Stocks Are Leading Indicators

Stocks are leading indicators.  This is true because of how the market is designed.  People who play this game, make bets about the future of a stock.  Regardless of their betting direction, it's that looking into the future, that makes the market trade in advance of factual information.

The people that are making these bets often have very good reason to do so.  They understand the prospects of what they are buying and selling.  They understand the fundamentals of the business.  This understanding, can come from having a ground level perspective, just keeping your eyes open socially for trends, or in illegal cases, insider trading.

It's these bets, from people with a perceieved knowledge of the situation, that makes stocks leading indicators.  This means a stock doesn't report good earnings, and then move higher, it moves higher, then reports good earnings.  While it is true, you will see stocks pop the day after results, those people are late, or traders.  In 99% of cases, they've missed a great run already.

This game is not that easy.  You can't just see the results, make your bets on winners, and keep winning (okay well sometimes, thanks AAPL!).  The results these companies report, are old, and we're making bets on the future, not the past.  This is a "what have you done for me lately" market, with an extremely short memory.  You have to know a key piece of information, and you have to be right about it.

In 2010, I saw Apple, and Android's products, in everyone's hands, and concluded RIMM's life was short lived.  I saw the business niche Blackberry had eroding.  I saw RIMM's stock topping out, going from an out-performer, to an inline stock, and eventually to an under-performer, on up, or down days.  I knew RIMM was up against two very big, very tough, great tech companies (GOOG and AAPL), with more evolved ecosystems, not to mention NOK, MOTO etc..  That was enough to put RIMM on my do not buy list for 2010.  RIMM got massacred that year.   Six month's after my call, I must've seen 20 of my 300 Facebook friends, long time Blackberry enthusiasts, say they were switching over.  Selling at any point in the last two years, was pretty much, correct.

The stock was, and still is, the perfect leading indicator.  The overcorrection in RIMM is the red herring here.  If RIMM's business was just slightly slowing, it's stock would've declined at a more gradual pace, especially with a back drop, of a slightly appreciating market.  Even when accounting for a shrinking PE, due to slower growth, I would've expected RIMM's stock to find bases, at $40, or $50 based on it's pretty good earnings.  Good stocks do that.  They get hit with a decline that wasn't warranted, or was just profit taking, therefore become attractive, and become good buys.

Photo By N. A

RIMM's stock didn't do that.  It decided to go right to $15 in almost a straight line.  I understand about over-correction, but that was ridiculous.  As it happened, I knew I was even more correct than I had imagined.

If you had just paid attention to the conference call, and watched the earnings reports, you might have never even seen this decline coming.  People are still scooping up RIMM, for what they feel is "on the cheap".  Right now, it appears RIMM will bring in at least $4 a share this year.  If that's true at $15, the PE is only 3.5.  That seems very cheap right?

I trust my gut, and the stock action, way before the earnings predictions.  The stock is screaming, very loudly, EPS is going to shrink, and fast.  It's way more likely now that RIMM will only earn $2, or possibly, god forbid, post a loss in 2013.  Otherwise, why would the stock plummet so far?

The people who rode RIMM down, weren't listening to all the signs I've been teaching you.  I do feel sorry for them however.  They missed every signal, saying sell.  They missed increased competition.  They missed the stock action giving them many technical points to sell.  They missed the change that was going on the ground, where Apple, and Android, just had better products, and ecosystems.  They forgot that RIMM was trading as a high growth tech stock, a 35 PE, and couldn't afford to have slowing growth, in this booming sector.  They forgot RIMM had all there eggs in literally one basket, and wasn't really innovating new products.  They forgot RIMM lost its title as the "only phone for business use".

Looking back, it's obvious.  However, the past doesn't make you money.  As I sat there Dec 31st, 2009, that was the time to really be right.  Like we talked about in "What Goes Up, Doesn't Need To Come Down", sometimes you have to go against the grain.  Your not going to have all the reasons these people were wrong, laid out for you in a nice post on "The Dice".  What you will have, is the stock action itself, and the ground level evaluations, both leading indicators.  If the stock action, and the fundamentals seem to be aligning, it might be time to make the buy.  If overall, the stock action is going against your perceived  fundamentals, that should send off alarm bells.  You need to be damn sure those earnings are there, and growing at their perceived rate.  Most of the time, you'll just be plain wrong.

What Goes Up, Doesn't Need To Come Down

People actually attempt to apply the laws of gravity to stocks.  It so drilled into our heads, that what goes up, must come down, people try to apply this physical law to stocks.  A stock can go up, stay up, and then go up some more. 

The amount of terrible advice, and mis-information out there is astounding.  People suggesting to sell, or buy, for all the wrong reasons.  Like I've mentioned before, so much of this game is just keeping an open mind, not allowing yourself to get stuck on one piece of information, and discrediting the nonsense.

You'll hear people say,  "I sold because the stock had run too far", or "I bought because the price has been cut in half."  I'd say about half the people who invest in stocks, never calculate a PE ratio.  It's the only true way to value companies, yet some could care less.  You need to be always evaluating where you stocks are currently.  Just like we talked about in the "Dreaded PE Ratio", keep checking your stocks to see how they are valued.  As the price moves up or down, and as the companies earnings do, that PE will change.

This will sound funny, but these kinds of folks must prefer just to guess if a stock is over, or undervalued.  Wallstreet calls buying a stock after a big upwards run, "chasing".  It calls buying a company where the stock is declining rapidly "catching a falling knife".

The mistakes I see daily in this game are inexcusable.  I'm left stunned that someone who's supposed to be very intelligent, deciding a stock is a sell, for all the wrong reasons, while it's as clear as day to me, the stock is a buy. The reasons why people can be so incorrect on a stock's direction can vary greatly.  With so many factors, reasons for being completely wrong, are easy to find. 

The most glaring reason is the stock action itself.  When you see a successful company's stock, trending higher over a period of years, it's much easier to stay on the bandwagon.  You have been correct for years, all the other investors have been correct also, so who are you come in and spoil their party?  If you are right, and the stock has peaked, and will decline soon, you'll have hundreds of stocks owners telling you just how wrong you are. 

It works the same in reverse.  A stock that has fallen heavily over a period of time, the people that owned the stock and sold it, hate it, because they lost big bucks.  They will trash that stock until the end of time.  The people still in the stock, hate it also, because they are losing money big time.  Then's there's a select few, that have taken the losses, but still believe in the underlying company.   When a new buyer like yourself, come in and decides this stock has fallen too far, maybe the business prospects changed, or the valuation has gotten too cheap, understand that most people will call you crazy.

Going against the grain is necessary, and very profitable.  You need to be agnostic towards the stock, and company.  This is where good traders make their money.  Greed, Stubborness, Denial, are all human emotions, and when applied to the stock market, will lose you money. It counter-intuative, but it's usually when the naysayers are the loudest, that your buy, or sell call, will be the most correct.

Let me tell you why "Stocks Are Leading Indicators"...

The Dreaded PE Ratio

The amount of shares outstanding varies from business to business.  One company might have 1 million shares outstanding, while the next, 1 billion.  Not only that, the float size can change at any time, depending on the company's actions.  They might sell more shares into the market to raise money, or decide to buy back shares to shrink the float, and increase Earnings Per Share (EPS).  Sometimes companies do "splits" and "reverse-splits" which restructure the float, and share structure.

The amount of shares outstanding, is simply the amount of pieces a business has been broken into.  In the example above, the billion dollar company has been split into a billion pieces.  That's 1000 times more shares than the company with a float of one million shares.

How do we then compare these companies Apples to Apples?  We use a "PE Ratio", or a price-to-earnings ratio.  This ratio allows us to see the company for what it earns, per share outstanding, and factors the current price of the stock.  Sometimes, people call the PE, the "multiple".

Basically the ratio, takes the "Price" of the stock, and divides it by the "EPS".  You can calculate the earnings per share for any company, by taking their total income for the year, and dividing it by the amount of shares outstanding.  This will get you the "Earnings" for the stock.  You can then take the price the stock is currently trading at, and divide by the EPS, and come up with a PE ratio.

This is exactly why the price of a stock has almost zero value.  You can't look at a stock like Apple trading around $440, and call it expensive.  Tomorrow Apple could do a 10-1 share split, increase their float tenfold, but the share price going forward would only be $44 each. 

Buying Apple at $440 with a billion shares outstanding, is the same as buying it at $44, with 10 billion shares outstanding.  The price may seem more attractive, but both buys are exactly the same.  Sure, you can buy 10 times more shares at $44, but there's also 10 times as many shares out there.

You can't just compare EPS to EPS, because we'd be completely ignoring what price the stock is currently trading at.  The last step, dividing the Price by the EPS gets you a PE ratio, which will factor the price the stocks are trading at, as well.

If your calculations lead you to conclude that Apple is trading at a 16 PE, and MSFT is trading at a 12 PE.  You can say for certain that MSFT is cheaper than Apple at that point in time, assuming earnings projection for the year are accurate.  In some cases, you'd buy MSFT because it was a better value. Other times, it's okay to pay more for a better quality stock, with better growth options if that's what you decide makes sense.

Different sectors, and different size companies have a different baseline, for what is a usual PE for that "group" of similar stocks.  Safe, establish companies might only warrant a 10-12 PE due to slowing growth.  A small cap tech stock,  with a hot story, might warrant a PE of 100.

There is a ton more about PE's I can't discuss in this blog post.  Understand one thing about PE's though, they are subject to interpretation.  PE's make the market.  Usually at what growth rate a stock has, has a big impact over what PE it deserves.  In the end, the market will decide what fair PE is for certain stock in certain sectors.

The winners in each sector always deserve a premium to the rest of their group, because that business has superior earnings, and prospects.  The best companies, in their respected sectors, are called "Best Of Breed".  If you see a best of breed company, trading in line with it's pears, after previously out performing, check out their core business.  If they truly are a better company, it's might be just the time to snatch them up.

Time to bend the laws of gravity, in "What Goes Up, Doesn't Need To Come Down"...

Cash Is King

How much money do you need to get started in the stock market?  The answer is as much as it takes, to keep you interested.  You need to care about your stocks, and care about the money.  This will cause you to pay attention to the latest news releases, and earnings reports for your stocks.  It will cause you to sell the stock, taking 10% losses, but saving that other 30%, had you rode it down.

An Example.  Fred invests $500 in Starbucks, and loses 10%.  His investment is now $450.

Jim invests $50000 in Starbucks, at the same price as Fred,  and loses 10%.  His investment is $45000.

Fred is down $50, and probably feeling pretty okay.  Jim is down $5000, and is probably seriously considering selling.

Think about that.  These are the same percentage losses, with the same entry point, only the amount of shares are different.  Who's correct to sell, or not, I'm unsure.  I do know both bets are exactly the same.  They must have the exact same answer.

Photo By scottchan

Caring about the money will make you take caution when the stock is sliding, and the nice profits from correct bets, will keep you playing this game.  You need to care about the money, and that goes both ways.

If I were starting a new investment account today, I'd like to have at least $5000 to get started, with a focus to get that level to at least $10,000 as soon as possible.  If that sounds like a lot to you, don't fret.  This market isn't going anywhere.  Taking a year off the market, to save, and study your possible buys, would be the ideal thing to do anyway.  I know you won't do it, I sure didn't.  I needed to "get in", but that feeling also causes you to miss great entry points.  Overall it's bad investing.

With $10,000, I'd be looking for a high dividend and portfolio stabilizing stock.  The percentage dedicated to my high dividend yielder, would vary year to year.  If I felt we are set to boom that year, that dividend yielder might be 20% of my portfolio.  In scary times it might be as much as 75%.  I trade around this core holding, and use it as my rock.

Some people might suggest a basket of dividend yielders to make up the 20-75%, I do not.  A basket is when you buy multiple stocks to spread around your risk.  I don't like that strategy.  This stock is my rock, like I said.  I need to trust it absolutely.  Good safe dividend yielders will find a floor, even in the worst crashes.  If the market wants to cut Altria (MO) in half, making the dividend a growing 12%, I don't care what's going on in the world, I'm a buyer.  I've never seen anyone lose, long term, buying a safe dividend, that was way too high.

Pay attention to what stocks are making money, when the market as a whole seems to be selling off.  That trait is special to only certain stocks.  Big money gravitates to a few key names in time of crisis, own some of those stocks.  Some of my best days are when the market is down one percent, and my stocks are flat.  Those are hidden profit, but they add up to generally outperforming.

The business needs to be able to pay that dividend, and grow that dividend, for years.  I watch one stock, listen to one set of conference calls, and trade around the holding as I see fit.  This also ensures you are collecting dividends on a high percentage of your portfolio at all times.

Photo By David Castillo Dominici

From there you can use the remaining portion to buy stocks you like, and speculate.  I tend to carry only about 5 stocks at any one time.  It keeps me focused, and keeps the percentage of my portfolio for that certain stock, higher.  With 20 stocks, the average stock would represent only 5% of your portfolio.  Even a double wouldn't get the blood pumping much.  You'd also incur more trading costs, being in and out of all those holdings.  Besides when you invest in too many different stocks, you end up taking an average, and that's not a good thing to me.  That's why I'm not a big fan of mutual funds in general.  You also can't keep up with the news, and the conference calls.

When I'm speculating, I only like to have 5% in any one spec.  In this case, that's $500.  I'm talking very small cap stocks here.  Stocks with no earnings, and big growth stories that could take years to develop.  If your Uncle Bob, approaches you with a great tip, resist the temptation to go "all-in".  Invest $500.  If the story develops further down the road, add more.  Five bucks says you don't.

People over invest in Uncle Bob all the time.  They lose their money, have no idea why, and become a thorn in new investors side, with their negativity.  In reality they invested too much money, in a super small cap they didn't understand, one that had all or nothing type of risk, and never followed what was going on with the company, or the stock, the whole time.  I have a word for that, but I do not call it investing.

Keep your investment level high enough, so you can clearly feel the positive and negative swings.  Balance that against broad market sentiment, and the fundamentals of your stock.  After a bear rally, I watch the technicals, to see a certain stock, or a certain group of stocks level off, and form a base.

A base is simply a period of time after a selloff, where new buyers come in with support, not letting the stock dip below a certain level.  This creates a sideways-like trading that is the foundation for the future move higher.  After further evaluation, I will either cut my losses, hold the stock, or buy more as the stock drops depending on the circumstances.  As your stocks trade higher and lower, whether they are a buy right at this moment, or not, changes.  A stock cut in half can be dead money, or a huge opportunity, depending on the fundamentals.

On to "The Dreaded PE Ratio"...

Averaging Up or Down

Averaging up, or down, can be a solid tactic to maximize your profits.  It's also a very dangerous one.

Let's say you have purchased 100 shares of Apple at an average cost of $400 per share.  If your reason for buying, or your "thesis" is correct, then as the share price drops, you actually have to like the stock more.  This applies even more greatly, if an outside force is impacting the market, and your stock, is poised to beat earnings.

If Apple's stock price were to sell-off, rather than sell the stock, a keen buyer, may average down, by buying an additional 200 shares.  That would mean this person currently owns 300 shares at an average cost of $366.66.  This is the definition of "averaging down".  This buyer now owns more stock, but at a lower cost basis.  They could sell the stock if it get back to even, or ride all 300 shares to even higher profits.  They don't however, have to wait until $400 to be back to even, that comes at $366.66.  

It works the other way too.  "Averaging up" means buying more shares on the way up.  I prefer averaging up because you are chasing a stock that is already going the direction you want, but both methods while completely necessary to good investing, carry risk.

That person in the first example, who bought a 100 shares of Apple, looked at the fundamentals, listened to the conference call, studied the technicals, and all that happened, was they lost $50 per share.  This can happen to different stocks, and different people, for different reasons.  I can't really blame you if you make a good buy, and the next day, an unexpected market event, starts a bear rally.  

That's why it's right to average down, when you are sure the stock is cheap, and the general market activity is a bunch of hocus-pocus, that doesn't affect your stock, on a day to day basis.  This stock must have great qualities.  Earnings, earnings growth, possibly a dividend for support, and visibility, are all needed to average down safely.  

Most of the time, you'll just be plain wrong.  The stock was wrong.  The timing was wrong.  The investment amount was wrong.  A whole bunch of the time, when you evaluate a stock, and it goes down, it is correct to sell.  Compare your stock to the overall market, if it's under-performing it for any length of time, you should have a good idea why.  You can always sell, sit on the sidelines with your money, and then come back in at a lower price, and when the stock is finding support technically.  Most of the time, you'll probably just move on to better things.

You can't just sell the stock every time one falls though, because there is no doubt, as the price falls, the stock gets cheaper.  I know doesn't sound very ground breaking, but it is.  That 200 shares at $350, are a way better buy, than the 100 shares at $400, if the company will rebound eventually, and appreciate in value.  

$350 shares, are 87.5% of the $400 price.  That's 12.5% savings on those shares.  It's so much easier to make money in a stock, when you get the correct "entry price".  It's not a bad idea to dip your toe into a stock, knowing you'd like to increase your position at a later date.  This way you can average down, or up, as the situation demands it.  You won't always be able to get in, at the perfect price, so having the ability to buy more shares is a back up plan.

When you are averaging down, you are chasing a stock that is moving lower.  When averaging up, you are increasing your overall cost basis, in the hopes of even further profits.  Both those are extremely risking strategies unless you are correct about the longterm fundamentals of the business.  The good news is, if you are correct about direction the stock will take, you can't go wrong with either strategy.  

This is why "Cash is King"...

Big Caps Vs. Small Caps

The word "Cap" is short for Market Capitalization.  Market Capitalization is simply the amount of shares a company has in their float, multiplied by their current stock price.  This number is supposed to give you an idea of a company's overall value, and size.

There's small caps, mid caps, and big caps.  All they're referring to, is how big and established the company is.  Most people who own, and trade stocks, use mostly big caps to do so.  These companies are established.  They have been around for years.  They have name recognition.  They have an earnings history.  They have a chart you can study.  They have big name CEOs.

Big caps are the easiest, and safest stocks to trade, for all the factors I just listed.  For a company like IBM to lose half of their share value would be completely shocking.  It would take a market crash at this point, or a complete business catastrophe, to ever get back to that level, and it the decline could take weeks.  By contrast, a small cap could lose half it's value in a day, pretty easily.

With small caps, a lot of time we're taking about companies who aren't currently making money.  You have to be extremely careful with companies that aren't making money.  If they aren't making money, they are burning, or spending it.  At some point, if that little company can't turn a profit, it will need more funds to survive.  They can add debt, if a lender is willing to lend them money, they can sell assets, or they can attempt to release brand new shares into the market.

Any shares issued by a company after they've had their inital public offering (IPO), are called a "Secondary".  When this happens, most of the time, it's a bad thing.  As more shares are added to the float, your current shares become less valuable, because there are more of them distributed.  The company is in a sense, selling more pieces of itself into the market, and they will recieve money back for each piece.  We'll talk about "Dilution" more in a future post. 

Understand, there is more risk in small caps, but there is also more profit to be had.  You would be surprised how many small and mid caps, go virtually unnoticed, even if they are doing a great job.  Quality small businesses do go largely unnoticed in this game.  Big money likes established names, and predictable earnings.  Much of the time, they completely ignore these smaller companies, even knowing they are good, and will wait until they grow more.  Basically you will find gems out there, and it will be easier than you think, because these small companies just don't get exposure.

Most people when they start this game make the huge mistake of allocating a lot of funds, to small cap companies.  The market offers all kinds of business' from very safe, to very risky.  I'd prefer the first stock you sink some real money into, is a reliable big cap.  You'll have more information to work with, and the stock will have less volatility.  You'll have a trust that this company will be around for a long time.

There's a huge difference between buying McDonalds, a big cap, with great earnings viability, and a dividend, and a small cap Chinese semi-conductor company, with no earnings, that trades on the Chinese stock exchange.

Let me teach you "Averaging Up And Down"...

The Conference Call

Most public listed companies are expected to release their results every 3 months.  Smaller companies may just put out a press release, but more established companies use a "Conference Call".  During this time the company releases their results, from the 3 previous months, via a audio presentation, telling you revenues, earnings per share, and other details.

The conference call is proceeded by a press release with the basic details of how the 3 months turned out. Then it's up to the management team, to clarify those results, and answer questions.  Different companies have different ways of measuring success, because businesses are different. Wallstreet calls them "Metrics".  You always want to know what metrics Wallstreet gauges a certain stock on.  Those figures allow analysts to make projections, and come up with an estimated earnings per share (EPS) for the current year, and in future.

These conference calls contain a ton of amazing information about the market.  You get to know the management team on a personal level.  You can hear their confidence, or lack thereof, in their voice, and about the business' future.  You hear them answer tough questions.

The best part is nobody really listens to conference calls.  For the most part they are boring.  Actually sitting down and taking 30-60 minutes to review you stock, every three months, is too much work for the average investor, and even for some pros.  Here we have an amazing resource, where at times, I've literally heard CEO's say, there is no way we don't make more money than last year.  They don't say it in those terms, but they say they have more customers, that will pay a higher price point, which always equal more money, if they execute.

These CEO's are obligated by law to tell you the truth, and 99.9% of them do.  They are all however, masters at bending that truth.  A good CEO can paint a beautiful picture when times are great, and still a pretty decent one, when times are tough.  They know how to spin their business' to make them sound better, and there's nothing wrong with that.  You just need to be able to read between the lines.

The first stock you buy, why not listen to a conference call, watch a couple of earnings periods before you buy?  This is some of the work involved in determining how to value a stock.  A lot of the time it's just watching, reading, and listening.  The majority are too lazy to do all that.

That's great news for anyone who isn't.  If you put in just a little time a week, and listen to the conference call, you should be able to eventually make an informed decision on whether or not, you think something is buy, or a sell.

Listening to the conference call is probably the smartest thing you can do in investing.  There is nothing more important than fundamentals in this game.  If a business has good fundamentals, it has good profitability, with growth potential.  You can find out right from the horse's mouth, if now is the correct time to buy that certain stock, or whether there could be danger ahead.

Most people don't listen to conference calls, good thing your not most people.  Now, on to "Big Caps Vs. Small Caps"...