Choosing Stocks

Most if not all employees generally get paid frequently such as once a week, every two weeks, etc.  Not many employees would accept a pay cheque once every few years as the risk of not getting paid is too high.  Working for years only to have your employer go bankrupt and losing years of pay is just too risky.

Yet when it comes to investing, this is routine.  Houses are bought with the expectation that they will be held for decades and then sold for a profit at that time.  This works well until after having spent years paying down a mortgage, a motorcycle gang moves in next door.  So much for your investment.

When buying stocks, think like an employee, demand regular payments from your investment to minimize the risk of holding it.  One way to do this is to regularly buy and sell stocks in the hope of making enough profitable sales to both cover the fees and also generate an above average return.  This requires a lot of time and work, is very risky and is almost universally unsuccessful.

The other way is to have any profits accrued by the company to be paid regularly to the shareholders.  This minimizes risk, if the company goes bankrupt in the future, at least some cash was returned to the shareholder.  Also, it’s hard to distribute cash to shareholders if the company is not earning a profit.  Accounting tricks can be used to show growing earnings, but accounting tricks cannot conjure up cash.

There are two main types of companies, dividend paying and growth companies.  Dividend paying companies will take a portion of earnings in excess of what is required to run the company and regularly distribute these to shareholders.  Growth companies retain their earnings and invest them back into the company.  One way an investor can profit is to hold and hope that over the long term the company value is retained and they can profit when they sell.  This causes frequent panics as any drop in the share price means either a loss of potential profit or an outright loss.

Another problem with growth companies is that diversification is difficult.  Since all earnings are automatically invested back into the company, over time the investment becomes a larger and larger part of a portfolio increasingly concentrating risk.  With a dividend paying company, the dividends can be invested in other companies, reducing risk over time.

This sets the first criteria for choosing a company; it must pay dividends.  The next criteria is determining what is an acceptable dividend.  The long term investment return is about 7%.  A simple rule is then if a company is paying less than 7%, it must have less than average risk in proportion to how much the dividend is below 7%.  If a company is risky, than the dividend must be proportionally higher to reflect the risk.  Johnson & Johnson pays a low dividend since it has been paying an increasing dividend for decades and the dividend rate reflects the lower expected risk.  A small company like CERF on the Toronto Venture Exchange pays a high dividend because of a short history of paying dividends and the perceived risks of both being a small company and listed on a junior exchange.

By investing only in dividend bearing companies, an investor can dial in an acceptable return at an acceptable risk level.  Risk levels can be determined by looking at various financial ratios, debt levels and historical growth.  In addition to these metrics, there is another even more powerful way to determine risk, ask the foremost experts on the company, the CEO or directors.

Actions speak louder than words.  Rather than asking the CEO or directors if a company is good to invest in, look where they are putting their money.  If they own a large amount of shares in the company or even better, own a large amount of shares and have been recently buying shares, this is a very good sign that the company is priced well below value.

For a CEO, the most rational action is to sell any shares he owns in the company that he is running.  If the company fails, not only will the CEO lose his investment, he is also at risk of losing his job.  The only reason a CEO has for buying shares in his company is if he expects that the return greatly exceeds the risk.  If he already owns a large amount of shares and starts buying even more, he is either a fool, or knows that future success is almost certain.

Since buying or selling by insiders such as the CEO, directors or other officers of the company is such a powerful indicator of a company’s future performance, all such trading must be reported to securities regulators within a short time after the trade has occurred.  This information is then available to all investors on the internet.  For Canadian securities this information is available at http://www.sedi.ca.

Insider ownership and insider buying are the most important criteria for choosing which stock to buy.  The foremost expert on a company is the person running it, the CEO.  This is the first thing to look for when choosing a stock to buy.  If the CEO owns few or no shares or if there is no recent insider buying, then look elsewhere.  If the CEO owns a lot of shares and is buying more, this is a very strong indicator that the price of the stock is below its value.  Insider selling is not as important.  Selling is the most rational thing a CEO can do, since it greatly decreases his investment risk.  Insiders will also sell shares that are given to them as part of their compensation.

To choose a stock to buy, first look for high insider ownership and preferably recent insider buying.  Next, from these stocks, look for dividend bearing stocks.  If your risk tolerance is low, look for stocks yielding below 7%.  If your risk tolerance is high, look for stocks yielding above 7%.  Personally, I prefer to buy the highest yielding stocks.  Buying a range of high yield stocks greatly increases the chances of above average returns.  If five high yield stocks are bought and one or two fail, the overall yield will still be above average.

Of course, it is still necessary to look at the company’s finances and see that debt levels are low, the earnings match or exceed the money being distributed and that the company has a good history of growth.  This will result in a small number of companies from which to choose.  Or if sufficient funds are available, some or all the companies may be bought as portfolio diversity reduces risk.

Investing 101

A few years ago investing was difficult, information was not freely available and was controlled by gatekeepers such as the brokerages, financial advisers, etc.  The gatekeepers pretended that only they could understand and interpret the complex financial voodoo of the market.  Investing was dangerous and difficult and definitely not something to be done by amateurs.  One wrong investment and a lifetime of savings could be wiped out.  Only with their solid grasp of the arcane knowledge, secret language and complex mathematical formulas and chart fitting were they able to make the correct investment choices.  Yet even with their knowledge of the divine, it was still difficult to consistently generate average returns or beat the market over the long term.  Of course, all this arcane knowledge came at a cost.  Special talents honed by years of study must be compensated.

Then came the internet.  Everything was exposed, and not just on the porn sites.  Financial theories, company information, stock prices, all of it free and readily available.

Although the gatekeepers still kept watch at their gates, they were unable to prevent the hordes from overrunning the fences.  Information became free.  Not only did information become free, powerful tools to filter and interpret that information also became free.  The gatekeepers are still at their gates trying desperately to block the flow of information and maintain their lucrative enterprises.  Sorry, but their time is over, investing is now easy and virtually free.

A good shopper knows to buy when things are on sale.  In other words they buy when the price of an article is less than its intrinsic value.  For things like groceries and the like this is generally fairly easy.  For something like stocks, after decades of being told how complex and difficult it is to value stocks, few people have the confidence to judge a stock’s value.  What they don’t realize is that very few people, or even nobody can truly value a stock.  The wizards can look at financial ratios, previous growth history and lots of other things and confidently tell you the exact price a stock is worth.  This is like knowing last week’s lottery numbers, you have perfect information on the past, but this doesn’t guarantee that you can predict the future or this weeks lottery numbers.  If it was, then with the processing power available today, all a company’s management would have to do is just get the numbers right and profits are guaranteed.  So far, the real world doesn’t work this way.  Most likely, a company that did well in the past will do well in the future, but this is also not guaranteed.  What is well proven is that the majority of companies over the long term do well with some doing better than others, and a tiny minority that completely fail.  Invest in a wide range of companies, hold them to avoid transaction fees and you are guaranteed at least an average return which will still be better than the majority of fee based investments.

To truly understand investing it is necessary to go back to the basics of why there is a stock market.  Not everyone is gifted with the ability to run a business.  Some are doomed to always be an employee.  Some may be able to work for themselves, but can’t supervise others to work for them.  A very tiny minority have the skills to actually run a business with multiple employees and even fewer have the abilities to run large businesses.

The problem is that those few with skills to run a business don’t always have the money to start or run a business.  The large majority, who individually have small amounts of cash, collectively have lots of money.  What is required is a way for the majority to pool their money and put it in the hands of the gifted few to start and run a business.  The gifted few would then use the cash to create and run their businesses and reward their investors by returning the profits earned by the business.  Of course, the gifted few would be paid proportionate to their skills as is only right.

As it stands now, there is no test to determine who has the gift of management or how great a gift they have in advance.  The only way to tell is to give them some cash and see how well they do.  This will quickly weed out the poseurs from the savants.  To facilitate this, an open market has been formed whereby the would be managers hawk their skills in running a business to the the crowds with money.  The successful managers will get more money and more pay while the unsuccessful will lose out.

For example, a prospector discovers a gold deposit.  Extracting the gold will require building a mine and refinery and also all the necessary infrastructure to sell and deliver the refined gold.  Large amounts of money have to be spent before even a single gram of gold can be sold.  Not only must sufficient funds be raised, but managers are required to oversee the building and operation of the mine, refinery and selling of the refined gold.  Once the everything is established and running, profits are assured as long as the costs to extract, refine and sell the gold are less than what the gold sells for on the open market.  All that is required for the mine to succeed is money to build it and managers to oversee the construction and operation.

This is why stock markets were created.  Wannabe managers identify a potential investment such as a gold mine and then ask multiple investors to pool their cash and lend it to the managers to build and run the gold mine.  If the managers are successful, they will be able to generate a return on the investment and give a portion of the profits back to the investors.  Each investor will receive a portion of the profits proportional to the amount of money they have invested.  If the investor is unhappy with the return or it they need cash for other uses, then they can sell their share in the company to another investor.

To make it easy for a company to raise money, it will split itself into small pieces and sell these at a low cost such as $10/piece or share.  Since it is difficult for a manager to handle all the buying and selling of company shares as well as actually running the business, the trading of shares in the business was contracted out to specialist marketers.  Whenever a share of the business was bought or sold, these marketers would charge a small fee for facilitating the trade and dealing with all the paperwork.  These are known as brokers who have set up various markets where shares can be traded such as the Toronto stock exchange, New York stock exchange, NASDAQ and many others.

When you invest in the stock market, you are lending money to a manager or managers for use in running a business with the expectation of a profit.  This profit can be either returned to you as a dividend or it can be reinvested into the business to grow the business or a combination of the two.  Although it is possible to make money by buying and selling stocks, this is not the original intent of the stock market.  The market exists to connect investors with money to managers with leadership skills.  As an investor your role is to provide cash for a manager to use in running a business.  The manager’s role is to use the cash given to him by multiple investors to use in the business to generate a profit.  A small portion of that profit will be given to the manager to compensate him for his labours with the bulk returned to the shareholders to reward them for risking their funds with the manager.

If the manager does well, his reputation will grow and other investors will want give him cash as his skills become evident.  With greater cash, the manager can generate greater profits for both himself and his shareholders.  Shareholders that are dissatisfied with a managers performance can sell their shares to someone else.  If a manager is successful, shareholders can either buy existing shares from other shareholders or the company can issue new shares to sell, effectively dividing the company into smaller pieces to allow wider ownership.

When a stock trade occurs, only three people know about the trade; the buyer, the seller and the broker.  This is where the gate-keeping occurred in  the past.  Of these three, only the broker had the means to profit from this information.  For an investor, this kind of information may be perceived as valuable as it may provide insight into the actual value of a company.  Although this may occasionally be true, generally the price at which a stock has traded is not a good indicator of its value.  Nevertheless, because the gatekeepers control this information, it is treated as a valuable commodity and dispensed either with a significant time delay after a trade or immediately at added cost.

Every publicly traded company is expected to provide regular financial updates to their shareholders.  These are generally provided every three months.  Again, in the past it was difficult for the companies to communicate directly to their shareholders.  It was easier to send the information to the brokers who would then dispense the information to the shareholders.  Another way to dispense the information was to provide it to the newspapers or other financial publications.  Although the shareholders received this information for free,  the information was mailed out resulting in long delays between the company releasing the information and the shareholders receiving it.  Again, the gatekeepers were in position to profit.  Not only could they charge for timely access to the information, they could inflate it’s perceived value by assigning all kinds of strange and powerful attributes it.  Special wizards trained in the dark arts who had made blood sacrifices under the full moon were the only ones who could properly interpret the information and for a small fee, provide it to an investor.

This has all changed with the internet.  The information is now freely available to everyone with an internet connection.  There is still an advantage to having the information before other investors for those who deal in large share transactions.  For the small investor, time is not of the essence, only patience.  Remember that you are investing in a company, you are not trying to wring small gains out of numerous transactions.  You are lending money to a manager to use in a business to generate profits.  This takes time.  To expect a profit immediately after giving someone money to use in a business is insane.  It may work for a short time, but very, very few people can consistently do this long term.  The only parties guaranteed to make money because of frenetic trading are the brokers since they charge a small fee for every transaction, regardless of any profit or loss generated by the transaction.  Of course it is in the broker’s interest for there to be numerous transactions as this guarantees significant fee income.  This has created a culture where the original intent of the stock market has become perverted from a place where money is pooled to create businesses to a place where stock trades are executed for their own sake.  The gatekeepers profit while naive shareholders lose.

It is a well established fact that a majority of businesses are successful over the long term.  In the short term, some businesses may be less successful than others.  Some businesses may go bankrupt, but this is very rare.  In general, most businesses will do well over the long term.  If you invest in a wide range of businesses, you are virtually guaranteed to achieve average investment results.  If you minimize your investment costs as much as possible by minimizing unnecessary trading, you will beat almost all actively managed investment vehicles which after fees underperform the average.  Active investing reduces volatility over the short term at the expense of reduced gains over the long term.  In my own experience, investing and holding well managed companies will result in volatile results over the short term with above average results over the long term.  The secret is to invest in a broad range of well managed companies and then hold them while the managers run the business and dispense the profits.  Constantly trying to second guess management only results in high fees and reduced returns.