Sometimes people want to start buying shares, do not make a move and then bore their mates claiming that they almost made a killing.
Spotting a good business, though, is not the same as spotting a great investment opportunity — and then acting on it!
If I had never invested in the stock market before and wanted to start buying shares, here are five questions I would ask about any potential share purchase I was eyeing. I still use them as an experienced investor.
1. How big is the customer market?
Selling low-priced items to just a few customers is not the way for a business to thrive.
A business might not need lots of customers, if the unit price is high enough (Rolls-Royce (LSE: RR) is an example).
But I think a business needs a certain financial size of total customer demand to succeed at scale, both now and in the future.
2. What sets the company apart from rivals?
A big market is not necessarily a profitable one, though.
In fact, the opposite can be true: a large, growing market can attract lots of participants, pushing down selling prices. That is exactly what Tesla and other electric vehicle makers are wrestling with right now.
So I look for a competitive advantage that can help set a company apart from its rivals and charge a premium price. Rolls-Royce has thousands of engines flying right now and is expected to do so for decades. It built them, so it is the obvious choice to service them.
Whether it is customer base, brand, technology, or something else, a competitive advantage matters. Think of Apple: it has all three of those.
3. Show me the money
A competitive advantage on its own would not tempt me to start buying shares in a company, though. I also look to see if it can convert that advantage into a strong business model too.
When civil aviation demand is strong, Rolls-Royce tends to do fairly well. Yet during the pandemic it incurred huge losses (£3.1bn in 2020 alone, for example). A key weakness in Rolls-Royce’s business model is that when planes stop flying, its earnings tend to plummet.
Compare that to National Grid: come what may, power distribution demand is pretty resilient.
4. What’s on the balance sheet?
National Grid has another attraction: its dividend yield is 5.3%.
So if I was to start buying shares by putting £100 into National Grid, I ought to earn £5.30 annually in dividends if it maintains its payout.
There are two reasons that would not be my move.
First, diversification is an important risk management strategy. So I would not start buying shares by investing in just one. On top of that, I do not like National Grid’s £44bn net debt. Servicing that could lead to a dividend cut in future.
Before investing, I always look at a company’s balance sheet.
5. Does the valuation leave space for share price growth?
Even if I find a great company, I only buy its shares if I judge their price to be attractive. Otherwise, the business might grow yet the share price can fall.
Getting started
Applying those criteria, if I was ready to start buying shares I felt met all five criteria, I would set up a Stocks and Shares ISA or share-dealing account and make my market move!
