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I spend quite a bit of time looking for brilliant stocks to buy for my portfolio. Sometimes, however, what seems Like a brilliant bargain comes along and I end up regretting my move later.
I've learned, to my cost, that I need to avoid these three potentially costly mistakes when looking for stocks to buy.
Mistake one: investing in something you don't understand
It used to be considered a funny historical anecdote that, during previous stock market bubbles, investors would have invested money in companies that had not yet decided what their line of business would be.
However, fast forward to the last few years, 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 does.
But there are other situations in which a company may be very clear about its business model, but an investor does not understand it.
In these cases I believe that what happens is not investment, but speculation. When Warren Buffett looks for stocks to buy, he sticks to what he understands. Me too.
Mistake two: Focus on the business case, not the investment case
Is Scientific Judges (LSE: JDG) a big deal?
I think it is.
In fact, in some ways the business model is reminiscent of the one that Buffett himself uses in Berkshire Hathaway. Judges buy proven instrument manufacturing companies, provide some central support, and use the cash they funnel back to the center to help fund further acquisitions.
Like Buffett, Judges is careful not to overpay for acquisitions, as that undermines appeal. Ironically, however, that danger is exactly what is deterring me from adding Judges shares to my portfolio at the current P/E ratio of 34. It may not sound astronomical, but I don't think it's attractive.
A profit warning in November pointed out some of the risks involved, including difficult market conditions and customers delaying placing orders.
I would still like to own Judges shares, but only if I can buy them at a price I consider attractive.
A good business does not necessarily imply a good investment. In this sense, assessment is crucial.
Mistake three: focusing too much on the positive
When a stock drops to what seems like a bargain price, there can often be good reasons for it.
Intellectually this is easy to understand, but emotionally it can be difficult to remember.
So when I look for stocks to buy, I try to ask myself because Other investors are willing to sell to me at what I consider a bargain price.
Only by honestly trying to understand both the bear case and the bull case when it comes to what looks like a bargain stock can an investor hope to avoid at least some value traps.
