Five Questions to Ask Before Buying a Stock

Five Questions to Ask Before Buying a Stock

Are You Defined by the Stocks You Buy?

The Emerging Markets Giant in Waiting

Stock investors (me included) tend to define ourselves by the stocks we buy.

The kind of stock market we’ve had recently—one that has fallen and can’t get up, at least not yet—looks very different to different kinds of investors.

Growth investors look at a chart of the S&P 500 and see a frustrating stretch of range-bound trading followed by a frightening collapse and a failed bounce. Growth investors know that they will make the bulk of their annual gains from the action of just a handful of super-strong stocks, and a market like this one—where the S&P’s 25- and 50-day moving averages have fallen below the 200-day and the index itself is miles below all three—isn’t going to grow many of those.

SPX Chart

A value investor, on the other hand, watches this kind of market correction with the same glee that an Iowa farmer experiences when he gets a late-season rain. Stocks whose prices have fallen are potential bargains, and after a period of stubbornly high P/E ratios, the heavens have finally opened and delivered some great value opportunities.

One man’s meat is another man’s poison, as the proverb says.

One practical outcome of this situation is that when I’m contacted by subscribers asking whether the current dip represents a buying opportunity, I have to ask some clarifying questions first.

And that got me to thinking that there are some questions any stock investor should be prepared to answer before they pull the trigger on a new buy. Here are the five that come quickly to mind.

1. Why are you buying this stock?

This isn’t as obvious as it sounds. Yes, you’re buying it to make money, but are you buying it as a short-term momentum play? A long-term core holding for income? A value investment for selling at a predetermined “full value?”

Some potential investors have just heard a stock’s story and think it sounds promising. Some are lifetime devotees of the firm’s products, like the Cabot employee who’s a wrestling fan and loves World Wrestling Entertainment (WWE). And some have just received a hot tip from a talking head on cable TV.

But you need to be able to sum up your ruling reason for making the buy. Think of it as the stock’s elevator pitch. The more clearly you understand why you’re buying, the better.

2. Why will you sell it?

Again, this isn’t as obvious as it might seem. A growth investor should have a clear, written down set of maximum loss limits, either the standard 15% and 20% (for negative or supportive markets, respectively) or a technical point of support that marks an explicit danger signal.

Value investors will have a target price (which may be increased on the way up) at which the stock is fully valued.

And even buy-and-hold investors should make plans for what to do if a core holding turns up its toes and heads for the basement.

3. Does the market support your choice?

A market that’s trending down puts pressure on all kinds of stocks, making it harder for any kind of stock to push higher. Cabot’s growth disciplines use the direction of the market as an important red, yellow or green light signal, telling us whether the wind is at our back or in our face. We pay attention.

Value and income investors aren’t quite as concerned about the market, as their investment decisions are more influenced by fundamentals, but anyone who hopes to see a higher price in a stock should know which way the tides are running.

4. When are earnings due?

You might think that this question would only be relevant four times a year, but it’s still important to know the answer. Quarterly results can send a stock soaring or plummeting, and you should probably avoid making a big bet on any stock that’s going to release its results in the next couple of weeks. (If there isn’t an official earnings date, look for the previous quarter’s date and pencil in the next one in three months.)

5. Is this really the right action to be taking now?

For growth investors especially, the urge to buy can be powerful, and can sometimes have you reaching for the BUY button when you shouldn’t. Sometimes the right thing to do is to sell. And sometimes the right thing is to do nothing. Look at all your options (including using options!) A quick inventory of your available courses of action can often steer you in a better direction.

If you have any other good questions for stock investors who have their online brokerage account open and need some guidance, I’d love to hear them. Just send me an email.

My stock pick today reflects both the turmoil in China and the stability of India, the Giant in Waiting among emerging markets. It’s Dr. Reddy’s Laboratories (RDY), a diversified drug manufacturer that’s been a solid performer. Here’s some of what I wrote about it on July 16.

Dr. Reddy’s Labs began as a pharmaceutical pirate—it’s as simple as that. Founder Dr. Anji Reddy used his PhD in Chemical Engineering and his experience in a state-owned pharmaceutical company to reverse-engineer Western drugs and figure out the manufacturing process. Then the company just turned the crank.

The world changed for Dr. Reddy’s Labs in 2005 when the Indian government officially agreed to recognize and enforce international drug patents. You would think that this change would have spiked the company’s guns. But strangely enough, it was probably the spur of having to comply with international laws that kicked Dr. Reddy’s Labs onto a development track that has been paying huge dividends ever since.

Dr. Reddy’s is still a major manufacturer of generic drugs, with more than 200 generics marketed in over 20 countries. The company’s products include tablets, capsules, injectables and topical creams that address ailments in gastrointestinal ailments, cardiovascular disease, pain management, oncology, anti-infectives, pediatrics and dermatology. These products bring high-quality, regulatory compliant medicines to millions who might not otherwise be able to afford them.

But the company is now a fully integrated global pharmaceutical company that manufactures active ingredients, does contract research for other drug makers, and researches and markets its own original drugs. Dr. Reddy’s just grossed $1 billion in sales in the U.S. market for the first time, thanks to its fiscal 2015 launch of 12 drugs here.

RDY is a solid business with excellent growth prospects and a small (half-percent annual) dividend. It’s not likely to go on a rampage, but neither is it going to fall on its nose. The stock’s breakout to new all-time highs is a bullish sign, and RDY should have the momentum of the Indian market behind it. We recommend buying RDY here. BUY.

RDY chart

Note: RDY came through the market’s late-August turbulence, and is still in contact with its rising 25-day moving average.


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