I spend a fair bit of time hunting for brilliant shares to buy for my portfolio. Sometimes, however, what seems like a brilliant bargain comes along and I end up regretting my move later.
I’ve learned, to my cost, that I need to avoid these three potentially costly mistakes when looking for shares to buy.
Mistake one: investing in something you don’t understand
It used to be seen as a funny historical anecdote that, during previous stock market bubbles, investors had put money into companies that had not yet even decided what their line of business would be.
Fast forward to the past several years, though, and to me that looks a lot like what is now known as a special purpose acquisition company (SPAC).
That is an extreme way of buying shares in a company you do not understand, as you do not know what it does.
But there are other situations where a company may be very clear about its business model, but an investor does not understand it.
In such cases I think what is going on is not investing, but speculation. When Warren Buffett looks for shares to buy, he sticks to what he understands. So do I.
Mistake two: focusing on the business case, not the investment case
Is Judges Scientific (LSE: JDG) a great business?
I believe it is.
In fact, in some ways the business model is reminiscent of the one Buffett himself uses at Berkshire Hathaway. Judges buys up proven instrument-making businesses, provides some central support, and uses the cash they funnel back to the centre to help fund more acquisitions.
Like Buffett, Judges is careful not to overpay for acquisitions as that undermines the attractiveness. Ironically, though, that danger is exactly what puts me off adding Judges shares to my portfolio at the current price-to-earnings ratio of 34. It may not sound astronomical, but I do not think it is attractive.
A profit warning in November pointed to some of the risks involved, including difficult market conditions and customers delaying placing orders.
I would still like to own Judges shares – but only if I can buy them at what I see as an attractive price.
A good business does not necessarily make for a good investment. In this regard, valuation is crucial.
Mistake three: focussing too much on the positives
When a share falls to what seems like a bargain price, there can often be good reasons why.
Intellectually that is easy to understand – but emotionally it can be difficult to remember.
So when looking for shares to buy, I try to ask myself why other investors are willing to sell to me at what I see as a bargain price.
Only by honestly trying to understand the bear case as well as the bull case when it comes to what seems like a bargain share can an investor hope to avoid at least some value traps.
This post was originally published on Motley Fool
