margin, trend. It is important to ask why if there is a big deviation from the industry peers. This might help you to see an investment opportunity that is overlooked by others.
3) Who are the customers of the company?
As mentioned earlier, businesses or services that target end-consumers or corporate clients are usually very different. In the event that you plan to invest in a stock that target end-consumers, you would want to question yourself if the company is targeting the mass market or the high-end market.
Businesses that are targeting the mass market usually have a lower profit margin as compared to businesses that focus on the exclusive market. A good example would be the smartphone industry. Apple products such as the iPhone are commonly known to be priced higher than its competitors such as Samsung, Huawei, Xiaomi and others.
Aside from that, investors should also understand the age group of the target group. For example, healthcare providers are likely to target the ageing society, while social media companies are targeting the millennials and Gen-Z.
By understanding the client mix of the company, you will have improved knowledge and understanding on the company’s growth potential.
4) What is the size of the company?
The size of the company is important as a bigger company would have a better capacity to grow.
Here are some of the areas that an investor should look into:
- Market capitalisation of the company. Some institutional funds could only invest into companies with a certain market capitalisation so larger companies would be able to attract more institutional funds.
- Size of the market share. It is crucial to note if the company that you plan to invest in is a dominant player in the industry that they are operating in. Market leaders tend to have an advantage when it comes to pricing, technology and other areas. However, even if the company isn’t a market leader, you could still compare it with the market leader and see the growth potential of the company.
5) What is the moat of the company?
The term economic moat, popularized by Warren Buffett, refers to the company’s ability to maintain its competitive edge in order to protect its long-term profit, market share and growth. A moat can be defined as the water around the castle and how it was used to protect the medieval castle from outsiders.
There is plenty to look into when we look into the moat of the company, but here are the few areas that you should focus on:
- Balance sheet of the company. This is one of the most important areas that I look into as companies that are piled up with debt, would struggle in an economic downturn.
- Cashflow of the company. A company that consistently run in a negative operating cashflow should serve as a red flag for investors. It is also important to see how the management utilize the free cash flow of the company.
- Cost advantage. From their earnings, margin and growth trend, you will see if the company has a cost advantage over its competition. Companies with sustainable cost advantages can maintain a very large market share of their industry by squeezing out any new competitors.
- High switching costs. It is important to see if the company has established itself in the industry. If they have, suppliers and customers would be subject to high switching costs then they try to switch to a new competitor.
These are just a portion of the investing checklist that will help you discern the company better before you make your investment decision. This checklist offers you a structured way to proceed when conducting your research into a company that you potentially want to invest in. This is especially important in a volatile market condition where the markets experiences periods of unpredictable and drastic movements in price.
Investors should revisit some of these questions during this time to see if there is a change to the fundamentals of the company that they have decided to invest in. With this method, your investment decision will be driven by rationale analysis, and not influenced by your emotions.
Billy is passionate about the capital market and believes in investing for the long haul. Prior to this, he was an economist at RHB Investment Bank, covering Thailand and Philippines market. He also worked as a financial journalist at The Edge Malaysia and has experience working with an asset management firm. Aside from the capital market, Billy loves a good conversation over a cup of coffee, is a fitness enthusiast and a tech geek.