When a stock is not a buy (5)

Fotolia_54867638_XS_7If you are considering buying a stock or share then it is usually unwise to buy on a whim. Most serious investors will have a series of metrics they use for gauging whether a stock is a buy. These will include things like the P/E Ratio, the yield, etc.

However whilst these metrics are important, investors must take a holistic view before reaching any decision. That means not just looking at why the stock might be a buy but also looking for any warning signs that might suggest it is not a buy.

Essentially I use six tests for judging whether a stock might not be a buy. In previous posts I’ve covered the Good Value Test, the Cash Flow Test, the Business Model Test and the Debt Test.

The subject of this post is the Product Diversity Test.

Product Diversity Test:

Essentially this test has a close correlation to the Business Model Test. It is important to have an understanding of the products the company has to offer and the markets in which it offers them. The key thing is to understand the range of products. Does the company have a range of products or is it overly dependent on one or two products? If the company makes all its money from one single product then that for me would probably be a warning sign.

It may have a dominant market position for that product but what happens if for instance there is a major technology shift and consumers move with the times? If demand for that one product were to collapse then suddenly the company could have a serious problem. This does happen. Who buys film for their camera anymore? Digital cameras and smartphones came along and we don’t need film for taking photographs now. And just think about the impact that had on Kodak.

Times change, that’s progress. The issue is not change because change is inevitable. The issue is whether the company is equipped to cope with any changes that might come along.

In deciding whether a stock is a buy I want to know whether the company has the ability to sustain and grow its dividend. For the company to do that it needs to have profitable revenue streams.

A good company will have a diverse range of established products which will be its cash cows. These are the revenue streams of today.

Then it must be constantly developing new products or what I would call rising stars. These are the revenue streams of tomorrow.

If I can’t be confident that the company is well placed to sustain and grow its dividend then for me that is a warning sign that perhaps I should avoid the stock.

There is no room for sentiment, just hard-nosed logic. Reliable dividends which can then be reinvested are an essential part of a good return over time for me. And I never take my eye off that ball.

The last post in this series will put the business and management under the microscope with what I call the ‘One Trick Pony’ Test.

Read also:

When a stock is not a buy (1)

When a stock is not a buy (2)

When a stock is not a buy (3)

When a stock is not a buy (4)

When a stock is not a buy (6)

© RJ Sutton and Mann Island Media Limited 2014. All Rights Reserved.

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