How to Select a Stock - Part I- Understanding a Business

In my previous post, I wrote that you need to make intelligent guesses to select a good stock. How do you do that is the topic of this post. There are many factors you should consider before you take a decision to invest in a stock. In this post I will talk about the most important thing you need to do before you take a decision.

You need to understand the business you want to invest in. You can ask why should you do that. After all, a stock price is just a number that keeps changing on a ticker. All you need to figure out is when and how this number changes. There are short cuts and there are long-winded ways to figure this out. Unfortunately, I am a believer in old-fashioned long-winded ways of doing things. Fortunately, these methods work. After having invested in stock market for some time and observing various players in the market, I have come to believe that all short cuts fall short of making money for you on a consistent basis. You need to face a reality here. If you want to invest in a stock, understand that you are going to own a company (even if you own only one share of a company, you technically become a partial owner of the company!) Does that make you want to buy a stock now? J Now, owning a business is not easy. You don’t want to own a business without knowing how it works. Try finding out everything you can to figure out the details of the business- key success factors, dynamics of the business, which companies are doing well, why they are doing well, what’s future going to look like, etc. And if all of this looks overwhelming, let me assure you it’s not. Even if you spend 2 hours every day for a week, you will be able to collect sufficient information on any business. To make it easy, start with a business you are already familiar with. This could be an industry you work in, or a business you are interested in, or any business you somehow have managed to understand to an extent.

If you are not willing to do this much of research, I am afraid you should not be thinking about investing in stocks. It’s very easy for me to tempt you into investing assuring you that you don’t need to devote much time. But that will be a lie- a lie that many people have used to fool innocent beginners- a lie that has been causing misery to many retail investors for decades. But if you are willing to invest some time in conducting research, I can assure you that you will reap rich rewards. Every second you invest in conducting research will be worth it.

Now, let’s talk about ways to understand a business. A very simple way could be using Google. You can read through industry reports, analyst reports, articles, etc on the industry and company to understand the basic dynamics of a business and relative standing of the company you are focusing on. A caveat though, use stock analyst reports only for understanding the dynamics of the business. You don’t have to believe their recommendation entirely. Stock analysts have their own reasons to recommend a stock.

Other ways of understanding a business could be speaking to somebody who is currently in the same business. You could also go through the annual reports of the company you are researching to understand the intricacies of the business.

At the end of your research you should be able to answer these questions:

1. What are the things that are required for a company to succeed in this business?
2. Who are the main players and what is their relative standing in the market?
3. Which companies have got competitive advantage over others in the industry and why?
3. What can change the fortunes of a company in this business?
4. How the future looks like for the business and the company?
5. If you come to know about an important event related with economy or industry, will you be able to assess its impact on the business?

If you are able to understand a business, you have taken your first step towards being a retail investor. There are a few more steps like past financial performance, quality of management, future growth potential, etc which you need to understand before you select a stock. I will discuss about them in my next few posts.

Till then, have fun.