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Thursday, July 12, 2007

 

Investing, Part 2

Before we go back to the stocks, a few quick words on Iraq. It was an eventful day because the first report card on the surge was released and it accurately portrayed a mixed picture of some progress amidst continuing carnage caused by suicide bombs, IED's and, a steady flow of weapons and fighters from Iran, Syria and Al Queda. Naturally the media played up the negative. The House Democrats, responding to their base and, in particular, the Moveon.org crowd, quickly passed a resolution to bring the troops home on deadline on a narrow party line vote (only 4 GOP defections and 10 Democratic defections). Of course, this bill is probably headed for defeat in the Senate, since there are not enough GOP defectors to give the Dems the 60 votes they need (with Johnson out sick and Lieberman voting nay, the Dems have at most 49 of their own votes). Even if it passed, the Dems could not override the President's veto in either house, so this is merely a political show to soothe the base. What it does do is create four very negative impacts: it undercuts and dispirits the troops and our military leadership; it causes our Iraqi partners to doubt our commitment; it provides hope and comfort to the enemies; and it encourages terrorism by showing weakness and division. Sorry to be so blunt, but these are votes that will surely come back to haunt all of those who have reduced this war to a political football. It also reflects the lack of intestinal fortitude in the American people, particularly the Baby Boom generation, a point that has been made here many times before.

The current aggressive strategy needs more time as the surge, such as it is, has only been fully in place for less than two months. And, as Senator McCain and others have pointed out, the correct response would be to add 60,000 more troops, not bring home in defeat the ones already there.

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Now it's back to my stock picking strategy. As stated in the last post, I am always on the lookout for interesting companies, finding them in my reading, but also in the course of everyday life, as I see products and services that are best in class and represent profitable opportunities. Though I do not believe in stock tips relative to short term special situations, I am willing to listen to advice from people I respect or who are in position to know a company from the inside. These experts might be speakers at a meeting, they might be columnists like Ken Fisher in Forbes, or my full service broker. Yes, I do have one though he understands that I will make very few trades with him. However, when he recommends a stock to me, if I act on it in a taxable account, he gets the order. He knows his main role is to consolidate our joint account holdings and handle the consolidated account if something happens to me. Otherwise, he knows most of my trades will be with the discount broker, and he understands that makes sense since I make all my own decisions.

When I find a company, that, as Cramer says, is only the beginning of the process. I need to learn more about it, its management, strategy and financials. Also, you can glean a lot about a company by finding the answers to a few simple questions. Is the company overcompensating its top executives? What are the recent insider trades, buys or sells? If they are sells, are they at least option related? Is the Company over leveraged (too much debt)? Who are the independent Board members? Does it look like they are management cronies or do they have the ability to look out for shareholders? How does the company treat shareholders? Does it pay a dividend and what is the history of that dividend (annual increases are best)? All of this information can be easily obtained from Yahoo Finance or from a number of other services (such as my discount broker, E Trade).

I don't pay a lot of attention to the earnings statement or P/E ratios. My feeling about earnings is that they are frequently managed and always variable. I like Fisher's price/sales ratio better as a valuation tool. I pay much more attention to the balance sheet than the income statement. You will see that the two most important valuation tools in my formula are the price to book value ratio and the debt to equity ratio. I want to buy stock that is actually worth something and that is not overly leveraged.

However, the decision as to whether to put a stock on my buy/hold list is usually not impacted by the financials (unless they're gross). I have to believe in the company and its strategy. If I do, I assume the financials will improve, and that's when Wall Street will pay me off.

So the buy/hold list is always changing, however slowly. Maybe 10 or so companies a year will be added and a similar number might come off, either through mergers, or because their strategy changes, or simply because I lose confidence and belief in what they're doing. The common theme is that the reason I put them on the list is no longer operative. And sometimes, I just get annoyed like anyone else. There was an insurance holding company I had on my list many years ago, but when they stone - walled it when questioned about past race based underwriting practices that resulted in price discrimination, I decided that that was a company that I could no longer invest in, in good conscience. They were very profitable, treated shareholders well, and had a great business outlook, but their core values, as I perceived them, didn't cut it for me. So it was off the list, even though I knew I was cutting loose a very profitable company. If I remove a company, I sell my whole position and never look back. The symbol comes off my Yahoo portfolio list. As for the new companies, the actual buy decision comes out of the formula, which you finally get to see on the next post (another "cliff dweller" as former Mets manager Wes Westrum used to call them).

If all this sounds like it takes too much time or effort, or if it's not fun for you, well I would direct you to the nearest index fund manager who will be happy to take your money and provide near market returns every year with pretty low expenses. You would have done just fine today, believe me. Individual stock accounts are only for people who enjoy that kind of thing. Life is too short to waste on avocations you don't love.

Question from a loyal musingsreader: "Please define what you mean by a long term and a short term investor. " Long term investors buy stocks with the idea that they are likely to hold them for two or more years, and are willing to be patient waiting for their stocks to move. Short term investors buy a stock hoping to see some movement within weeks, pick off a few points, sell, and maybe wait for it to go down and then buy it again. Short term stock players really have a trading mentality. They buy special situations and they get bored if nothing happens to their stock within a month or so. In that case, they are likely to sell and look for something else that might move more quickly. I'm not talking about day traders - but their mentality is not that different.

I have always perceived of myself as a long term investor, willing to see a stock lay there (like a latke, as my very first broker used to say) or even go down, before being rewarded. Long term investors really hate to pay taxes, and especially short term capital gains taxes. The only thing they hate more is losses, and if they have a common fault, it's that they will sit with a losing position forever, waiting to get even or ahead.

Though I was always fairly lucky with stocks, I made mistakes like everyone else and tried to learn from them. There were three factors that caused me to realize that I needed a formula to take the emotion out of my decisions. One, I always had trouble with the sell decision. For most investors, it is much harder than the buy decision. Second, the market break in 2000-2002 convinced me that when stocks were overvalued, I needed to be directed toward higher quality stocks with healthier book values and less leverage. Third, was my analysis of what I call my Dell Computer episode. We'll start with the Dell story next time.

The oldest Wall St. adage of all is to buy low and sell high. Of course, that is not very helpful advice. In one way or another, we're all trying to do that but it's very difficult. My formula is designed to result in a tendency to buy lower and sell higher. It works for me, but is not recommended for anyone else. Musingsreaders may find it helpful in designing the investment plan that works for them.

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Yesterday, I bought 700 shares of FSII at 3.10, continuing what may well prove to be an unhappy average down. But I don't question the formula at this point. It may need tweaking in the future, but for now, it works for me just as it is. After the miserable Tuesday we had, were you in the mood to buy an underperforming small stock on Wednesday's opening? That's what my formula directed me to do. FSII closed today at 3.16 so no damage done yet.

Comments:
You are killing me here with these "cliff dwellers". Your approach is vaguely reminiscent of Philo Kavetch episodes. Keep posting ... I gotta get that formula.
 
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