Join me for the first Small Investor Investing Twitter show. I’ll be answering questions on investing and personal finance by Twitter live from 8-9 PM Eastern Standard Time Sunday night (3/4/2018). Also look for a post on the basics of stock investing here at the site, and feel free to send in your questions as comments or via twitter @Smallivy_SI.
See you Sunday night!
SI
With the big run-up in stocks this year and many people expecting a pull-back or an outright bear market, perhaps you’re getting nervous and looking for ways to protect the gains you’ve made. Hedging refers to taking positions that will reduce your loss should the market drop while still allowing for gains should the markets continue to perform well. Today I thought I’d discuss some hedging strategies for those who are looking for a little protection. Understand, however, that any hedging strategy you employ will reduce gains in the future.
In speaking about hedging we’ll assume that the investor is primarily long to start with, meaning that the investor will make money if the stocks he/she owns go up in price. (When you buy a stock, bond, or mutual fund, you are “long.” When you sell short or buy an option that goes up in price when a stock goes down, you’re “short.”) Most people are long most of the time and this makes sense because the market’s long-term tendency is always up. Being short for a long period of time would be like entering a turbulent river and expecting to travel mostly upstream. Hedging a short position can also be done just by doing the compliment of the trades I describe. For example, buying a call option instead of a put option. (If you are not familiar with options, check out Options Trading: QuickStart Guide – The Simplified Beginner’s Guide To Options Trading
One often associates hedging with risk, largely because of the term, “hedge fund” applied to the high risk/high return funds purchased by wealthy individuals. These funds get their names because they can take long or short positions, but often these funds are not hedging. Instead they are using large amounts of leverage to make large gains from relatively small movements in the markets. This causes a substantial risk of losing money. True hedging actually reduces risk.
To hedge is to take up positions that are designed to offset long positions, such that the investor will be less susceptible to losses due to falls in the market. For those who play roulette, you would be hedging a bet of $100 on red by putting $50 on black as well. You would be reducing the amount you would win if red were rolled since you would lose the bet on black, but you would also be reducing your loss should black be rolled since your small win on the black bet would reduce the loss on the red bet. If an investor is perfectly hedged, he/she will not lose money no matter what the market does. But by taking up these positions, one also limits or eliminates the possibility for making gains while the hedges are in effect. The following are ways to hedge a long position:
Selling shares of the same stock short- This is also called “selling short-against-the-box” and forms a perfect hedge provided that equal numbers of the shares are sold short as are held. No matter the movements in the stock, no money will be gained or lost. (Note that if the stock price goes up an investor would need to add cash to the account or pay margin fees, since this would result in negative cash balances in the account). Selling short-against-the-box has little purpose other than delaying gains from one year into the next for taxes.
Selling shares of other complimentary companies short- In this strategy, the investor sells short shares of a company that he/she expects to decline if shares of the company he/she owns fall in price. For example, if he owns McDonald’s, he might sell shares of Wendy’s short, figuring that is the market turns against fast food companies shares of both companies will fall.
Buying put options- A put option is a legal contract by which someone agrees to buy shares of a stock for a predefined price before a certain date. This can be though of as an insurance contract on the shares of the stock. In exchange for this agreement the owner of the shares gives the seller (called the writer) of the put a certain amount of money, called the “premium”. For example, a put option for selling 100 shares of XYZ stock at 50, good for three months, might cost $300 when the price of XYZ was at $51 per share.
Writing covered calls on the stock– Here a contract is written that allows another individual to purchase your shares for a fixed price. This limits the amount the investor can make on the shares (since if they go up above the agreed to sales price they will be purchased for the sales price) but reduces losses somewhat if the shares decline in price due to the premium collected.
Buying short ETFs– This involves buying short exchange traded funds (ETF). These are financial instruments that are designed to go in the opposite direction of a particular market segment or index. For example, an owner of several mining companies might buy a short basic materials ETF as a hedge against a fall in commodities prices or a slowdown in goods production.
Selling a portion of the position The simplest way to guard against losses in a position is to simply sell some or all off the position, and is probably the best thing to do if you really need the money in the short-term since it is the most cost-effective way to be safe. This, of course, reduces the possibility of future gains, however.
If you’re interested in individual stock buying and this strategy, I go into far more detail in my book, SmallIvy Book of Investing: Book1: Investing to Grow Wealthy
Have a question? Please leave it in a comment. Follow me on Twitter to get news about new articles and find out what I’m investing in. @SmallIvy_SI
Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.
A couple of years ago I got into a lengthy discussion of stock pricing with a reader. Unfortunately the exchange ended up being by email (I’d much rather readers post comments to the blog – I get so few of them). I contended that stocks are priced based on the dividend they pay, or actually, based on the potential future dividend. The reader basically said that I was incorrect and that stocks are based on a lot of factors, the dividend being a very minor one. (In actuality, we’re both right, and I’ll explain why in a minute). In any case, he cited Apple as a company that would never pay a dividend; therefore, the idea that it was priced based on potential future dividends was ludicrous. A few days after our debate, Apple announced that it would start paying a quarterly dividend of about 2%.
How is he right? Stock pricing isn’t like pricing at the supermarket. You don’t walk in, pick up an item from the shelf and see a price sticker on it. (Yes, I know that we’ve gone to bar codes now, and the price (might) be on the shelf, but bear with me – I’m from the 80’s.) Prices fluctuate constantly and for a wide variety of reasons. Some people look at earnings and decide what a stock should be worth. Some look at how likely it is for the stock to have an earnings surprise and bid the stock up accordingly. Some people sell shares and don’t care what the price is because they have a large profit and just want to unload it, or they need to pay for their daughter’s wedding. Some people see a stock go up or down in price, and buy or sell it because it went up or down in price. They figure that if the price is going up, they’ll be able to sell it at a higher price.
Very few of these people are probably thinking about the dividend that the stock is paying. Heck, a lot of these stocks may not even have a dividend. So I must be wrong, right?
Well, even though all of these people don’t know it, they are basing the price they pay on the projected future dividend. Note that the “projected future” part is very important. Note also that there are fluctuations int he price – the dividend just sets the price range.
For more information on why you can have too much diversification, try one of these great books:
You see, the amount that people are willing to pay for a stock depends on its potential future return. This return must be enough to justify the risk that is being taken on. If one can get a 5% return from a bank CD, one wouldn’t even think about buying a stock unless one thought a 8% return or greater was possible. Why trade a certain return of 5% for a possible return of 6%? You wouldn’t. You would drop the price you were willing to pay for the stock until the potential return was at least 8%.
Also, the more uncertain the return, the greater the return must be. If you are buying shares of McDonalds, for example, you can assume that the amount of traffic at their restaurants won’t change by that much during any given year. It isn’t like everyone is going to swear off Big Macs at once. You can therefore predict with reasonable certainty how much the company will earn during the next year (or the next five years), and therefore you know about what the price will be. (Here you’re also assuming that the price to earnings ratio will remain about the same, which isn’t too bad an assumption.)
On the other hand, if you are buying shares of a silicon chip maker like Cypress Semiconductor, the future becomes far less certain. You don’t know if research and development won’t pan out, or the Koreans will dump a bunch of cheap chips on the market, or what. You also don’t know if interest in electronics will remain, or if manufacturers will choose Cypress chips or one from their rivals. Because they are somewhat of a commodity, the fortunes of a company can be pinned to a few cents savings per chip made. Because of this uncertainty, shares of Cypress are priced cheaply relative to shares of a company like McDonalds. Note that the PE ratio for Cypress is 17.5, while that for McDonalds is about 18.5. People are willing to pay a little more for more certain earnings.
But wait, that’s earnings, and I was talking about dividends, right? Well, let’s say that a company never, ever paid a dividend. What return would a shareholder receive? Another way to look at it is, what value would the company be to the shareholder if he never received any share of the profits? True the company might be making a lot of money, but the investor would never see a cent of that. Without a dividend, there is no return to the shareholder. He would not even see capital gains because no one would be foolish enough to buy the shares from him. (OK, someone would be, but that’s beside the point).
Learn how to use mutual funds from the founder of Vanguard:
So, when people are buying stocks, they are trying to figure out what the future dividend will be, and what their return would be based on that dividend, and then pricing the share price accordingly. Granted, this is a Ouija board-type of pricing where people may not even know they are pricing it based on the dividend, but they really are. The reason that people pay more for shares with growing earnings is that if the earnings of the company are higher, they will be able to pay a bigger dividend. Many who price stocks based on earnings forget this fact, but that is what they are doing (that is why earnings matter at all). It is kind of like how the main reason people paint houses is because if they don’t the wood will rot, but they are probably thinking more about how the house looks than wood rot when they decide it’s time to paint again.
Note also that the piddling 2% Apple is paying may seem small, but if you bought the shares back a year ago when the price was half of what it is now, you would now be receiving a 4% dividend on your investment. If you continue to hold the stock and the dividend continues to increase, you effective yield will continue to climb. You might be making 8%, 12%, or 20% in five years.
So, dividends do matter, even if many people have forgotten that fact. When it comes to pricing, it’s all about the dividend.
Join the conversation and help make this blog more exciting! Please leave a comment. Also, if you have an investing question, email vtsioriginal@yahoo.com or leave the question in a comment.
Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.
I’m still making my way through Darren Hardy’s The Compound Effect. One of the things I’m beginning to understand is that it isn’t the individual choices we make that set our destiny so much as the habits we form. For example, right now I’m trying to lose the 50 pounds or so I gained back after dropping the same weight several years ago. The last time I lost weight it was because I had changed my habits. I regained it when I changed them back.
You see, back in my mid-thirties I realized that I was going to die young if I didn’t lose some weight and start exercising. I started jogging about 3/4 of a mile in the morning, then walking back. This continued three mornings per week for about three or four weeks (and I hated starting every time, but was always glad when I had finished my jog), at which point I was able to jog all the way out and back, running 1 1/2 miles per morning. After this I would walk around the block (another 1/2 mile or so), After a month or two of doing this, I started running around the block instead of walking after going out and back, increasing my total to about 2 miles. Finally, after doing this for several months, I increased the distance I went out, upping my run to about 2.25 to 2.5 miles. At that point I decided the run was far enough and running farther would just wear out my body. I was able to run 5K’s and actually registered a time in the mid 20-minute range.
I also changed how I ate. Instead of cleaning the plate when I went out to eat, I would eat about half and then save the other half for lunch. I found that the whole meal would be about 1500 calories, so eating a half portion was about right. At home, I would leave one thing off, like the side of corn or maybe the potatoes. At Mexican restaurants I would just have a few chips rather than finishing the bowl and asking for a second or a third. One thing I noticed was that when you’re out, many of the things you do centers around food: stopping for ice cream, pie and coffee, or just a sugary coffee drink. I found other things to do that didn’t involve eating.
As a result I went from a high of about 248 down all the way to about 215 pounds. My pulse had dropped to about 50 beats per minute, to the level where they would need to take a couple of readings and get one over 50 before they would let me give blood. I had a lot more energy, my blood pressure was lower, and generally I was in good shape.
For more information on why you can have too much diversification, try one of these great books:
Then life started to get in the way. While I was exercising regularly, I often didn’t really want to get up and go out into the cold to jog since it was hard to get going to the point where I fell into a rhythm. (After I would started, however, I discovered that actually the best temperature was about 35 degrees or so since I could wear a sweatshirt and cap and not get sweaty about half way through, so I preferred cold mornings to one that was in the 60’s or 70’s.) When I reached about 39, however, I started getting heel spurs which would cause my feet to ache if I tried to walk after sitting for a while. Jogging would cause the condition to worsen for several days after. As a result, I stopped jogging as much, then finally quit entirely. I changed my habit of exercising.
I also found myself eating more full meals when I went out to eat. I also started getting soft drinks again in restaurants (I went to water before). Worst of all, I started doing more business trips and vacations, where I would be eating out every meal and having a big breakfast at the hotel. (I normally didn’t eat breakfast, so that added another 50 to 800 calories onto my diet each day.) I went back to 220, then 230, then into the 240’s. Finally, after a few holidays and trips, I found myself in the 250’s, higher than I had ever been.
Learn how to use mutual funds from the founder of Vanguard:
From reading The Compound Effect, I realized that what got me into such great shape was that I changed my habits. It wasn’t the first day I went jogging or the choice of having water at lunch instead of a Coke one day that made me lose weight and get into shape, it was the habit of doing those things. Likewise, changing habits back to eating full meals out and drinking a soft drink more often than not when we went to a fast food chain caused me to go right back to where I had been and then some. Once again looking at an early fifties heart attack, I’ve changed back, cutting my meals and counting calories to stay below 2000 per day. As a result, I’m down to 242 again. I plan to stay with this, and start jogging again after I lose another five pounds or so (so that it isn’t as hard on my heels) and keep those habits this time.
So what does this have to do with personal finance? Well, just like with losing weight and getting healthy, putting yourself onto a firm financial footing doesn’t mean doing one thing and then going about your life. If you stick $100 into five shares of Intel Corp today and never do anything else, you won’t retire a multimillionaire. But if you put away $100 every week or two and invest regularly, you’ll find yourself in 20 or 30 years financially independent. It isn’t the individual choices – it’s the habits that make the difference.
So what are your habits? Are they good, taking you where you want to go, or bad, holding you back and making you unhealthy or poor?
Join the conversation and help make this blog more exciting! Please leave a comment. Also, if you have an investing question, email vtsioriginal@yahoo.com or leave the question in a comment.
Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.
The title of today’s post is an old Wall Street axiom related to asset allocation and greed. It means that people who buy stocks (bulls) and those who sell stocks short (bears) can both make money. There are times when each of these strategies are effective. Those who hold for too long, or put too much in any one stocks, however, eventually get slaughtered. It is important to remember that no stock will go up, or down, forever and one must always be wary of the possibility of sudden movements the other way.
As long-time readers of this blog will note, I tend to favor less diversification than is the standard. Many money managers will advocate investing in hundreds of stocks, saying most investors should not even buy single stocks because they can’t get enough diversification unless they have millions of dollars. The trouble with that philosophy is that 1)while it is true this provides downside risk, it also limits one to just making the market averages or less after fees, 2)one has little control over taxes because the taking of capital gains is up to the whims of the mutual fund managers, and 3)it leaves one subject to the little games that the mutual fund managers play, like buying the hot stocks just before reporting holdings to look like they were in the best companies all along.
For more information on why you can have too much diversification, try one of these great books:
There is nothing wrong with holding some mutual funds. If one has quite a bit of money mutual funds provide good insurance against sharp declines that single stocks endure. If one only has a few thousand dollars to invest, however, it makes little sense to spread that money out over 100 or 1000 stocks. The advantage of being able to double or triple that $3000 in a year or two outweighs the risk of losing $1500 or $2000, or even the whole amount due to a missed earnings report or a scandal at the company. Note also that investing over the long-horizon of years also reduces risk because over time most good companies will grow in price even though they may decline in any period of weeks or months.
Here again, though, one does not want to be piggish and face the slaughter. For this reason my strategy is to concentrate in a few, great stocks, adding money all of the time to my investments, but when a position gets to be so large that I would not want to risk that amount, I pare it down and invest some of the funds in another stock. This is true even if I think that the company has great prospects and will continue growing indefinitely. I could be wrong and I don’t want to give back all of the gains I have made should the stock turn against me. One strategy is even to sell enough to recover all of the money that had been invested. Additional shares can then continue to be sold as the stock makes new highs. In that way most of the profits made are secured as the stock rises should the stock turn around and fall. It also gives a psychological boost to know you will make a profit no matter what, allowing one to “let the rest ride” with confidence.
As a portfolio grows from a few thousand dollars into hundreds of thousands, mutual funds should be purchased to lock in gains and provide security through diversification. A portion of the portfolio remains concentrated in individual stocks with good prospects, however, but not so much so as to risk a loss that one cannot sustain.
Learn how to use mutual funds from the founder of Vanguard:
Join the conversation and help make this blog more exciting! Please leave a comment. Also, if you have an investing question, email vtsioriginal@yahoo.com or leave the question in a comment.
Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.
Stock picking is an art form that requires experience and an inherent feel for which companies will do well, but there are many factors that can be used to screen stocks and narrow the choice down to a few. Today I thought I’d discuss my method of picking stocks. I’ll start my listing the factors I look at, and then discuss some of the factors in detail.
The theme of this blog is serious long-term growth, not trading stocks or making small profits then selling. We’re looking for stocks that will grow over the next several years, not just short-term fads. I’ve found it is easier to spot long-term trends than predict what the market will do over any short stretch. In fact, the long-term trends are often pretty clear – it is surprising that more people don’t seem to look for them. Here are the factors I look at, relatively in order of importance:
Let’s go through each of these factors in detail.
Buy a classic guide to value investing: The Intelligent Investor: The Definitive Book on Value Investing. A Book of Practical Counsel (Revised Edition) (Collins Business Essentials)
The long-term price trend
The first thing I tend to look at, which is an obvious but an often over-looked trait, is the price of the stock itself. As said above, the market price will tend to follow the fair value, just as a paper boat floating downstream in a turbulent river will tend to move at the average velocity of the stream, although there may be many changes in velocity if observed for only a short period of time. If a company is increasing share holder value, making the company’s stock more valuable, this will be reflected int he price of the stock eventually.
When looking for candidates, I will flip though several stocks looking at the 5-10 year price history (High-Low-Open-Close charts or candlesticks, preferably) and look for those that I could set a ruler on and draw a relatively flat line. This can be done in a chart book (Dailygraphs, for example), in a publication like Valueline, or, less easily, on the web at Yahoo or another site. The issue with doing this online is that you often need to provide the symbol for the company, so you can’t easily flip through a set of price graphs, and you obviously won’t look at the charts of companies of which you have not heard.
Also, I try to avoid companies that are increasing very rapidly in price. While these companies are the lifeblood of the momentum investor, which is also a perfectly valid investment method, these companies tend to fizzle out and fall back down to earth, producing a bell-shaped curve (see Krispy Kreme for an example). In a later post I’ll go into the two main investment philosophies, momentum and value, and provide some tricks for those wanting to do momentum investing.
An example of a company with this type of price trend is Aflac (AFL). While there are some deviations, over the period growth is relatively steady, so the people running the company obviously know how to grow the business. As long as they don’t change what they do, and the business climate is such that what they have done will continue to work, and the company has not grown as big as it can following that business model, then I would expect this trend to continue.
Learn how what you hear in the news doesn’t matter for investing: A Random Walk down Wall Street: The Time-tested Strategy for Successful Investing
Earnings growth rate
A second factor I look at when picking stocks is the earnings growth rate. As said previously, we’re looking for stocks that have shown persistent growth and that we expect to continue to grow over the next several years. As also said, a stock price will tend to grow along with the underlying value of the company. Why is this true? To understand the reason, we need to look at the reason people buy stocks and other securities. This is a little complicated, so please bear with me.
The value of an investment depends upon the rate of return and the risk of the investment. In general the greater the risk, the greater the investment return required by investors. For example, a bank account carries very little risk, and therefore people will put money in the bank even when they receive very little interest in return. The interest rate paid by banks is based on the rate at which banks can loan out the money and the rates at which the bank can borrow money. Because the risk on commercial bonds is greater than for a bank account since companies tend to default on bonds more often than banks default on deposits, and because banks are insured by the Federal Government against default, the interest rate paid by bonds will be higher than bank account interest. Note also that if the interest rate that banks goes up, the price of commercial bonds will drop so that their effective yield increases (a bond pays a fixed amount, so if the price of the bonds drops the effective interest rate increases). This is because investors need the bond to pay a certain percentage more than the bank in order for them to take on the additional risk.
Stocks also pay “interest,” although in the case of stocks the payout comes in the form dividends — current and expected future dividends — rather than interest. When a company is new, it pays little if any dividend as it retains capital in order to grow the company, but as it matures it begins to pay a larger and larger share of profits out as dividends until the company becomes fully mature and pays most profits out as dividends. The fair value of a stock is based upon what individuals expect to be the future dividend of the stock, the degree of certainty that individuals believe that the future dividends can be predicted, and the perceived risk of investing in the company (the perceived likelihood that the company will cease to exist). Because the dividend is related directly to the earnings of the company, the larger the company’s earnings, the larger the future dividend.
Now, investing in stocks is more risky than investing in a bank account, so investors will require that the rate of return from an investment in a company is several percent higher than what they could receive from a bank. If not, why take the added risk? The rate of return when the company is mature and paying dividends will be the dividend amount per share divided by the price of a share of stock (the yield). So, the price of a company’s stock will grow if earnings increase since they then would be able to pay a bigger dividend. This price will increase as long as the yield is sufficiently greater than what can be earned in the bank.
So, if earnings are increasing by 10% per year, say, all other things being equal (bank rates remain the same), then the fair value of the company will grow by about 10% per year, so the price of the stock should also grow by about 10% per year, over the long-haul. In general I look for earnings growth rates of 10-30%. Less than this will not be worth the additional risk of owning stock, more than this is unsustainable, and will usually result in the shares being overpriced.
Care should also be taken not to buy a company that has had good earnings growth but now earnings will be slowing. An example of this is Freddie Mac in the mid 90’s. Up to that point, FRE’s earnings grew reliably. In the mid-nineties, however, the opportunities for making good mortgages began to decline, and so earnings growth rate began to decline. This caused the stock to stagnate for many years. Because investors pay more for a stock with a high earnings growth rate than one with a low growth rate, the relative price of the stock (reflected in the price/earnings ratio) will also tend to contract as the rate of growth in earnings slows.
Dividend growth rate
Continuing on with what I look for when picking a stock, we turn to a factor closely related to the earnings growth rate, dividend growth rate. As I said during the post on earnings growth, the fair value of a stock is based in part on the return people expect to get from the stock relative to what they can get from the bank, bonds, and other sources. While people will buy stocks early on expecting to make most of their profits from capital gains (when the stock goes up in price and they sell the shares), as a stock matures and stops growing rapidly investors who are looking for a steady return will start buying the stock. They will buy primarily based on the dividend rate.
Because people will be willing to pay more for the stock if the dividend is higher than what they can get from other investments of equal risk, a stock will tend to go up if the dividend is increasing. If it is increasing very rapidly, because earnings are increasing rapidly, people may actually bid the price up to the point where the yield drops below equilibrium because they are buying the stock based on future dividends, not current dividends. The price of the stock will also go up if interest rates are falling (because bank interest rates will also be falling), and vice-versa. The rate of taxes on dividends relative to those on capital gains will also have an effect. If the Bush tax cuts expire as is expected and dividend tax rates return to 20%. more investors will start buying stocks with small dividends, opting instead for price appreciation, so that they can delay paying taxes.
I therefore look for stocks that have a steady dividend growth rate of at least 10%, if the stock is fairly mature, since I can then expect to get both a good dividend and a growth in price of at least 10% over the long-term. Care must be taken to ensure that earnings are also growing at a steady rate or the company won’t be able to continue to raise the dividend.
Return on Equity
Continuing the traits I look for when picking stocks, one that I took from Warren Buffett’s playbook is Return on Equity (ROE). ROE is a measure of how well a company is run. Basically it is the amount of earnings that a company makes on the money that it has. (For a more detailed description, along with some formulas for its calculation, see: http://beginnersinvest.about.com/od/incomestatementanalysis/a/understanding-return-on-equity.htm ).
I tend to look for companies with ROE of around 15-25%. It is also important to compare the ROE of the company against that of its peers in the industry, since this will indicate how well it is run compared to its competitors. Note that some industries, such as retail, tend to have larger ROE’s than other industries, so ruling out a company simply based on ROE of less than 15% would not be advisable.
Debt
The next trait I look for when picking stocks is debt. Here, opinions differ on whether debt is good or bad for a stock. If a company takes on debt, they can fund more rapid expansions, buyout competitors or businesses that bring them into new markets or that they can use to fill a gap in their company, and take advantage of other like opportunities. Just as with personal debt, however, it always costs more for a business to buy things using debt since they must then pay not only for the item they are acquiring, but also the interest.
I find that the types of companies I want to own generally have little if any debt. Ideally a company will be making enough of a profit from its business and have managers who manage the business well, allowing them to make needed purchases without going into debt. Often when you find stocks with the type of price movement I favor — steady increases in price — you’ll also find a balance sheet free of debt. A free balance sheet also allows the company to take on debt if needed for an opportunity if needed. Once a company is laden with debt, it becomes far less nimble.
Note, however, that some types of businesses, banks for example, will generally have more debt because they are in the business of borrowing money, loaning it out to others, and then making money on the difference between the interest they can charge and what they must pay. I would therefore not rule out a company entirely just because they have debt. I would compare their debt load with those of their competitors, however.
Cash flow
elated to a low amount of debt or an entirely clean balance sheet is the 6th trait, a good solid cash flow. Cash flow is the amount of money the company has coming in from their business. A company with a good cash flow has more than enough funds for day-to-day operations, and can use their cash flow to pay for expansions, research, and other opportunities. An ideal company would be one that has a large cash flow from a solid business line that allows them to develop other business lines. For example, a software company that creates a software package that everyone buys, such that they make far more from the software than they need to spend on marketing and support, can then take the extra profits and use the money to develop other software packages or even move into other business lines. They take far less risk than a company that does not have the cash flow because they do not need to borrow to do development. If the new business line fails, they simply close it down and move on. They do not have a huge debt hole to dig out of.
One unusual example of this is McDonald’s. While one may think of their business being burgers, they have actually amassed a large real estate portfolio. Using profits from one restaurant, they earn enough cash to buy a second restaurant. This continues until they have acquired all kinds of properties. As the cities grow around them selling their burgers and fries, the value of their land increases. Later, if the business at the restaurant begins to slow, they can sell the land for a nice profit and acquire more restaurants elsewhere.
The business type/strategy
The final trait I look at when picking a stock is the type of business and general traits, demographics, market conditions, etc…. This might seem like the first thing to look at, but I generally find it is easier to look for stocks with the other traits of which I spoke and then look at the business and decide if I think they will be able to continue to grow. The trouble with going the other direction is that a company may have a good business and the climate is right, but the company is run poorly so even though they may sell a lot of products all of the money goes out the door.
As a side note, Warren Buffett has said that he will not invest in a company unless he fully understands the business. He therefore has been reluctant to invest in technology companies, instead buying insurance companies, retailers, and the like.
When I’m looking at a business, I look to see if they have a product/business line that will continue to be needed and profitable in the future. For example, at the present time Baby Boomers are getting towards their 60’s, a time at which they will start needing hip and knee replacements, giving up some hobbies and turning to others, and so on. Harley Davidson has been an excellent company for the last several years, during the time that the Boomers were making a large disposable income and buying Harleys for rides on the weekends. These folks have already bought their bikes and all of the gear, and are now starting to look at retirement (many shocked to see that they don’t have as much to show for their years of high income as they would like). I therefore would be reluctant to buy Harley Davidson, even though they’ve had a great run, because I can’t see at this time where they have a good opportunity for growth. Perhaps they will find a market I’m not aware of, however, and prove me wrong. At that point I may buy in again.
Got a question or comment about personal finance or investing? Please leave a comment.
Follow on Twitter to get news about new articles. @SmallIvy_SI
Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.
So you’ve decided to take the plunge and buy your first individual stock. Now what? In order to place a stock order, it is important to learn the lingo of stocks trades. This allows you to communicate clearly with your broker to avoid misunderstandings. If you’re buying online, knowing what the different orders are and which ones to uses is equally important. Learn these terms and you’ll be sounding like a pro in no time.
Here are the types of orders for buying or selling stocks and other securities, plus some other ordering terminology, that every investor should know:
Buy – An order to buy a security.
Sell – An order to sell a security.
Bid price: The highest price at which someone is willing to buy shares at a given time. For example, someone may be out there ready to buy 500 shares of XYZ corporation for $30.25 per share.
Ask price: The lowest price at which someone is willing to sell shares.
Market Order – An order to buy or sell a security at the current market price. Because at any given time the market price includes the Bid price (the price someone is willing to pay for a security) and the Ask price (the price at which someone is willing to sell), if you put in a market order to buy you will pay the ask price, and if you put in a market order to sell you will sell at the bid price. The difference between the Bid and the Ask is called the Spread. In actuality, professionals in the markets will buy shares from someone at the bid price and then sell it to others at the ask price, so they will get to keep the spread as profit.
Limit Order – An order in which a price is set as a threshold for the sale. For example, a buy order with a limit of $50 would execute when the Ask price of the stock was at $50 or lower.
A Beginner’s Guide to Investing: How to Grow Your Money the
Smart and Easy Way, only $6.99 at Amazon
Stop– An order to buy or sell a stock if it passes through a specific price.
All or None – An order which is executed only if all the shares can be bought or sold in one lump.
Good ‘Til Canceled (GTC) – An order that will stay open for a month after it is entered. Normal orders are only open for the trading day and must be reentered if not executed on that day.
So, if you wanted to buy 100 shares of XYZ corp, which was currently trading with a bid price of $50 and an ask price of $50.25, and you wanted to pay mno more than $50.50 per share, you would tell your broker:
“Buy 100 shares of XYZ corp with a limit of $50.50.”
Because the ask price was below your limit, assuming there were 100 shares available at that ask price and there were no one else in front of you, you would end up buying 100 shares at $50.25 since that was below your limit price. If there were only 50 shares available at that price and 50 more at $50.50, you would get fifty shares at each price.
The above terms can be combined. For example, one would say “Buy 100 shares of XYZ at the market” to buy 100 shares of XYZ corporation at the market price. One could say “Buy 100 XYZ, limit of $50 or better, GTC” to put out an order that would stay open for a month in which 100 shares of XYZ corporation would be bought if the Ask price dropped to $50 or lower during that month.
Note that stop orders can be stop limit or stop market orders. If you place a stop limit order, it will create an order to sell (or buy) if the stock price reaches your limit with a minimum (maximum) of your limit price, where a stop market order will sell (or buy) at the market price if your limit is reached.
Try Anti-Monopoly, a twist on the classic game.
You may be thinking that this is all well and good, but which orders should I uese and when? Let’s now go into the strategies I use when selecting the type of order to use.
The investing strategy I use and that I promote with this blog is to invest for the long-term and make a lot of money with each successful trade. We’d like the stock to go up 1000% or more over the time period that we hold it. Because of the long time period involved, we are not that concerned with getting a few extra pennies per share on a trade. For this reason, I generally use a market order when buying. This will cause the order to be filled within the next few trades (we may need to wait a few trades if there are people ahead of us with market orders). On a stock that trades a lot, said to be “liquid,” market orders are generally fine and we won’t get a crazy price, which can happen in stocks that trade rarely and therefore are illiquid. There, a limit order is needed to prevent getting a bad price. Buying stocks at-the-market prevents us from missing a good buying opportunity and seeing the stock shoot up out of range be cause we’re waiting for the price to drop by a few cents. If you make $30,000 from a stock trade, it won’t matter much if you pay an extra $50 for the shares.
Get The Compound Effect for only $9.52
When I’m looking sell because I’ve made a good profit and I’m worried it may evaporate, I also find that it is best to use a market order and get out. I’ve had the experience before when a gain turned into a loss because I set a limit and it didn’t fill before the bottom dropped out. Again, it is usually best not to quibble over pennies.
If I’m in the process of accumulating shares and I feel that the stock has good long-term prospects but there is probably nothing to cause it to shoot up in the near-term, I may set a limit order and wait. I may also enter with a market order to get some shares, and then place a limit order a little lower to buy more shares if the price then dips. (Note with a limit order I also tend to use Good-Til-Canceled since it may take a few days to execute.) When setting a limit, I pick an odd amount (for example, $20.16 per share or better) because there will generally be other people with limit orders in and people tend to like round numbers. With a limit order, the first in line at the price gets the shares. If the stock is thinly traded, or illiquid, I will never place anything but a limit order. This is because if there are only a few buyers or sellers, the price may easily change by 10% or more between trades. Looking at the typical spread for the stock (difference between the bid and the ask price) and the volume is a good way to tell if the stock is illiquid. I also always use a limit order when selling stocks short or covering a short position, generally setting the limit slightly above the ask price in the latter case to make sure it executes rapidly, but giving me protection fram radical price movements.
Stop orders, often called “stop loss” orders, are sometimes recommended as a way to limit losses. For example, you buy 100 shares of xyz, and then set a stop loss order at $36 so that if the stock drops by 10% you’ll get out automatically. I generally don’t recommend stop loss orders for two reasons. The first is that the market will set all kinds of prices based on rumors, news, and just fluctuations driven by trading (the stock goes down a little so more people jump out, causing it to continue down). These fluctuations really mean nothing about the underlying business, and we don’t want to get out of a good company just because it becomes temporarily unpopular. The second reason is that various traders use stop loss orders to make profits and get shares at lower prices. A stock may move down temporarily, hit your stop causing you to sell your shares, and then shoot back up, leaving you behind.
One case where I may use a stop order is when a stock has gone up a lot and I’m looking to take some of the money off of the table and move it somewhere else (the stock has gone up enough that I don’t want to risk the loss). In that case I may set a stop loss a few dollars below the current price, and then move the stop up if the stock rises until it eventually hits. This is nice psychologically since you don’t feel like you’re selling a stock that is a winner and will climb higher, but in general I’ve found I end up just losing a couple of dollars when my stop gets hit and I should have just put in a market order and sold the shares.
As said above, there is what is called a stop market and a stop limit. A stop market will sell the shares at the market price if the stop price is reached. The stop limit will put in a limit order at the stop price if the stop is reached. Never use a stop limit because if the stock falls below your limit price, the order will not be executed and you will still own the shares.
Finally, I may use an all-or-none order for a thinly traded stock to avoid getting a few shares and having to pay minimum commissions on more than one trade.
So there you have it. Time to buy some shares.
To ask a question, email vtsioriginal@yahoo.com or leave the question in a comment.
Follow on Twitter to get news about new articles. @SmallIvy_SI
Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.
Funny thing. Pretty much since I started working a real job, paid off my car, and decided that I would never have a car payment again (or a credit card interest payment, ever), I started projecting how much our net worth would be at different stages of our lives. I had always assumed that I would work until I was about 70, and that long work career, combined with regular investing and living a comfortable but financially responsible lifestyle that grew with time but always allowed a substantial majority of the income from our investments to compound, caused me to project that we would have no issues with money by the time we retired. Despite a terrible ten years or so in the stock market after I first made those projections (right before the dot-com bubble burst, the housing bubble burst, and then the multiple years of slow growth ensued), we are tracking well with my original projections. Depending on the rate of return I assume over the next 25 years, I think we’ll end up somewhere between maybe four times and fifteen times what I would consider the bare minimum needed for our minimum income needs in retirement. Probably closer to the former, but if the stock market does great and we see returns at the top of the possible range, the latter.
But then I started playing around on the Vanguard website the other night. They have a neat tool that runs a whole series of Monte Carlo simulations for you. (In a Monte Carlo simulation, you run a whole series of calculations to determine the range of possibilities of where you could end up.) These simulations take a mix of cash, stocks, and bonds and run simulations based on random but historically accurate returns for each of these categories and project where you’ll be twenty, thirty, or forty years out after retirement under different market conditions. The purpose of the simulator is to show how much income you’ll be able to spend and have a good chance of making it all the way through retirement without running out. For example, if you expect to have $1 M at retirement and pick a portfolio of 50% bonds, 40% stocks, and 10% cash, you may find that you’ll make it through a retirement of 30 years without running out of money maybe 70% of the time. It is also meant to show the advantages of adding bonds and cash to your portfolio since your risk of running out of money will generally go way up if you stay in all stocks and spend a healthy amount of cash each year if you start with a modest nest egg at retirement.
If you start with substantially more than you need, and plan to spend an amount that is very modest compared with the size of the portfolio (less than 1% per year, for example), a funny thing happens. Even in the all stock portfolio, your chances of making it all the way through a 30 year retirement without running out of money can become almost certain. Even in the worst of circumstances where the stock market does terrible a lot of the time, you can still expect to die with a few hundred thousand dollars net worth because you started out so far ahead of the game.
What is really odd, however, are the best scenarios – the ones where the economy does really well, like it did back in the 1980’s and 1990’s, and everything just works out really well. In that case, because you’re entirely invested in stocks, you can see your net worth grow from the simply comfortably wealthy into the leagues of unreal wealth – $100 M, $300 M, even the ultimate level, a billion dollars! Imagine joining that elite circle with Warren Buffett, Donald Trump, and Bill Gates. OK – so I still wouldn’t be quite at their level, and they still wouldn’t return my calls. And they would be like trillionaires by then. And they’d all be dead by then. And I’d be the next day. But still!
Standing where I am today, that hardly seems possible. But then again, starting out with a couple of thousand dollars in an emergency fund when we were in our twenties, I could not image being where I am twenty years later even though the math said it would happen if the economy continued to perform as it had for the last couple of hundred years. The power of compounding at stock market returns, which can average anywhere between about ten and twenty percent annualized over a given fifteen-year period, does not stop just because you’re retired. That thirty year period between retirement and death is no different from the one between twenty-five and fifty-five, provided you don’t withdraw funds too rapidly and allow your investments to continue to grow.
So will we die as billionaires in fifty-five years? Probably not. But we’ll probably leave a significant inheritance and make a sizable donation to some cause unless the markets do really badly between now and then. Historically badly. Still, it shows the advantage of working to retire with more than just the bare minimum, since then you can let your money continue to grow in the stock market rather than needing to convert it all to cash and bonds, or worse – give it to some insurance company to get an annuity. So here’s to all the potential future billionaires out there who just look like middle-class workers with older cars right now.
Got a question or comment about personal finance or investing? Please leave a comment.
Follow on Twitter to get news about new articles. @SmallIvy_SI
Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.
The SmallIvy Book of Investing, Book 1: Investing to Grow Wealthy
You probably spend most of your day looking at your phone. Maybe you’re texting friends, browsing the web, or paying solitaire. What if you could be using some of that time learning how to improve your future?
The electronic version of my book on investing and money management, The SmallIvy Book of Investing, Book 1: Investing to Grow Wealthy, is going on sale starting Today for only $1.99. This book starts by giving you all the information you’ll need about stocks, bonds, and other types of investments, including the risks involved. It then tells you how to manage that risk to use investing the generate additional income so that you can grow your wealth more quickly than you can with a job.
The middle chapters discuss what you should be doing at each stage of life if you want to become financially independent – that magical state where you don’t need to work to support yourself and your family. It also provides a plan for cash-flow management – how to budget your money and start your savings compounding and so that you’ll have the money you need for things like new cars, college bills, and retirement.
Next, the way to invest if you’re serious about making money, not just playing around with investing, is discussed. Here the information about risk and reward given in the first chapters is put to use to show how you can take reasonable risks for a chance to beat market returns with the portion of your wealth beyond what is needed for necessities.
Finally, mutual funds are discussed, including their use in IRAs and 401k plans.
Take a look at the book on Amazon and be ready Monday to get your copy at this special price. Download a copy for just $1.99, then use some of that time you spend starting at your phone to be learning about investing and money management. Also, if you do buy a copy, please consider leaving a review on Amazon to let me know what you think.
Thanks!! SI
Questions? Comments? Let me know what’s on your mind by using the comment form below!
Follow on Twitter to get news about new articles. @SmallIvy_SI
Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.
Jeffery Bogle
In addition, if you hold a bond until it matures, no matter where the price has gone during its lifetime, the company or government that issued it will pay you the face value, usually $1,000 per bond for corporate bonds. Because of this, the closer to maturity the bond is, the closer it will stay to the redemption value. If you buy short-term bonds (or a short-term bond fund), the potential return you’ll receive will be less than you’ll find with long-term bond funds, but the volatility of their price will also be less since the bonds will be near redemption.
The issue with holding all bonds is that your return will be less than it will be with stocks over long periods of time (about 5-8% versus 10-15% annualized per year). With a middle-class salary, if you contributed 15% of your salary to your 401k but only bought bonds your whole career, you’d end up with millions of dollars less than someone who put all of their money into stocks for the first thirty years. Holding 100% bonds can also make your portfolio more volatile during periods where interest rates are rising rapidly or inflation takes off because bond prices are very sensitive to changes in interest rates and inflation. It is therefore safer to have a portfolio consisting of 80% bonds and 20% stocks than a 100% bond portfolio.
So with bonds, you tend to want to add them to your portfolio as you get closer to needing the money, which is usually your retirement date. The Bogle rule assumes that you always want a few bonds, just to reduce volatility, but that you’ll want to have the majority of your assets in stocks until you’re entering retirement. Having some stocks even in retirement is needed because it helps fight inflation, keeping your spending power from declining late in retirement, so even at age 70 you would still have at least 30% of your portoflio in stocks. As you got older, you’d sell some of those stocks and buy more bonds to increase the amount of cash you’d receive each year to make up for the reduction in spending power you’d have if you kept receiving the same amount of cash each year due to inflation. Because life expectancies are longer than they used to be, such that people are living twenty to thirty years into retirement, the Bogle rule has also been adjusted to “buy your age minus 10% in bonds” so that you’ll have a bit more in stocks when you enter retirement.
An alternative to having bonds in retirement is raising cash by selling stocks and putting the money into a money market fund or bank CDs. Because it is very rare for the stock market to be down for more than 5 years, and because the level of declines that do extend beyond five years tend to be very minor, having five-years worth of cash in your portfolio can help you avoid needing to sell right after a market crash because you need to raise cash. This kind of strategy, where you have a larger cash position and forego bonds, can make sense at times like right now where interest rates are very low, such that bonds really aren’t paying enough to generate enough income for living expenses, and rates are expected to rise. You can also mix in alternative income investments to bonds, such as high dividend paying stocks like utilities, real estate through REITs or by buying rental properties directly, and investments like limited partnerships which pay out a large percentage of the money they make through pipelines and the like. (Be cautious with this last one, as you could end up filing taxes in multiple states with limited partnerships.)
Good times to buy bonds are the following:
If at least one of these conditions were not met, I would probably forego buying any bonds until I was within about five to ten years of retirement since the returns I would get from the stock market would be so much better. I instead would accept the larger volatility in exchange for the better returns. Then again, I have an iron stomach when it comes to stock market fluctuations, knowing that as long as I have several years until I need the money that the market will likely come back from any drop. If seeing your portfolio decline in value really affects you, however, such that it would make it hard to sleep at night, mixing in a few bonds even early in life with the understanding that you’re reducing your future returns in exchange for less volatility may be worth the sacrifice.
Finally, if you buy a target date retirement fund, they do the bond/stock ratio adjustments for you. Just pick a portfolio with a date near when you will retire and let it go. If you want to be a bit more aggressive, pick a date ten years after you’ll retire. If you want to be more conservative and reduce volatility, pick one ten years before you retire.
To ask a question, email vtsioriginal@yahoo.com or leave the question in a comment.
Follow on Twitter to get news about new articles. @SmallIvy_SI
Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.
