Do Not Buy a Stock Unless You Can Answer These 4 Questions

Investing in stocks is a good way to grow wealth for the long haul, and while there is some risk involved in buying stocks, doing your research can help you make smart decisions for your portfolio. But what if you are new to investing and are not sure which stocks to start with?

You may be inclined to simply buy stocks you have heard of, and while that is a reasonable starting point on the road to investing, you may want to dig a little deeper to determine which companies are ultimately worthy of your money. Whether you are new to investing or have been doing it for years, you must answer these fundamental questions before adding a stock to your portfolio.

1. How does the company make money?

Sometimes, a company’s primary revenue stream is pretty obvious. For example, if you are buying stocks of Haidilao International Holding Ltd (HKG:6862), the company’s business model involves selling hotpot cuisine to the masses. But sometimes, the way a company makes money is less obvious. 

For example, plenty of investors recognise Tencent Holdings Limited (HKG:0700) as the leading social platform and technology company in China, being the owner of social platforms such as QQ and WeChat. But few investors know that Tencent is also the world’s largest games company in revenue terms. Even lesser investors realise that the company is a global investment empire in disguise, and has quietly amassed a list of 150 investments, including stakes in household names such as Tesla Inc. (NASDAQ:TSLA) and Uber Technologies Inc. (NYSE:UBER).   

It is important that you buy stocks in companies whose business models you truly understand. As an investor, you should have insight into how a company operates, where its revenue comes from, and if the business has good growth prospects, before adding it to your portfolio.

2. Does the business have a wide moat?

There are plenty of companies that do similar things or have comparable business models. But your goal should be to buy stocks of companies that have a true edge over the competition. Answering this question demands that you only buy businesses that can defend themselves against attacks by competitors. To do so, you would need to be able to accurately predict the business’ long-term future.

For example, ByteDance is quickly becoming the greatest emerging threat to Tencent. ByteDance’s short video app, known as Douyin in China and TikTok internationally, is increasingly popular. According to SensorTower, TikTok and Douyin have collectively been downloaded over two billion times so far. As ByteDance’s short video app becomes popular, many Tencent users are increasingly spending more time on ByteDance’s apps rather than on Tencent’s WeChat which undermines Tencent’s online advertising business. As an investor, you should consider if Tencent can defend its key moat of absolute leadership in the social connection arena before an investment. 

3. Does the business have great management?

When you buy stocks in a company, you are effectively a part-owner of the business, hence you must have confidence that the people running your company are persons that you respect, trust and admire. We think that two important qualities of a leader are: owner-oriented and driven. 

An owner-oriented Chief Executive Officer (CEO) is one who has his personal interests directly aligned with the shareholders of the business. Warren Buffet clarifies this point when he describes how an owner-oriented CEO should run his business. As he said in his 2004 shareholder letter, “My message to [the CEOs] is simple: Run your business as if it were the only asset your family will own over the next 100 years.” 

We also like a great CEO to be driven to change the world in some way. We call this his BAG – Big Audacious Goal. CEOs who have a BAG use it to fire themselves up so much that they cannot wait to come to work every day. The BAG also tells everyone in the organisation the most important thing to focus on. 

Bill Gates’ audacious goal for Microsoft Corporation (NASDAQ:MSFT) was to put a computer on every person’s desk. On the other hand, Jeff Bezos, in his garage, dreamed of having every book ever printed in any language available to everyone in the less than 60 seconds. That spawned, Inc. (NASDAQ:AMZN). Audacity sometimes pays off, big time. 

4. What might go wrong with this company?

Even great companies tend to have an underlying weakness, and it is better to figure out what those are before buying their stocks. For example, Amazon’s success has been largely attributed to great leadership, but what happens if CEO Jeff Bezos steps down? Could this lead to “significant succession risk”? 

At the same time, Amazon faces intensifying competition in its core e-commerce space, as it ventures outside the U.S. to new markets overseas. Is Amazon able to compete as effectively in a different environment? Also, Amazon’s huge market influence is drawing additional regulatory pressure, both in the U.S. and overseas. The potential for antitrust and regulation across the globe could negatively impact Amazon’s operating results and stunt its future growth.

Just to be clear, these may not necessarily be reasons not to buy Amazon. The point is that no company is perfect, and every company is subject to that “what if” scenario. With the business environment as dynamic as it is, it is important that you figure out the weaknesses of a company and the risks it faces before you make an investment decision.  

In summary, investing in stocks can be a rewarding experience. But you must develop a strategy that aligns with your goals and personal appetite for risk. Asking the above questions helps unearth vital information useful to ensure that you are putting your money into a worthwhile investment. That way, you are less likely to regret your decisions after the fact.

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