Investor Strategy: The Basics

Let’s start with a disclaimer: I am invested in capital markets and especially in my own ventures. But I never discuss investments beyond my family and an occasional paid professional (a tax adviser, accountant or estate planner). I am not a broker or investment adviser. Although A Wild Duck occasionally discusses economics in the “macro” sense (as in the previous post about Bitcoin), personal finance is definitely not within our purview. In general, our banner states the venue faithfully: Politics, Economics, Technology, Law and Social Phenomena.

Most proclamations have an exception. Today is no exception, but it comes close…

No. I am not about offer personal financial advice. But I will share with Wild Duck readers an off-the-cuff investment primer that I sent to a close family friend — let’s call her “Beth”. Beth is middle-age, alone, and has a substantial estate. Yet, she has never played an active role in directing her investments. In the past, her husband handled these affairs. Once on her own, she parked her assets in a low yield savings account. (Currently, these yield barely 1%).

Beth posed a very simple question. In fact the email had only one line:

Subj: Market Investing
How does one learn to play?

I write quickly, especially when the topic relates to things that I have pondered for years. So, I outlined a duck’s-eye view of basic investor concepts, investment vehicles and trip wires. These are things that every novice should know. Of course, they are not simple text book facts. They are sprinkled with Ellery’s bill-nosed, Wild Duck opinions. Again, don’t mistake this for advice! It is my personal view of basic markets and investment vehicles and only as it might apply to a particular friend. Her age, net worth, family & career status, risk tolerance and financial objectives may differ substantially from yours.

If you want to skip the primer and jump directly to the method I use to value a company, then scroll down to [ 8C ], below. But if you are a novice, consider learning the basics.

_____________

Dear Beth,

“How does one learn to play?” This is a question that can be discussed for hours and hours…Months and months! The “experts” talk about investing with buzzwords:

  • Financial objectives (for example, growth, security, tax savings, etc)
  • Time Horizon: Long term, short term, cash conservation, College savings, etc
  • Trade & Fund details: Load, commission, index tracking
  • Fundamentals -vs- Technicals (I am very opinionated about this one!)
    Learn about the P/E ratios. Understand that markets are futures oriented.
  • Strategy: Straddles, Saddles, Insurance
  • Investment vehicles: Puts & Calls, Tigres, Spiders, Zero Coupon, Munis, etc
  • Life Stage: Saving for retirement, already retired, planning to sell a house, divorced, putting kids through school? etc

These are just details. They don’t influence strategy as much as paid professionals would lead you to believe. But let’s begin with comments about 2 items on that list:

Cramer likes a technical approach. Poppycock!

♦ The question of objectives, is hogwash! Asking if you want “growth” is like asking if the Pope is Catholic. We all want the same thing: “Make a lot of money and minimize risk”.

♦ If someone suggests investing on the Technicals (as opposed to researching Fundamentals), run away as fast as possible. They are soused with Jagermeister. They believe in snake oil and the Magic Fairy. Harken to them and ye’ shall be a pauper. 1

My personal advice…
_ _ _ _ _ _ _ _ _ _

1. You Will Lose Before You Will Gain
Don’t put all your eggs in one basket and definitely don’t bet the house! Start with small nibbles. Stay the course. Don’t “double up” (See #4: Strategy).

First, you will lose a little money (so keep earning it at your regular job). Then you will lose some more! You will discover that the market never meets with expectations. You will see the folly of short term strategies and you will learn the tough way – from personal experience and your own risk. It is a way that you will never forget!

2. Find a ‘Personal Groove’ That Overcomes Emotion & Fits Your Risk Tolerance
Eventually, you figure out a pattern that works for you. This is not because your objectives are unique. (Everyone has the same investment objective: Put savings to use to make money). The reason that you need to discover a personal pattern, is because your style fits with your understanding of economics, your constitution for risk, and your patience to stay the course.

3. Sectors
Stay with stocks or funds that deal in markets that you know something about and that relate to your interests. Never get involved with a sector that is far flung from your personal education or experience, especially when purchasing or shorting individual stocks. (More about this in #5: Diversification). Even if you get very trusted and good advice about something that is not related to your field (uranium mines, for example), the market will someday change (perhaps far in the future), and you will be caught without any industry knowledge, because you don’t read about that sector every day.

4. Strategy
You will hear about an investment strategy called “Dollar cost averaging”. It is excellent advice for anyone. It helps you to weather the short term and midterm bumps while continuing to grow your investment. It takes patience and it forces you to resist getting caught up in fads beyond your means. Again, it is very good advice. I wish that I had followed this advice throughout my investment career.

5. Diversification
It is difficult to remain diversified if you invest only in markets with which you have intimate familiarity. (On the other hand, your career history is quite eclectic—so perhaps you can!!) So, I apply this conventional wisdom only to mutual funds. My individual stocks are clearly not diversified. The real issue here is that a lack of diversification dramatically increases risk. I wouldn’t say it is a bad thing, but you need to be aware of this.

6. Management, Loads, Personal Service
I don’t like any of these things. There will always be equal amounts of contradicting advice. Why? Because, for every investor that buys stock in a winning company, another investor loses on the other side of the transaction. You don’t need advice, you need an understanding and tools.

7. Margin Investing
Definitely not for everyone. Big risk. Gives you leverage, but so does writing puts and covered calls – and with far less risk.

8. Understand How to Value Equity
…Don’t Confuse a Great Company w/Great Value

Suppose you just bought a high-value product that everyone is talking about from a company with a hot reputation. (Let’s call the manufacturer “Q”, but think of the Apple iPad or the Tesla Roadster, or whatever works for you.) You learn to use it quickly and find that it performs better than you thought possible, and at a fair price. Should you invest in Q?

Next, you study the competitive landscape. You determine that products from other vendors don’t provide a satisfying experience and the pundits agree. You also learn that competing products costs more to build – but sell for less, because everyone wants to own the product that you have. Would you invest in Q now?

It gets better: Q is growing fast, entering new markets, and has a great reputation. It’s supply lines are solid and the founders health is much better than originally reported. There are no scandals concerning officers or directors. Now will you buy stock in this great company? Why not? Wait! There’s more…

You research things that directly influence revenue & profit. You discover that competitors must pay Q a high licensing fee because they have solid patents. Their orders are growing fast and you want to get in during their best growth ever. Call your broker now! Right?

Not necessarily. I don’t want this section, Basic Investor Strategy #8, to get too long, so I am going to cut to the chase. A company has at least 3 different values:

  • Book Value: The value of its factories, tools, inventory, cash and other assets
  • Market Cap: The cost per share times the number of shares outstanding
  • Earnings Growth vs. Expectation: The hard part and the only part that matters!

A) Book Value
Book value has little to do with anything, unless the company is performing so poorly that it is at risk of being taken over and dismantled (i.e. so that the individual assets can be sold). Why doesn’t book value matter for to an investor? Let’s say that a computer programmer working from home designs and sells software that everyone wants. He sells 1000 copies each day for $10,000. His total daily cost of running the business is a cup of coffee and an internet connection. The low value of his production environment does not detract from the value of his income. In fact, with the exception of adding a marketing budget (to acquire even more customers), his low costs add to the high overall return.

B) Market Cap
Market Cap refers simply the (share price) times (the total number of shares). It reflects the current value that existing investors place on the company, or more precisely, what they believe to be its prospects for future success. If you agree with them (and if you are primarily a speculator – as we assume), then you wouldn’t be investing in the company. Get it?! Your goal is to find an undervalued company and then prove the other investors wrong.

Market Cap is based on short term sentiment that often has a great disconnect with the fundamentals of a company. Or in the case of Q, the market cap may already be pumped up very high because everyone believes it to be a great company and expects the share price to keep growing faster and faster. In this case, we say that good news has already been factored into a high valuation.

What if the share price multiplies out to a market cap that is in the stratosphere? To make a long term gain, the company would have to own the earth within a few years. With overvalued shares, even a great company may have nowhere to go but down!

C) Earnings Growth vs. Expectation
This brings us to the only factor that matters when choosing to invest in an individual company. 2 I don’t really have term for this one, but it is essentially this:

Anticipated growth in future earning
—vs—
the expectations of other investors

Translation: Do you believe that the current share price is undervalued? By “value”, I mean, do you believe that during the period you expect to hold the stock, other investors will increase their opinion of the company’s future prospects?

To answer this question, you must really do some research. Lots! And it must be your own personal research; Not the opinion of others. If an influential opinion or popular consensus is already surfacing, then you have lost your edge. You can no longer win at proving the market wrong. So how do you begin your research?

You will need to know the market cap, the P/E ratio (look it up), the competitive landscape, the safety of supply lines, future product plans, and current product fads. Even during the very high growth period for Crocs or for Cabbage Patch Kids, shrewd investors realized that these were product fads. It is very unlikely that the companies behind these products could diversify and conquer new markets with the rapid penetration they recently enjoyed. So, the likelihood of sustaining the growth is low. Finally, you must add up all of this data and weigh it against an educated guess as to whether the company will keep growing without excessively watering down that growth with simultaneous growth in the number of shares.

That was the end of my letter to Beth. Of course, the last paragraph contains a lot to ponder. I suspect that it will prompt a lot of questions and comments from Wild Ducks, and it is as far as I wish to take this primer. I intended only to spark contemplation and move you toward an entrance.

1 If TV financial advisor Jim Cramer is reading this Blog, forgive me. as with Bill O’Reilly, the blather (or your technical approach) makes for entertaining television. It is not a viable investment strategy. Not even for the short term.

2 The bold claim that “This is the only valuation that matters” is based on some assumptions. In this primer, I am focusing on growth medium term, growth investing and ignoring very legitimate investment strategies, such as dividend investing, mutual funds, bonds, or applying a disciplined approach such as dollar cost averaging. I believe that all of these are effective approaches to market investing. But in my discussion of picking stocks, I am talking about growth stocks and market timing.

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