How's the Chart?Charts are a great time saver, and for that reason it's where we begin. You don't have to be a technician to uncover potential problem stocks quickly and eliminate them from contention. Glimpsing at a chart provides three ways to erase a stock from your list: One, if it's been in a long downtrend, avoid it all costs; two, if it's been flatlining for years; and, three, if it's too volatile for your risk tolerance. Note, however, that eliminating a given stock doesn't mean forgetting about it. Take, for example, the stock in a downtrend. Since we don't know when the institutional money (i.e., mutual funds) will be done selling, it's simply wiser to wait for them to finish distributing. You can use a 10-day moving average to let you know when the downtrend may be ending. The same thinking applies to a flat-liner. Instead of guessing what's going to make it finally break out, apply the same moving average to let yourself know when the stock is finally moving. Meanwhile, stick to charts that don't have problems. (For more detail on how to use technical analysis, check out "Tracking Elephants," parts
How's the Sector?Here's something few people are aware of: Academic studies show the sector a stock is in is actually more important to its performance than the company itself.
What's Your Thesis?Why buy this particular stock, in this sector, and why now? That may sound like an obvious question, but it's often overlooked. You should have a specific reason to buy something, one that you can articulate in a sentence or two. It can be something fundamental, i.e., fiber to the premises. Have you found an overlooked value, do you have some insight into a new product, do you believe the new management can turn the ship around? All that is part of your investment thesis.
Stop-LossThe ideal time to determine a stop-loss is before you buy it -- while you are neutral, and have no emotional investment in the name. Stop-losses come in many flavors: percentage, trend break, support, moving average. (We will discuss this topic in agonizing detail in the future.) Your thesis may be your primary motivation for selecting this stock, but it's also a reason to jettison it down the road. When your thesis no longer applies to a given company, it's time to say "buh-bye." Let's say you bought Motorola ( MOT) because you so totally respect Ed Zander. If he resigns, guess what? Your purchase thesis has just become inoperative. Your time horizon is another type of stop-loss. Not only should you determine how much you are willing to give up on any investment, but also how long you are willing to forgo other investments by locking up cash in this name.
Risk-RewardThis is another overlooked aspect of a stock selection. How much potential upside can you legitimately expect vs. your downside risk? The reason this matters is that all stock-pickers are imperfect. Nobody should expect to be right every time. Indeed, if you are right half the time, consider yourself above average. That's why risk/reward is so important. The investor who bats .500 must not only offset his losses but also his commissions on all trades, and his taxes on the winners.
News and EarningsLastly, potential purchasers must familiarize themselves with all of the recent news on the stock, if for no other reason than to avoid an unpleasant surprise. Trust me, that's no fun. Learn if there are any significant upcoming dates that could affect your holding. I've seen unaware investors buy stocks the day before earnings, only to have a weak report crush the stock price (ouch). Are there any upcoming court decisions, or a new-product introduction on the horizon? Pay particular attention to litigation, government investigations or regulatory agencies. These items are not usually fatal, but they introduce another element into the mix. Indeed, sometimes it even creates opportunity. When Altria ( MO) (then known as Philip Morris) was in class action litigation, the stock became a teenager. If you understood the litigation, and were willing to accept the risk, there was a lot of upside. Finally, if you want this checklist to be of any value, I suggest you actually track every stock you buy or are considering buying. Save them all in a binder and then input the results to a spreadsheet such as Excel. The goal is to create a data source that allows you to eventually be able to see where you are going right -- and what you might be doing wrong. It's an invaluable tool.
P.S.Notice that this list contains elements from the technical, fundamental and quantitative schools. When it comes to stock selection, I'm agnostic -- I use whatever tools contribute to the process. Just as you do not build a house with only a saw, there's no reason to ignore other tools, if they have value.
|1.||Expect to Be Wrong||2.||Your Fault, Reader|
|3.||The Wrong Crowd||4.||Bull or Bear? Neither|
|5.||Know Thyself||6.||Prepare for Battle|
|7.||Bite Your Tongue||8.||Don't Speak, Part 2|
|9.||The Zen of Trading||10.||The Folly of Forecasting|
|11.||Lose the News||12.||Tracking Elephants, Pt 1|
|13.||Tracking Elephants, Pt 2||14.||Nothing Doing|
|15.||Surviving Silly Season||16.||The Zen of Trading|
|17.||Curb Your Enthusiasm|
|Check back for more of Barry Ritholtz's |
Apprenticed Investor series