The Poor Investor

Investigatory Value Investing

Tag Archives: warren buffett

Turn Your Portfolio Inside-Out

Often people tell you exactly what stocks they’re buying—what stocks you should buy—but, you don’t often hear others tell you what stocks not to buy.  Charlie Munger often quotes Carl Gustav Jacob Jacobi by saying, “Invert, always invert.”  This quote merely states that the solution to a problem might be in its opposite.  So how can this apply to stocks?

There are many ways in which this is applicable.  One of the most important things to consider is the fact that nowadays you have nearly unlimited opportunities in the market.  Anything you want to invest in nowadays, you probably can—from Swiss gold to soybeans.  Furthermore, you can buy and sell whenever you please, especially with today’s low transaction fees.

Well, what about the opposite?  What if you didn’t have nearly unlimited opportunities?

Warren Buffett often talks about the idea of having a “punch card” with only 20 punches on it.  He posits that if investors had only 20 investment decisions they could make in their lifetime and each time they made an investment they had to “punch” their card, would they make the same decisions?  If you were forced to invest in this way, would you buy the stocks you are buying now?

Well, let’s think about the opposite.  With only 20 punches, what types of investments would you not want to invest in?  Well, to first think about what not to invest in, you need to first think about what you would want to invest in.

To keep it simple, I would want to invest in companies that have all of the following qualities:

  • Strong, durable competitive advantage(s)
  • Large profit margin to sustain difficult times
  • Long operating history showing interest for shareholders
  • Business model not subject to changes in technology
  • Reasonably valued

So, what companies do not have the above qualities?

Car companies are a good case-in-point for the first two aspects.  For one, no car company, besides Tesla, really has any unique quality.  Car companies may have recognizable brands but no one company really offers anything truly different from any of the others.  I’m actually surprised GM is a Buffett investment.  As far as the auto industry goes, Tesla is the only company that stands out as being “different” from the crowd and has any real durable competitive advantage outside of brand recognition.  Thus, I’d stay away from all automobile investments excluding Tesla.  I certainly wouldn’t use one of my card punches here.

The second point, having a large profit margin, is another problem for car companies.  Some of the large auto companies’ net margins for 2014 are as follows: Ford- 2.21%, Honda- 4.85%, Toyota- 7.10%, GM- 1.8%, Fiat- 1.04%.  Apart from Toyota, none of these companies had a large net margin.  And over the last 4 years Toyota also struggled.  Toyota’s net margin was 1.11% in 2010, 2.15% in 2011, 1.53% in 2012, and 4.36% in 2013.  Clearly, there’s not much room there to make mistakes as a car company.  The profit margins are just too slim.  I’m not going to punch my card for slim margins, are you?

Car companies do have long operating histories though.  Here, they get a pass.  But what investments exist today that do not have long histories?  Generally, these are found in the technology sphere.  There’s Box, Inc. founded in 2006, LinkedIn launched in 2003, Facebook in 2004, Twitter in 2006, Groupon in 2008, Zynga in 2007, King Digital Entertainment (markers of Candy Crush) in 2003 and Yelp in 2004.  While these companies may seem like they’ve “been around a while,” generally we want to look for companies that have been around for decades with a stable operating history.  Companies with stable operating histories give you an idea of how they treat shareholders.  For example, you want to ask questions like: Have they raised dividends consistently?  Were they efficiently allocating capital?  Were they honest with shareholders?  Did they buy back shares?  This is not to say the above companies won’t do those things, but there’s just not a long enough timeline to answer these questions adequately.  Ask yourself again, are you willing to bet your punches on it?

To put this in perspective, let’s look at some lesser-known companies: Hawkins was founded in 1938, Cincinnati Financial in 1968, Stepan Company in 1932, United Guardian in 1942, C.R. Bard Inc. in 1907, Nucor in 1940 (with origins dating back to 1900).  These are the types of timeframes I’m referring to when I think of a long operating history.  The history shows not only what management has accomplished, but also that the company has a solid business model that will sustain it over the years.  Also, many of these companies have both been giving and raising dividends regularly for over 25 years.  It’s usually the names you never heard at first that turn out to be your truly great investments.

In contrast are the technology companies mentioned above (the names you know), there’s a good chance these companies won’t be around very long.  There is good reason for this and it brings us to the next point: business model not subject to changes in technology.  Almost all technology companies will have trouble withstanding the test of time due to the fact that technology is always changing.  Warren Buffett often says his favorite holding period is forever.  Do you think you could hold the technology companies mentioned above forever?  Think about the 20 punches on your card.  Do you want to use a few of these punches on technology companies?  That’s for you to decide but “no thanks” over here.

Even whole industries can be vulnerable.  A problem likely to occur with car companies is that they won’t withstand the test of time.  New competitors are moving in (like Tesla) to revolutionize the car market.  Even Apple is thinking about entering the market.  The last 50 years won’t be like the next 50 years in the automobile industry.  Always be on the lookout for underlying paradigm shifts like these.

Next brings us to the point of reasonable valuations.  It is easy to readily point out some of the technology companies mentioned above.  LinkedIn trades at 15 times sales, 10 times book value, 132 times EBITDA, and its earnings are negative.  Can it grow its earnings fast enough to sustain these levels?  Perhaps, but I’m not going to waste one of my 20 punches on it.  Nor will I waste my punches on Twitter selling at 21 times sales with no earnings, Facebook at 18 times sales and 73 times earnings, Box at 12 times sales and 16 times book, and Yelp at 100 times earnings, 9 times sales and 130 times EBITDA.  I’m not saying these companies won’t do well—they may do fabulously— I’m just not going to bet my punches on it.

Think about your current investments.  Did you waste one of your 20 punches?  Would you bet one of your punches on a whole industry?  Do you own a company in one of those industries that you wouldn’t use a punch on?  It’s always good to turn things upside-down and look at them in completely the opposite way.  For instance, do you have a case for shorting any of the stocks in your portfolio?  If so, what’s the potential downside?  And what if you could never sell any of the stocks you purchased, would you have bought any of them?  Reevaluate your decisions.  Think critically.  And invert, always invert.

Disclosure: Long UG

Who You Know or What You Know?

I’ve recently finished my MBA and am now searching for employment opportunities. In this search I’m reminded, quite starkly, of the oft-quoted phrase, “It’s not what you know, it’s who you know.” The great thing about the stock market is that it works in exactly the opposite way. In the stock market, it’s not who you know that matters but what you know. The market, as Ken Fisher puts it, is “The Great Humiliator” and does not care who you are or who you know, “it wants to humiliate everyone.” In fact, who you know often works against you and may even entice investors towards illegal activities, as exemplified recently by a few well-known individuals.

The “what you know” I’m referring to here is your own analysis of individual companies and the markets in general. In fact, if you would have listened to common wisdom (the “who”) you might have sold in May, went away and missed out on a 2.1% gain in the S&P 500. You might have missed the boat on Apple at around $427 a share when everyone was claiming the sky was falling only to watch it rise to $633 a share, a lost opportunity of $206 per share. Once, when I was new to investing, I told a friend not to invest in Sirius XM when it was trading around $0.30 per share and he missed out on a potential 10-bagger. Or, you might have listened to friends who told you to buy Facebook when it first went public at $38 per share only to watch it drop to $18 in the first three months.

Nothing works better in investing than coming up with your own conclusions. For one, you won’t have the conviction in the company you are buying if you go based off of someone else’s recommendation. Even if someone is spot on about a company’s valuation and tells you that company X will go from $5 a share to $15 a share—even if this person is absolutely right and has a compelling enough reason— are you going to be able to hold the company’s stock when it goes from $5 a share to $1 a share before it goes up to $15 a share? Will you really have that level of discipline and, more importantly, trust in someone else’s judgment? Only by doing your own analysis, coming up with your own valuation and buying a company that you have strong conviction in because you put in the hard work will you be able to hold through the downs (or buy more) and not sell too early during the ups. This person’s recommendation may be 100% accurate but you might be enticed to sell at $7 for a $2 gain because you just won’t have the commitment you would have had if you came up with the idea in the first place.

Secondly, if your investment is in a company someone else recommends, you probably won’t have any idea of what to look for when things are going south. Are insiders selling? Did a member of management leave? Is this good or bad? How do you know if you didn’t investigate the company thoroughly? Now, say, the company has to raise funds by issuing stock— is this good? Was this part of the company’s plan all along? If you weren’t following the company, if you didn’t do your homework, you wouldn’t have any idea on these questions or any others. There won’t be any tip-offs to tell you when things are going well or if the management is running the company into the ground when you don’t put in the long hours of work it takes to investigate a company thoroughly enough to have conviction in it.

These are just a few of the reasons why you need to think for yourself when it comes to investing. This is why I don’t like recommending companies, it takes away from a core part of what will make someone a successful investor. I like to use companies as examples to illustrate ideas and how to think about companies, not as advice for what to buy. And with that, I will leave you with a quote from the Oracle of Omaha himself:

“You have to think for yourself. It always amazes me how high-IQ people mindlessly imitate. I never get good ideas talking to other people.”  -Warren Buffett

Track Record is Everything

In a book by Peter Krass called The Book of Investing Wisdom, there is an essay by Warren Buffett entitled Track Record is Everything.  The crux of this essay is that past performance history, aka track record, is one of the best single guides as far as judging businesses and investments go.  With that in mind, I thought it’d be useful to show readers of this website what my track record has been thus far for recommendations made on this site.  This should help new readers judge whether the information they obtain from this site is useful.  Though, I should note, as most of my regular readers know, I do not often mention stock “picks.”  However, I do recommend some stocks from time to time to help illuminate some idea or point out glaring inefficiencies in the market (see my post on Apple).  Although, these recommendations come with the caveat that every investor should do his or her own research before coming to a conclusion.

So, let’s get right down to it.  Here is how my “picks” have performed:

Stocks Recommended Recommended
Date Symbol PPS at Date Current PPS Sell PPS Sell Date % Change
9/13/12 dell $10.63 N/A $13.85 2/24/13 30.29%
9/13/12 nvda $13.68 $15.21 N/A N/A 11.18%
9/13/12 atri $218.87 $269.40 N/A N/A 23.09%
3/11/13 aapl $431.72 $515.00 N/A N/A 19.29%
4/22/13 ntcxf $0.81 $1.07 N/A N/A 32.10%
Average= 23.19%
S&P Return (since 9/13/12)= 22.01%
Difference= 1.18%

So far, my “picks” have out-performed the S&P 500 by 1.18% (used the first pick start date for simplification purposes).  Only one sell recommendation, Dell, was given so far.  Now, as Warren Buffett clearly notes in his essay, a 5 – 10 year track record is much more important in making judgments.  However, this site has not been around that long to establish such a track record.   At that time, I will revisit this topic.

Pawn Stars, Shark Tank, and Investing

Two of my favorite television shows are Pawn Stars, on the History Channel, and Shark Tank, on ABC.  These shows entertain, and most importantly, inform viewers.  A lot can be learned from both of these shows.  A lot can also be learned from the characters on these shows.  Rick Harrison, part owner of the pawn shop with his father and son, is one such character;  Kevin O’Leary, from Shark Tank, is another.

Rick Harrison started in the pawning business at age 13.  He co-founded the Gold & Silver Pawn Shop in 1988 with his dad, Richard Harrison, at age 23.   When Rick was 8 he had his first grand mal epileptic seizure and was bed-ridden for most of his childhood.  This proved to be fortuitous as he developed his love for reading during this time.  He read lots and lots of books.  One book series he particularly enjoyed was The Great Brain by John D. Fitzgerald, about a boy who always had new schemes to make money.  No need to explain the irony here.  His love of reading became the foundation of his life as he found his love of curiosity and knowledge.  He finds television boring, also ironic in that his show is one of the top hits, and finds reading to be the most exciting way to pass time.  Described in his own words, from his book, License to Pawn, he says “…much of the enjoyment I’ve gained from life has stemmed from a book — either researching some arcane item or reading to learn how to do something practical with my hands.”

So what can we, as investors, learn from Rick Harrison?

  • His love of knowledge and reading is extremely beneficial.  For him, knowledge of an item is key to buying it for the right price.  He also discovers items at antique stores and other pawn shops because of his knowledge.  It is no different in investing.  You must love reading and knowledge.  This includes reading “arcane” material as often times lesser known information can give you a leg up on other investors.  It can also help you find rare opportunities like Rick.  Many of the most successful investors are avid readers.  Warren Buffett admits to loving to read annual reports.  His partner, Charlie Munger, put it best when he said, “In my whole life, I have known no wise people (over a broad subject matter area) who didn’t read all the time – none, zero. You’d be amazed at how much Warren reads – at how much I read. My children laugh at me. They think I’m a book with a couple of legs sticking out.”
  • He knows how to say no.  Rick always turns down items if the price isn’t right and he can’t make a solid return on his investment, even if he loves something.  In investing, you have to learn to pass on many opportunities.  A company many be attractive but the price may not be right.  Other times, the company isn’t right.  Sometimes, you may really like the company or its products but the management is running it into the ground.  These are just a few of the many reasons to pass on a potential company or stock.  No matter how much you like some investment, or some aspect of any investment, you have to learn to say no.  As Peter Lynch says, in Beating the Street, “Never fall in love with a stock; always have an open mind.”
  • If the price is right, he sometimes takes a perceived gamble.  If Rick sees an item that he thinks could be worth $100 to $2500 bucks, sometimes he’ll buy it for $500 dollars because the potential return is so high it’s worth the risk.  Now, why do I call it a perceived gamble?  It all comes down to expected value.  Rick might have an 80% of losing $400 here and a 20% of making $2000.  His expected value is $80.  On average, if he makes bets where the expected value is positive he comes out ahead.  So, it’s not really a gamble.  He’s also not betting the house here, he’s only risking $500, not $1,000,000.  He’s not going to risk his store on something that might be fake.  As such, sometimes you might decide to go after a stock that’s a long shot but has a positive expected value according to your calculations.  So, putting 1-5% of your portfolio in it might be worth it.  The problem with this is that the math will never be 100% accurate in investing.  This is why I say sometimes.  You do it when you’re more certain about the odds — something that won’t happen very often, if ever.  You cannot build a portfolio, or a business for that matter, going after long shots.  A good analogy is found in baseball.  It’s best to swing at the pitches right down the middle and hit base hits with near 75% certainty than swing for home runs, out of the strike zone, with 5% certainty of hitting one.  You can score a lot more points with the base hits.
  •  He always pays a lot less for something than it’s worth.  If he believes an item is worth $2000 or an expert tells him he can get $2000-5000 for an item, he never pays $2000 for it.  He’ll usually pay something like $1500 for the item to make sure he can profit off of it.  In investing, this is called margin of safety.  You don’t buy stocks to make 1% off of them.  You factor in a larger margin of safety than that, perhaps 20% or so, in case you make a mistake.  Why?  Because you, and Rick Harrison, never know what someone will actually pay for something, be it a stock or a piece of antique furniture.  The stock could actually be worth $1.10, you pay $1.05 for it, but the market might never price it at $1.10.  Just like the item Rick bought might be worth $2000, but he might only be able to get $1800 in the market.  
  • Always factors in the amount of time it will take him to sell something.  When Rick buys an item, like a book, that might take a lot longer to sell than, say, a signed Beatles album, he factors that in to what he’ll pay for it.  It also takes up room in his store for a longer period of time.  Just like if you buy a stock that might take 3-5 years to appreciate in value versus one that might take only 6 months to 1 year to appreciate the same amount, you would want to pay a lot less for the former to factor in opportunity cost, inflation, and the time value of money.

A lot more could be said about the show, and Rick, as it relates to investing, but suffice it to say the show is full of tidbits and useful information that can work to your advantage as an investor.

Likewise, Shark Tank is also a great show for an individual investor to watch.   While I won’t go much into the show and how it relates to investing, as a lot of this is self-explanatory for anyone who watches it, it may, or may not, surprise you to know that Kevin O’Leary, known as “Mr. Wonderful” on the show, also runs his own mutual fund.

Besides being a television personality, Kevin O’Leary is a Canadian entrepreneur and investor.  He started a software company called Softkey with $10,000 from his mother and grew the company to ~$3.8 billion when it was purchased by Mattel (at that time it was known as The Learning Company).  He also had several other successes that you can read all about in his book.

O’Leary Funds was started in 2008 when Kevin O’Learly was looking for someone to manage his money but couldn’t find the right person.   The company was co-founded by Connor O’Brien.  The company’s philosophy is simple, to “provide investors with value and yield.”  It does that through three core principles, “income, capital appreciation, and capital preservation,” according to the company’s website.   The company also describes its funds as being long-term oriented and disciplined.

So what is Kevin O’Leary’s investing philosophy/approach?

  • He never buys a stock that doesn’t pay a dividend.  This is something his mother taught him long ago and he firmly believes in it.
  • He buys companies that are growing free-cash flow and calls earnings “mumbo-jumbo,” saying, “you can’t lie about cash.”
  • Believes commodities aren’t attractive but the service providers are, saying, “I’d rather own the pipeline than the oil that flows through it.”  He believes if you own commodities you are speculating, not investing as commodities don’t produce a yield.
  • Thinks diversification is the only “free lunch” in investing and that you should not dedicate more than 5% of your portfolio to one investment.  He also owns multiple currencies as a way of diversifying.
  • Uses gold as a “buffer,” or “stabilizer,” and leaves it at 5% of his portfolio.  Gold, to him, is not an investment, merely a hedge that he sells when it becomes more than 5% of his portfolio and buys when it becomes less than 5%.
  • Likes to invest in countries where GDP is growing at >3%.  Some examples he gives are Brazil, India, and China.
  • Believes China will overtake US global economic leader and invests accordingly.
  • 5% of his net worth goes to venture deals.
  • Believes people should invest 20% of your earnings the day you start working for the rest of your life.
  • Believes people should always “spend the interest, never the principal.”

Here is an example from his “Global Equity Yield Fund” of what he is buying:

While a lot can be learned from these two individuals about investing specifics, the most important lesson lies between the lines.  What makes Rick Harrison and Kevin O’Learly so successful at what they do is their passion and discipline.  They believe in what they do and they hardly ever deviate from their rules.  The times they do, you can watch with your own eyes the lessons they learn and exactly how they get burnt by not being disciplined.  You can even hear in their own words why they don’t do this or that because they have learned from their mistakes.  Above all, they’re nice and honest guys (despite the fact that Kevin is seen as cold-blooded on the show).  So turn off Mad Money with Jim Cramer, because it will only drive you mad as you watch all your money fly out the window, and turn on Pawn Stars and Shark Tank and actually learn how to be a successful investor.

Investing: Life Lessons

From the last issue of The Marathon Perspective, written by Jim Kennedy of Marathon Capital Management.

LESSONS FOR LIFE:

1. At the heart of every investment is a value proposition. Sometimes it’s disguised as a good balance sheet, other times as a prospective stream of future earnings or cash flow, and other times as the seed of an idea by a competent management team. Regardless of the proposition, with some conviction you need to identify both the future investment return and the anticipated time frame for that return. The key words here are “conviction, return and time frame.” Strive to have all three before you enter into an investment. None of us will be right 100% of the time, but having these three partners at your side will increase your odds of success.

2. Stay away from “story” stocks and water cooler tips. As investors, we are bombarded by ideas 24/7: the Internet, friends, talking heads on network shows, publications, etc. Use the simple rules noted above (conviction, return, time frame) and you will be able to cut through the clutter and avoid the less than honorable promotions. Just remember that every “story” or idea can be made to sound terrific by the right promoter. Take the time to look behind the curtain and do a little homework. Walk away from things that don’t smell right. A simple perusal of SEC filings and other research materials can save you lots of heartache and money.

3. Learn from your mistakes. To paraphrase Einstein: the definition of insanity is to do the same thing over and over and expect a different outcome. We all make investment mistakes. The sad truth is that we don’t always learn from them. As painful as it sometimes is, revisit your bad investment decisions and try to figure out why they went south. Not only will this exercise reveal weakness in your investment process, but it will make you a better investor in the long run. No one gets it right every time, but by understanding your mistakes, you increase the odds of success going forward.

4. Sell your losers. Remember our premise from above: conviction, return, time frame? If one or more of these change and the equation becomes unacceptable based on your risk tolerance and investment goals, sell. Too many investors hang on to losing positions even as the red flags mount. Strike the phrase “I’ll sell when I get back to break-even” from your vocabulary. Your only thought should be “opportunity cost.” Think about it this way. Suppose you put $10,000 into XYZ stock and it went south on you. At the end of the year it was worth $5,000, but your conviction in the name has been cut in half because management did not deliver on its promise. At the same time, you research ABC stock and are enamored with its prospects. You wish you had funds to put into ABC, but you’re “stuck” in XYZ for now. The wise investor sells XYZ (remember that loss of conviction?) and redeploys that capital into ABC. The foolish investor will not admit a mistake and will “hope” that things turn out okay with XYZ. Fast forward 18 months: the foolish investor feels pretty good because XYZ is up 20% from its nadir, while the wise investor has made twice as much on ABC and is ready to redeploy capital again. Compound this type of behavior over a multi-decade investment time frame and the “opportunity cost” to the foolish investor is enormous.

As a side note: try to differentiate between a “mistake” and “steak on sale.” We are big proponents of averaging down on an investment, but only if your conviction is high and it satisfies your other investment criteria.

5. Check your emotions at the door. Woven throughout these discussions is an undercurrent of emotional investing. As difficult as it can be, you should approach every investment opportunity and decision rationally. Think about the past two years: when were you the most nervous about your investments? We’ll bet it was right near the bottom of the markets.

As Warren Buffett says: be greedy when others are fearful, and be fearful when others are greedy. Our phone rings off the hook when the markets are going through a rough patch. But history has shown time and time again, the best time to invest is when everyone else is scared. Were you taking money off the table in late 1999 and early 2000? Probably not, as most investors believed that trees do grow to the sky. Hindsight is always 20/20, but so is rational, fundamental investing.

6. Do your homework. One of the ways to remain rational while those around you are running for the hills is to understand what you own. If a stock is nothing more than a symbol and quote in the newspaper, then you will be subject to the foibles of investing. On the other hand, if you believe that by owning stock you actually own part of a business, you will become somewhat immune to the short-term fluctuations in share price. The foolish investor flits from idea to idea without doing any serious homework, while the wise investor digs into a story and either develops a reasonable level of conviction or moves on to the next idea. Most investors do more homework and research buying a new refrigerator than putting $10,000 to work in the stock market. There’s something wrong with that equation.

7. Read and think. If we had a nickel for every time someone asked “where do you get your ideas?,” we’d be long retired. Ideas come from every direction, but if you aren’t ready to assess them and make rational decisions, you may as well throw your money out the window. This is where reading and thinking enter the equation. The more you read, the more knowledge you will acquire on a wide variety of topics. This base foundation of knowledge is the bedrock of the investment process. It doesn’t mean you become an expert in any particular area, it just means that you are that less likely to make a mistake. Thinking is just as important. Many of us read, but how many of us think about what we’re reading? One of our favorite sayings is “research is to see what everyone else has seen, and to think what no one else has thought.” Turn off the Internet, T.V. and iPod and think for one hour a day. You’ll be amazed at what you find.

8. Management, management, management. We have an advantage over the average investor, in that management teams are more willing to meet with institutional money managers than with individual investors. It doesn’t mean they won’t talk to you on the phone or meet with you on occasion, but it’s a rare individual investor that has the time and perseverance to undertake such activities. With that said, there are ways for individuals to get to “know” management. Read the SEC filings that detail management’s background and pedigree; look at the top executives that a CEO has chosen to run the organization; listen to quarterly conference calls, particularly the unscripted Q & A session at the end of prepared remarks; ask friends, relatives and acquaintances if they know anyone in the industry; look at the board of directors – is it independent with the background and experience necessary to guide the organization? At the end of the day, a bad management team can run a good company into the ground. If you can not develop a reasonable level of confidence in management, move on to your next idea.

9. To concentrate or diversify. This one is a function of your willingness to embrace the investment process, being mindful of your risk tolerance and time frame. Think about your life – how many jobs, spouses, pets, houses, kids, cars, etc. do you have? Most of us are willing to concentrate our “investment” in just about everything else in life, except when it comes to the stock market. This is not an endorsement
of concentration in the stock market – that would be too risky for the vast majority of investors. But for those willing to do a lot of homework, concentration can be very rewarding. The average investor might own 5 – 10 mutual funds investing in a variety of equity classes (e.g., large companies, small companies, international, etc.). This is a prudent way to spread equity risk, but at the end of the day, you end up
owning hundreds and sometimes thousands of individual stocks within these funds. Most people become closet indexers without ever realizing it. Contrast that with owning 10 – 20 individual equities that you know well. Sure it takes a lot of work, and you will lose money on a number of your choices (remember, we all make mistakes), but if you’ve done your homework and develop conviction through your reading and research, we think this can be a very rewarding investment approach.

10. Don’t lose money. This one comes back to the Warren Buffett school of investing: Rule #1 is don’t lose money; Rule #2 is don’t forget Rule #1. This one is much easier said than done, and yet, even Warren Buffett has lost money on some of his investments. But the key message here is that permanent loss of capital is very difficult to come back from.

Here’s a very simple concept that is foreign to most investors. When you first look at an idea, focus on how you can lose money, not on how much you can make. We are all enamored with how much we can make in any given investment, but how many times has your judgment been clouded by the “upside.” It is human nature to dismiss the red flags when you are excited by the tremendous potential of something. Our recommendation is to catch your breath, step back from the “story”, and look at the situation rationally. It’s okay to take a flyer on something that has lots of upside, but you can’t build a portfolio around too many ideas that result in goose eggs. So weigh the risk vs. reward carefully before investing a dime, and make sure that you stay within your investment discipline and risk tolerance.

11. Last but not least, wait for your pitch. You can not be an expert at all facets of investing, but you can become very good at certain approaches and styles. Don’t be afraid to say this one’s “too hard” to figure out and assess; there’s another pitch coming your way soon. Wait for the one that’s in your sweet spot and swing away.

We’ll leave you with a final cautionary note on the proliferation of Exchange Traded Funds (ETF’s). For the uninitiated, ETF’s are similar to mutual funds in that they allow an investor to put money to work in a particular sector or focused approach. As opposed to open-ended mutual funds that set their Net Asset Value (NAV) and allow buys/sells at the closing price each day, ETF’s trade continuously throughout the day.
These “trading vehicles” have taken Wall Street by storm and have attracted billions in assets. Call it a hunch, a cool breeze at the end of summer, or maybe just the ramblings of an old buy-and-hold investor unwilling to pass the torch, but there’s something going on here that just doesn’t feel right. That doesn’t mean that all ETF’s are questionable, but we highly recommend that you understand the structure of what you are investing in, asking such common sense questions as: does the ETF hold the underlying assets (e.g., stocks, bonds, gold, commodities, etc.); does it use leverage; is it a financial derivative of some other financial investment; what guarantees sit behind the “fund”; do you as an investor “own” the underlying asset in the event of liquidation; who “manages” the fund and where does it reside?

The bottom line after the last couple of years in volatile markets: fool me once, shame on you; fool me twice, shame on me. If someone can not explain something to you in plain English, and you have trouble understanding what you are investing in, walk away.

Notes from The Poor Investor:

The Marathon Perspective is another casualty among what is quickly becoming a dying breed: quality newsletters and writings pertaining to investing (among other topics).  In Jim Kennedy’s own words, “Eventually, the strong will survive and the choices will narrow, but for now the online universe is a thousand miles wide but only an inch deep.”  In other words, it’s becoming increasingly hard to “separate the wheat from the chaff” when the internet offers so much more “chaff.”  For most of us the lessons of investing will be hard-learned, especially when many of us foolishly emulate advice from books and websites which offer little value and insight.  My hope is that this website will provide investors with an abundance of “wheat.” 

Investing in the Stock Market: What Beginners Should Know

There seems to be a contradiction in what the “experts” tell us about investing in the stock market.  I’ve heard investment professionals who have said the process is simple and that individuals just make it too complicated.  On the other end of the spectrum, I’ve heard that investing is extremely difficult and only those that put in extraordinary amounts of time and effort will be able to be successful.  I’ve also heard the in-between argument, that it’s not too difficult but you still have to “do your homework.”  My belief is that they’re all right.  However, investing really is only as complicated as you want to make it.

The concept of investing itself is very simple.  Investing is foregoing money now to obtain more money in the future; more, meaning, after taxes and inflation are considered.  When it comes to stocks, an investor is buying a slice, or fractional ownership, of something, usually a business.  One can either buy a slice of a company, a sector, or a slice of a market index.  For instance, you can invest in General Electric (a company), an exchange-traded fund that tracks clean energy (a sector), or an S&P 500 index fund that gives you the exact return of the S&P 500 (a market index).  Each of these provide various levels of challenges and time commitments; hence, why investing is only as complicated as you want to make it.  Moving from an individual company to a market index is, generally, going from the most to the least complicated.  (There are other variations of these forms of investing, such as investing in mutual funds, that will be covered in a separate post).

Let’s start with the least complicated: the market index.  There are many market indices to choose from, the NASDAQ, S&P 500, Dow Jones Industrial Average, Willshire 5000, to name just a few.  If you’re going to go this route you should at least study the basics of market index investing, such as fee structure and how to buy into an index fund, be familiar with the makeup of each of these indices, and know the benefits of dollar-cost averaging and tax-deferred accounts (such as a Roth IRA).  Then just decide which market you’d like to buy into.  This is all the leg work you have to do on your own.  Then, after learning about index funds and what they’re all about, you can basically take a “set it and forget it mentality.  This is why investing in index funds is called passive investing.  Set up a tax-deferred account for automatic disbursement into an index fund with a small percentage of each paycheck and every year or so you can check on it just to make sure your money’s still there.  By the time you’re ready to retire you should have a pretty nice nest egg. For example, the S&P 500 has returned around 9.4% annually, from 1965-2010, with dividends reinvested.  $100 invested in a Roth IRA in the S&P 500 at the start of 1965 without any annual contributions would have grown to nearly $5700 at this rate.  If you started with the same $100 and contributed $100 each year, it would have grown to nearly $71,000 (fees are usually nearly negligible for index funds).  In my opinion, index investing is the best way for the majority of people to invest because all the complexity is taken out of the process.

Next, let’s look at ETFs, or exchange-traded funds.  These are baskets of securities that track the ups and downs of various markets or sectors.  The ETF market has grown over the years and gives an individual investor nearly every opportunity to invest in whatever market he or she wants.  There are index fund ETFs for nearly every market index.  For instance, the ETF with ticker symbol SPY tracks the S&P 500.  If you want to invest in gold, there’s a gold ETF, symbol GLD.  Sick of rising gas prices?  Invest in an oil ETF, symbol OIL.  Or, how about a double oil ETF that goes up or down at twice the rate of oil?  There’s that too, symbol UCO.  However, be careful to look at the fee structures of these as many can be costly.  ETFs are considered more complicated than index funds because, for one, they trade the way stocks do.  Also, there are many more options.  If you want to invest in an agriculture ETF, for instance, you really need to know the ins-and-outs of the agriculture market.  Mix that agriculture ETF with a gold ETF and now you have to track and learn about both markets.  Plus, you can’t just have a set-it and forget-it mentality with all ETFs, it really depends on which ones you buy.  Some you need to track daily, others, hardly ever.  Some are extremely volatile.  Personally, I am wary of ETFs and do not invest in them myself for various reasons.

(See this interesting article about ETFs: http://www.springreef.com/springreef-insights/exchange-traded-funds-etfs-proceed-with-caution/)

Depending on how one looks at stocks, investing in an individual company can be the most complicated, yet the most rewarding.  Buying a stock is just buying a slice, or part ownership, of a company.  Sounds simple, right?  Someone can even make the process extremely simple by saying, “I shop at Walmart and really like the store so I’m going to buy the stock.”  This can, and does, work out for people… sometimes.  But is this really a prudent way to invest?  Do you really want to risk your hard-earned money taking this approach?  My belief is that in order to invest prudently in a company you should know the basics of accounting, business fundamentals, and have studied the stock market well.  You should also know yourself really well to be a disciplined person who does not let emotions get to them and can view the world objectively.  If you do not meet that criteria, at the very minimum, I do not believe you should invest in individual companies.  There are way too many pitfalls to investing in individual companies where permanent loss of capital can be the end result.  Also, if you’re going to invest in individual companies, your goal is to beat out index investing at the very least, a pretty tall order (remember the S&P 500’s 9.4% annual return?).  So, if you can passively invest at around a 9.4% return annually, you really need to be extremely dedicated to learning about individual companies if you’re going to go at it alone.  However, for those who wish to put in the time and effort, investing in individual companies can be the most rewarding, as the greatest investor, Warren Buffett, can surely attest to.  If you had invested $1,000 in 1965 in the stock of Berkshire Hathaway, Warren Buffet’s company, you would have nearly $4 million today.

The main goal of this blog is to explore the last part of the investing process presented, investing in stocks, with the ultimate goal of empowering the individual investor.  Over many posts, I’ll explore the strategies and philosophies of the greatest investors, analyze individual companies, present market history and data, show tools which can be used to guide the investment process, discuss my own strategies, explore business fundamentals, psychology, and other topics related to investing.  

——Written by: The Poor Investor

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