The smart investor in the stock market doesn't "listen to his gut" or "follow her instincts" about the market, they use a rational process to identify great companies.
If you want to buy a stock, you should be able to state, in writing, the reasons. This is known in the business as a "buy case."
A buy case is a simple, to-the-point summary of why this stock makes sense for your portfolio. It may help to visualize this as a presentation to your superiors and peers at work or some other group you would want to impress.
Most of us wouldn't be employed long if we recommended a course of action at work because we "had a hunch". Your buy case should be as well thought out and researched as any project you tackled at work.
It covers five important points about the company and the stock and forces you to do your homework before investing. You may want more than five points - so much the better.
If you follow this procedure or one similar to it, you'll avoid buying (or selling) as an emotional response. You will have a well-thought out plan for your action. This plan will also serve as a way to continually validate your decision. If the company veers off your summary in any way, you should know why and decide if you still want to own the company.
5 Points of a Stock Buy Case
Here are the five points your buy plan should cover:
1. What does the company do? If you can't explain the major business activity of the company in two or three sentences, you shouldn't be investing in it. This doesn't mean you have to know every technical detail, but you should have a broad overview.
2. What part of the economy does this business serve and is it growing or does the company own a large share of that market? You invest in a company anticipating long-term growth. Companies that are built on fads or outdated technology are not good prospects. The technology sector is more volatile than consumer staples, but also offers more growth potential.
3. Is the company riding a demographic or economic trend that has long-term implications? Companies that serve retirement needs of Baby Boomers have a 76 million plus market. Companies that define their market too narrowly limit their potential growth.
4. How do you value the company using standard market ratios? Using many of the tools found at The Tools of Fundamental Analysis how does the company compare to its industry peers? How does is compare to the overall market? Why do you believe it is under valued?
5. What do you see that makes you believe the company has room for sustained growth? Why do you believe the company is in a good position to grow and the stock is not priced to reflect this potential? Maybe the stock has been beat up because of some bad company news you judge to be temporary. Maybe the sector is out of favor and generally depressed. Whatever reason, you should have a reasonable answer for why the stock price is lower than it could or should be. This is your growth margin.
When you have built a convincing buy case (at a certain price), you are ready to invest. You may want to broaden your research beyond these five points.
Stock Buy Case also Good Sell Case Too
Retain the buy case and review it at least once a year or more often if the stock takes a big hit to see if any of your assumptions or conclusions have changed.
When you build a buy case before buying a stock, you force yourself to make a rational decision.
Investing on instinct is the same a guessing, sometimes you'll be right and sometimes you'll be wrong - not a great way to a solid financial future.