5 Mistakes To Avoid When Picking Stocks

January 29, 2020

When picking stocks, avoiding mistakes can be just as important as picking winners. Today, we will take a break from our Fun with Options Series, and focus on how we can avoid stock picking mistakes. For now, I will define a mistake as a “permanent loss of capital”.

Having said that, of course mistakes are inevitable. Investing is all about predicting the future, and we live in a complex dynamic unpredictable world. That said, I believe the following is a good checklist to consider, to help avoid mistakes in the stock market.

ONE: Avoid The News!

Remember, fear sells. So ignore news that simply won’t matter 5 years from now. 

News is always presented in a way that can spread easily and get the maximum number of readership. News can create significant price volatility in the short term. Usually it’s best to simply ignore daunting macro/geopolitical events. 

For example, the past few days, we have had the Coronavirus scare. Yes, this is an important development. Will it affect the markets in the long term? No one knows...but here is what happened with previous similar scares.

Source: Unknown.

TWO: Avoid Bad Businesses...

Next time a stock you own falls, the way you feel at that time is a good indicator of how convinced you are about the company's competitive durability.

Business is hard. It’s competitive. Capitalism is brutal. 

If a business is successful, it will soon have many formidable competitors. So you need to ask yourself: how likely is it that this business will get dethroned from its current position?

Investing in businesses that do not have a durable competitive advantage (or in the case of Mavericks, ones that will have one in the future) is risky. It is particularly hard if the business hits a rough patch (all businesses do so at some point). The decision whether to hold onto your shares then becomes very difficult, if not impossible, if you cannot determine whether a business is flawed or simply going through a difficult stretch. 

Imagine being an Apple shareholder in 2018. The stock fell ~40% from its high that year. If you understood its competitive position, you would know that Apple is a great business with a very strong and sticky ecosystem. So you should not have been too worried about the future of the company. Remember, stock market volatility is normal. Of course, ignoring this volatility is easier said than done. It isn’t psychologically easy. But buying good businesses makes it easier. 

THREE: Avoid Too Much Debt

Low or manageable amounts of debt gives a company flexibility, even a competitive advantage in a bad market environment. Keep this in mind before buying a stock.

Just like in our personal lives, if you borrow more than you can handle, and if there is a hiccup in the future, a company could find itself in a distressed situation. Recall lenders have first dibs on any assets a company has, if something goes wrong. In the case of a bankruptcy, stockholders can get wiped out. 

FOUR: Stay Away if the Price is Too Damn High!

Paying more than a business is worth can cause you to have mediocre future returns. I am convinced this is the case when it comes to Dependables. One should be price sensitive when buying Dependables. 

Caveat: On the other hand, this may not necessarily be the case when it comes to Mavericks. In their case, a high price might actually seem cheap many years from now. Look at Amazon, one of the most successful Mavericks of our time. It was already worth almost $200 Billion 5 years ago. Today it’s worth $900 Billion. 

Mavericks, after all, are companies that are innovating and trying to change the world. That makes them very hard to price.

If successful, such companies are poised to become the best companies of our time.

So I wouldn’t expect them not to sell at a premium. 

Think of it this way…wouldn’t you expect a Tesla to cost significantly more than a Toyota Corolla?

FIVE: Avoid Company Leaders That Don’t Inspire You

You want to partner with and buy stock in company leaders you’d want to go work for. People who inspire you. People you’d feel comfortable managing your hard earned money.

That’s a personal decision of course. And it’s not easy because as public market investors, we don’t get a chance to meet such leaders in person. But it’s important and necessary. We must develop our own informed opinions about company leadership.

Looking at the investments I have written about so far, I feel pretty good about the leadership at KKR, Nintendo, and The Trade Desk (TTD). Both KKR and TTD are founder led companies. For these leaders, their company is a large part of their identity and they will do everything in their power to ensure their companies remain successful. That’s what you want as a silent partner (as a stockholder, that’s exactly what you are). At Nintendo, the CEO slashed his own salary 50% so he wouldn’t have to fire his employees when the Wii U failed. That unselfish empathy for their stakeholders is important.

When I invested in Wells Fargo however, it didn’t have a leader. The CEO (Charles Scharf) was hired after the fact. He seems credible on paper (he was formerly CEO of Visa). During his last job (CEO of BNY Mellon) however, his company underperformed the market. So that’s a red flag. So, for me, the jury is still out on him. That said, I believe a bank is a relatively straightforward business to run. So I am currently breaking this rule on the checklist. We’ll see whether that was a good decision or not.

SIX (BONUS): Only Buy for the Long Term

Don’t buy a stock with the intention of selling it in a few days, weeks or months. Would you do that if you bought a house? Or a farm? Or a local business?

So, why with a stock?

On average, unless something goes really wrong with a company, the longer you own a stock, the less likely you will lose money. This is especially true when you buy good businesses.

As I said before, investing is about predicting the future. So mistakes will surely happen. But having a checklist like the above can be a good way to proactively avoid common mistakes.

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See you next week!