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.

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"...

Dividend Stocks and Money Management

Altria, or MO was about 75% of my portfolio to start the year in 2011.  This would not be considered a normal investment strategy, but it did allow me to make 18.5 percent on my total portfolio last year.  There is a time and place for all kinds of strategies, but MO made it easy, the whole year.  I love this stock for many reasons, and I'm going to try to explain, why this stock is so amazing.

Established companies payback shareholders in a couple different ways.  The stock can go higher, that is capital appreciation.  They can pay a dividend, most likely quarterly, so that you get money while you hold the stock.  They can also buy back shares in the market, essentially removing those shares, from the share float, making every share, slightly more valuable.  The float is how many share the company has released into the wild.  Essentially, how many pieces the company has been broken up into.  

Lets say you buy 100 shares of Altria tomorrow at $28, for a total investment of $2800.  Using round numbers Altria will pay you 6% a year on your investment, or $168 per year.  Doesn't sound like much?  Well keep listening...  Altria also increases their dividend about 1-2 times a year on average.  Meaning, instead of making 6%, next year, if the stock price is still at $28, you might make 7%.  As the years go on, the dividend yield you recieve on that original investment goes higher, so you dividend return on that money can be sky high, after many years of increases.

When you also have a company that buyback shares, they lower the share count, which increases the EPS automatically.  If the EPS (earnings per share) increases, they can also increase the dividend.

Basically if company A, has 100 shares outstanding, and makes $100 a year, then the EPS is $1/per share.  If that same company decides to buyback 5 shares that same year, and they have no increase in earnings throughout the year, next year, they will make $1.05 EPS because you can now divide $1 earnings per year, by 95 shares, rather than 100.

Basically the less shares outstanding the better for all investors.  If that float, is shrinking due to a buyback, that's a good thing overall.

Altria has a "pay out ratio" of 80%, meaning they will pay out 80% of all profits in the form of a dividend.  So they buyback shares, which decreases the float, and increases the EPS, which allows them to increase the dividend, that increased dividend increases the dividend yield, which likely increases the share price.  That is the virtuous circle I was talking about.

As always, feel free to ask me anything about this, in the comments section below.

Stocks that have safe, growing dividends are very resiliant in an up or down economy.  I use this stock to anchor my portfolio, and I would recommend you do the same.  By having 50% or more of your portfolio in a safe dividend earner, you will have a much easier time beating the market.  From there you can add the risky high fliers that really make this game exciting.

The reason I like one stock for my big dividend play, is because I just need to be right one time.  If that part of my portfolio works, then I can afford to lose, and take risks in other areas.  I can focus a lot of my energy just making sure this secure part of my portfolio really is secure.  I only have to listen to one conference call a quarter, instead of five.  Watch for one set of earnings reports.  This is not the type of investment you can afford to lose on.  Your high dividend yielder, should have money to pay that dividend for years.  It should be secure, and the business should have no real way to be undercut, or go broke.

From here all we need to do, is "Keep It Simple"...

Bulls, Bears, and Pigs

There's a classic saying in investing, "Bulls make money, Bears make money, but Pigs get slaughtered."  There are two different opinions, on the overall direction of the market, and they are called Bulls, and Bears.  Bulls think the market, or a certain stock, will go higher.  Bears think think the opposite.

Both parties are able to place their bets the way they want, as Bears can "Short" the market, and basically play to profit on the downside.  It's a good thing, because it keeps the market is check.  You need Bears.  If you're a Bull, and correct in your opinion, the Bears are the ones that are paying you.

A Pig is either a Bull, or a Bear, that has stayed in a trade for too long, gave back all their profits, and then some.  Pigs are stubborn.  They won't listen when the facts change.  They've been right for so long, they'll ignore all the signs that go against their opinion.  They'll ignore the both the fundamentals, and the technicals, and it will drive you mad, but also drive you find great prices on merchandise.

Fundamentals, are the actual dollars and cents behind the business.  When companies report their earnings, it's all there for you, in black and white.  Wallstreet calls these accounting numbers, the "Balance Sheet".  It calls quarterly earnings reports, "Earnings".  To know a companies "Earnings" and have an understanding of their "Balance Sheet", is essential.  Without that you might as well put a blindfold on.  You just have no idea what shape the company is in.

Technicals, are what the chart says.  You can look up any companies chart, and begin to analyze certain things.  How many shares are trading per day, which they call the "Volume".  You can analyze patterns and make suggestions as to what you believe will happen going forward.  Technicals do have merits, and I use them on every trade I make, however I do believe fundamentals are trump card.  When both fundamentals and technicals align, I like the stock even more.  Basically, if the company look poised to grow and make money, and the chart looks healthy, it's probably a good buy.

Companies either have "cash" or "debt" on their balance sheet.  Companies with good amounts of cash per share, can weather storms.  See, when a company reports a loss for the quarter, they are burning up money.  When that money runs out, they either have to borrow more, or issue new shares into the market, if they can.

Sometimes debt can absolutely swallow a company.  When you see a company in debt, and losing money, you should probably cut your losses.  I start by never buying them.  Or at least not unless I'm speculating, which means investing a small percentage of my portfolio, on something higher risk.

On to "Dividend Stocks and Money Management"...

I Don't Know Everything

I hate to admit, but no, I do not know everything about the market.  In fact, I probably don't know more than 25% of the game at this point.  That percentage however, is higher than more than 99% of the population.  My basic understanding of how the market works, is a rarity.

Think about that for a second.  Isn't that kind of sad?  Many people spend a majority of their lives trying to be financially responsible.  They want to retire with a good money.  They get insurance.  They invest in real estate.  They even invest in the market, or at least someone does for them.

Photo By N. A.

They give up this right to control their destiny, because apparently it's too hard.  That must be it, or why is nobody really doing it successfully?  I say that because you never hear people talk about it socially.  If people really love something, they can't keep it quiet, yet I never hear people discuss stocks with passion (like I do, or want to).  That never happens in regular social circles, unless your in "The Biz".

The reason is you've been taught to hate the stock market.  That right, I said taught.  You probably didn't even realize it happened, but there is a distain for stocks, and investing, and it's very prevalent.    It started with the Great Depression.  People lost a lot of money, for many different reasons, and it took a lot of years before people even wanted stocks.

We had a huge crash, and huge recovery in 2008-2009.  It was what got me to pay attention to the market. I kept reading headlines, about massive losses, so I started to watch the action every single day.  This is that contrary opinion coming through huge for me.  I knew this was my opportunity to get in, and that I had to. I was very correct in doing so.  I was buying stocks at prices that would make you shake your head today, and the whole time the general consensus was the their was much more pain to go.

You have to understand that people were taking massive losses, but I watched the market closely, and bought right into fear.  There were days when the market would lose 8%.  (Buying AAPL at $82, still makes me smile.)   I've watched so many TV shows, video clips, read news articles, listened to so many smart people, tell me just how wrong I was to buy stocks here, but I knew it was right to do so.  People who started picking up stocks into the fear, out-performed extremely.

You have to understand when I recommend a stock, I'm saying I'd buy it at a certain price point.  I'm not suggesting you buy it yourself.  I want no responsibility for what you buy, or how you trade.  I'm not doing the trading.  You are the Captain of your own ship, and you steer at your own peril.  You have to understand what your buying, why it's good, and how long you might hold it for.

Most importantly, I don't know everything.  I'm still learning just like you are.  If you think I'm wrong, call me on it, but make sure you can support your case in a proper manner.  That is how learning happens.  There are different investing styles, but your style has to work, and mine does.  All I can speak to is how I've done it, how I'll continue to do it, and if and when the next bust comes, I'll be out before much damage occurs.  All because I pay attention, and I'm not too proud to cut my losses, and admit when I'm wrong.

Let me tell you about "Bulls, Bears, and Pigs"...

Why I'm Qualified

One of the worst mistakes you can make in this game, is assuming that someone's credentials, makes them good at suggesting what direction a stock will trade.  It's normal to assume, that someone with a great education, full knowledge of a certain sector, someone that converses with different CEO's, that they understand the business the best.

The problem is, then taking that knowledge, and balancing it against, where the stock is currently trading, what's it value is, what it's earnings in future will be, and what the current market sentiment is.  This is where the connection breaks down horribly.  It's not enough to understand a business inside-out, you need to know how to apply that knowledge.

You know what qualifies a great stock picker?  Simply results.  Results in this game are always money.  If a Goldman Sachs (GS) money manager with a billion dollars to invest, was able to return 12%, and that same year, you returned 15%, on your $5000 portfolio, you are the better trader that year.  If you did that consistently over a bunch of years, I would have no problem saying that you are a better trader than one of guys at Goldman Sachs.  You are, and there's no arguing this.

Results are simply gained by being intelligent, knowing what to look for, knowing what information to discredit, and having a contrary opinion.  Investing requires you to hold a contrary opinion to be profitable.  In general, who ever is selling a stock, thinks it'll probably go lower, and anyone buying it, believes it to be going higher.  It's that difference of opinion that makes the market.

Results are what I have to offer you.  My full three years of investing, I have never lost money, in fact, each of those years I returned an average of 47%.  If you could return 47% over a ten year period, they would consider you a God on Wallstreet.  Over long periods of time, like 15-20 years, 25-30% is considered godlike in this game.

Unfortunately, I can't return 47% for you each year.  Those numbers are skewed by a particularly large 2009, my first year, I grew my portfolio by 162%.  That means if I invested $100,000,  I ended up being $262000 in my first year.  Those years are not typical.  2010 I returned 4%, and returned 2011 18.5%.

These would be considered great results by anyone who knows investing.  In this last year, I returned 18.5%, and I did it against a market that was flat for the year.  Flat meaning stocks did not go up or down.  Most people made nothing, or lost,  last year.  Many big money managers did to.  My strategy was actually safe through this time.  I can honestly say, I made 18.5%, got to speculate 20% of my portfolio, on small fun stocks, and still crushed the market, and most pros.

I've started this year also, and looked poised to out-perform.

What I do for a living, how old I am, what sex I am, those are things that have merit, but really, the only that matters in this game, is results.  If I sound like I'm making it out to be a big competition, that's because it is to me, and it should be to you too.  People have to choose sides, and opinions all the time in this game, and I love that.  You do have people that are right, and wrong, and there is a clear answer.  Competition breeds results, and will make you pay better attention.

They suggest X, I suggest Y, and when Y hits exactly as I knew it would, it makes me happy.  I liken it to a checkmate in chess.  The best part is you also win money.  The better part is your are literally out smarting people with PhD's, people who are in the pits of wall street, and the talking heads on TV, at least in terms of stocks direction, which ultimately determines price, which is the only thing that matters.

Why am I qualified?  More than my results, it's my way of thinking.  I've always been against the grain.  I see both sides to every argument, without bias.  I'm willing to listen to what the other guy is saying.  I'll learn from anyone.  I argue my points with passion, and I'm never scared to make a prediction, and stand by it, right or wrong.  It's this kind of thinking, that will be the most valuable thing you take from this course.

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It's almost time to get started, but first I have to admit "I Don't Know Everything"...