The 5 Things You Need to Know Before Buying Any Stock

Being in the trading and investing business for over forty years – as a market-maker, a mega-bank derivative hedging and trading specialist, and a hedge fund manager – has taught me a few things about buying stocks, too many to even list on all the pages of a legal pad.

But there are really only five things that matter, five things that I’ve learned over all those years that have to be present for me to buy a stock. And it doesn’t matter if you’re buying a stock for a trade or as an investment for the long-term. The five things always apply.

What differs, mainly, is the order of importance. When you’re looking at long-term investments, you have to take a more “ground up” approach and look at a company the way any Wall Street analyst or banker would.

Traders on the other hand, especially “retail” traders (which basically just means all of us), are looking for short-term gains. They’re bent on trading and taking profits as opposed to tying up their capital, especially in sideways or volatile markets.

If you’re trading, you have to emphasize those factors which are contributing to current price action, momentum, and movement.

But whichever side of the fence you’re on, the five things you need to know remain the same.

So here’s what they are and how you can apply them to help you more consistently pick winning investments and trades.

Because most people plan on buying stocks as long-term investments, the order of importance of the five things you have to have should be:

  1. The company must have products or services that can fill a gigantic addressable market and be the best or among the best at it… or be a disruptor on their way to changing the space.
  2. Revenue, profit margins, and profits – what analysts call “earnings,” in sum. They matter.
  3. Capital structure matters a lot more than most people think, because there are critical clues to a company’s prospects in its capital structure.
  4. Intrinsic value, which is an assessment of a company or its stock in terms of traders’ and investors’ perception of the company and its prospects. Narratives relating to the company, and behavioral investing factors that stem from an assessment of intrinsic value (as opposed to market value) are akin to a secret sauce that if present (or better yet, persistent) can catapult a stock.
  5. The picture of investor psychology manifested through price action, captured in charts, has to be corroborative.

Again, that order makes sense because it’s how any Wall Street analyst or banker would look at a company and its stock, from the ground up.

But of course, not everyone buys stocks as investments. Especially in markets as volatile as these, maintaining a trader’s mindset is crucial to building and keeping wealth.

In fact, my number one rule of investing is, every investment starts with a trade.

I started my career as a trader, and I’m still a trader. However, my best returns and my most profitable trades became investments, meaning they kept going up and I didn’t sell them for short-term gains. Some went up 5000%, 10,000%, some more. But they all started with a trade.

If you’re more inclined to think like and act like a trader, you still need to know the five same must-haves above, but you need to address them in a different order, with a trader’s mentality.

Spoiler alert: the order becomes 5,4,2,1,3.

The first thing I look at when I’m thinking about trading a stock, when I’m thinking about buying a stock, is (5) what does the chart look like.

Because the trend is always your friend, I like buying stocks that are going up, and you see that in a chart. I look at a one-year chart. I want to see if the stock is moving up or has started moving up after some consolidation, maybe after falling for some period.

I do sometimes buy a stock that’s fallen and hasn’t consolidated or turned up, but those more speculative buys are based on some potential turnaround technical, like the stock being grossly oversold.

Of course, there’s more to technical analysis than just looking at a chart to see if a stock’s going up or is bottoming, which I’ll flesh out in more detail in upcoming Total Wealth articles.

But for starters, a rising stock is a good one to buy.

The second criteria I want to see or feel when I’m putting on a buy-trade is (4) popping intrinsic value.

Stocks move on narratives, on crowd psychology, on news, on perception, and that’s powerful stuff, especially over the short-term, which when you’re trading is the most important time to be on the right side of the action.

After intrinsic value you want to have (2) earnings prospects demonstrably better, which might take the form of analysts’ upgrades, or company announcements, or positive forward guidance.

What the company does (1) is always important, and I look to see if it’s expanding into its gigantic addressable market that will bolster its future earnings and profitability and backstop the stock price.

Lastly, when I put on a trade I’ll look at (3) capital structure, especially a company’s debt. If it pays a dividend on its equity shares, I look at what the balance sheet looks like in terms of the cost of the dividend and how sustainable it is. If the debt is high, but debt-to-equity is reasonable relative to capital expenditures, I don’t need to worry about much else.

In future Total Wealth articles and segments, I’ll come back to these criteria a lot and apply them to the specific companies you’re interested in trading and buying.

But for now, and the future as far as you need to see, always check the box on each of these five must-haves before you ever buy any stock.

— Shah Gilani

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Source: Total Wealth