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5 Things to Think About When Buying a Stock

Value investor with a deep passion for understanding and a desire to improve results over time.

5-things-to-think-about-when-buying-a-stock

The Ballgame

Choosing which stock to buy can be intimidating. In a universe of thousands, where most eventually go to zero, knowing what to look for is crucial. Fortunately, there's a useful metaphor you can probably understand right away, as long as you know a little bit about baseball. In any game, you have the same five elements:

  • Players
  • Umpires
  • The field on which the game is played
  • The weather that day
  • Stats about the players for fans

Sure, there are other things going on, but these are five areas you can reliably expect to be present during any game, and knowing each one of them can either help you determine who's going to win on a given day, or it affects the outcome itself. Similarly, there are five dimensions of stock market investing that will ultimately determine a stock's short, medium, and long term outcome. Let's dive right into what these are.

5-things-to-think-about-when-buying-a-stock

Batter Up: Stocks and Player Stats

There's no conceivable way you could have a ballgame without baseball players, and there's not really a conceivable way you could invest in a stock without first understanding what the stock represents. Since every stock is just a small slice of a business, it's important to take a good look at this business, just as you might use a talent scout to find great individual players for your team.

While individual business valuation can be done in a number of ways, a value investing favorite is the discounted cash flow (DCF) method. By projecting how much money you think a company is going to earn in the future, then taking into account the time-value of money, you can make a reasonable estimate as to how much the entire business is worth today, then divide that by the number of shares to get what the stock's intrinsic value might be today.

The Umpire: the SEC and the Feds

Taking a look at the business in isolation is important, but you also need to consider the rules of the game, and how they're enforced. In our case, we're going to think about two really big entities that can determine how stocks perform: the Securities and Exchange Commission, or the SEC; and the Federal Reserve, or the Fed.

The goal of the SEC is to make sure the rules are fair and enforced, so it's really important to understand that they can step in and make a dramatic difference on an individual security, and very quickly. An example from the early 2020s is the potential delisting of ADRs (American Depository Receipts) from American stock exchanges, should the companies not comply with audit rules. Now, it's possible that the business you own (your player, in our baseball analogy) can perform extremely well, but if the umpire calls them out, well... they're out, and that's it.

The Fed, on the other hand, more or less makes the rules of the game. They determine what interest rates will be, ultimately influencing whether certain types of stocks are bought. It's helpful to keep in mind Buffett's adage that interest rates are like gravity for stocks, meaning that as rates rise, stock prices generally fall, and to understand that certain types of stocks will do better in an environment when rates are rising. If the Fed changes the "rules" of the game, it might not really matter how good your players are, or at least not as much as it might matter otherwise.

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The Playing Field: Institutional Forces

If you've ever been to a ballgame at an opposing field, you know how much tougher it is for the players to perform well. They're not familiar with the nuances of the stadium and field itself, and the crowd's jeering doesn't really instill focus. Similarly, if large institutions who control massive sums of money start to move cash from one place to another, it can make a material impact on a player's performance.

Index investing, or passive investing in an index of stocks, has absolutely exploded in prominence, especially since the turn of the 21st century. What this means is that if a stock is included in an index, and a fund buys the whole index, the stock in the index will go up in price. Similarly, if a stock leaves an index, it is no longer supported by incoming cash, so it's possible it will perform far worse, even over fairly long periods of time. Understanding that massive flows of funds can affect an individual stock's price is important. For further research on fund flows, check out Investopedia here.

Today's Game Was Rained Out, or Macroeconomic Conditions and the Market

Have you ever seen a baseball game where there was a rain delay, and then the tide of the game turned after the game commenced? It turns out that some individual players do well when there's mud on the field, and others do much worse. In a similar way, macroeconomic forces can cause certain stocks to perform better or worse than others.

Macro considerations can often include geopolitical risk, so thinking through how a war breaking out near the region where your company owns a factory might affect how the business performs over time. You could have a great player, but if the player is injured, they're not going to be able to go out there, and your player might get injured if the weather gets bad enough (and I will concede that this analogy is far from perfect, but bear with me here).

Imagine that we're playing a baseball game on another planet, where it rains down sulfuric acid instead of water, and you have an idea of the destructive potential of macro forces to damage an individual stock. A pandemic is a lot like acid rain; some players own raincoats and can play in the acid better than others, and some stocks are going to be much better positioned, generally speaking, than others for various different types of macro winds.

Baseball Cards and Technicals

Can you imagine being an owner of a team, and recruiting a player without knowing any statistics about them? It would be useful to know how likely they are to get on base, for instance, or (for pitchers) how likely they are to allow runs to score. Those stats can be thought of as fundamentals, which you'd use to do a DCF-style valuation. However, there are way more statistics beyond the common metrics everyone looks at, like how well left-handed batters tend to do against right-handed pitchers.

Just as baseball card might represent a player's meaningful stats on the field, a stock has a cornucopia of useful data attached to it, easily referenced by searching online. Traders dissect this information every day, just like you might have discussed player stats as a kid when trading baseball cards.

We use technical indicators to understand some of what's going on, and this can be extremely helpful. Every stock trades based on supply and demand, and while we tend to spend a lot of time trying to figure out why there should be demand, taking a look at a chart and doing some technical analysis can help you to confirm or disconfirm a thesis.

One Last Thing

One last thing for you to think about: as Ben Graham and Warren Buffett have famously pointed out, the market is a weighing machine in the long term, but a voting machine in the short term. This means that your players (individual stocks) need additional context beyond how great they are by themselves. There's also the way the players interact with other players on the team, and a team of great individuals doesn't always end up being so great itself.

Similarly, some teams seem to be made up of less spectacular players who actually get along really well and perform better as a team, and these are often championship teams. Consider diversifying in complimentary ways when you're thinking about your portfolio, just as you'd make sure your players got along on a team. For more on this, take a deep dive into portfolio management with me!

This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.

© 2022 Andrew Smith

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