Introduction

General Advice

• Don't listen to professionals
• Ignore hot tips, recommendations from brokerages, etc.
• Don't invest in what you don't understand
• The price of the stock is its least important measure
• Know where future growth is coming from
• You don't need to make money on every stock you pick: a few big winners offset a few losers
• "Stocks are most likely to be accepted as prudent at the moment they're not"
  • Optimism is highest when stocks are about to crash and lowest when they're about to rebound

Market cap and P/E ratio

Market cap

shares outstanding × stock price

• Invest in a company aiming for its market cap to rise (a tenbagger has 10x increase in its market cap)

Notes on "internet" stocks

• To safely buy in:
  • buy companies that indirectly benefit from the web
  • "free internet play" :: companies with real earnings and reasonable stock prices with internet ventures
  • buy companies that can use the internet to cut costs/ streamline operations

Definitions

Shares Outstanding

The number of shares owned (restricted and unrestricted)

P/E Ratio

a 500 P/E ratio means at current earnings, a company needs 5 centuries to make back the investment

Float

shares owned by investors (unrestricted only)

Market Corrections

Declines of 10% or more (ever couple of years)

Bear markets

Declines of 20% or more (every 6 years)

Why the average investor has an advantage over experts

• As a customer, you know which new developments can be big winners based on what you'd buy

Taxes

• Dividends are taxed as unearned income, in addition to corporate profits being taxed
• Long-term capital gains are taxed at half the rate of ordinary income taxes

Preparing to Invest

• Stocks fluctuate an 50% in an average year - a $50 stock will likely hit $60 and $40 in that year
• Ignore gut feelings
• Stand by stocks as long as the fundamentals haven't changed

Picking Winners

• If you're buying a company for some specific venture, make sure you know the fraction of the company that venture is
  • Ex. don't buy PG for pampers unless you know what percentage of their revenue is from pampers
• Big stocks move less, thus should be long term holds

Six Categories of Companies

Slow Growers

Usually large and old companies, typically pay generous and regular dividends

Stalwarts

10-12% annual growth, large companies; keep a few in the portfolio to be recession proof

Fast Growers

Agressive new enterprises, 20-25% annual growth :: Good when they're not in fast-growing industries :: Look for new companies with good balance sheets and profits, then sell when they stop growing

Cyclicals

Rise and fall regularly :: Flourish at the end of recessions

Turnarounds

Beaten down, typically prosper as the overall market does :: benefit from government bailouts :: restructuring; i.e. getting rid of some diworeseification :: good companies but bankrupt

Asset Plays

Sitting on something valuable that you know but Wall Street has overlooked

• To determine which category a stock fits in make sure you understand the basic business
  • The simpler the better usually

Signs of a Good Stock

• Good fundamentals regardless of how the stock is currently doing
• Out of favor/overlooked by traditional fund managers - sounds dull or ridiculous
• They do something dull/disagreeable/depressing
• Spinoffs of companies
• No institutional ownership or analysts following it
• Nongrowth industry with little competition
• A niche - i.e. drug companies, newspapers, chemical companies
  • public confidence in it - i.e. tylenol
  • Patents/government authorization provides a niche because only companies with that authorization can do what they do
• People have to repeatedly purchase it
• They benefit from technology
• Insiders are buying - Employees and executives in the company are heavy owners
  • This means shareholders become the priority to the business rather than salaries
  • Sources: Vicker's weekly insider report, the insiders, barron's, WSJ, investor daily
  • Insider selling isn't necessarily a bad sign
• The company is buying back shares
• They don't have to rely on spending to make profits (cash in doesn't depend entirely on cash out)
• They can set the price at whatever they want and retain customers

Stocks to Avoid

• The current hottest stock in the hottest industry; the one with the most favorable publicity
• Ones with too much competition or where competition could easily begin to exist
• The next amazon, disney, etc.
• Diworseification :: companies that spend their money in random acquisitions instead of buying back shares or raising dividends
  • It's usually not worse if the company establishes the success of each of its ventures before pursuing another
  • Diversifying companies are fine if their holdings have synergy (a restaurant company should acquire restaurants, not airlines)
    • Share buybacks with cash are still better
• The whisper stock
  • Wait for earnings for these companies
• Companies with most of their earnings from a single customer (middlemen)
• Stocks with exciting names
• Companies with very nice headquarters
• They dilute earnings by issuing new shares

Earnings

• A quick way to tell if a stock is overpriced is to compare the price line with the earnings line
  • Buy when the price is well below earnings and sell when it's well above
• Future earnings come from: Reduced costs, raised prices, expanding into new markets, selling more product in the old markets, or refactor/close a losing operation

P/E Ratio

• The number of years it will take the company to earn back the amount of your investment assuming earnings stay constant

Dividends

• Stocks that don't pay dividends tend to spend the money on diworseification
• Stocks that do tend to be less volatile

2 Minute Monologue

• Reasons you're interested in it, what has to happen for it to succeed, pitfalls in its path

Hidden Assets

Def

Assets not listed on the balance sheet

• i.e. patents, tax breaks
• Parent companies typically have lots of hidden assets

The Final Checklist

General

• P/E ratio, trailing P/E, how it compares to the industry
• Institutional ownership :: lower = better
• If insiders are buying
• Is the company buying back shares :: Shares outstanding are decreasing
• The record of earnings growth; are they consistent or not (may not be important for an asset play)
• Balance sheet (debt-equity ratio)
• Net cash per share - essentially the stocks floor

Slow Growers

Dividends

Have they consistently been raised, have they always been paid

• What percentage of earnings are being paid as dividends - a low percentage is a cushion in hard times

Stalwarts

• Big and unlikely to go out of business
• P/E ratio for price
• Check for diworseifications
• Long-term growth rate and if it has kept up previous momentum
• Check how it did in previous recessions and market drops

Cyclicals

• Watch inventories and supply-demand relationship
  • Look for new entrants/developments in the market (usually bad)

Fast Growers

• Investigate the fraction of the business that comes from whatever new product is supposed to make it a fast grower
• Growth rate in earnings in recent years (20-25% range ideal, 50% typically signifies that it's in a "hot" industry)
• That the company still has room to grow
• If it's selling at p/e ratio or near the growth rate
• If expansion is speeding up or slowing down
• Few institutions own the stock and few analysts have heard of it

Turnarounds

• Can the company survive a raid from its creditors
• Cash/debt ratio
• Debt structure and how long it can survive in the red while fixing its problems
• How is the company turning around? :: Getting rid of unprofitable divisions, cutting costs, increasing prices, etc.

Asset plays

• What's the value of the assets? Are there hidden assets?
• How much debt is there to detract from these assets
• Is the company taking on new debt, making the assets less valuable?

Overall

• Understand the nature of companies and the reasons for holding them
• Categorize stocks to get better expectations from them
• Big companies move less than small companies
• Look for companies that have proved their concept can be replicated and are already profitable
• Avoid 50-100% growth rates (per year)
• Avoid hot stocks in hot industries
• Distrust diverseifications
• Invest in simple, dull companies
• Invest in moderate growers (20-25%) in nongrowth industries
• Look for companies with niches
• Seek When buying turnarounds/depressed stocks, find ones with good financial positions and little debt
• Follow a story line for a company
• Trust companies with high personal investment from management (insider ownership)
• Insider buying is a good thing, especially when several insiders buy at once

The Long-Term View

Designing a Portfolio

• Sticking to a strategy is the best way to maximize long-term gains
• It's best to own as many stocks as there are situations where:
  • You've got an edge
  • Discovered a prospect that passes all tests of research
• The more stocks you own the more likely you find a tenbagger
• The more stocks you own the more flexibility you have to rotate funds between them
  • e.g. replace a stalwart with another, or just sell some of it
• Lynch owns half of his assets in 100 stocks, two thirds in 200, and the rest in 500 (essentially in 3 ranks)
• Find opportunities in turnarounds/fast growth companies
• If something bolsters his confidence he promotes it
• Balance stocks of the different categories:
• Don't buy overpriced stocks
• Stay invested in stocks long-term, and rotate stocks based on the fundamental situations
• Avoid hearing opinions on stocks that lead to bias

Category	sell when…
Slow Growers	the fundamentals have deteriorated or 30-50% gain (lost market share, no new R&D), diworseifications (or announcements of further), bad cash-debt
Stalwarts	p/e strays too far from trailing or industry average, price goes above earnings line, new products with mixed results & little future endeavors,
	p/e strays too far from trailing or industry average, price goes above earnings line, new products with mixed results & little future endeavors,
	no insiders bought shares in the last year, a major division is slumping, the growth rate is slowing
Asset plays	once someone shows up and makes it apparent that there are assets - i.e. a top investor
	they issue more shares to finance diversification, institutional ownership rises too high
Cyclicals	end of the cycle, when something has started to go wrong (raising costs), your reason for buying has ended, inventories are building up
	falling commodity prices, building new plants instead of modernizing old plants for cheap
Turnarounds	after it's turned around, debt is rising quite a bit, inventory is rising, inflated p/e relative to earnings growth, sells mostly to one customer
Fast growth	at the end of the second phase of rapid growth, if it's high rated by Wall Street analysts, p/e ratio surpasses projected earnings growth

• For fast growers, cyclicals, and turnarounds:
  • Keep as long as earnings are growing and expansion is continuing (check the story every few months as if you were hearing it for the first time)
  • Replace with new fast-growers if the price is way up and the story starts to sound dubious
    • The fast-grower you replace it with should have a declined or stagnant price with a better story
• Never sell unless the fundamentals/story change
• Load up during price drops
  • Abolish the idea of selling during price drops
• Market usually drops October-December
  • TODO stock up cash for the end of the year

The Most Dangerous Things People Say About a Stock

• It can't go lower than this
• You can always tell when it's hit rock bottom
  • Don't buy a stock just because it's gone down far
• It can't go higher than this
  • If the story and fundamentals are good and it isn't overpriced - it can and probably will
• Eventually they always come back
• When it goes to $10, I'll sell
  • Sell when you wouldn't buy more of the company
• It's taking too long for anything to happen - this is actually favorable

Summary of this Section

• Buy during market declines
• You can't predict the direction of the market
• Compounding 20-30% gains in stalwarts is quite profitable
• Long-term, stocks catch up to their fundamentals
• Stalwarts with heavy institutional ownership and much Wall Street coverage and are overpriced will decline
• Don't buy mediocre stocks because they're cheap
• Don't sell outstanding fast growers because they seem overpriced
• Continually monitor the story of a stock
• Prune and rotate stocks based on fundamentals - when stocks are out of line with reality, swap them for better alternatives
• Add/subtract to your bets in stocks when they seem favorable/unfavorable