Part 5 — 10 Questions You Have to Answer Before You Buy Any Stock

So far in this series, I have shared the first eight of 10 questions that you should answer before you decide whether or not to buy a share of stock in a particular company. The gist of these 10 questions is to help you understand the company you are investing in and items to pay attention to when sizing up what’s on the horizon, both good and bad. After all, how do you know how to gauge a company’s business and the competitive landscape if you don’t have a firm understanding of what the company does and how it makes money for itself and its shareholders? These are some of the tools I use each time I look at a new opportunity that I may share with subscribers to my Growth & Dividend Report newsletter.

If you missed that guidance, I encourage you to check out my previous columns: part 1, part 2, part 3 and part 4. These tackle the first eight questions:

1. What does the company do?
2. What are its key products or services?
3. At what business unit or units does the company make most of its profits?
4. Who are the key competitors and how are they impacting the market?
5. What is driving growth at the company?
6. What is driving the company’s profit picture and, if it’s not improving, why is that?
7. What does the company’s balance sheet look like?
8. What valuation metrics are key?

If you haven’t reviewed those questions yet, and maybe even if you have, you may want to do so, because the remaining two questions build on the previous answers.

9. What’s the catalyst?

One of the more frustrating things I have heard during the last 20-plus years when it comes to looking at stocks is “It’s trading below X times earnings. That’s cheap!” Every time I hear this, I pause and remember that stocks tend to be cheap for a reason.

Flipping this around, it means you should have a reason for buying a particular stock at a certain time. If not, well, you’re pretty much throwing darts at that point.

Wall Street lingo borrows a term you may remember from your high school chemistry days — the catalyst. I profess that while I did well in math and other classes, chemistry was not my strongest subject. A catalyst, in simple chemistry terms, is a substance that increases the rate of a chemical reaction.

The same concept holds for investing in stocks as well. In some of the earlier questions, we identified potential catalysts — new products, new product categories and so on — that are expected to drive top- and bottom-line growth. Other catalysts include accelerating, if not favorable, economic or psychographic (the where and the how companies and consumers are spending) data. Here are several examples of catalysts:

• The introduction of Apple’s (AAPL) iPhone 6 smartphone models in September drove big shipment volumes for Apple and boosted the shares from $99 in early September to just over $129 in late February. Adoption of those newer smartphone models benefitted key Apple suppliers like Skyworks Solutions (SWKS), which saw its share price climb to $102 this past March from $55 last September.
• Similarly, the sharp drop in coffee prices that began in 2011 and lasted into early 2014 occurred at a time when Starbucks (SBUX) was rapidly expanding internationally and overhauling, as well as improving, its food offerings. During that time, the company’s earnings grew from $0.76 per share in 2011 to $1.33 in 2014, and its share price climbed to a high of $40.73 in late 2013 from $16 in early 2011.

Source: World Bank

• Similarly, shares of The Hershey Company (HSY) benefitted in 2011, 2012 and 2013 due to the sharp drop in cocoa bean prices.

Source: World Bank

• The growing adoption of streaming video through Netflix (NFLX), Amazon (AMZN) Instant Video, Hulu and similar services has boosted demand for Internet infrastructure equipment from the likes of Cisco Systems (CSCO).
• The continued shift toward online shopping has done wonders for Amazon shares, but the purchased items still need to get to you or the intended recipient. Beneficiaries of that pickup in shipping have included United Parcel Service (UPS) and FedEx (FDX).
• During the last few months, we’ve witnessed a huge drop in oil prices (see the chart below). There are many uses for oil in our economy, one of which is jet fuel. As oil prices have fallen, so too have jet fuel prices (see the second chart below), which are a key cost component for airlines like American Airlines (AAL), JetBlue (JBLU), Southwest (LUV) and others.

Source: U.S. Energy Information Administration

As you see in several of the above examples, catalysts often have a ripple effect that allows for multiple investment opportunities along the supply chain (Skyworks to Apple) or pain points (the growth in streaming that led to Internet bottlenecks that you probably experienced as sporadic Internet speeds, like I did). We’ll discuss more next week, with Question 10 recognizing that these multiple avenues offer a greater number of opportunities for you. In the above example, Apple’s shares quickly climbed in response to iPhone 6 excitement, but Skyworks shares offered the greater return.

In chemistry, the exact opposite of a catalyst is something called an inhibitor. A formal definition reads something like this: a reaction inhibitor is a substance that decreases the rate of, or prevents, a chemical reaction. To us, an inhibitor is a lot like a headwind that slows the speed of a plane down, while a catalyst is more like a tailwind that pushes the plane along, often resulting in a shorter flight time.

One of the best examples of an inhibitor or a headwind that led to a near-death spiral for one company in particular was the smartphone explosion. That explosion, which only grew as Apple and Google (GOOGL) entered the race with their software platforms, transformed the landscape and laid waste to early market share leaders Blackberry (BBRY) and Palm.

Sometimes a catalyst for some companies can be a headwind for others. Take the current bout of falling oil prices. It’s good for airlines and likely good for consumers, but not good for oil-producing companies, which have already cut capital spending and announced layoffs earlier this year due to the initial fall in oil prices. These drops also are likely to curb demand for alternative energy solutions like solar and wind, which makes falling oil an inhibitor, or headwind, for companies like First Solar (FSLR), SolarCity (SCTY) and SunPower Corp. (SPWR).

The bottom line is even if shares of a company’s stock are cheap, if you can’t identify a catalyst — or if you uncover an inhibitor — you probably should move along and look at another stock instead.

I’ll be back next week with the final question you have to answer before you buy any stock.

In case you missed it, I encourage you to read my e-letter column from last week, which detailed the eighth question on our list of 10 questions to answer before you buy any stock. I also invite you to comment in the space provided below my commentary.

Upcoming Appearances

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