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10 things you must know about the stocks you buy

October 07, 2015

By Richard Barrington | MoneyRates.com Senior Financial Analyst, CFA

Stock market chart

Forget the hot tips and online chatter. Great investments are built on long-term business fundamentals. The more you know about the nature of a company's business position, the better you can assess the odds of that company proving to be a good investment over time. Be advised though, this is not easy work. Fundamental analysis is for people who want to find stocks they can be comfortable holding for the long term, rather than for people looking to make a quick buck.

Here are 10 things you should know about the companies whose stocks you buy:

1. Competitive landscape

Success attracts competition, and so with any successful company, you need to assess which competitors are going to try to take business away from that company. Competitive advantages can come on both the product and cost side of the business. This means products that are prized by customers and not readily matched by competitors, or cost advantages such as economies of scale or more efficient processes that allow a company to maintain a pricing advantage.

2. Supply chain risks

What does a company depend upon to produce its product or deliver its services? There may be raw materials that can become scarce in periods of high demand, or essential components that are only available from one supplier. Potential choke points in the supply chain can create cost pressures that attack profit margins, or limit availability enough to stunt growth. Keep in mind that in labor-intensive businesses, the availability of suitable workers can be a form of supply chain issue.

3. Customer concentration

Diversity in a customer base is good. Businesses that are heavily dependent on one or two major consumer markets for a majority of their sales are at risk to any change in fortunes on the part of those customers. They are also vulnerable to being squeezed on pricing by those major customers.

4. Market penetration

How much market share does a company have? Commanding the majority of a market may seem like a dominant position, but it can also limit growth potential. Perhaps the ideal situation is a relatively small market share that is steadily growing.

5. Market saturation

This is different from market penetration. Penetration is a measure of what share a company has of an existing market. Saturation is how much of the potential audience has been exposed to that market as of yet. A market that has just started to spread has more growth potential than one that is already well established globally.

6. Product life cycle

If a company's big earners are getting somewhat long in the tooth, it is important to ask whether they have competitive replacements on the way, and whether they have a history of successfully reinventing and rejuvenating their product lines.

7. Economic exposure

Economic cycles are inevitable, but some industries are more sensitive to them than others. You should understand how companies you invest in are exposed to an economic downturn and how well-equipped they are financially to survive it. It is also important to consider whether the economy is at a phase of the cycle where this kind of sensitivity would be a positive or a negative in the near future.

8. Legal issues

If there are any serious law suits, patent challenges, or regulatory investigations pending, it is important to assess the impact of a negative outcome. While companies will naturally try to downplay the likelihood of adverse rulings in these cases, judges and regulators can be somewhat unpredictable. You should view these situations as wild cards where you at least consider the "what if" of being on the losing side.

9. Growth model

Based on many of the above factors, you should attempt to create a realistic projection of future earnings growth. Too often investors make the mistake of simply projecting past growth rates into the future, but for fast-growing companies in particular past growth is often unsustainable. Identifying fundamentally where earnings growth will come from can give you a more solid foundation for future expectations.

10. Valuation compared to growth outlook

Successful companies often trade at high valuations, and you should not necessarily let that scare you away. The question is whether or not the earnings growth looks strong enough to grow into current price levels and eventually support even higher prices.

Again, fundamental analysis is hard work, but it can be very rewarding. If your analysis is correct, it can help you identify stocks that you will be happy to own for years to come, and that is better than trying to jump in and out of the story of the week.

Comments: What info is absolutely essential for you before buying stocks?

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