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.

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