Image source: The Motley Fool
I spend quite a bit of time hunting for smart stocks to buy for my portfolio. Sometimes, though, what it seems like a good deal comes along and I end up regretting my move later.
I learned, to my cost, that I need to avoid these three potentially costly mistakes when looking for stocks to buy.
The first mistake: investing in something you don’t understand
It was often seen as a funny historical anecdote that, during previous stock market bubbles, investors had invested in companies that had not even decided what their business would be.
Fast forward a few years, however, and to me that looks a lot like what is now known as a special purpose acquisition company (SPAC).
That’s an extreme way to buy shares in a company you don’t understand, since you don’t know what it’s doing.
But there are other cases where a company may be very clear about its business model, but the investor doesn’t understand it.
In such cases I think what is happening is not investing, but speculation. When Warren Buffett is looking for stocks to buy, he sticks to what he understands. So do I.
Second mistake: focusing on the business case, not the investment case
Is it Science Judges (LSE: JDG) good business?
I believe it is.
In fact, in some ways the business model is reminiscent of the one used by Buffett Berkshire Hathaway. Judges buy businesses that make proven tools, provide some support, and use the cash they put into the center to help fund more acquisitions.
Like Buffett, Judges are careful not to pay too much for a purchase as that reduces the appeal. Ironically, however, that risk is the very reason why I stopped adding Judges shares to my portfolio at the current price-to-earnings ratio of 34. It may not sound like astronomy, but I don’t think it’s attractive.
A profit warning in November pointed to some of the risks involved, including difficult market conditions and customers who were slow to place orders.
I would still like to own shares in Judges – but only if I can buy them at what I see as an attractive price.
A good business does not necessarily mean a good investment. In this case, moderation is important.
The third mistake: focusing too much on the good things
If a share falls to what appears to be a low price, there are usually good reasons why.
Intellectually that is easy to understand – but spiritually it can be difficult to remember.
So when I’m looking for stocks to buy, I try to ask myself why other investors are willing to sell me what I see as the price.
Only by honestly trying to understand the bear case and the bull case when it comes to what appears to be an auction share can an investor hope to avoid at least some value pitfalls.
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