Stock Investing: FAQ (cont'd)

Answers to more questions I get asked routinely:

1. Should I just go ahead and buy the stock I want, or should I wait for a price drop? What if it's really expensive? 

Stillborn Qwikster: Even the name was a terrible idea

I've told the story before of my Netflix gaffe: owned it in 2009 and 2010 and saw my investment increase over 300% in that time. Then in September 2011 Netflix announced it was splitting off DVD rentals from on-demand, such that existing customers would effectively pay double current prices for to keep their existing arrangement. It was such a bone-headed, greedy, out-of-sync-with-the-customers move that I lost all respect for CEO Reed Hastings and his previously brilliant management team, and I sold my shares immediately. A month later Netflix reversed course, apologized to its customers, and started building back the trust. I should have bought it back but I was skeptical ... Now the stock is up another 400% since my sale and I'm still waiting for that buying opportunity. Worse, Netflix is not the only company I've made that mistake on.

Some people have to feel they got a bargain. But for me, I generally don't worry about timing my purchase to a price dip. I'm buying companies I intend to hold for a very long time-- 3 years or more, on average. Longer if possible. Warren Buffet says, “Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.” In my current portfolio, the stocks I've held more than 6 months average a 34% annualized gain. If there's a company I've been watching and understand, which makes amazing things, and crushes their competition, and carries little debt, their stock on the rise, then I have little interest in timing the purchase just so.

2. I've heard people say "Sell in May and go away." Is there a time of year when things usually drop, so I shouldn't invest?

No, there is no such time of year. That's an old legend, once sort-of true, when the world moved slower and news was once or twice a day and traders spent half their summer at the beach club on Long Island. Those days are gone. Now things move fast and they change constantly. It never slows, not really. Get in as soon as you can, because the power of compounding will increase your invested savings exponentially over your lifetime. The sooner you get into the market, the wealthier you'll be when it's time to retire.

3. Do you have any tips? What's hot right now?

Disney never disappoints

This is one of those useless questions that everyone asks, because their investing philosophy is different from mine-- or more likely-- they do not yet have one. The answer is dependent on things only they know: what they do for a living; the industry or industries they understand and follow; the companies they already do business with; their savings and investing timeline; their patience with volatility, or their "risk profile." What I (seasoned and tolerant of risk) might recommend would likely make them seasick with wild price swings. What they (new to the stock market and accustomed to having a managed IRA) might find interesting would make me sleepy with the boring steadfastness of a dividend-based, low-growth return.

Generally I duck the question entirely by pushing them to a familiar name which grows pretty consistently despite a steady, blue-chip status: Starbucks, Disney, Berkshire-Hathaway (Buffet's conglomerate). A little something for everyone.

4. A lot of stuff I read says I should diversify across industries, like a little bit each of energy, biotech, banks, manufacturing... What do you think?

Short answer is Yes, you should diversify across industries, as well as across nations, growth stages, market caps, even asset classes (bonds, real estate, etc). But the reality is most of us know some areas a whole lot better than others. I've mentioned before that I know nothing, repeat nothing, about commodities. Or insurance. Or medical/health care. So while I should own stocks in those areas, I do not. Because at the end of the day, the single most important rule for me is Buy what I know. That's it. How can I possibly do a deep analysis-- either prior to purchase or later, when I'm keeping track-- if I don't genuinely understand the product they make, or the process by which they make money?

So I have industries I feel I get. Auto manufacturing, online retail, social networking, finance, entertainment, and so on. Limited, but within my wheelhouse.

5. If you only had enough money for one investment, would it be real estate, stocks, bonds, gold... ?

Stocks. Hands down. Nowhere else can I average over 20% per year on my capital. Even in a bad year I eke out 10% overall. The only thing which comes close to that would be private lending, which is very risky and a totally different kind of investment.

Looks great but it's not for everyone

Gold, it should be noted, has historically been a safe haven for cash in an unsafe or unstable financial world. Lately gold prices have dropped hard. But if you look back 100 years or 5,000 years, gold has been a great place to put your money. On the other hand, gold earns nothing. It just sits there. You have to have total faith that it will appreciate over time. Unlike a stock, there is no management team working their asses off to earn shareholders a return on that gold. So while there's virtually no risk that you'll lose your entire investment, there is also no promise that your asset will appreciate.

Real estate is generally a good investment, but again, it's a specialty requiring different skills and different expertise. Buying shares in a REIT (Real estate investment trust: many are traded over the counter as an exchange-traded fund) is not a bad idea if you are looking for broader diversification.

6. Choosing stocks and managing a portfolio looks confusing and difficult. Why can't I just put it into an index fund or a mutual fund and forget it?

You can do that, of course. Choosing stocks and buying for a long term hold is not for everyone. Direct stock ownership requires diligent research at the front end followed by years of tremendous patience and often a strong stomach after that. I do it because I make far better returns choosing my own stocks and managing my own portfolio than I would any other way. I also enjoy the process. But if you're the sort of person who is terribly busy, or easily distracted, or who would forget to look in on their stock holdings, or who hates that particular brand of responsibility-- yes, there are other ways to be in the market which require less from you. You will have to determine your own priorities and your own temperament and go from there.

7. How do I know when it's time to sell a stock?

There are only 4 reasons to ever sell:

• Your original investing thesis has changed or was incorrect;
• One of your holdings has grown too big and your portfolio needs to be rebalanced
• You found a better place for the money 
• You have a need for a tax loss to cancel some other substantial gain

I go into more detail regarding each of these reasons in a previous post, which you can find here.

Stock Investing: Fun with Financials

Let’s say you’ve been doing your qualitative research and have found several companies whose stock looks very interesting to you. These are businesses you understand at a basic level. They make a high quality product or service—and hopefully you’ve experienced that firsthand as a customer. You’ve decided that these companies have a wide moat, or a sustainable advantage, against their competitors. You’ve read up on their executive management and find them to be smart, capable, and relatively transparent leaders whose moves and choices make sense to you even as an outsider. Finally, you can see that these companies are growing both in size and popularity, or at least you see no obvious red flags pertaining to their potential.

Fantastic. You’re ready for some basic arithmetic. You may have been putting this off, or you may have been looking forward to some hard numbers. Different strokes. So let’s have a look at the companies’ financials to see how they’re doing on their ultimate purpose: making money for their shareholders.

First up, visit Yahoo Finance, enter the name or stock ticker of a company you want to look at and pull up their summary page. Down the left column is a list of 3 types of financial reports the company puts out quarterly: the Income Statement, the Balance Sheet, and the Cash Flow Statement. I find it easiest to copy these into an Excel spreadsheet to simplify and speed my analysis.

First let’s have a look at Return on Assets, which is simply the Net Income figure on the Income Statement divided by the Total Assets figure on the Balance Sheet. It represents the efficiency of the company in utilizing its assets to make a profit. You’d like to see upwards of 10%.

Return on Equity, another marker of efficiency, this time the company’s ability to use the combined equity of all current shareholders to make money, is Net Income divided by Total Shareholder Equity, another Balance Sheet item. Again, you’re looking for something above 10%.

Debt is a measure of all substantial borrowed money held by the company (to buy equipment or raw materials, to finance hiring or marketing or research) should equal less than 25% of Total Revenue. If a company is ringing up sales 3 or 4 times its total debt, that’s a good sign (though some capital-intensive industries, like heavy manufacturing or airlines, require more borrowed money). Ideally, Debt should be close to zero.

Debt-to-Equity Ratio, which is Long Term Debt divided by Retained Earnings and Total Shareholder Equity added together, measures the same debt against ownership equity in the company. For obvious reasons, this number should be as low as possible, but let’s be on the lookout for companies with a Debt-to-Equity ratio of 40% or less.

The Current Ratio is a simple one—it’s the measure of a company’s ability to pay off its most immediately-due debt with cash on hand. Using the Income Statement, just divide Cash and Equivalents (usually stocks or bonds or other asset which are effectively liquid) by Total Current Liabilities. You should see something higher than 2, or more than twice as much cash as current debt. This is important if those current lenders (many of whom may be vendors selling materials or labor to the company on payment terms) call the debt: in other words, if those lenders need the money immediately, can your company just pay them or is it going to mean trouble? A good indicator of the quality of financial management.

Next up is Accounts Receivables Growth: Is the amount owed the company by its customers—credit extended by the company—rising over time? On the Income Statement, locate the Accounts Receivables line and check to makes sure each successive year is higher than the previous. On Yahoo Finance you can click around to locate the quarterly reports from the company as well as the annual ones, and make sure the number rises quarter by quarter as well.

Next we’ll visit an area in Yahoo Finance’s company coverage called Key Statistics, a link on the left of the company summary page. Here you can find other very interesting data, some of which you could calculate but is easier just to look up.

52- week Price Change is in a block on the right margin. It’s simply an indicator of how far the stock price has moved up (or down) in the past year. You’d like to see the stock price rising over that time, of course, even if you’re considering buying on what you expect is a temporary price drop.

Also on the Key Statistics page you’ll find the PEG Ratio, in the middle-top section. This is an indicator of the Price-to-Earnings Ratio divided by a company’s expected growth rate.  The P/E Ratio (Price per share divided by earnings or profits per share) is a common old-school measure of a company’s profitability, a less useful marker now in the tech and information economy than it was in the days of manufacturing, but it’s still a good benchmark. The PEG ratio looks at that figure in light of the company’s growth rate. In general, the lower the number the better, as it indicates that the company is possibly undervalued by the market.

In my next post, I’ll detail some additional metrics I’ve found useful in choosing companies with the potential to completely upend the marketplace they operate in, changing the rules  of their industries or even inventing entirely new ways of doing business, and leaving others in their wake.

Drifting to Fifty | Random unrelated nugget of the week

The single most useful tool in your kitchen is a good, generally expensive, 9-inch chef's knife. If you never drag the blade edge sideways on a cutting board and you hone it briefly after every use it will stay sharp 4 times as long. 

Stock Investing: When to Sell

So you've got a portfolio now. You have 1 stock in it or 50 stocks in it. You're doing okay, not as well as you'd hoped, which is natural and normal. This is a long long ride, as I've said. There a likely some up and some down overall among your holdings. When do you sell one?

It's very simple, very straightforward, and easier to know when to sell than it is to choose to purchase a particular stock. You'll still get it "wrong," of course-- either selling near a bottom or selling too soon or too late or whatever. Nothing you can do about that without a crystal ball to know the future. Let it go. You can only operate on the information currently available.

Markets rise, markets fall-- but overall they rise. Never sell on market movements, you won't know when it's time to buy back in and you'll miss the rebound.

There are only 4 reasons to ever sell a stock you own.

RIM Blackberry Z10 - oops

1: Thesis Wrong/Thesis Changed: the reason you bought that stock in the first place-- your thesis-- has changed, or was incorrect in the first place. So say you bought because you thought the new product line was going to a be a sensational hit, and it turns out to be a dud. Or you loved the CEO's track record and now she's leaving the company. Or you thought they had a wide competitive moat, no real competitors, and months later some other company is rapidly taking market share from yours. Whatever: if you check what's happening with the company you own and something substantial has changed since you bought, and it worries you, that's a good reason to get out.

2: Rebalancing: your stock has risen so much that it's now a big percentage of your entire stock portfolio. Imagine you started with 10 stocks of more or less equal dollar weight, so each held about 10%. But now months or years later one company is worth substantially more, and holds close to 40% of the portfolio by dollars. Yes, it's a good problem to have. But if you're managing risk, you'll be worried that that one company could run into trouble, causing its stock to fall and making a lot of your paper profit disappear. Rebalancing means selling that company down to be more level with the average dollar size of the rest of your holdings, thereby minimizing the risk overall. I hate to bail on clear winners, but sometimes there's just too much unintended exposure on one stock. Gotta do it.

Common mid-life crisis solution

3. Better Place for the Money: Obviously it's always better to let a winner ride; that is, let a rising stock keep rising, theoretically forever. You sell it and you will make nothing on any coming rises in valuation, no matter what that company does in the future, and you'll have a capital gains tax to pay on your stock's appreciation since purchase. (You'll pay even more if you held it less than 12 months, as that gain is now classified as regular income). But sometimes you just have to sell: Maybe you found another company you like, and you need capital with which to buy it. Or perhaps your eldest child is ready for college and needs tuition. Maybe you want to reward yourself with a trip, or a new car or boat (depreciating assets = BAD). Whatever the need, that's what you invest for: to make a little money into a lot more money. Just do it is as infrequently as possible and plan for the tax hit. (Sophisticated investors will calculate the tax into the purchase price of the thing they need the money for, and then choose based on the combined cost.)

4. Need the tax loss: Finally it may be that you have a substantial tax you wish to offset by claiming a loss on your investment. If you have a stock that's declined since your purchase, even if your thesis is still solid and you believe in the company's future success, sometimes the loss is helpful from a tax perspective so you dump it. You can always buy it again later (wait 30 days!), and maybe at a better price than the first time.

That's it. I would never sell with the idea that the company has reached my desired valuation, a common reason. That sounds to me like unnecessary churn, exposing you to higher trading costs and the possibility of missing out on a great run by a company you've already vetted and enjoyed.

If I'm thinking of selling and my reason can't be squared with one of those above, I hold.

Drifting to Fifty | Random unrelated nugget of the week
An asset is something that is worth more than you paid, or which puts money in your pocket every year: a rising stock, treasury bills, fine art, long-held real estate. A liability takes money out of your pocket every year. Which one is your car? Exactly. What about your house? Hmmm...