Why it’s always important to “look under the hood” before you buy

By Brian Tycangco

Before you buy a car, you do the research. You check the safety record, read buyer reviews, compare gas mileages, look at options pricing, cross-check it with competitors… and of course you look under the hood. It's common-sense due diligence.

But for many people, it's different for stocks. The careful scrutiny, eye for detail and desire to understand the inner workings of their purchase… they just aren't present. Instead… hearsay, a magazine cover, a hot tip from the shoeshine guy and a kiss and a prayer take the place of research.

It doesn't make any sense.

Do you know what you own?

"Know what you own, and know why you own it."

This is one of the golden rules of investing according to one of the most successful investors in history, Fidelity's Peter Lynch. He started to manage the Fidelity Magellan Fund in 1977 - which grew from US$100 million in assets to US$16 billion by 1990. Peter Lynch delivered a 29 percent average annual return for the fund… over 13 years. That's otherworldly performance.

Knowing what you own means a lot more than just the basics… knowing the brand, colour and miles per litre of your car is a start but won't get you far.

Knowing what you own means knowing exactly what a company does… the products (or services) it offers… their quality and value proposition… the size and consistency of the company's profit margins… how much it pays in taxes… how much debt it owes… its prospects for growth… and the qualifications and experience of the people running the company.

It means understanding how much you're paying for shares relative to a company's intrinsic value (i.e., the underlying value of a company given its ability to generate profits)… how the shares are valued relative to its peers in the industry… why such value is being placed on them… and what price you think is the right price for the shares.

It also helps to have a personal connection with the company… a reason that motivates you to want to become a shareholder.

For example, you've used its product in the past and like it so much, you recommend it to your friends. You might be working in the same industry and know the company has a terrific reputation and is expanding. Or you might happen to know the owner of the company and believe he'll do a great job running the business.

Understanding all of this helps you see the bigger picture, and the scope a company has to grow for years in the future.

What happens in a correction - if you don't understand…

When you don't have a good understanding of what you own - and why you own it - you run a big risk of getting shaken out of strong companies and left with weak, poorly-managed ones when markets correct.

That can happen more often than you think. Typically, stock markets experience declines of up to 5 percent at least several times in a single year. Over the past 50 years, the S&P 500 Index, for instance, has experienced a correction of 10 percent (or more) a total of 29 times.

That's when the so-called weak hands are shaken out of the market… and when investors who understand what they own keep calm, and may buy more.

Warren Buffett, CEO of Berkshire Hathaway, is known for sticking with companies he considers fundamentally strong even through the worst of market corrections.

In 2008, American Express, one of Berkshire Hathaway's top holdings, fell 64 percent. Another of his top holdings, US Bancorp, cratered 21 percent. But instead of selling, Buffett's Berkshire held on to its Amex position, while adding another 1.5 million shares of US Bancorp.

Buffett had been closely following both companies for years - and understood them intimately. He knew that American Express had prudent risk management to limit its exposure to bad accounts. And he also knew that US Bancorp was extremely well-capitalised and would be one of the first to emerge from the rubble.

He's been rewarded handsomely for holding American Express and increasing his exposure to US Bancorp. Since the end of 2008, American Express shares have increased 540 percent, while US Bancorp shares have risen 263 percent.

The best way - often, the only way - to make money investing is to know what you're buying… and why you're buying it.

 

Brian Tycangco
Brian Tycangco is an Editor and Investment Analyst with Stansberry Churchouse Research, an independent investment research company based in Singapore and Hong Kong that delivers investment insight on Asia and around the world. He's been working in the financial world since 1995 and has carved out a reputation as "Master Stock Picker". He's seen just about everything there is to see in these markets, met with the leading CEOs of every industry in Asia, and knows the ins and outs of doing business and making money there. Brian has been a stock broker at a large Asian trading house, an equities analyst for a major European investment bank, as well as editor and chief investment strategist for one of the longest-running Asian investment newsletters in the world. Click here to sign up to receive the Asia Wealth Investment Daily in your inbox every day, for free.

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