Friday, February 01, 2008

Rule #3: Do your homework.

The importance of this rule cannot be stressed enough. Do not buy a company because its recommended by your friend or relative. Do you own homework on the company before pulling the trigger. This may include reading all available articles and press releases by the company. Reading the quarterly and annual reports and SEC filings. And even reading any analyst reports on the stock to get an idea of what others are thinking.

Ideally your homework should cover the following points.

  • What does this company do? What business is it in? How big is this company?
  • Has the company had a consistent past record of sale, revenue and earnings growth? Or is the company headed for a turn around?
  • The most important part of your homework, the investment thesis. What makes this a good investment? Is the company offering any product or services that is revolutionary or just executing better than others? Does it have a strong brand name? Or is the company just plain undervalued? Are there any business or economic trends taking place that could make this company valuable in the future?
  • Equally as important, what is the time frame for this investment? What do you estimate the company/stock to be worth by that time frame?
  • What are the risks associated with the thesis?
  • What is the exit strategy?

I have made this mistake many a time of buying companies without doing due diligence. For example, I bought this company Insteel Industries (IIIN) because I read an article at The Motley Fools about how this company has a great future. This company made steel reinforcing products, and we were at that time in a commodity bull market (and still are). The company was down from its highs, and I thought this would be a good time to open a position. After I bought it, it went down further, and I continued adding to my position, until I realized this company is going no where and sold it for a 30% loss.

Another mistake was buying the drug/biotech company called Dendreon Corp. (DNDN) because I heard a called in Jim Cramer's Mad Money show say there is a good chance that its provenge drug has shown excellent results in studies and would be announced at a medical conference. As expected, the study results were not that great, and the stock moved lower from where I purchased. But since this was strictly a trade, I cut my losses quickly.

Never buy a stock based on tip, rumor or speculation. It will more often than not leave you in a world of pain.