Why I Do This

     Before I publish any more posts on how to profit in stocks, I thought it would be appropriate this Valentines  Day to explain why I bother with this blog. First of all I do it for my daughter because she asked me to. Secondly I do it because I enjoy it. It takes less than 1 hour to make a post. If my daughter can learn some of these concepts that I have learned over the last 40 years, then it was a success. I have made this info public so anyone with a desire to learn more about investing can read my short and to-the-point lessons at will. I am not an expert at investing. I have never worked in the industry and now I am too old anyway. It has always amazed me that money management is not taught in junior high and high schools. I have recently heard of some progressive private schools offering this subject but they are the exception. When a young person leaves school and goes to work making money, they are not prepared to invest any savings. Our school systems are doing a great disservice to our young. It is especially important today because the traditional pensions my generation earned are becoming more and more rare. Instead, self funded retirement plans are the norm today. Not only is the employee forced to fund his own retirement, he must invest the funds so they will be there for him at his retirement. In addition, the social security benefits that I enjoy today may not be there for future generations. The contributions made today to social security by the working folks are being used to fund my benefits. Bottom line: The deck is stacked against every generation born after the Baby Boomers. What to do about it? Get wise about investing! Use this blog as a start but not an end. Read about financial matters anywhere you can, your future may depend on it.

The Short Sale

     There is a way to profit from a stock if you know that it is going to fall in price by using a technique called a short sale. The premise is simple, borrow shares and sell them. If you are right and the stock falls, you simply buy back the shares and replace them to the rightful owner. The difference between the sale price and the purchase price is profit. BUT what if you are wrong and the stock goes up instead of down? Your losses are only limited by how high the stock can go. How high can it go? Unlimited! While you suffer from losses while the stock rises, you have to pay the lender any dividends that come due and the brokerage firm where you borrowed the shares gives you what is called a margin call. That means that you have to put-up more assets as collateral in case the sold shares keep appreciating. Can you see why I don't sell short? Its best to let the pros play this game. Instead I will keep with my "buy long" strategy, where I buy shares and hope and pray they go up. My next post will be about some strategies I know about and what I think about them.

Forecasting and Stock Strategies

     Forecasting market movements is a fools game. Nobody knows what the stock market will do in the next 12 months. This doesn't keep every so-called expert from trying though. Instead of predicting what the market averages will do, I just want to try to predict what stocks are likely to do well if the market does continue its steady assent. If the market does poorly, then I just wait until it reverses while cherry-picking bargains amid the rubble. It always pays to have a buy list in case stocks do go on sale. How do I assemble my list? First I read financial publications like Barrons and The Wall Street Journal for ideas. I don't believe everything I read but I appreciate the information. Look at the political environment, the direction of interest rates and changing trends in technology and consumer behavior. Think through the implications of these changes. What industries are likely to benefit from these changes. This is VERY important: write down your thoughts and keep a record of them, you may be exactly correct but forget everything. Next, after determining what industries (sectors) will benefit under your assumptions, search for the best and most undervalued companies in that sector. Watch them for a period of time before buying them. If they are still falling and you buy too early, you have caught a "falling knife" and will suffer. Basic forecasting is not rocket science, for example, interest rates have recently bottomed at the lowest levels in decades. They are bound to go up as long as the economy is improving. Is this a sure thing? No, but it is as close as it gets to one. What benefits from higher rates? Banks and companies that invest large amounts of cash obviously. What drives rates up? Inflation and a hot economy. What benefits from inflation? Gold and fixed assets like real estate. You get the picture, its common sense. I call my assumptions for the future Themes. One of my current Themes is my expectation of increased defense spending. There are about a dozen of large defense contractors who will benefit under this scenario. A google search will reveal them. My concern is to not pay too much for them. You might have guessed that I am very cost conscious when buying. I can be called a Value investor as opposed to a Growth investor. A Growth investor will pay a higher multiple for a stock because his basic premise is that a stock in motion is likely to stay in motion. The Value investor likes "fallen angels" or stocks that have stumbled but are fixable over time. Also by paying attention to valuation (P/E ratios), and buying low P/E stocks, a level of protection is built-in if the market tanks. Think "less distance to fall". There are an unlimited number of strategies to pursue stocks. You are only limited by your imagination. Next I will discuss a strategy that I have never tried and never want to because it is too risky. Just because you don't use it doesn't mean you shouldn't know about it. It is called Selling Short.

Closed-End Funds

   The Closed-End Fund (CEF) is an ancestor to ETF's. There are important differences between the CEF and ETF and open ended funds. When the CEF is created, the fund company raises a specific amount of money from new investors in an IPO (initial public offering). Then the money is invested in the assets specified in the fund's objective sector: stocks, bonds, MPL's or whatever. No new money is allowed in. The fund does not issue new shares to new investors. They also do not buy back shares of existing investors. If you hold shares in a CEF, then to sell, you must sell them on the secondary market just like a stock. The shares are priced throughout the day, allowing for a liquid market. Now here is the interesting part, the shares may trade at a price that is different from NEV. Remember that NEV (net asset value) is the sum of the value of the assets in the fund divided by the shares outstanding. Usually, a CEF trades at a discount to its NAV. This means that you can own the asset for less than they are worth. It also means that if you bought the IPO you have a loss. DON'T BUY IPO'S. If you buy a CEF at a discount, say 10% to NAV, you probably feel pretty smart. It may not last. Some CEF have traded at a discount for their whole lives. The trick here is to identify an asset class that is currently out of favor but you suspect that it will be in demand in the future. Even buying a CEF at a deep discount and selling at less of a discount will result in a profit. Premiums for CEF's are rare. Usually CEF's are purchased for the income they generate. Some asset classes I like for the CEF structure is Preferred Stocks and Convertible Stocks. These are hybrid shares that are not easily understood by many investors. Letting a professional manage them makes sense. Closed End funds can be selected from lists in Barrons weekly publication or The Wall Street Journal. The premium or discount from NAV is listed as well as the last years performance. Some funds in the asset classes I mentioned had returns of 30% or more last year and still traded at a discount. I would not chase an investment unless the outlook is still superior. My next post is about how I forcast the next market winners.

Exchange Traded Funds (ETF)

Before I get into ETF's, and how they differ from traditional Mutual Funds, I need to explain how mutual funds work. First of all, there are two basic types of mutual funds: open ended and closed ended. Normally, when mutual funds are discussed, we are talking about open-ended funds. These are funds that hold stocks, bonds, or whatever and the investments in the fund can change based on the decisions of the manager. He may find new investments that he adds to the fund at any time. "Open-ended" refers to the flexibility of the investment portfolio to change. On the other hand, a Closed-Ended fund starts life with a basket of stocks and keeps them for the life of the fund. I will discuss the Closed-End fund in my next post. Both of these types of funds are priced at Net Asset Value (NAV). Net Asset Value is calculated by multiplying the number of shares times the closing price of those shares and added up, then divided by the number of mutual fund shares outstanding. That's a lot of math. Imagine the fund has 600 stocks, there is no way that NAV could be calculated and published throughout the trading day. This is why the NAV is only calculated at the end of  the trading day. So how does that affect you? Well, if you owned an open-end fund and had a nice gain in it and one morning you turned on the T.V. and saw that the stock market was falling dramatically, you would want to sell your fund to preserve your profits, right? Too bad, you can't. You have to wait until the market closes before your order to sell gets executed. However, if you owned an ETF, it can be sold during the trading day. It trades like one single stock. The mechanics of an ETF are complex but the end result is that it gives you trading flexibility, low fees, tax advantages and transparency. There are now over 1500 ETF's  currently traded and they cover almost every asset class,ie, stocks, bonds, commodities realestate, etc. I use ETF's to make sector bets based on my forecasts. For example, if I think that defense stocks will outperform the market, I will buy an ETF  that holds defense related stocks. This one trade provides me with diversification in the sector with low fees.In my next post I am going to talk about Closed-End mutual funds which are the unloved cousins of ETF's.

MUTUAL FUNDS

As I mentioned in previous posts, I sometimes use mutual funds rather than investing directly in stocks. Some sectors of the market are more difficult to analyze due to unique accounting or business traits. Sectors like banking, real estate investment trusts (REITS), master limited partnerships (MLP), are good canidates for using a mutual fund for investing. There are some things to know before handing over your money to a mutual fund company. The first thing I look at in a mutual fund is the fees they charge to manage your money. Naturally, you will have to pay for the expertise they bring to the table, your job is to not overpay. Some mutual fund families specialize in low fees which is good for the investor, however, be aware that customer service may be lacking. The second thing I look at in a mutual fund is what is in the portfolio. I "kick the tires" by checking some of the stocks in the top ten holdings. Basically, if I wouldn't buy these stocks (due to high valuations) or any other reason, I look elsewhere. I also look at past performance even though this is not predictive of future returns. The fact is that 80% of mutual fund managers cannot beat the performance of an unmanaged index which is their benchmark for performance. If a fund has had superior returns than the index and other competing funds, look to see if the same manager is still there. Long tenured fund managers with index beating performance are rare. Don't buy a fund based on the performance of a hot manager who is no longer in charge. Finally,pay attention to when distributions are made to fund shareholders. If a fund usually makes a distribution in December, I would not buy into it before the distribution date. The reason is that some of your investment is just handed back to you, creating a tax liability and reinvestment task. This is only true in taxable accounts, retirement accounts don't have this problem.
     This is just a brief overview of mutual funds. Investing through mutuals can be an easy way to gain exposure to stocks but can also be a way to get mediocre returns with high fees. The pitfalls are many so learn the basics. A very popular way to invest in mutual funds for the last 20 years has been to buy a low fee index fund from a company like Vanguard or Fidelity. These are unmanaged funds that will track the general market like the S&P 500 index. Some experts predict that managed funds will outperform in the coming years. Only time will tell. A competing product to mutual funds has emerged in recent years. It is called an Exchange Traded Fund (ETF). Billions of dollars have left traditional mutual funds and flowed into ETFs. I will explain the differences in my next post.

Ratio Analysis

I have talked about the P/E ratio and how to manipulate it to predict future stock prices based on changes in earnings or multiples. What if a company does not have any earnings? Sometimes young companies are so busy selling and developing products that they are not yet profitable. Usually these are smaller companies with limited resources to accomplish profitability yet. This can be a rich area to mine for investment. So how do we analyze such companies? Another tool in the Ratio Analysis tool box is the Price/Sales ratio. This ratio is best used as a comparison with other companies in the same business. If nothing else, it can give the investor an idea if the stock price is too high compared to other businesses. What this ratio is telling you is how many dollars you are willing to pay for $1 of sales in this company. The hope here is that if sales growth is high, then earnings are soon to follow.
     Another ratio that may be used is the Price/Cash flow. Cash flow may also be expressed as EBIDTA which stands for earnings before interest, depreciation, taxes and amortization. Sometimes, companies have a lot of depreciation which clouds the earnings picture. This accounting measure cuts through the crap to determine whether this company can actually pay its bills.
     As a conservative investor, I like to stick with established companies with a long record of earnings and increasing dividends. However,  I also recognize that the really spectacular growth comes from young companies on the cutting edge. This is why I bring up these two ratios. I would only consider a small portion of my portfolio in these small-cap names. That being said I would point out that late in a bull market, small caps tend to outperform the large cap stocks. The current bull market in stocks is over 7 years old, nearly a record. I usually invest in small caps through mutual funds because the names in this space are unfamiliar to me and I don't have time to sift through the hundreds of stocks to identify potential winners. Sometimes its best to leave the heavy lifting to the pros. My next post will be about investing in mutual funds. Its not as simple as"investing and forget it". I will talk about pitfalls that should be avoided.