One Question You Need to Ask Before Buying Any Stock Now

Warren Buffett is known for only investing in businesses which he understands. He says individual investors should look at being a shareholder as being a “part owner” of the business.

Too often this basic principle of investing is forgotten. Lately, it’s been too easy to forget. The recent market volatility can drive the market value of a business up or down 10% in a day makes it tough to think of owning stocks as owning part of a business. At the end of the day though, what you’re buying is part of a business.

That’s why I’m encouraging every investor to ask themselves before they invest in a company, “Would I start this business today?” (Keep in mind I’m not talking about trading stocks here which is basically buying a piece of paper and hoping to sell it at a higher price).

If you ask yourself this question, you’re not going to get caught up in the hot trends or try to pick the bottoms in sectors (which are very dangerous).

“Recession-Proof” Fallacy

For instance, a few months ago, one of the hottest sectors around was the pawn shop and payday lenders. They were popularly referred to as “recession-proof” businesses.

The basic rationale was people are headed for tough times. Unemployment is rising and raises and bonuses would be minimal this year. A lot of those people will be hard pressed to come up with cash to pay for bills. Inevitably, more cash-strapped consumers would turn to payday loans and pawning their valuables to raise extra cash.

Makes sense right?

It did to a lot of people.

While financial stocks were plummeting in July, shares of Cash America (NYSE:CSH), EZ Corp (NASDAQ:EZPW) and other pawn shop/payday lenders were actually up for the year. It looked like these “recession-proof” businesses would flourish.

But what if you asked yourself, “Would I start this business today?”

You would have avoided the impending fall in these stocks. That’s because when you start a business you have to take a much more fundamental look at them.

Back in November, only a few days after Obama was elected, we warned the election was an absolute disaster for payday lenders:

The average borrower pays $500 interest on a $325 loan. Payday loans – which are marketed as a service for financial emergencies – are often converted into long-term, revolving, extremely high-cost debt for working families.

Not surprisingly, the payday loan industry was less than thrilled at Congress’ intervention. They spent $30 million initiating and promoting a ballot in Ohio and Arizona to overturn the interest rate cap. Opposing grass-roots campaigners spent $475,000 to thwart them.

In the end the payday loan industry lost in Ohio by a 2 to 1 margin and in Arizona by a 3 to 2 margin on Election Day last week.

Payday loans were being positioned by political leaders as one of the “fall guys.” (Remember, the U.S. isn’t too big on personal responsibility, so there’s always a fall guy). A massive PR campaign wasn’t able to sway public opinion. These places, which offer very high risk borrowers loans with large fees and high interest rates, were deemed “part of the problem.”

A lot of regulation was headed towards “predatory” lenders. It was inevitable. Who would want to enter a business that was about to get hamstrung by regulation?

Yesterday, we got a peek at what is coming to these businesses. President-elect Obama announced intentions to “extend a 36 percent interest cap to all Americans” and “require lenders to provide clear and simplified information about loan fees, payments and penalties.”

Regulation is coming to payday lenders in a big way. Payday lenders, which experience default rates as high as 70%, cannot stay in business if they charge more than 36%. And if you thought like a potential business owner, the writing was on the wall the whole time.

Shortsighted Wall Street, which rarely thinks that way (until it becomes painfully obvious), seemed downright surprised by the announcement. Shares of companies with payday lending businesses like EZ Corp, Cash America, and First Cash Financial Services (NASDAQ:FCFS) fell 15%, 12%, and 15% respectively.

Boom Time for Builders?

The payday loan business is just one example. Two days ago we looked at red hot infrastructure stocks. The Obama plan had a lot of investors bidding them up. And record low mortgage rates brought investors back into homebuilders.

“A great building boom is on its way. Roads, highways, bridges, mass transit systems, tennis courts, and even a $2.5 million duck pond (yes, a duck pond, just check out the Main Street Economic Recovery plan to see thousands of “pork” projects). The U.S. is going to build its way out of this mess and construction companies are going to make a killing. These stocks are going to soar.” Or so the thinking went.

Again, it makes sense from an investment perspective, right? Pretty basic, but it could pay off.

Now, think of it like a potential business owner. Ask, “Would I start this business today?”

The answer (although quite obvious) can be found by asking a few more questions.

How can I compete with companies willing to take on projects for “time and materials”? Can I compete with companies which are willing to not turn a profit? How much extra work will I get from the 41 states which are already cash-strapped as it is? Will the private sector fill the gap? Will demand for houses pick up again in the next few months or year?

I could go on and on, but you get the point.

Construction is not going to be a great business for a long, long time. There’s just too much capacity and not enough demand. Why would you possibly want to get into that business right now?

If you think like that, you’ll avoid trying to pick a bottom in homebuilder stocks and avoid the hype for publicly traded infrastructure stocks.

Nobody Said It Would Be Easy

Now, I realize if you ask yourself “Would I start this business today?” there aren’t too many businesses going to get a “yes.” We’re in what will be a long drawn out recession and there aren’t too many businesses which look attractive. Frankly, it’s going to be tough to find suitable investments you’ll want to make. (we’ll continue to hunt them down at the Prosperity Dispatch -sign up 100% free here).

But when it comes to committing your hard-earned investment capital, isn’t that the point?

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