As we have stated many times before, choosing the right investments, in particular the right stocks continues to be a major sources of frustration for millions of investors. The urge to buy the latest "hot tip" from a friend, financial news report, a broker, and yes even a financial newsletter can be a very disappointing experience.
What I hope to show you here, is careful thought and analysis goes into each and every one of our recommendations at the Investor Alert. Choosing the right stock is only part of the equations. Picking the right stock in the right market is the key. Unfortunately, you can invest in the greatest companies on the planet, but if the stock market and business cycle are maturing, you will eventually lose money. Wall Street likes to take advantage of investor's ignorance of the important market cycles.
Three Key Market Cycles
1) The Business Cycle—The business cycle charts the course of the economy as it moves from expansion to peak then to recession. Knowing which direction in which the cycle is heading can keep you from making the painful mistake of buying a company just before it starts its cyclical downturn.
2) The Stock Market Cycle—The stock market cycle is a leading indicator of the future direction in the business cycle.
3) The Interest Rate Cycle—This cycle charts the interest rate trend from rate increases to rate decreases.
We know from history that certain sectors of the market do very poorly when the Federal Reserve begins to raise rates. On the other hand, some sectors begin to perform quite nicely. For example, When the Fed begins to raise rates, stocks in the sectors of the consumer discretionary, financial, technology, industrial, utility, and materials under perform. Conversely, stocks in the healthcare, and consumer staples area outperform.
Once you understand where the market is in terms of the three key market cycles, an investor can begin to evaluate individual companies based on Fundamental and Price Analysis.
Fundamental Analysis
1. Return on Equity (ROE) —The average return on equity in U.S. corporations is around 12%. Since 12% is average, and we are seeking to outperform the market averages, we want companies with the highest ROE available. Once a company's ROE is identified, we then place the company into its respective category. We screen and evaluate each based on the categories below.
2. Consumer Monopoly or Brand Name Products —In our screening process, I have found that companies who dominate their industries, or at least compete aggressively year in and year out, have a higher predictability rate for earnings growth and success, than those who could be labeled as "one trick ponies". Niche companies are also considered as long as they have the track record to back it up.
Institutional money managers have a fiduciary responsibility to the investors they represent. When considering a company for investment, money managers want guarantees. These guarantees include consistent and predictable earnings. The first places these managers look for consistency are companies who dominate a niche or industry. If the market temporarily mis-prices a company due to a temporary circumstance, we begin to get interested.
3. Debt Burden —A company that dominates a niche or an industry creates a lot of excess cash and profits. Companies who do not dominate try and grow through acquisition in hopes of one day creating a monopoly. Growing through acquisitions creates an increased debt burden since the acquiring company is not dominant. Accounting tricks are used to book the revenue and hide the debt. The debt burden in this case would be virtually impossible to reduce or eliminate.
Companies that dominate their industries can merge with another dominant company, and have no problems reducing debt. On the other-hand, a dominant company that acquires a non-dominant company risks mediocre results if an economic downturn occurs.
4. Earnings growth over the past 5-10 years —We want to know if the company's earnings are rising, erratic, or declining. If a company's earnings are rising, we want to know at what rate? Are sales and revenues increasing? Why?
5. Is the company buying back stock? —From retained earnings. Companies that feel their no business more valuable than their own, and use retained earnings to buy back the company stock. This sends us a very important message. We also want to know if the company insiders are buying or selling their own stock. If they are buying, we want to know if the purchases are option related or are they using their own money. Specifically, we look for Directors, CEO-COO, President, CFO and the Chairman of the Board. They are privy to information that Vice Presidents may not.
6. Total return to investors —Every April, Fortune Magazine prints a special issue entitled "Fortune 500". Fortune categorizes each company according to market cap, revenues, and assets. I quickly learned at a very early age that one column carried more weight than all the others combined. I ranked each company based on the total return to investors over a 1, 5, and 10-year time frame. I looked for companies that were consistently ranking among the top year in and year out. Using this method in conjunction with the previous five steps adds consistency and validity to the stock selection process.
Price Analysis
1. Initial rate of return—This number gives us an immediate look at how the company is performing, and is used to predict how the company has done the past 5-10 years.
2. Per share growth rate—This determines what a company's annual growth rate over a 5-10 year period.
3. Value relative to government bonds—We want to know if we can get a better return on the 30-year treasury or the stock.
4. Return on Equity (ROE)—The higher the better, 12% is average; we are looking for 15% or more.
5. Projected annual compounding rate—Growth rate the past 10 years predicted forward, then reduced.
6. Price I'm willing to pay—Target buy price
Other Considerations
1. Investors Intelligence Data—Bull (vs.) Bear ratio. Basically used as a contrarian indicator that gauges investor expectations.
2. VIX Ratio—The VIX Index is a sentiment indicator that measures optimism and pessimism in the market place. It is often used as a contrarian indicator since it also gauges investor expectations.
3. Corporate Earnings—Current earnings, revisions, guidance going forward.
4. Geopolitical Events/Shocks—Oil prices, War, Terrorism,
5. Fiscal/Monetary Policy—Raising or lowering of interest rates and taxes.
6. Inflation Data—GDP, the Trade Deficit, and the Dollar.
Once I gather all the data, I begin selecting stocks that have the most favorable risk reward characteristics going forward. Unfortunately, the newsletter business and financial newsletter advisors are being judged by the same yardstick as mutual fund managers. In order to gain notoriety faster, and sell more newsletters, financial writers are being judged on their stock picking abilities almost immediately after a recommendation leaves their lips.
Investment publications like the Hulbert Financial Digest rank newsletters based on performance which is pressuring newsletter writers to recommend riskier and more volatile stocks to achieve immediate results. If Warren Buffett's stock picks had been judged in the same manor as financial newsletter writers, then Coca-Cola and Gillette would have raked Warren's stock picking abilities through the mud.
We will not succumb to the pressures of choosing stocks for immediate results or instant gratification. If we happen to get immediate results, then fine. But our goal will continue to be investing in great companies, at great prices, at the right time. Even investment legend Jim Roger's once said that "he is a lousy trader" and his investments normally take two years to pan out. To illustrate my point, I'll leave you with the lesson of the Chinese bamboo tree.
One of my favorite stories is the lesson of the Chinese bamboo tree. It's actually a miracle, kind of like the magic of compounding. The Chinese bamboo tree starts from a seed. You plant the seed, and the first year you water and fertilize it and nothing happens. Then the second year you water and fertilize it and still nothing happens. This process continues through the 3rd and 4th years as well. But in the 5th year as you continue to water and fertilize the seed, sometime in the 5th year the Chinese bamboo tree grows 90 feet in six weeks.
Now, let me ask you a question, did the Chinese bamboo tree grow 90 feet in six weeks or had it been growing all along where nobody could see it? The story of Chinese bamboo tree can be applied to some of our stocks and the market in general. A wise rich man once told me "get rich slowly son".
In this day and age of instant gratification, the "I want it now "attitude will stop many from reaching their financial dreams. Daily, people a being suckered into thinking they can become professional day traders. Most investors cannot wait 2-3 years for a large reward.
