The First Question to Ask Before Buying Any Stock

Finding the 'perfect' stock – and how to handle it... The first question to ask before buying any stock... To be successful, you must obsess about this... How to limit your losses if your bet doesn't pay off... Two recent examples to prove this point...

We've found a 'perfect' stock...

It's something that doesn't happen often.

I (Matt Weinschenk) have worked as an analyst for Dr. David "Doc" Eifrig's Retirement Millionaire advisory for the past seven years – and 12 total in the investment-research industry. And in that time, I can count on one hand how many times I've found a business as good as this one...

The company boasts gross profit margins (net sales minus cost of goods) of more than 80% and a dedicated customer base that delivers recurring sales. Plus, it has gobs of cash flow, no debt, and a skilled management team.

Unfortunately, it sports the valuation of a "perfect" business, too – at greater than 40 times earnings. That's a hefty price tag. And it's the main reason we're not recommending the stock in Retirement Millionaire at this moment.

That doesn't mean we won't in the future – or that you can't do well buying expensive stocks...

Look at the returns of credit-card companies Visa (V) and Mastercard (MA), for example.

These two stocks have looked expensive for the better part of the past decade... and yet, they continue to rise. As the following chart shows, on a split-adjusted basis, Visa is up roughly 800% and Mastercard has risen close to 1,000% since October 2009...

After seeing those returns over the past decade, you can see that investors missed out many times along the way to make significant profits with Visa and Mastercard. And it brings up one simple question... How do you know when it's too late to buy these types of "expensive" companies – or any stock at all, for that matter?

To answer, you must start by asking yourself another question...

If I buy this stock today, exactly what bet am I making?

Of course, the crux of any investment decision lies in analyzing the business.

But once you've decided that you're interested in a company, every investor must consider this question. If not, you won't have realistic expectations with your investment.

Too often, investors build a hodgepodge portfolio of stocks that they simply think are "good stocks that will go up." But that way of thinking could lose you a lot of money if you aren't careful...

With every investment you make, different scenarios exist that will allow it to prosper or will turn it into a loser. If you want to be successful, you must obsess about all the risks.

You can make money a lot of ways in the market...

You can buy a "cheap" business with a lot of problems. As it gets less cheap and the stock rises, you can make money – so long as the company's problems don't get worse.

You can buy expensive growth stocks. As investors get more excited about these companies – or as our colleague Steve Sjuggerud likes to say, as "Melt Up" euphoria sets in – the stocks will power higher, potentially leading to big profits.

And you can also profit from all kinds of holding periods...

You can hold stocks for 10 years – like we do to make triple-digit gains in Doc's income-focused Income Intelligence advisory. Or if you use the proper strategies, you can hold stocks for two months – like we do in our options-focused advisories Retirement Trader and Advanced Options.

The key to success is understanding exactly what you're doing in each case...

And more important, focus on how it can go wrong.

Too often, inexperienced investors overlook the risk and blindly throw their money into a stock. But every investment comes with some level of risk...

Each business you invest in faces cutthroat competition from competitors – at least a dozen other companies, in most cases. And many companies sell to customers who are running their own unpredictable businesses. They rely on a growing economy to keep sales rising.

Those are just a couple of examples. Any number of factors can juice a stock's share price or sink it... Presuming you can perfectly predict what a stock will do is not only arrogant, but it could also wreck your portfolio.

It's easy to gauge a stock's upside... You think it's a good business at a good price. If you're correct, it goes up. But it's much more important to understand the risks involved before committing your money to an investment.

When we recommend a stock in any of Doc's services, we "stress test" every possible downside and address what could go wrong. And to limit our risk, we use a "sell stop" – a predetermined exit strategy, in case the investment doesn't play out as we expect. All of our Stansberry Research editors take similar approaches in their research and analysis.

But you must also consider what could happen that would cause shares to drop to that level...

For instance, sometimes, we'll find good businesses... but know their products are tied to the business cycle.

Some businesses can churn through any type of economic conditions... They're essentially "recession-proof."

Others need a thriving economy to stay profitable. If we choose to invest in companies like that, we're making a specific bet... This is a company we want to own, but a recession in the next year will make it difficult to profit.

Other times, you'll find a sector with a huge amount of hype... For example, software-as-a-service ("SaaS") businesses like Salesforce (CRM) and Workday (WDAY) attracted the eyes of speculators in recent years. As a result, their stocks thrived... Salesforce gained roughly 140% from the end of 2016 through earlier this year, while Workday soared around 240% in a similar span.

Many of these "cloud software" companies run good businesses. But thanks to all the investors jumping on board, their valuations were stretched to an extreme. (Today, the stocks in the BVP Nasdaq Emerging Cloud Index trade at an average of 239 times forward earnings and 6.9 times sales!)

If you were to invest in any of these stocks, you would need to realize you're betting that investor sentiment will not shift against them. If it does, it could quickly trigger a sell stop as wide as 25% or 30%... leaving you with a significant loss in a short period.

In fact, the tide recently shifted in a big way for one of these companies... If you had bought Workday's stock back in July when it peaked at more than $224 per share and put a 25% sell stop in place, you would already be out of the position today. It dropped to less than $168 per share briefly in mid-September – a decline of about 25% from its peak.

Buying an expensive stock also means you're buying a stock whose growth expectations are high. This scenario is often referred to as "priced for perfection." That means with the stock's current valuation, the company must keep hitting its sales growth targets to support its share price. Even if it misses projections by a small amount, its shares will tumble.

How often have you bought into a growth stock without realizing you were betting that the company would continue to hit its sales growth targets forever (or at least as long as you hold)?

Let's use one of our recent recommendations as another example...

Earlier this year, we recommended shares of tobacco giant Altria (MO) in Income Intelligence.

It was rather easy to define the stock's potential upside. Shares traded at a cheap 12 times earnings, and it paid a huge yield of nearly 7%. Folks were pessimistic on the stock, given the decrease in demand for cigarettes. But Altria kept raising prices and increasing revenue.

As we noted in the issue, the downside included the potential regulation of the e-cigarette business that Altria had ventured into with its investment in e-cigarette company Juul Labs. At the time of our recommendation on January 17, we explained...

The stock does have risks. In late 2017, the U.S. Food and Drug Administration (FDA) announced it was reviewing the rules for nicotine levels in cigarettes. Now, it's considering banning menthol cigarettes. And the e-cigarette business could run into new rules, too. An adverse announcement from the FDA could send MO shares down. But at current valuations and with a yield of 6.6%, that's a risk we're willing to take...

An adverse ruling could dim Juul's bright future. And that's part of the reason we can get Altria shares so cheaply today.

Our bet was simple... Altria could potentially give us double-digit gains due to its profits, and we were willing to risk up to 25% of our capital allocated to the position (our trailing stop) in case heavy-handed regulation came down against the company.

At first, the market slowly realized the same thing we did... Altria's stock was priced too cheap. Shares quickly rose 22% through early April. But since then, reports have emerged of people getting seriously ill from using e-cigarettes (also known as "vaping"). The FDA eventually stepped in and talked about banning flavored vapes.

Amid the negative sentiment around e-cigarettes, Altria shares fell sharply last month through our stop loss, and we sent out a notice to our Income Intelligence subscribers to sell their shares. Given the dividends we collected along the way, we booked a 7% loss.

No one could predict that the Trump administration would pick e-cigarettes as a target for increased regulation. But before we put our money to work, we knew that was part of the risk we were taking. By using a clearly defined stop loss when we placed our bet, we were able to limit our losses and move on to other positions.

Here's another example of the importance of understanding risk – and it's a fish story...

Recently, we recommended a salmon fishery to our Income Intelligence subscribers.

You probably have never thought about it, but growing salmon is a great business... You put the salmon in the water, watch them grow, and then sell them for a return of something like 20% on your invested capital.

On top of the profit-making business model, we identified what we believe to be the best operator in the business. This international company has the lowest cost of salmon production and has provided steady returns to its shareholders for years.

But here's what we don't know... the price of salmon.

Like other commodities, supply and demand cause salmon prices to rise and fall. In 2016, a sea lice epidemic in Norway cut the harvest by 9%. As a result, salmon prices soared.

But this year is different... Salmon prices have declined steadily since April. In September, Finland-based financial-services group Nordea Bank downgraded the entire salmon-farming sector, cutting price estimates while noting expectations for growth in global supply over the next two years. That was part of the bet we made in August. As we wrote in that month's issue...

Salmon prices have been healthy for years. We expect they will continue to be, but even if they soften, [this company] has a great cost advantage over competitors.

We wanted to buy into a sturdy business that runs profitably through all salmon market environments. We accepted the unpredictability of salmon prices with the goal of owning a high-quality business that pays a generous, consistent yield.

And most important, we have a sell stop to limit our downside should something surprising happen to salmon prices. Meanwhile, we intend to earn 20% to 25% a year as partial owners of a salmon-farming operation as long as things go well.

That's a bet we're willing to make. And even with salmon prices near two-year lows, our shares are down only about 7% right now. We've got a lot of safety built into our bet.

Now, let's wrap up by going back to our perfect, but expensive stock...

We believe investors can only make one smart bet with this stock – a long-term one.

We don't know if this stock – which we're still considering for Retirement Millionaire in the future – could support such a rich valuation if the broad market were to drop or the next recession were to come. But we do know it's a quality business that will persist over time.

That's the bet – the risk-reward decision – we'll have to decide on before recommending it.

And that brings us to one of our favorite mental tricks that you can use in your own investing... It's something that can help clarify your thoughts on a stock before deciding whether to buy it or not. It's one of the best ways to choose long-term investments.

Before making this kind of bet, you must ask yourself...

Would you buy this stock today if the market were closed for the next 10 years?

In other words, if you check back in on this stock in a decade, will the business have created value at a rate that's good enough to provide a worthwhile return?

If the potential reward isn't worth the risk you're taking on, maybe the investment isn't as perfect as you think. But no matter what, you must have realistic expectations going in.

New 52-week highs (as of 10/9/19): Digital Realty Trust (DLR) and Aqua America (WTR).

In today's mailbag, we're sharing more reaction to this year's Stansberry Conference. If you missed our coverage of the event, you can catch up here, here, and here. As always, send your notes to feedback@stansberryresearch.com.

"I followed Thursday's Alliance Meeting through the live-stream connection you offered. A great service, especially for your overseas customers like myself. Thank you so much!

"I enjoyed the presentations very much, Danielle DiMartino and Porter offering the most sticking insights to me.

"What I've written to you before, I gladly repeat today: you guys do an awesome job and I am a very happy customer." – Paid-up Stansberry Alliance member Henk W.

"Bravo, another great gathering. [Dennis] Miller, as unrepentantly irreverent and insightful as ever. The stunning intellect of [Jim] Grant, [Nouriel] Roubini, and [George] Gilder – and with no intent to ignore that of others, what a Dean's List of presenters! The arguments of the Market's 'Fair value' or its 'excess exuberance' were both solid. I tried to weave the middle from them but hatched only the same shrug as most others. I take home many good ideas, but in some cases found the language... surprisingly backstreet. Thanks for your work!" – Paid-up subscriber Jim L.

Regards,

Matt Weinschenk
Las Vegas, Nevada
October 10, 2019