The very first thing that I need to know for myself is whether I am buying to security to own it, or to trade it. There are times when I switch between the two as I analyze a stock more, or switch once I already have in my account, but my analysis differs significantly depending on my chosen path for the security. Most of the financial analysis and research that we are familiar with are for us to buy a security to trade, so it is easy to get biased, but I believe that keeping this distinction in mind is very important. Investment returns have two components: dividends and earnings growth; it’s really that simple. But, speculative returns, or short-term performance returns, are driven by “multiple expansion”, which is heavily driven by sentiment. It is important for me to keep reminding myself about the game that I am playing, else it is too easy for me to get depressed (or jubilant) and get swept in what the market is telling me.
Especially when we buy a stock to trade, one of the key tenets of investing is about anticipating and quantifying surprises to the market. More than anything else in the financial statements, surprises to the top-line drive the stock (duh). So, it behooves to spend most of the time understanding the things that impact the top-line. My current mental model to analyze the top-line is here.
We need to understand the firm’s competitive position, which can be understood by doing the analysis suggested here. Next step will be to understand the company’s management, which can be a source (or a detractor from the company’s competitive position).
We can do a lot of a financial analysis, but it is also worth understanding (for trading, not owning), who the marginal buyer and seller is at any point. It is hard to guess who may be the marginal buyer, except making gross generalization (which could yet prove to be useful), but it is relatively easy to analyze the marginal sellers. There is a research by the a professor (I need to dig this up) that characterizes the price action exhibited by the security before a long-term holder sells it.
Finally, I like to have a little checklist before I push that “buy” or “sell” button, which I am developing here.