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Picking StocksTwo Arrows

The Stock
by WealthEffect Staff

(Three Questions for the Money)


Is it a company you love?
  Is it a stock you can live with?  
  Is it a return on investment you can accept?  

Before you buy a company's stock, you should first be sold on the quality of its business. You should have the confidence that it has competitive advantages, that these advantages are sustainable, and that the management will make the most of the company's potential.

Peter Lynch, the legendary mutual fund manager, argues that success in the stock market has as much to do with your stomach as with your mind. Owning stocks is easy, just as long as you're making money. If only we could listen to Will Rogers who advised us to, "Buy good quality common stocks and hold them until they go up. If they don't go up, don't buy them."

Look at what happened with Coca-Cola: if you bought shares in 1973, you've made thirty times your original investment. And you made these profits with a great company, not with some esoteric speculation.

But it wasn't a smooth ride. After only a year, you had lost half your money and the cover of Life magazine was questioning the future of the stock market. After nearly a decade, you were still down 50%, inflation was rampant, and the world economy was in serious decline.

In the face of all this bad news, would you have had the courage of your convictions? Would you have stood up to all these pressures to sell, any one of which could've turned your thirty-fold profit into a miserable illusion? Well, at least with a Coca-Cola, you never had to doubt that you owned a great company whose profits were continuing to rise year after year.

But what if you own some unpredictable company whose business you don't really understand, whose once "can't miss" stock has plummeted, whose profits are all over the map? How can you be comfortable that the value of the business is rising? How can you possibly wake up each morning hoping its price has gone down?

In a bull market such as we've had for these many years, these questions don't matter much. But bull markets don't last forever. You might believe in the long-term case for stocks, and you'd be right, but your belief has to stand up in bad times as well as good. As Mark Twain wrote, "A virtue which has not been tested in the fire is no virtue at all."


Another wonderful feature of great companies is that you can estimate your expected rate of return in the long run. This estimate won't be exact, but it will be reasonable. In Coca-Cola's case, I think you can expect to earn about 10-11% a year over time in a stock market which will likely provide considerably less attractive annuals returns.

If that return on your money is acceptable to you, and you are willing to hold the shares for at least a decade, then you have yourself a buy. If you insist on a higher expected return, then you have to wait and hope you get your chance. For example, if you insisted on a 15% expected return before you invest, then you will have to wait until Coca-Cola is about half its current price!*

Suggestion: Go to Strategy

* If you want to better understand expected return, visit Return on Investment (ROI).