Most of us tend to rely on our stock broker's advice when it comes to buying and selling of shares. Remember that the onus of the investment still lies with you. While a stock may be a great business, it may not be a great investment. Similarly, it may be a good investment pick but it may not be suitable for you. Any stock recommendation can never be accepted in black and white with a sense of finality. As an investor the onus is on you to ask some serious questions to your broker before buying the stock to ensure that you are buying into the right story.
What is the story behind this stock?
Every research report must have a key action point and you need to understand that action point. Try to understand the logic for selecting this stock? There could be a variety of reasons for the same. It could be an upgrade in the revenue or better profitability or better-operating margins. It could also be some investment decisions which could be accretive to profits in the future. Even assuming that the analyst is justified in his analysis, you need to understand what are the risks that this stock could create to your portfolio and to your overall financial plan? This is the point at which you need to understand the conviction behind the stock recommendation.
Is the price impact going to be in the long term or short term?
This is a very important question that you need to ask. Some recommendations are structural and some are more immediate in nature. Normally, where the stock call is trying to ride the momentum of the stock, the impact will be immediate. If the broker is betting on the stock to undergo some structural changes, then the impact may not be immediate and you may have a waiting period. Be clear on this front.
Understand the assumptions behind the stock
Having understood the underlying theme of the report, the next step is to understand the underlying assumptions. Why does this matter? Your analyst may have made an assumption that rates may remain low or that the commodity cycle may turn. Check in the market if such assumptions are practical or not. Here are a few questions. Is the analyst's projection for the sector in tune with what other analysts are projecting? You also need to check with your financial advisor as to what are the specific tangible and intangible benefits that the analyst sees in the particular stock. This will require some channel checks by the broker.
Are you running with the hares or hunting with the hounds?
This is a more poetic way of asking whether the broker is going with the general herd or trying to say something contrarian. It is easy to make money with the herd in the short run but very hard to make money with the herd in the long run. Be clear that you are chasing momentum and not value in such cases. If you are chasing value then your homework should be thorough. Let your broker offer you the justifications either ways.
Is there a margin of safety in the stock?
Margin of safety is the extent to which the valuation of the stock is higher than the market price. Greater the gap, greater is the margin of safety. If the gap is just about 10-15% then there is no great idea in chasing the stock. You need a clear margin of safety where the stock in question is quoting substantially lower than the perceived value of the stock. Only then there is a margin of safety that will justify buying the stock. This is your insurance against any market vagaries.
What is the market saying about the stock?
The market is generally right and you need to give it the benefit of doubt. After all it represents the collective view of thousands of investors. What the market is saying refers to what other analysts are saying and also the channel checks. Check if the broker recommendation is actually in tune with reality. Has the analyst considered the viewpoint of stockists, regulators and competitors about the perceived risks? You need credibility!
Wait, is there conflict of interest?
This is a very delicate but very important question. What are conflicts of interest? For example, the analyst may have recommended the stock but an arm of the broker may be having an investment relationship with the company. Alternatively, a group company may be doing consultancy work for the target company. The investment and proprietary arm of the broker may have already accumulated the stock in their books in advance. Don't just go by disclaimers and put these questions to your broker, however uncomfortable.
Finally, what is the portfolio fit for me?
Here, the focus is on the word "me". That is the bottom line and the proof of the pudding lies in its eating. However great a stock it may be, it needs to fit into your overall financial plan. Am I already overexposed to the sector, then it does not matter how good the stock is? If the stock has a risk profile that does not suit yours then forget about it. The idea is to ensure that the stock must fit into your portfolio both in terms of risk and return.
The author is senior equity research analyst at Angel Broking. Views expressed are his own
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BS Primer: Planning to buy a stock? 8 questions you must ask your broker