Friday, October 23, 2015

Frequently Asked Questions - Continued

Still more questions I see often:

What does it mean when I buy a stock and it goes down immediately? Should I sell it?

Most of the time you should do nothing, unless it drops enough that you’d consider buying even more. Stocks go down about 1/3 of the time, it’s just a fact of the market. And in my experience, that frequently happens just after I’ve purchased, a phenomenon I’ve never understood. No matter: assuming you did your homework prior to buying the stock in the first place, and that you continue believe in the long term success of the company you bought, then you should just sit on your hands and wait it out. I’ve had companies drop 10%, 20% or more in the weeks after my purchase. My recent buy of GoPro (GPRO) is down about 40%.

If your stock drops substantially, it might be worthwhile to reexamine your investing thesis regarding that company. Did something important happen—a big lawsuit, a change in business strategy, executive leadership fired or departed, a new and daunting competitor—or is it simply the market getting worried about something small, like an unusually bad earnings report or a rise in inventories? If something substantial has taken place at the company that makes you question the future of the business, you could sell and chalk the whole thing up to a learning moment. But if it’s a smaller thing you probably want to just ride it out.

Why is it a big deal that the Fed might raise rates? What does that mean and should I worry?

The Fed is the Federal Reserve, a government body which tries to manage the supply of money in the economy in part by raising and lowering the Fed Funds Rate—an interest amount banks charge one another to borrow money held at the Federal Reserve. This rate has been effectively at zero (.25%) since late 2008, in the depths of the great recession.

In the short run, raising the fed funds rate tightens the money supply by making it more expensive for banks to borrow funds to lend, and that makes the loans then made by those banks more expensive. Which means it costs more for people to borrow, which generally slows buying behavior, which slows the rate of the rise of stocks and can cause a few days of market price declines. Raising the fed funds rate is a slow-motion braking system for the economy.

Historically speaking, the current rate is absurdly low. It must come up sometime or the Federal Reserve has no levers it can pull to loosen the money supply, a necessary ability. Ultimately, businesses and individuals will continue to borrow to buy equipment and materials, to hire and train workers, to buy buildings, and so on, regardless of the borrowing costs. People adapt. So in the long run, raising rates generally means nothing.

What is the greatest stock purchase you’ve ever made?

Apple, Hands down, no contest, but it was completely a luck play. I bought Apple stock in 1997—when Steve Jobs returned to the company and got Microsoft to invest $150 million, which he used to develop and introduce the first iMac—for a split-adjusted $0.54 per share. Which seems brilliant in hindsight, but I was just getting started as an investor and didn't do even basic research. I made a dangerously speculative investment because I loved the new products and I reasoned that the founder could maybe turn the company around. 

At about $119 today, Apple has been better than a 200-bagger for me over that period. And while I've sold shares off periodically over the years to rebalance my overweighted portfolio, I never sold it all. The argument can be made that that one success has made possible much of the rest of my portfolio over the years. Certainly it showed me the rewards possible from investing patience.

What is seed investing? How is that different from venture capital? Can I buy stock in a company that has not “gone public”?

Seed stage is the first outside money to be invested in a company—when the founders discover they’ve tapped their own savings, credit cards, home equity and relatives’ generosity to the breaking point and they want early investors to help fund the company’s growth. Seed investment is extremely high-risk, because a failure of the business in the future means those investors lose everything. By the same token, of course, it can be highly lucrative if the company succeeds. But even then the investors rarely see their money for several years or longer.

Venture capital—VC—is the next stage of outside financing in a young company. VC funding usually comes with strings, such as strategy advice, leadership/management assistance, seats on the company’s Board of Directors, and so on. VC firms are professional investors who are well-financed, generally well-connected, and experienced in getting small upstart companies from seed-stage to the next level, where the business can be sold to a larger firm or taken to the stock market with an initial public offering, or IPO.

Shares of seed-stage and VC-backed companies are generally unavailable to most people. Those shares are held by the founders and those early investors, who tend to be wealthy, experienced investors who both fully understand the risks and illiquidity of private stock ownership and who can afford the losses which frequently result.

I’ve read about companies lately splitting their shares into two different classes of stock. What does that mean?

This is the new trend. It’s confusing for existing shareholders because the new shares trade under different ticker symbols and at different prices. But what’s happening isn’t really all that important or exciting for most of us.

Basically, a company splits shares to make them appear more affordable to a broad range of potential buyers: “Why spend $100 for a piece of the company? We’ll do a 2-for-1 split and they’ll only cost $50!” But you’ll get half as much ownership, so it doesn’t matter. But the different-classes splits we’re seeing lately do something else: they divide voting shares held by management (and existing shareholders) from non-voting shares which can be bought and sold as well, usually at a small discount. It’s simply a way of having shares split without diluting the voting shares crucial for founders and executive leadership to execute their will, which as an investor is a good thing.

If you’re deciding which class of shares to buy, it comes down to whether you prefer the small discount (usually 5-10%) that non-voting shares provide, or the right to vote your shares—in a company which millions, or hundreds of millions, of outstanding shares.

What is an appropriate amount to keep in cash as I manage my investment portfolio?

As a rule of thumb, I try to keep about 10% of my investment portfolio in cash. Warren Buffett has called this “dry gunpowder”—the cash needed to be able to take advantage of surprising market opportunities, such as a sudden price drop on a particularly great company. It’s also just a good habit to hold a little back for rainy days.

What represents a great buy today?

Speaking for myself, I’m not really a value investor, I’m a growth investor. A stock’s price today is of less importance to me than its price many tomorrows away, and I’ll pay what seems like a lot per share if I think the company will be bigger and more valuable in the distant future, regardless.

There are always terrific businesses available; it’s a matter of “risk” tolerance (really volatility tolerance, which is not the same). I frequently look at companies widely considered to be overpriced by the media and the Wall Street types on TV and which sometimes see wild swings of their share prices—Netflix (NFLX), Amazon (AMZN), Zillow (ZG), Tesla (TSLA), etc—because these companies aren’t priced in the market by traditional profit-based pricing models. They are shaking up industries, changing the way we do business and live our lives as citizens and consumers. They break the rules, and they frequently forgo profits near-term to reinvest for maximum long-term impact. Their share prices reflect not their earnings but their potential.

Also great buys today are those firms I consider to be “forever stocks,” the ones you can buy today and probably forget about for 20 or 30 years. When you look up in the distant future (or your newborn nephew is told he has stock you gave him decades before), these well-run, long-term managed companies will likely still be doing well. These companies provide a product or a service that will likely still be valuable then as it is today: Disney (DIS), Starbucks (SBUX), even Ford (F) and Hershey (HSY).

I’ll continue to keep track of questions I get and revisit the FAQ posts from time to time. I urge you to read previous FAQ posts here and the second part of my FAQ here if haven’t read them before. And of course feel free to comment on anything you see on this blog or ask me questions directly. I will try to get back to you quickly.  

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