CHAPTER
11

Investing in Stocks

In This Chapter

• Should you invest in individual stocks?
• Diversifying your portfolio
• Using different strategies for choosing stocks
• Resources for gathering information
• Developing your own strategy

Millions of books have been sold detailing various surefire schemes to beat the market, most of which make more money for the author in book sales than they ever make for the investor.

In this chapter we’ll examine methods of evaluating stocks, from the crazy to the technical to the fundamental, and determine which one is best.

Deciding Whether to Invest in Stocks

Back in the days when the young Warren Buffett was learning at Benjamin Graham’s knee, stocks were one of the few investments available to the individual investor (the others being insurance and bonds). Stock ownership was primarily an activity of the affluent middle class (or the truly affluent) and the majority of people saved in a bank, had a pension from their job, and bought insurance to cover burial expenses and leave a legacy. Students put themselves through college, or parents paid out of then-current income. Endowments and pension funds bought bonds. We all know those days are gone.

Beginning in about the 1980s, the scene began to change, and it wasn’t good news for individual investors. We saw the rise of mutual funds, hedge funds, and big endowments that were able to take advantage of technology to make massive investments according to algorithms; invest in horrendous amounts of number-crunching analysis; and move the entire market by their decisions and nano-speed trading. In addition, we saw the disappearance of pensions, allowing companies to shift investment decisions and all investment risk to their employees at far less cost than providing pensions. It was David against Goliath.

Nevertheless, in the story, David wins. He wins by being nimble and thinking through his strategy using the materials at hand. If the individual investor has any advantage, it is that they can be more nimble, play individual best-guesses, and maybe beat the big guys.

As I discussed in Chapter 10, I believe that most investors can get all the investments they need through a diversified portfolio of mutual funds, and do well with them. But some of us just have that yen to see what we can do, and whether we can produce better results than the big guys. If you are so inclined, I urge you to learn as much as you can before investing your money, and to devote only a small portion of your total net worth to individual investments.

Before you begin investing in individual stocks, you should be certain that you have an adequate emergency fund, are fully funding your retirement savings, and don’t need the money for at least 5 years. It’s just a prudent standard—remember, although stocks may reward you to a greater degree than mutual funds, they are also far more risky.

A Word on Diversification

Before deciding on an investing strategy, let’s return to our principles of diversification (see Chapter 8). Whether you choose to orient your portfolio to growth, value, or income, or use crazy, fundamental, or technical approaches, you should aim for a sufficient number of stocks to diversify your risk.

Let’s say you’ve purchased Pfizer, Novo Nordisk, and Merck and Company. You have three different companies, but very little diversity: they’re all giant (large to mega-cap) drug companies. The only diversity you have is that one could be considered an ex-U.S. (international) stock: Novo Nordisk.

Now let’s say you’ve purchased Whole Foods, Air Lease, and IPG Photonics. Now you have diversified by the following:

• Size (large-/mid-/small-cap)
• Sector (consumer defensive, industrials, technology)
• Industry (grocery stores, rental and leasing services, semiconductors)

There’s no diversity by location—all of these stocks are headquartered in the United States, although they do business around the world. As you get started, it’s not critical that you have a fully diversified portfolio, but you should aim toward diversification. You can balance the portfolio by allocating money to mutual funds in areas where it’s harder to evaluate and purchase individual stocks—for example, emerging markets, or internationals in general.

Wait to begin buying individual stocks until you can invest in three to five stocks with a reasonable number of shares. If you’ve never invested in stocks before, you might want to begin investing with a relatively small amount—say, $1,000 per company. Although it doesn’t really matter if you own one share of stock that trades at $1,000/share (if it’s a good one) or 20 shares of a stock that trades at $50/share (if it’s also a good one), I recommend that the beginning investor choose stocks whose price is under about $50 to $60/share. Prices whose share price is quite high discourage other investors, and there’s some psychological satisfaction in having a nice chunk of stocks. There’s plenty to choose from in that category.

A nicely diversified portfolio clocks in at about 10 to 20 companies, chosen for diversity in size, industry, and sector. More than about 20 stocks and you’re going to have a really hard time keeping up with the news, regularly evaluating them, and making informed decisions on when to buy and sell. But how do you find these stocks to evaluate?

Choosing a Stock-Purchasing Strategy

You’ll need to choose a method of stock analysis, and an orientation that you believe in to finding stocks that meet that method’s buy and sell signals, then work that plan. There are three general methods of purchasing stocks: the crazy methods, the technical analysis method, and the fundamental analysis method.

The Crazy Methods

If you are thinking about a method that relies exclusively on someone’s opinion, promises quick money, or espouses a “foolproof” system that “guarantees” you high returns with little effort, the system you’re considering belongs in this category.

The hot tip This one comes from your brother-in-law, a guy at church, somebody you sat next to on an airline, or (worst of all) a guy on a television show. If you listen to these people as one source of ideas, be sure to check out the company using an evaluation method you apply to all potential stocks. (By the way, if the hot tip comes from somebody inside the company, or someone who has insider knowledge, that’s called a federal crime. Don’t act on it or you won’t have much need for income in the future—because you’ll be in jail.)

Buying what you like Just because you like a product doesn’t mean others will. I, personally, loved clothes from a specific store, but that didn’t make it a stellar investment for me, alas.

A kissing cousin of this is a method once propounded by Peter Lynch, who produced great success for investors when he managed the Magellan fund, one of the best-known actively managed mutual funds of all time. He alleged that he would sit at a mall and watch what stores had the most business, and what people were buying, to choose companies to invest in. I’m skeptical. And even if it worked for him (many people believe the then-success of that fund was simply that the whole market was doing quite well), there are several problems with this method:

• You’ll end up with a narrow portfolio of mainly consumer goods and retailers, because that’s what most of us know.
• Just because a product is popular doesn’t mean the company is well run. In my misguided investment in the clothing retailer, I noticed that the store was always packed. But my daughter got a job there, and that was when I realized that the store never had the right sizes in stock. You can’t make sales if you don’t have the right stuff.
• By the time you know about the company, everyone else has already figured it out and run up the share price.

Media recommendations You have absolutely no idea how these were selected. Remember, television, radio, magazines, and newspapers are in business to entertain and sell advertising space. Imagine if they told you the same boring advice month after month. And even if they could predict the future, by the time that advice goes out to millions of people, the “news” is already factored into the price of the stock. Financial magazines in particular have a record for horrible predictions, and many have moved away from forecasts and focused on consumer articles, where they actually do add some value.

Super-special insider newsletters Some of these are decent sources of possible ideas, and insiders in the investment business do read them. The more reputable ones follow a specific analytical method, and show you that analysis so you can make your own judgments. The more hype in the promo letter or email, the less I’d be inclined to subscribe. Why? Because if the author is so good, why is he even still working? If the ideas are so good, why does he need to hire a direct mail company to bulk mail 100,000 people with his exclusive ideas?

The worst of these are the penny stocks promotions. Unsophisticated investors are lured by the idea that there’s a low price to investing in these because they literally sell for a few cents a share. A few problems with that:

• In order to make any meaningful amount that’s worth the time you’re spending and the trading costs, you have to invest a pretty big chunk of change.
• These companies go belly up a lot.
• They’re often not traded on an exchange, or trading is so sporadic that you may not be able to sell them at any price.
• It’s often impossible to get any information on them, and no analyst follows them.

My other least favorite type of newsletter is the kind that tells you how you can make a fortune in day trading or playing the options market. Trust me, you don’t have the computing power, speedy access, or market knowledge to day trade. And neither do the hedge funds, which go out of business regularly with these so-called strategies. Options are a very sophisticated and complex strategy, and anyone reading a book on beginning investing should not even attempt this without a lot more experience and a huge war chest.

Schemes of all sorts There are lots of schemes and methods that claim that if you just follow them, you’ll beat the market. They’ll usually follow some specific buying method that won’t require you to actually dig into the quality or potential of the company. Their popularity waxes and wanes depending on how they’re currently performing in the market.

The one I see most often is Dogs of the Dow. The idea is that once a year you buy the 5 or 10 highest-yielding stocks out of the Dow 30, hold them for a year, then switch out the following year for the current 10 highest yielding. The idea is that the worst performers will yield the most (because the price is depressed), and since they’re the worst, they have the most potential to improve. Unfortunately, they may also do so badly that they get thrown out of the Dow, and no matter how much yield a stock pays, if the price drops, your total return can be tiny or negative (meaning you’ve lost money).

Be highly skeptical of anything that promises a simple system, needing no judgment or effort, which promises to help you get rich quick.

Technical Analysis

Technical analysis is the idea that if you follow certain markers and indicators, you can predict what a stock will do, and the best time to buy it. I’m not a believer in technical analysis because I don’t think research supports it. Time and again research has shown that past performance is no indicator of future performance. In addition, market timing studies have shown that the best investing results are obtained by being in the market and staying in. If you guess wrong and are out of the market on the few best days, you can lose most of your potential earnings.

Technical analysts don’t much care about the fundamentals of the company. Instead, they study and produce charts showing changes in sales volume of the stock, price ranges, and a variety of movement indicators. Hedge funds and some mutual fund managers are very much into various proprietary algorithms that they believe will predict the stock’s performance and allow them to pinpoint appropriate buy and sell points. They’re wrong, and the regular demise of so many hedge funds and the underperformance of active managers demonstrates this. If the big guys can’t make it work, with all the computing resources in the universe, I don’t think the individual investor has much hope.

Fundamental Analysis

The orientation I favor is fundamental analysis. It’s based on a belief that you can, with research, identify and buy good companies at good prices that are currently being undervalued by the market, but whose value (and price) will improve over time. Depending on your own beliefs, you select companies based on their growth potential, their being currently undervalued by the market, or their dividend/income potential—or a combination of these factors.

Warren Buffett is a successful example of someone who uses fundamental analysis principles. While none of us has the wisdom, depth of knowledge, and access to information that Buffett has, I believe it’s possible to make a reasoned and researched choice of companies the market has so far ignored. Analysts have been known to be wrong, and the market does not always behave rationally. In fact, I once owned stock in a company that Warren Buffett bought out. Note, however, that Buffett advocates that most investors should invest in index mutual funds.

There are many, many sources of information on the internet for stock data, but the four I use most frequently are Morningstar.com, Value Line, S&P Capital IQ, and BetterInvesting.

Morningstar.com Morningstar has almost replaced the need for most investors to read annual reports, because all the numbers and graphic representations are easily available on the site. With the premium service (which you purchase or access through your library) you can review analysts’ opinions as well. Morningstar will show you the price history of a stock, give you a rundown on what the company does, who its competitors are, the latest news, and all kinds of statistics and financial information.

I particularly like a section in the analyst’s report that details what the bulls and bears say—a summary of reasons to have a positive (bullish) or negative (bearish) outlook on the stock. That, plus a look at the stock’s competitors, can give you an inkling of its prospects.

Morningstar offers a lot of stock-screening tools: you can see their 5-star picks, stocks in specific sectors, international stocks, and so on. They also offer portfolio tools to survey the balance and return potential of a group you’re thinking of buying (just create a model portfolio), and tons of articles on any topic you might want to learn about. As with all advice, test their analysis against your own judgment—analysts can be wrong.

Value Line Value Line is a terrific, albeit pricey service. However, it’s available in nearly every library, and if you’re serious about investing in stocks, you should make a Saturday morning trip to learn about what it has to offer. Value Line may have a different take on a stock than the Morningstar analyst, so it’s well worth getting this second opinion. Individual company reports are crammed with data.

Value Line can give you lots of ideas for stocks you may want to consider—they issue lists and reports of hot stocks in hot industries. They also offer sector reports, their opinion of sector or industry potential, and rankings of stocks for timeliness and safety (1 being the best and 5 the worst). Unless I had a good reason to disagree with Value Line, I’d be very reluctant to choose a stock that didn’t rate at least a 3 on both factors.

Reviewing their lists is a terrific way to build a list of companies you might be interested in, as well as identifying companies you might never have heard of but which offer potential worth examining. You can choose several sectors that would offer you portfolio diversification, then review the best companies in those sectors.

Value Line is a treasure trove of market commentary and instruction. You won’t understand everything you read at first, but you’ll learn a great deal over time.

S&P Capital IQ S&P reports are usually a service of your brokerage company, but they provide another analyst opinion, lots of data, and a rating by S&P (Standard & Poor’s). It’s worth getting these opinions in order to weigh them against your own judgment.

BetterInvesting BetterInvesting used to be known as the National Association of Investment Clubs, and I still highly recommend joining an investment club and learning their methodology (see Chapter 22 for more information). However, even without joining an investment club, you can be a member of BetterInvesting, attend online training and stock study seminars, and access a vast amount of information on how to analyze stocks. They publish a magazine that highlights their stock selection of the month, stocks they feel are undervalued (with numbers analysis), and articles on current issues in the market. (Full disclosure—I write a quarterly mutual fund column for them and sometimes write cover articles.)

BetterInvesting offers a software tool to produce a Stock Selection Guide. It takes a while to learn but is the best tool I’ve found for evaluating stocks based on fundamental analysis. It’s available online or as a complete software package called Toolkit. BI’s method involves choosing stocks that have growth potential based on previous performance, growing sales and profits, and improving price ranges. You also seek out factors that appear to indicate the stock is undervalued (a low price-to-earnings ratio, or P/E), determine a high and low potential price to estimate risk, and add in dividend payments to determine total return potential.

One slogan popular at BI is the five stock principle: for every five stocks you analyze properly and purchase, three will do about what you predict, one will do far worse, and one will do far better. I’ve found that to be true over the long haul, and it’s pretty good odds. But you do have to be prepared that you’ll select a few stinkers, even with the best effort at analysis.

Obviously, each of these resources has a method they use for evaluating a stock, but I’ve referred several times to “using your own judgment.” How would you go about that? Here are some questions to ask while looking at the above resources.

Do you understand what the business does? You may not understand the details of every product line or service, but you should be able to explain the nature of the business, understand the sector and industry, and have some idea of how the company would make money, and what events or conditions would affect the business.

This is one place where it’s really worthwhile to take a look at the annual report. Generally, annual reports will have a letter from the chief executive officer (CEO) of the company, explaining how the business did, what challenges it faced in the previous year, and how the company will be affected in the future. You can decide whether this is accurate information or just happy talk. A CEO is almost never overly pessimistic. If he or she says something is wrong, it’s probably worse than that.

Does the business make sense to you and do you believe it has potential? A clothing store has to have fashionable clothes in enough supply and at the right time. A restaurant has to deliver tasty food without making people sick. A firm that books travel around the world will probably be hurt by terrorism, bad weather, and economic downturns.

When the company’s offerings are business to business rather than business to consumer, potential may be harder for you to judge, but you should still research the industry and analyst comments to get a better understanding.

Does the company do business in an area you feel comfortable with? Warren Buffett has said he avoids technology stocks because he doesn’t understand them. Personally, I don’t like fashion or restaurant stocks because I think they go in and out of style too rapidly. Many people have purchased health care companies on the promise of baby boomer demand, but that demand has turned out, in some cases, to have a much longer time horizon than investors expected. After you invest for a while and have some successes and failures, you’ll develop your own yardstick.

Is the company actually making money and does it have forward momentum? Many growth stocks have seen fantastic price increases but have no actual underlying earnings. This is particularly common with tech stocks and pharmaceuticals, where promise and investor hope may run up the price far beyond the worth of the company. Maybe you’ll catch the wave and ride it upward, but I view trading on growth potential alone as a gambler’s strategy.

I like to see stocks that have steadily increasing sales. But even if they sell a lot, they still have to make a profit, and the two don’t always go together—the company may experience runaway costs, poor investments in infrastructure or real estate, or roiling labor unrest. You can have steadily rising sales, but flat earnings. As with all wealth building, if you don’t hold on to what you make, you aren’t going to profit.

I like sales and earnings that are both steadily increasing, with no surprise dips. If you graphed the sales and earnings, they should look like railroad tracks climbing a hill.

Is the stock price increasing and is it reasonable now? Stock prices trade within a band every year. Morningstar gives you the 52-week range the stock has traded in, and you can look back at many more time periods. The stock should have a steadily increasing price band. Of course you’re going to be sorry you didn’t buy it way back when, but we’re looking for things that can still go up. It’s always hard to know whether a high price will continue to increase (pricing you out of the market, perhaps) or whether the stock will take another dip and allow you to snap it up. BI’s Stock Selection Guide projects a buy-hold-sell range based on your expectations of the forward high and low price and P/E ratio. Generally, in an initial screening you might look for stocks that are currently priced in the lower half of their 52-week range, but know why the price is currently low.

What’s the price/earnings ratio? Google the average P/E of the market, the S&P 500, or the Dow. I don’t think it matters all that much which one you use, but it helps to know how your proposed investment compares.

Growth investors don’t necessarily look for a low P/E, and in fact may feel that a high P/E indicates the potential for explosive future growth. Value investors are much more wary of high P/Es, and generally seek companies whose P/E is at or below the market average. Value seekers look for low P/Es as a signal that the market has undervalued or not recognized the company’s potential.

What’s the stock’s beta? Beta is a measure of how much the stock swings compared to the overall market. A beta of 1.0 means the stock moves in synch with the market. Less than 1.0 means the stock moves less than the market—a fairly placid and stable stock. More than 1.0 and the stock is much more volatile (and risky) than the market. Once again, the higher the beta, the more potential risk and reward. You shouldn’t necessarily avoid one or prefer the other, but it should be consistent with your expectations for the stock.

Does it pay a dividend, and has that dividend steadily risen? Dividends, reinvested, will account for the majority of the increase over time in your overall portfolio. In general, value investors want to see a dividend, while go-go growth investors will ignore the absence of a dividend. A company that pays no dividend is likely to be reinvesting everything in the business. However, at some point investors get fed up, especially if the balance sheet shows a lot of cash, and demand that some of the earnings be paid to them as dividends.

Certain sectors tend to pay higher dividends—utilities and other low-growth industries and companies generally pay dividends to encourage and reward investors who hold them. Real estate investment trusts (REITs) are required to pay out 90 percent of earnings to investors. But too high a dividend compared to others in the industry may indicate a company in trouble. Either they’re paying out too much in earnings to sustain over the long run (and perhaps fool investors) or they may even be borrowing in order to meet the expected dividend. In any case, a high dividend is worth investigating to make sure the earnings can sustain it, and to determine whether the company has concluded that it has no real growth or investment use for the earnings.

Seeking dividend stocks is certainly a valid selection strategy, especially if your investment goal is to provide a steady and stable income for such goals as retirement. Just know that you’re probably not going to make a killing on capital gains.

Investors generally like to see steadily rising dividends—maybe not huge increases, but a sign that the company is steadily growing earnings. Be wary, however, of huge share buybacks. This is sometimes done because the company believes too many shares outstanding are hurting the stock’s price, but it can also be a sign that the company is seeking to prop up the dividend by paying a perhaps higher amount on fewer shares.

How much debt does the company carry? Some industries traditionally carry a lot of debt, while some companies have none at all. It’s important to compare the debt load to the average of the industry (data for which can be found on Morningstar).

Have you established a target price? Based on your research and analysis, you should have a goal price in mind for when you would consider selling the stock as having met your expectations. Similarly, you should consider how much of a drop in price you could stomach before you would want to sell. BI suggests having a goal of a stock doubling in value in 5 years, but this is aggressive. You should have lower expectations for bigger companies. Large companies generally do not move as much in price or have as much earnings growth as smaller companies. On the other hand, they should be more dependable.

Just because your stock has increased or dropped does not mean you should take immediate action. It’s time to go back and reevaluate the reasons for the change. Generally, investors should let their winners run and get rid of the losers. Just because a stock was once priced a certain way doesn’t mean it will ever return to that price—it doesn’t have any memory. And just because a stock has doubled doesn’t mean it has stopped growing; some companies have explosive growth. I remember when Apple Computer sold for $15 per share. And it could again.

Buying individual stocks is indeed risky business, but it can have thrilling rewards. You should do what you can to inform your judgment with as much information as possible, while still using your personal experience to reach independent conclusions. There’s nothing wrong with sticking to a portfolio of diversified mutual funds, and they should be your core portfolio. Keep stocks as a small segment of your overall investments, building experience over time to choose what’s right for you.

The Least You Need to Know

• Invest in individual stocks only if you can afford the risk and have time to research companies.
• Be sure to diversify in order to protect yourself against stocks that decline in value.
• Don’t buy a stock based on random or unreliable recommendations.
• Fundamental analysis evaluates the nature and quality of the business to reach a decision about the worth and potential of the company.
• Use multiple information sources such as Morningstar.com and BetterInvesting to guide your analysis.
• Begin making a plan for how you will analyze a stock and make buy and sell decisions.