Investing: The 'not to do' list... - Views on News from Equitymaster

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Investing: The 'not to do' list...

May 11, 2007

When it comes to stocks, everyone from your friend to your colleague to an acquaintance seems to be keen to offer you an advice. Ideally, these ought to be persuasive as well as cautionary. However, the advisors seldom delve on the latter. No matter how appealing the 'quick buck' tips might be the successful investor is one who practices a sufficient degree of vigilance. We point out few ways to ensure this.

Don't buy into companies without sufficient financial history
Financing of start up companies is best left to specialized groups (venture capitalists and the like). For a retail investor, it is prudent to glance over the key historical financials (minimum 3 to 5 years) and make a peer comparison or evaluate the correctness of the direction in which the company is progressing. Even in a long-term investment, one must not forget that the rule of 'ceteris paribus' (other things remaining constant) may not always hold true, and thus it is necessary to periodically evaluate whether the investment still holds the same 'value' as it once did. Historical evaluation also helps in judging the management's integrity and business principles.

Don't invest in the business that you do not understand
The best way to safeguard one's capital is to not invest in a 'stock' but to invest in a 'business'. Nevertheless, it makes better sense to invest in business that you understand. This will not only help the investor in comprehending new business initiatives, but also in diagnosing the 'health' of the business. An understanding of the industry dynamics will also go a long way in cautioning you about the sector prospects.

Don't stress on diversification or ignore competition
While the principle of diversification may apply to portfolios, the same may not hold true for all businesses, especially if the concerned management does not have the bandwidth. For investors who believe that pursuing multiple business interests is in sync with the principle of diversification, we would like to quote Warren Buffet, "Diversification is a protection against ignorance. It makes very little sense for those who know what they are doing."

At the same time, involvement in the current business should not be at the cost of ignoring competition. Philip Fisher in his book 'Common Stocks and Uncommon Profits' says that every investor should judge his investment target by asking one formidable question - "What is it that the company is doing that its competitors aren't doing yet?" The company's awareness of its competitors' strengths and its own weaknesses gives an indication of the management's foresight and resolution to overcome competition.

Don't fail to consider price while buying a growth stock
Investors often make assumptions while selecting their targets. However, the businesses are subject to various internal and external risks, which may affect the earnings growth prospects of a company over the long-term. But if you have a portfolio of stocks selected with adequate margins of safety, you minimise your chances of losses over the long term. In this context, stock selection is of great importance. To quote Benjamin Graham, "Now, while losing some money is an inevitable part of investing, to be an 'intelligent investor,' you must take responsibility for ensuring that you never lose most of all of your money."

And finally, don't follow the herd
The herd mentality is oft associated to investors who wish to make a quick gain in a bull market, without being aware of the downsides. The high valuations of a company must never be directly correlated to better fundamentals and improved prospects, without adequate study. For, quoting Buffet again, "It's only when the tide goes out, that you learn who's been swimming naked."

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