By Neil George
Doing your homework to understand why to buy and to own stocks will pay off and help to avoid falling victim to market disasters.
As an introduction, let me start by giving you a strong dose of reality. The market isn’t there to help you make money — it’s there to take it from you. The market employs thousands of folks collectively making billions of dollars trying to milk the average investor, while still keeping up the illusion that over the long run something will eventually work out.
But it hasn’t — as an investment in the general stock market often proves out. If you look at the S&P 500 as a yardstick, so far this century investors have lost 7.4% in price movement alone. And with the measly average dividend of 2%, it sure doesn’t pay to be patient for the long run.
There is an alternative in selecting the right stocks for your portfolio. But you need to continue to think differently than what Wall Street wants you to do to get beyond the general market malaise. And this process starts with the income statement of your next stock.
Forget about earnings -– as they can be manipulated to serve the traders and fund managers. Instead, look at the operations of the company. You want industry leaders in revenues that are rising faster than their peers. And then, you want to see that as a company sells more -– that its margins not only remain fatter -– but actually get better year after year.
In addition, you need to ask yourself -– what will go wrong for this company’s sales and profits? On the sales side, think about the threats to the business and then go back and look at when the company faced similar challenges and what happened to its revenues. Then you can begin to get a handle on true risks to your stocks.
On the profit side -– you need to ask -– what can go wrong on the cost side of the operations? Rising energy costs, labor costs, other input costs -– ask the question and then look back at when the company faced those challenges and you’ll know what to expect when, not if, challenges come.
But while sales and profits might be the fun part of picking stocks -– it’s just the first half of your work. You then need to think like a banker and ask -– would you lend money to this company, and if not -– then you shouldn’t be buying its stock.
Look at the balance sheet and the debts of the company. Is it a good borrower and moreover, when does the next bank loan or bond come due? Then what are the prospects of not only rolling over the maturing loan or bond -– but how attractive would this company be to its existing creditors, as well as new ones. If it is a good credit risk -– it will more likely not be a bad stock.
The key to these exercises is to not only pick better stocks –- but to also avoid what I call front-page risk. This is where you’re reading the front page of the financial papers and you find your stock is the next disaster of the day. Knowing what you’re buying and why can’t stop this risk -– but it surely makes the risk lower.
This homework of picking stocks doesn’t stop after you’ve clicked buy on your broker’s website or put in the call to buy on the phone. But rather it starts all over again each and every month as you get your statement. Again, holding and hoping never did, nor ever will work.
You need to go down the list of each and every stock that you own and ask yourself -– would you buy this today all over again and why. If you can’t say yes and give a good reason -– then you need to sell and move to the next better stock.
This analysis applies to stocks that might have lost you some money. You won’t make it back by holding and hoping that you’ll break even -– because it almost always will get worse.
And it also applies to your best successes. Just because you picked a winner, that stock also could turn downward. If a stock can justify being a new best pick -– you should just let it ride. If the stock, however, seems to be resting on its past glory. Sell it. Take the profit and look for a better stock. Homework pays off in school and it also can pay dividends in investing.
Neil George, a contributor to Eagle Daily Investor, is the former editor of Personal Finance and has written for investment journals in the United States, Germany and other countries.