In many ways, an investment is like a marriage. Some people like to jump in head first with little idea of what they are doing. Sometimes they get lucky and it works out…other times things are not as they seem and it leaves them miserable. A careful selection with much research typically puts one in a better position to succeed, and can be very rewarding. Similarly, a poor selection can leave one broken.
I could go on about the psychological and executional similarities between a marriage and an investment but I will stop while I’m ahead. The point is that an investment can be extremely rewarding if carefully chosen, and can cause you to lose much sleep at night if it’s not going well. There are really 4 stages to an investment, and all need to be executed properly for the investment experience to be enjoyable (i.e. you made money):
For simplicity’s sake, I will analyze this from the lens of investing in a company’s common stock. The principles could be applied to investing in funds (ETFs, Mutual Funds), commodities (gold, silver), and even real estate.
The first stage of an investment is the research. This is the area many overlook, or do not give enough attention to. There are many methods of research: stock screening tools, news letters, pouring through investor-targeted materials, asking your broker, and even just asking a neighbor. The key, however, is that you understand some basic things about who you are giving your money to and what they will do with it. The typical value investor will ask himself 2 things: is this company a great company that will wisely use my money and is the current price of ownership (the share price) a good value? While no one has a crystal ball, or at least a reliable one, it’s difficult to predict what exactly will happen to your hard earned dollars you hand over to this company. However, as the old adage goes “those who cannot remember the past are condemned to repeat it”, a look into the past can give you clues as to the behaviors of the future. So many investors begin their research by looking at the history, both financial and organizational, of a company. The most direct way of doing this is reviewing the financial filings, which can be done using the SEC’s EDGAR tool. These documents, however, are very lengthy, some over 100 pages long. Many find it’s not practical to do this and therefore rely on the opinions of others that have done so.
One last comment on understanding a company…I cannot stress enough how important it is to move on to another company if you cannot clearly understand what it is they do. Too many investors have bought a company because their business sounded good, or the share price was climbing wildly. But if the company is a cow milking contracting firm out of Tibet, and you have no idea whats involved in milking cows, that it could be contracted out, or that such a thing was ever done in Tibet, it is best to stay away.
The second stage of an investment is the Entry. An entry is when and at what price you chose to begin the investment. This goes hand in hand with the second principle of value investing, which is buying good companys at good prices. There are two common measurement tools used to determine if a price is good: the P/E ratio and the P/B ratio. The P/E ratio, or price to earnings ratio, is computed by taking the earnings per share for an entire year, and dividing it into the current share price. If the earnings are negative, this ratio is pretty much worthless and you should avoid that company. If the earnings are positive, 99 times out of 100 the P/E ratio will be over 5. Its hard to determine what a proper P/E ratio is, but lower is better. Many investors use a benchmark between 5 and 20. Anything lower than 5 should raise suspicion about what could possibly be wrong about this company (maybe they milk cows in Tibet…with the exception that no cows live in Tibet and therefore they pull their profit numbers out of thin air), and anything over 20 should make you think carefully about why the perceived value of the company is priced so high.
The P/B ratio, or price to book ratio, is calculated by taking the book value of a company per share, and dividing that into the market capitalization. Market cap, simply put, is the price of a share times the number of shares outstanding. Book value is the value of a company after all liabilities, or debts, are subtracted from their assets. A company with a negative book value will have a negative P/B ratio…move along if you find this. Typically, the P/B ratio will be between 1 and 3. If it is under 1, you have to ask yourself what is possibly wrong with this company that it trades below its book value, meaning anyone with enough money could come buy the company outright and then turn around and sell it for a profit. If it’s over 3, you have to ask yourself what the company is doing that merits such a high premium over its book value.
Both the P/E and P/B values are important indicators, but also can be heavily manipulated. A company can go to great lengths (read: accounting tricks) to make its P/E and P/B value look attractive at a certain point in time.
Once you have determined that the company in question is a good value, it’s time to make an entry. The easiest way to enter is to buy a stock at the market price, by either calling your broker or logging on to your account online and making the trade. While this is easy, there are tools out there that can help you get a better price, which can also be used through your broker. The tools are called limit orders, stop orders, stop limit orders, and trailing stop orders. While they all have their uses, my favorite to use is the trailing stop.
Simply put, a trailing stop allows you to buy a stock when the momentum of its price is moving in your favor. If you have ever bought a stock before, you have likely been in a situation where you thought you bought at a great price, only to have the stock price continue to fall and you missing an opportunity to buy at an even better price. What a trailing stop order on the buy side does is allows you to set a percentage or number of cents above the current price of the stock. If the share price rises that amount, your buy is triggered. If the share price lowers, then your trailing price lowers as well. When the share price bounces back, you will get in at a lower price than originally. The beauty of the trailing stop is that you don’t have to continually watch the share price to determine when to buy. The trailing stop does it all for you, and you will usually get in at a better price than had you just bought when you made your decision to invest. Depending on how much you think the price of the stock will raise or lower, a good percentage to place on your trailing stop is anywhere from 5-15%.
Like any decision in life, it is important to remain realistic. Not all of us make good decisions, and the only way to determine if the decision was good was to review the decision periodically. The same goes for investing. Once you have entered your investment marriage, you need to review periodically if your decision was a good one. A poor way to determine if you made a good decision is to look at the share price. The share price reflects everyone else’s opinions about the stock. If you bought the stock at a good value, everyone else’s opinions were likely not very good, but you saw something that made you believe in the company. Furthermore, poor opinions will push the price lower, but if all the elements you believed in are still there, why would you get out now? Many people use a strategy called averaging down, which is a form of dollar cost averaging. I won’t go into the details in this article, but it basically involves buying more when the price is lower.
There are 3 events to pay attention to when reviewing your decision. The first is the earnings release, which happens 4 times a year (once each quarter). This is where the company tells the world (or at least the part of the world that is listening) how much money it made, and the state of its assets. If the company was making a profit, and then announces a surprise loss, you should think carefully about why you are invested in this company. No one will fault you if you get out…you didn’t give your money to this company so they could lose it, so you can let another guy live with this risk. Be very subjective, because human nature is to justify a decision, rather than analyze a decision. A poor decision is a poor decision, and getting out of that poor investment gives you an opportunity to make a new investment, and therefore a new and likely more seasoned decision.
The second thing to watch for are company events. These are things like announcements of dividends, stock splits, new markets they are entering, or special awards or recognition they may have received. Announcements of dividends and splits are especially encouraging…if the stock splits it means that the price, usually driven by P/E and P/B ratios, has gotten so high that they want to reduce the price and give you more shares. Splits are good signs. A dividend is equally good…this means that the company is making so much money they are ready to share it with its investors, in the form of x amount of dollars or cents per share. Similarly, reverse splits and termination of dividends are bad signs. If a company goes in a reverse split, it usually means the price of the share, usually driven by the P/E and P/B ratios, has become so depressed that they need to reduce your number of shares and increase the price of the shares, or face consequences (such as being de-listed from the stock exchange, another horrible thing). If a company terminates its dividend it once gave out (or reduces it significantly), this can be a sign it is having problems with cashflow, and needs to pay you less so it can recover its business. There are exceptions to all these rules, but the general principles almost always apply.
The final thing to watch for is changes in management. The phenomenon of the corporate entity is that it is independent of the normal human lifespan, and thus is indifferent to limitations of people. For a variety of reasons, management will change in the company, but the company will move on. In fact, forces inside a company can eject management from the reigns. Its important for you to know why. I won’t get in to all the different reasons why management changes but surprise resignations, especially of the CEO, are usually not good. Like surprise losses, you need to ask yourself if the reasons you invested in the company are still there. One twist is that, if this was needed and new management is good, and the new management has enough to work with (strong asset base, strong customer base generating recurring revenue), this could be an excellent event for the company. You need to do your homework. Once again, no one will fault you if you get out. You have now moved from a position of low risk to a position of potentially high risk, and you may not want to tolerate that risk.
This is where my analogy of an investment being like a marriage is not similar (or maybe exactly like a marriage, depending on who you ask). At some point, you will need to exit the investment to make a profit. In other situations, you may have to exit at a loss if your review turns up very ugly truth. Either way, you ultimately will get out.
When do you get out? This really depends on your goal for getting in. Some people invest with extra money they have for a certain time period, and when they need the money back they get out. This is probably a poor way to treat investments, because this means that you invested with money you really needed, which is dangerous. The exception to this would of course be investments in retirement plans that you will not need for many years (10 or more). 10 is a magic number because historically market cycles have behaved in 10 year intervals, give or take. During a 10 year run, you will see a little bit of everything. Investing money that you will need within the next 10 years puts you at risk of making an emotional decision just as everyone has decided they no longer want to be in the market. If you give it 10 years, and you pick good companies, you will be in a good position to see profits, and can get out when its time to go spend all the money!
A wise time to choose to get out is when the value or quality of the company materially changes. Over the years competitors enter and exit a market. This provides opportunities for growth and sustained profits. If it is clear that the company is no longer capitalizing on these opportunities, or if so many people now believe in the spectacular future of this company that they could not ever possibly live up to the expectations from their shareholders and the share price they have dictated, it is time to exit. You can use all the techniques we mentioned earlier to determine this.
How do you get out? Well I prefer to get out the same way I got in…using a trailing stop. Just as the trailing stop’s buy price will decrease so that you can buy at a better value, the trailing stop’s sell price will increase as the share value goes up so you can sell at a better price. This will let your profits run. Where you set the trailing stop depends on how much movement you believe the share price has. 5-15% is usually a safe range. Many people start with a large range, like 15%, and then tighten it as time moves on, locking in profits as the share price makes its wild climb. If you happened to pick a winner early on in the company’s life, you will witness one of the greatest phenomenon of investing…the staunch indifference of a company, followed by a wild euphoria of its potential, and ending many times with a massive crash in price when everyone realizes the party is over. You want to make sure you “take the money and run” before the lights go out. Trailing stops help you do this without losing sleep.
If I taught anything in this longer-than-I-expected article, it is that investment is both an emotional and intellectual ride. The best investments occur when minimal emotion is involved. The best way to control emotion is to look at just the facts. Happy hunting!