This article is an excerpt from the Shortform book guide to "One Up On Wall Street" by Peter Lynch. Shortform has the world's best summaries and analyses of books you should be reading.
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What are some red flags you should avoid when investing in a stock? How can you tell whether the stock share will soar or tank in the future?
Stock investing is inherently risky—if you are not okay with losing money, you probably shouldn’t invest. However, you can greatly reduce risk if you do your due diligence by doing thorough research into the companies you want to invest in.
Here are some questions you should ask yourself as part of your investing due diligence.
Does the Company Have Special Assets?
Identify if the company has certain types of valuable special assets because this can make the stock more valuable, writes Lynch. Special assets can be natural resources (precious metals, oil, land, and so on), brand recognition (think of Starbucks or Tesla), real estate, patents on drugs, ownership of TV and radio stations, or tax breaks.
(Shortform note: A different way to consider whether a company has special assets is to identify what experts call its unique selling proposition—what makes the business unique among competitors. Ask, Is this company doing something no other company can easily do? What about this company’s business model, product, or operations can’t easily be duplicated and therefore makes the company valuable? If you have positive answers to the above questions, you can consider the company to have a special asset.)
Has the Company Recently Diversified?
Lynch warns that you should be wary of companies that recently acquired another company. Often, a large company will do this hoping to increase its profits, but the resulting merger often fails to improve the parent company’s finances. This may be because 1) the parent company overpays for the deal, or 2) the parent company doesn’t understand the company it just purchased. The result is that the company often ends up selling off unprofitable acquisitions by restructuring. This cycle tends to repeat itself and is bad for investors.
(Shortform note: It’s likely also advisable to pay attention when a company is in the planning stages of an acquisition or merger. In 10% of cases, such deals fall through, which can have undesirable consequences for both the companies and the shareholders. In fact, 3% of the time, activist investors (usually hedge funds) bring the deal to a standstill, showing that investors often view acquisitions as dangerous.)
Are the Company or Its Employees Buying Back Its Own Shares?
It’s a good sign when a company buys back its own shares, asserts Lynch. By doing this, they take shares off the market. When there are fewer shares, demand drives the share price up—a boon for those already or soon-to-be invested in the company.
(Shortform note: Why would a company buy back its own stocks? There are several reasons, one of which is that the company feels its stocks are undervalued and wants to drive up that value. Another reason is that, by buying up stocks and reducing the number of outstanding shares, the company’s earnings per share (which we mentioned in our discussion of the P/E ratio) increases, making it look more appealing to investors—without the company actually having to increase its earnings. So while Lynch points to companies buying their shares as a good sign, it might also simply be the company’s way of making itself look better without making significant changes.)
Similarly, when employees buy their own company stock, it means they have faith in the company—another good sign.
(Shortform note: While employees purchasing company stock may well be a good sign for you as an investor, surveys show that few employees participate in such employee stock purchase plans. Therefore, it’s probably best not to rely too much on this metric.)
Does the Company Have a Large Inventory?
If a company—especially a retailer or a manufacturer—has a large inventory, it usually means it isn’t selling as much as it would like to, contends Lynch. Further, this inventory will depreciate in value and can’t be sold for as much in the future—think about clothing, which rapidly depreciates because it goes out of style. Consider avoiding such companies.
(Shortform note: Gathering the data you need to make an intelligent investing decision may seem tedious or boring, if not superfluous. But Benjamin Graham provides a compelling reason to do your due diligence before investing: When you purchase a stock, you become a part-owner of a company. That means you have both the responsibility and the privilege to pay attention to your company’s progress and speak up when you see management making poor decisions. When you take on the perspective of a company owner, gathering data on your business seems critical.)
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- Why individuals fare better in the stock market than professionals and firms
- A no-nonsense approach to the stock market
- Why you shouldn't follow the complex predictions of so-called professionals
