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There’s a lot of information out there about investing in the stock market. There are books, news articles, websites, even Jim Cramer screaming at you through the television camera…whom do you trust?
My advice is to trust yourself.
In this article, I will teach you how to pick winning stocks and offer you a few simple straightforward tips that will help you become a better investor.
What is a stock?
A stock is an equity security that gives investors fractional ownership in a company. Since 1871, the stock market has returned an average of 8.88% annually. If you invested $1 in the stock market in 1871, that dollar would be worth $161,302 today.
Despite solid average returns over extended periods of time, stocks are extremely volatile. In the past 17 years, the Dow Jones Industrial Average surged from 4,000 in 1995 to 11,723 in 2000. It then dropped to 7,286 in early 2002 (after the terrorist attacks of 9/11) and rose to 14,164 in 2007. In early 2009, the Dow fell to 6,547 after the mortgage crisis. Today the Dow is at 12,862. What a roller coaster ride!
The good news is that these stock market fluctuations offer great opportunities to capitalize on the temporary mis-pricings of companies. With the ups and downs in the market, there is no way companies are always priced efficiently. But, in order to capitalize on these opportunities, you must first identify the criteria for your investment decisions.
“Choosing individual stocks without any idea of what you’re looking for is like running through a dynamite factory with a burning match. You may live, but you’re still an idiot.”
-Joel Greenblatt
I’m here to help you turn that match into cash. First I’d like to share with you my 3 personal investing guidelines.
#1 – Invest with a Margin of Safety
In investing, I value a Margin of Safety above all else. This phrase was coined by Ben Graham, Warren Buffett’s mentor. It means leaving enough room for error to minimize the chances of loss. Always look at the downside and protect yourself from it.
#2 – Only invest money you won’t need for the next 5 years
A volatile stock market means there is a good chance you could lose a significant amount of money in the short-term. Give yourself enough breathing room to stay strong during the down times and recoup any losses you might incur.
The best investors actually look forward to down markets the same way you might look forward to a sale at your favorite department store. This is a great time to play offense while everyone else is running for cover and buy your favorite companies “on sale.”
#3 – Diversify in Numbers
There are 2 types of risks when investing in stocks: Market risk and non-market risk. Market risk is the risk associated with market volatility (ups and downs). The only way to avoid this is to keep your money in your pocket when the odds aren’t in your favor.
Non-market risk is company-specific and is prevalent when a company’s products don’t sell, workers strike, and costs increase.
As an investor, it’s impossible to know everything about a company. To protect yourself from these risks you need to diversify in numbers.
In his book You Can Be a Stock Market Genius, Joel Greenblatt says owning 2 different stocks eliminates 46% of your non-market risk. Owning 4 stocks eliminates 72% of the risk. Owning 8 stocks eliminates 81%; 16 stocks eliminate 93%; 32 stocks eliminate 96%; 500 stocks eliminate 99%. The more stocks you own, the less effect the performance of any individual company will have on your overall return.
How many stocks should you own?
My rule of thumb is to own between 6-8 stocks at a time. There isn’t much to gain by owning more. Instead, your portfolio will likely become “watered down” if you own too many stocks. Why incur the trading costs of owning 50+ stocks when you can own an Exchange Traded Fund (ETF) and get a similar return.
Now that you understand the basics, here are a few steps to help you get started.
Step #1 – Determine the Price
As easy as it sounds, you’d be surprised how many people trip up on this. Most people think about stocks in terms of share price: “Apple is trading at $460/share; Ford is trading at $12.80/share.” Share price doesn’t mean much unless you know how many shares a company has outstanding.
When you think about Apple and Ford, you should ask: What is the price (market capitalization) of the entire company?
A company’s market capitalization is its share price times the number of outstanding shares. The current price of Apple is $428B and the current price of Ford is $48.6B.
This is where you begin.
Step #2 – Analyze the Investment
Once you know the price of a company, there are all sorts of metrics that you can evaluate to decide if a company is a suitable investment. These metrics are derived by comparing the price of the company to the data obtained in the company’s financial statements. Remember these earlier articles?
Purpose of an Income Statement
Advantages of a Cash Flow Statement
Ah, there is a method to my madness!
Don’t worry; you don’t have to make all the calculations yourself. There are a ton of online resources that publish these financial calculations for you. Yahoo! Finance is a good place to find this information.
Here are the top 5 things I evaluate before I buy a stock:
Price/Earnings (P/E) – This is Market Capitalization divided by Net Income. The average P/E ratio in the stock universe is about 15. I shoot for a number less than that.
Price/Average Earnings for the past 7 years – To better understand a company’s earning ability, I like to look at its record for the past 7 years. I take the company’s current market capitalization and divide it by its average earnings for the past 7 years. You can look up historical earnings on Yahoo! Finance and in past annual reports filed at SEC.gov. I prefer this number to be less than 25.
Return on Equity – Calculated by dividing Net Income by Shareholder Equity (which is Assets – Liabilities). This will tell you how much profit a company generates compared to the shareholders’ investment. This indicates how “good” a company is. I prefer an RoE that is at least +30%.
Debt vs. Cash – I prefer a company have more cash than debt. Both of these items are easily found on the Balance Sheet.
Free Cash Flow – I require this number be positive. You will find a company’s Free Cash Flow in the Cash Flow Statement.
Using this information I determine pretty quickly if I think a company is cheap, good, stable, and suitable for investment. If a company doesn’t meet these criteria, I move on.
There’s no need to make this complicated. You don’t need a super high IQ or any crazy charts to pick winning stocks. You just need to define your values and be consistent. If you invest with a Margin of Safety in 6-8 stocks for a minimum of 5 years, chances are you’ll outperform most professional money managers. Trust yourself; nobody cares more about your money than you.
What if you have no interest in picking stocks?
If you have absolutely no interest in picking stocks you can buy an Exchange Traded Fund (ETF) that tracks the S&P 500 or most any other index. This allows you to take advantage of the long-term performance of the stock market without having to do a lot of work and calculations. ETFs are not actively managed like a mutual fund which means you pay minimal fees. SPY is an example of an ETF that tracks the S&P500 index.
If you have any thoughts or questions I’d love to hear from you in the comment section below.
If you’d like to join me on my mission to teach you everything I learned in business school in less than 45 minutes of reading, please enter your email address below:
Here’s what I’ve covered so far:
How to Make Money Without a Job
Purpose of an Income Statement
Advantages of a Cash Flow Statement
The $40 Self Directed MBA Finance Course
Thanks for reading and have an excellent week.
-Scott
Scott Mackes is a leader and founder of the site “Margin of Excellence”. Connect with Scott on facebook and twitter.
{ 2 comments… read them below or add one }
Scott – tough article to write. It would be more effective if you had shown the returns on your own portfolio using this methodology. How often should you re-evaluate? How do you keep your portfolio properly balanced? How do you evaluate news and its effect on your portfolio? Should you just pick stocks, ETFs (which trade like stocks), options, bonds? This is a very challenging topic to write on and I likely would have avoided it. There are probably 10 million opinions on how to do each of the above with an almost infinite number of permutations.
I’m not necessarily sure I believe the point about “don’t invest what you’ll need in the next 5 years” because that may lead somebody to not invest at all. Even $5/week is an investment for some and should be considered, even if it goes into an interest bearing account of some kind. Evaluate where your money is going and find a way to put that money to work for you. If you don’t know how to, interview financial planners that can, at the very least, help you put a plan in place that you can execute.
/rc
Ryan, thanks for your feedback. To answer your questions-
How often should you evaluate? I review on an annual basis.
News? I don’t really pay attention to it unless there is something big happening like a merger or acquisition which will affect my position. In this case I receive a letter in the mail from my brokerage company to notify me.
Should you just pick stocks or ETFs, options, bonds?
You should buy whatever you are knowledgeable about that will offer you the highest margin of safety. If you have no knowledge or interest in stock market, I would buy an ETF that tracks the S&P500 and dollar cost average.
Balanced portfolio? My two positions are cash and 6+ stocks that I believe are undervalued. I never quite understood the theory behind having a balanced portfolio consisting of multiple asset classes (unless of course all of those asset classes are cheap at the same time).
5+ year time horizon? There are a lot of folks out there who cannot retire on time because they lost 50% of their portfolio in 2009. I wonder their thoughts on the subject?
Financial Planner? It might be helpful to meet with a planner to set goals, but I would leave the execution of the plan up to the one investing the money. If you invest with a Financial Advisor, your money will most likely be invested in a mutual fund. 80% of mutual funds underperform the market average. Why would you pay your advisor and a fund manager to underperform the market when you can buy something as simple as an ETF on your own that tracks the S&P500?
I agree, there are a lot of opinions on the subject. My advice is to keep your strategy as simple as possible and always remember to think about the actual businesses behind the stocks when investing.