Why is it important to research a stock before buying it?

Question

I’ve been thinking about investing some stocks and everyone is telling me that I really should research each stock, look through their financial statements and track the news and understand everything about them.

But the more I read, the more it’s just confusing me. And the more I'm asking if it's actually necessary?

If the company is doing well - making lots of money etc then the price will be high and if the company is doing badly - product recalls and losses etc, then the price will be low. Any information I read will be public information and isn’t all of this information already factored into the price? By definition, the price I pay is always the fair price at the point in time I buy the stock.

And the thing is, I may have opinions about the economic or industry outlook, but I’m not an expert here - even if I was armed with more information, surely, I can’t predict the future any better than experts whose job it is to analyse stocks. Even those experts disagree and have their own opinion about what will happen.

Basically, what I’m saying is the only sure thing I know is the price I paid for the stock is the fair price at the time I buy it. Everything else is subject to bias and speculation.

So am I better off to just not even worry about doing any in depth research and just look at a few basic attributes like

• how volatile the price movements have been
• what type of asset class it is (eg. blue chip, speculative)
• P/E ratio
• dividends

These things won’t actually help me predict how the stock will perform but will give me information about whether the stock is suitable for my own personal situation and objective and the level of risk I'm willing to take.

Answer 1

The only sensible reason to invest in individual stocks is if you have reason to think that they will perform better than the market as a whole.

How are you to come to that conclusion other than by doing in-depth research into the stock and the company behind it?

If you can't, or don't want to, reach that conclusion about particular stocks then you're better off putting your money into cheap index trackers.

Answer 2

The following is only an overview and does not contain all of the in-depth reasons why you should look more deeply.

When you look at a stock's financials in depth you are looking for warning signs. These may warn of many things but one important thing to look for is ratio and growth rate manipulation. Using several different accounting methods it is possible to make a final report reflect a PE ratio (or any other ratio) that is inconsistent with the realities of the company's position. Earnings manipulation (in the way that Enron in particular manipulated them) is more widespread than you might think as "earnings smoothing" is a common way of keeping earnings in line (or smooth) in a recession or a boom. The reason that PE ratio looks so good could well be because professional investors have avoided the stock as there appear to be "interesting" (but legal) accounting decisions that are of concern. Another issue that you don't consider is growth. earnings may look good in the current reporting period but may have been stagnant or falling when considered over multiple periods. The low price may indicate falling revenues, earnings and market share that you would not be aware of when taking only your criteria into account. Understanding a firm will also give you an insight into how future news might affect the company. If the company has a lot of debt and market interest rates rise or fall how will that effect their debt, if another company brings out a competing product next week how will it effect the company? How will it effect their bottom line? How much do they rely on a single product line? How likely is it that their flagship product will become obsolete? How would that effect the company?

Looking deeply into a company's financial statements will allow you to see any issues in their accounting practices and give you a feel for how they are preforming over time, it will also let you look into their cost of capital and investment decisions. Looking deeply into their products, company structure and how news will effect them will give you an understanding of potential issues that could threaten your investment before they occur. When looking for value you shouldn't just look at part of the value of the company; you wouldn't just look at sales of a single T-shirt range at Wallmart when deciding whether to invest in them. It is exactly the same argument for why you should look at the whole of the company's state when choosing to invest rather than a few small metrics.

Answer 3

To a certain degree "the only sure thing I know is the price I paid for the stock is the fair price at the time I buy it" is absolutely right, by definition, and by the law of the free and efficient market and forces of supply and demand, freedom of public information about share price sensitive information, etc, etc, etc, and you've made a good point that eludes many investors I'd say.

However, in practise, the market has many participants, and they will all be arriving at a different idea of what the "fair price" is by way of a slightly different analysis and slightly different information. In theory they all have the same information, but unfortunately in practise there is always some disparity. When one participant feels a stock is undervalued though the last thing they want to do is say so, instead they will start buying stock. They might feel it is undervalued by 20%, but that doesn't mean they'll keep buying and buying until it gets to 20%, they might push the price up just a little, then let the price drift down again, buy some more, relax, buy some more, etc. Over time the price will rise of course because the supply will become weaker, but even if the participant is correct about the 20% the price might have only risen 7% by the time they acquire all the stock they want given their risk models, market exposure and margin guidelines, etc, and it might be more than a year later before the price has actually risen to 20%, presumably because more and more other market participants have come to the same conclusion.

The opposite can obviously also happen, a participant might dump stock it feels is over valued long before it hits the values it believes in.

So right away you can see that pricing might not really reflect value, or "fair price".

Answer 4

Most markets around the world have been downtrending for the last 6 to 10 months. The definition of a downtrend is lower lows and lower highs, and until you get a higher low and confirmation with a higher high the downtrend will continue. If you look at the weekly charts of most indexes you can determine the longer term trend. If you are more concerned with the medium term trend then you could look at the daily charts.

So if your objective is to try and buy individual stocks and try to make some medium to short term profits from them I would start by first looking at the daily charts of the index your stock belongs to. Only buy when the intermediate trend of the market is moving up (higher highs and higher lows).

You can do some brief analysis on the stocks your interested in buying, and two things I would add to the short list in your question would be to check if earnings are increasing year after year. The second thing to look at would be to check if the earnings yield is greater than the dividend yield, that way you know that dividends are being paid out from current earnings and not from previous earning or from borrowings.

You could then check the daily charts of these individual stocks and make sure they are uptrending also. Buy uptrending stocks in an uptrending market.

Before you buy anything write up a trading plan and develop your trading rules. For example if price breaks through the resistance line of a previous high you will buy at the open of the next day. Have your money management and risk management rules in place and stick to your plan. You can also do some backtesting or paper trading to check the validity of your strategy. A good book to read on money and risk management is - "Trade your way to Financial Freedom" by Van Tharp.

Your aim should not be to get a winner on every trade but to let your winners run and keep your losses small.