Tuesday, December 14, 2010

Investment Lesson #3 - Stocks

Stocks are one of the most popular and accessible investment vehicles for individuals as well as institutional investment firms. But what is a stock anyway?

According to Wikipedia:

The stock or capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors. Stock is distinct from the property and the assets of a business which may fluctuate in quantity and value.

Security, gee doesn't that sound safe? It's basically what is invested in a company also known as its market capitalization. You may have heard of stocks referred to as securities or equities. The value isn't just the value of the assets that it owns, it's also what price investors are willing to pay to own a piece of that company.

Back to Wikipedia:

Market capitalization/capitalisation (often market cap) is a measurement of size of a business enterprise (corporation) equal to the share price times the number of shares outstanding of a public company. As owning stock represents ownership of the company, including all its equity, capitalization could represent the public opinion of a company's net worth and is a determining factor in stock valuation.

When you buy the stock of a company you are basically becoming a part owner of that company. Although you might not make day-to-day business decisions, as a stock holder you do vote to accept or reject things like who should be president of the company, who should be on the board of directors, if they should continue to use the same accounting firm and other matters that the board of directors decide to present at a meeting with the stock holders. That's right, you actually get invited to a meeting though most of the stock holders at large publicly traded companies usually vote through a proxy. Some privately owned corporations issue stock but generally when we speak about stocks we're talking about tiny pieces of public companies that are bought and sold through the major stock exchanges via brokerage firms. There are several types of stocks, common stock, non-voting "preferred" stocks that pay dividends like bonds. Then there are some things like ETF's (exchange-traded funds) that are traded in the major stock exchanges which aren't really stocks but they represent groups of companies and then there are mutual funds which we'll get into detail later. It may sound complicated at first, and it gets even more complicated as you get deeper into it. That's why there are so many financial advisers, stock brokers, financial analysts and reporters broadcasting a never-ending stream of spreadsheets, earnings reports, graphs, ticker tape and, well--confusion.

The first point I should cover is why would a company want to go public and invite total strangers to become part owners? The simple answer is, to raise money. Why not just take out a loan? Companies do take out bank loans and issue bonds, which you've learned from our last lesson are loans that investors can buy and trade--but these are debts that must be paid back with interest. Debt reduces the value of a company. Stocks represent the equity of a company and doesn't need to be paid back. If a company is expected to be profitable, investors will tend to bid up the price of the stock. The price of the stock multiplied by the number of outstanding shares equals the company's market capitalization. The company can then sell some more stock which might somewhat dilute the value of those outstanding shares but the money raised does not need to be paid back.

It is to the company's best interest, and to their stockholders, to keep the stock price up. Sometimes companies even buy back their own shares to take them out of circulation and raise the value of the outstanding shares.

There are many factors that go into the value of a company's stock price. Obviously there's the number of outstanding shares, the hard assets owned by the company and the revenue it generates but there's also price to earnings ratio, debt ratio, price history, analysts' expectations, meeting estimated earnings and many other factors. Different industries are also valued in various ways. A hi-tech company developing a cure for cancer may need money for many years of research and testing before it becomes profitable, but if investors believe that the company will succeed, the stock price can go through the roof even while the company is loosing millions of dollars. Of course if the clinical tests fail the stock price will most likely come crashing down.

I should emphasis that I had no role model when it came to investing. In fact my father was very much opposed to investing in stocks and referred to it as legalized gambling. He blamed Wall Street for the economic recession that resulted in his becoming unemployed in the 1970's (see Recession of 1969-70) and he never invested in stocks. Neither did my mother, though she wanted to start a business, invest in real estate and do other things with the money she put away in the family savings account.

If there was only some reliable source of information that could guide me through this treacherous but potentially highly profitable stock market. In fact there was, or at least at the time I thought I found the sage who would make sense of the stock market. I was still in high school when Wall $treet Week with Louis Rukeyser first aired on the local public television station (PBS) but I tuned in every Friday evening whenever possible to listen to Louis Rukeyser explain complex investment strategies in simple to understand terms, quiz his panel of investment experts on the future direction of the market and find out what stocks his special guest was buying.

Years later when I still had my photography studio and was getting myself out of debt I decided to start investing in the stock market. I had a list of stocks which I thought might make good investments, not too risky with fair growth potential, and called up the local Merrill Lynch office, got in touch with a stock broker and set up an appointment. When I got to the office I was in awe, it seemed that I stepped right into a major stock exchange though it was just up the street from my studio which was at that time in Orange County, California. We discussed various stocks on my list and the broker suggested I buy shares in Weyerhaeuser. I was familiar with the name because I've seen it stamped on lumber, reams of paper and even my parents mortgage was through Weyerhaeuser's financial division. I bought 30 shares and became an investor. The broker was telling me strategies like buying more on the dips and selling if it outruns its 200 day moving average then buying back as it dips below the moving average but the stock didn't move very much. In fact, it was a very boring stock and underperformed the construction sector as well as the overall stock market. Obviously the broker recommended the wrong stock for me. I waited until it rose in price, just a bit, and sold out my position. Even though I sold at a higher price I didn't really make a profit because I had to pay the broker's commission. If I would have bought and sold several times like the broker suggested, I probably wouldn't have made more money but the broker would have received his commission every time I traded. This is known as "churning" and is illegal if overdone. In any case, I didn't loose my shirt and it was a good experience seeing how it all worked.

I still had an appetite for investing so I hit the books. That's when I found out about mutual funds. Oh sure, I knew something about mutual funds because many of the experts on Wall $treet Week were mutual fund managers but because it was a PBS series they were not allowed to advertise their funds on the air. Mutual funds are basically investment vehicles where a group of people pool their money and allow a manager to invest it for them. Sure, rich people have investment managers but they charge quite a lot for their services and have minimum investments of hundreds of thousands of dollars. Some mutual funds have minimum opening investments of just a few hundred dollars--some even waive the minimum if you sign up for an automatic monthly investment plan of as little as $20 per month. At least that's what it was when I was getting started. Some of these mutual funds were getting fantastic returns, far above the market averages and the mutual fund companies were hiring the best money managers and paying them a king's ransom. The Magellan Fund had returns averaging 20% when I looked into it and advanced as much as 116% in a single year! Alas, the minimum investment was far beyond what I could afford but I did find 20th Century (now American Century Investments), Strong Funds (now either out of business or absorbed by another company) and finally Fidelity Investments--the company behind the Magellan Fund.

At this point I wasn't completely out of debt and if there one thing I learned from all that reading was to pay off creditors before investing. Then an interesting event happened, Black Monday -- the stock market crash of 1987. Stock market crashes have happened many times in history. Perhaps the most famous was the crash that triggered the Great Depression in the 1930's, aka Black Tuesday, but similar events have happened long before, for example the panic of 1901 and tulipmania in the 1600's. It seemed like everyone was panicking in 1987, everyone except Louis Rukeyser. What did he know? Were his personal investments impervious to the crash? What he knew was that a crash was a perfectly normal event in the crazy world of stock market investment and it should be seen as a buying opportunity. In fact there is a style called "contrarian investing" where you basically try to do opposite of what the majority of investors are doing.

Once out of debt and into investing through mutual funds a few interesting changes occurred with me. First of all, it was much easier to save because I didn't have as many bills to pay. I also found that instead of buying the latest and greatest photography equipment or getting a new car, I was more interested in building up my investment portfolio. I did almost buy a house around this time but we'll get into that story in the real estate lesson. I set a goal of building my investment portfolio to $500,000, move to a quiet town and retire as early as possible--certainly no later than 55 years old. This was a time when my father was very ill and eventually died of liver cancer. Working, making lots of money and collecting material possessions didn't seem very important to me anymore.

My mom was getting interested in what I was doing and asked if I could help her out with some money she had set aside. Reviewing her finances, one of the first things I recommended was to pay off her mortgage. Even though there was only a few years left to pay off the house I was able to save her several thousand dollars in interest. We opened up a joint account at Fidelity Investments and deposited $20,000. I was much more conservative with her money and found out that her account would often outperform my own more aggressively invested portfolio.

It was around this time that I started working in the motion picture industry. I liked photography, but I didn't enjoy paying bills, going on appointments, collecting what was due to me, much of my profit would have to go back into the business in order to grow and things like health insurance for a self employed single guy was getting very expensive. Working a union job I got free health care, retirement benefits, a decent salary, had few expenses and it was fun, or at least it was a change from what I was doing the past 10 years as a still photographer.

I continued to read investment books. I found out that when the news reported on "The Dow" it was only a group of 30 companies picked by the company that owns the Wall Street Journal. There are other indexes that are useful for reporting stock market averages like the Standard and Poor's 500 (here's a link directly to Standard and Poor's), the Russell 3000 and the Wilshire 5000. All of these indexes give the "big picture" of how the overall market is performing. But who wants to be "average" right? I was looking for ways of doing better than the market averages.

One method involved investing in only no-load mutual funds offered by Fidelity Investments. The idea behind this is that there are far too many mutual funds to try and follow, about 9,000 in total, so by picking just one company and narrowing it down to only the funds without up-front fees or commissions, known as loads, you would be choosing from some of the best quality funds. There were still too many funds but by subscribing to a newsletter called Fidelity Monitor, you could get recommendations depending on your investment goal and model portfolios showing how well the picks performed.

Another method involved investing only in one Fidelity sector fund at a time. The way this works is that not all market sectors move in the same direction at the same time so if you can identify which sector is moving up the fastest, jump on that and ride it until another sector performs better. Investing in a sector fund was supposedly safer and easier than picking individual stocks and there were several indexes that could be used to verify movement in the various market sectors. I subscribed to a mutual fund newsletter called the All Star Fund Trader. because their single sector fund history included several years of outstanding performance, over 40% in some years, while managing to avoid the worst market downturns by switching into a money market fund.

Mutual fund investment newsletters are plentiful, all promising fantastic returns. There's even a company that rates the newsletters, Lipper. However, subscribing to these newsletters can get expensive. I was paying about $400 per year for just two newsletters. Somehow I wasn't getting the same returns they were reporting. Maybe I wasn't switching funds at exactly the right time? Maybe they had more money and thus lower fees in their accounts? As it turns out, most newsletters overstate their returns.

I was doing fine with mutual funds and was satisfied with the strategies and returns I was getting until the early 90's when I signed up for America Online and got access to a whole new world of real-time investment advice. One of the most popular forums at AOL became The Motley Fool which was started by a couple of brothers, David and Tom Gardner, just out of college. They wrote articles which turned into books about investing using an entertaining writing style. They suggested beginning investors start with an index mutual fund that tracks the Standard and Poor's 500 stock index. However, they also wrote about why small-time individual investors have an advantage over large institutional investors when it comes to picking individual stocks. Things have changed since I bought those few shares of Weyerhaeuser as discount brokerage firms started becoming more popular. You no longer had to deal with a stock broker, trading stocks could now be done online. I followed the Gardner brothers portfolios online and they outperformed everything I have ever seen before. I was interested in improving my returns so I started selling my mutual funds and buying individual stocks.

This was also around the time I met Rosie, got married and bought a condominium. We'll get into more details about our first home in the real estate lesson but let's just say that I was able to put a down payment of 20% and still had plenty of investment money left over to continue playing the market. I kept reading and taking on more risk, it seemed so easy to make money. I didn't know it at the time but I was riding one of the longest running bull markets in history.

As you've learned from the previous lessons, I don't like to borrow money. However, there are some situations where taking out a loan makes sense. One of them is to leverage an investment. My Fidelity brokerage account qualified for margin trading. What this meant was that I could buy more stocks than I had money in my cash reserves. The way it works is that I basically take out a loan using the stocks that I own as collateral. Fidelity would charge interest on the margin positions but the rate was low compared to other kinds of loans because it was secured by the value of my investment portfolio. I could pay off the loan by depositing more cash or selling some stock. Buying more stock than I could afford has it's risks. If the value of my portfolio falls below the outstanding margin balance I could get a margin call and some people have been wiped out financially when the stock price fell so rapidly that they couldn't sell the stock fast enough to cover the margin call. I used margin sparingly back then but don't use it at all these days.

There is another form of borrowing that I learned from reading The Motley Fool, but never used. If you believe that the price of a stock is going to fall, you can actually profit from it. The technique is called short selling or shorting a stock. The way it works is that you borrow some shares of the stock you want to short from the brokerage firm, sell it, wait for the price to fall, buy it back when it hits your target price and then return the stock to the brokerage firm. You get charged interest for the value of the shares you borrow so it is very much like taking out a loan. Some people have make fortunes on other people's misfortunes but short selling involves quite a bit of risk. The possible gains are limited (the price can only go to zero) but there are no limits to the possible losses you can incur if the stock price goes up.

By the late 1990's I amassed a sizable portfolio for Rosie and me as well as for my mom. I was also working on a job that required lots of overtime so I was earning a rather large salary but didn't have the time to enjoy it. We did have cable service at work and we had the financial news running in the background. It was impossible to ignore what was going on with the technology sector of the market. Anything associated with computers, networks or had a dot-com in the company name was skyrocketing in price. I started trading companies like Yahoo, Amazon.com, AOL, Microsoft, Apple and lots of lesser known start ups that have gone extinct since the Dot-com bubble. Of course I didn't know we were in a bubble and I was getting into dangerous territory but I was making lots of money. I didn't feel comfortable, one day I'd make a 20% profit on a trade and the next day I'd loose 40%, I still owed a hefty mortgage on the house, I was burning out at work. Keeping up the portfolio was taking up more of my time. I would get up before the stock market would open to place my orders and would use tactics like stop loss and limit orders to keep any losses to a minimum. These were the days when everyday people were getting into day trading and even though some of my orders would trigger buy and sell commands on the same day, I didn't want to get into what was looking more and more like gambling.

I decided to sell out most of my non-retirement positions and pay off the mortgage. I was a great feeling for Rosie and me not to owe on the house. Some of my friends thought I was crazy to do this, they were taking out home equity loans in order to buy more stocks. For about a year it looked like I made the wrong choice, the market kept climbing. I did continue trading in our retirement accounts and there was my mom's portfolio that I was still managing but I wasn't trading at a maniacal pace.

I also started investing in ETF's which are sort of like index mutual funds but they can be traded like stocks. The advantages they had over mutual funds included being able to set buy and sell order automatic triggers. The disadvantages included not being able to setup automatic reinvestment of dividends (some companies pay stockholders dividends on the profits) and having to pay the bid and asked for spread which is something that brokerage firms would rather you not find out about because it adds to their profit and isn't as up front as the discounted commission fees given to online traders.

At this point I also started investing in an index mutual fund. I read about John Bogle and his market theories. To quote: "Mutual Funds can make no claims to superiority over the Market Averages." In fact the majority of mutual funds under perform the market averages and in addition are tax inefficient because they tend to trade often and the mutual fund investors are taxed for any distribution even though they don't usually receive the pay out. I opened an account in his Vanguard S&P 500 Index Fund and set up an automatic investment plan starting at something like $200 per month. We never noticed the money going out every month and every year I increased it a little more.

When the dot-com bubble did finally burst I was in the process of buying our current home so I was almost completely out of the stock market and since my mom was moving in with us, her account was mostly in cash. Well, so I'd like to say, our retirement accounts were still heavily invested in stocks and I saw the value of our retirement portfolio tumble. At one point my retirement account was worth about half of what it was when the market peaked. Remembering my lessons from Louis Rukeyser and the Motley Fools, I didn't panic, I saw it as an opportunity to get back into the market so I started building back our investment portfolio.

Most of my new investments in our Fidelity account were either ETF's or stocks of companies I knew quite well. When I started working at DreamWorks Animation the company gave every employee 100 shares of stock when it first went public. I thought that was a good gesture so I bought another 100 shares in their employee plan. However, I always liked Pixar movies better so I also bought Pixar stock too. As it turned out Pixar far outperformed DreamWorks Animation until Disney bought Pixar in 2006.

Now I must admit that every once in a while I'd take a very small portion of my portfolio and invest in something outrageous. Once we were discussing electric cars at work and I discovered a company called ZAP, for zero air pollution, that imported electric cars, scooters and bicycles. I found out that their stock was trading very cheap because a deal they were trying to make to import Smart cars fell through. I did some research and found that many investors were shorting the stock and it was down to about $0.30 per share. I bought 1,000 shares for about $300. As it turned out the company announced plans to import cars from China, the stock started to climb, I bought another 1,000 at $0.50 per share and then something amazing happened, the stock was caught in a short squeeze. One day I looked at my account balance and found that the stock shot up to over $1 a share. I sold enough to cover my initial investment so whatever happened next would be pure profit. It went as far as $3 per share then started heading back down. I've heard of 10 baggers but this was the first time I experienced it.

This lesson on stocks came out much longer than I anticipated. Of course there's much more that I could have included. Here are a few more tidbits just to make the lesson more complete.

Warren Buffet - Berkshire Hathaway.

Warren Buffet is one of the wealthiest men in the world. He is the chief executive officer (CEO) and primary shareholder of Berkshire Hathaway, Inc. He made his fortune by investing in companies. There are many books about him, his investment style and his philosophy but what I found interesting was that you could hitch a ride on his current investment strategies simply by buying shares of his company. The original (A shares) Berkshire Hathaway stock never split, as I write this one share of Berkshire Hathaway will cost you $120,600. There's also a second offering (B shares) that does split and is much more affordable for the average investor. I owned some of these B shares for a while. During the time I owned them, the stock underperformed. Sure, Warren Buffet was one of those people who made some very good decisions early in his career and was able to maintain an average investment return of about 20% for many years, but eventually his investment portfolio became so big that now it is difficult for him to outperform the market averages. In fact many people would probably agree that his investment portfolio affects the overall market.

More foolishness.

What about the Motley Fools? They are still around but the outstanding returns they were reporting in the mid-nineties aren't looking so impressive these days. Much of their early successes had to do with them including America Online in their portfolio which at the time was one of the best performing stocks. As far as I know the main reason they bought share of AOL was because they started as an AOL forum and included the stock out of courtesy to their sponsor. Their other stock picks did go up, but lagged way behind AOL. They wrote several books about stock investing including one for more conservative investors called "The Foolish Four." The idea behind this was based on an older strategy called Beating the Dow or Dogs of the Dow. Basically, you buy the worst performing stocks from the 30 companies in the Dow Jones Industrial Average. The idea being that these are the best managed companies in the world and their excellent management team would do everything possible to keep up with the other companies on the index or Dow Jones will drop them from the list. How well has it worked? Below average and they stopped recommending that strategy. After the dot-com bubble burst the Motley Fool lost 80% of their staff and they nearly went out of business. If you look at their current portfolios you'll see that they can't consistently outperform the market averages.

We still haven't recovered from the dot-com crash.

Most of the hi-tech companies that fueled the dot-com craziness of the late-nineties were listed on the NASDAQ. An index which includes all of the companies in that stock exchange, called the NASDAQ Composite Index, reached an all time high of 5,132.52 on March 10, 2000. Today, over 10 years later, the index stands at 2,288.47, less than half its peak value. The overall market has done much better. For example, the Dow Jones Industrial Average which was at 10,367.78 on March 10, 2000 is now at 10,653.56.

Note: Just to clear up any possible confusion, you can't directly compare one company's stock price to another company's stock price and you can't compare stock indexes to each other by their "points." These are relative values and it is like comparing the currencies of different countries.

Don't try to time the market.

You've probably heard the old rule, "Buy Low and Sell High." When applied to stock trading this is known at "Market Timing." Basically, you buy when the market drops and stock prices are relatively cheap and sell when the market peaks and stock prices are expensive. The problem is, how high and low will the market go? Jumping in and out of stocks often causes what's known as a "Whipsaw Effect." The way this happens is that your buy order is executed then shortly thereafter the stock drops enough to trigger your stop-loss order. Forecasting market direction is difficult though in hindsight it seems easy to figure out when you should have bought and sold. I tried to time the market and have failed to do any better than average. That said, though I don't really believe in luck, I guess I've been lucky--that's a paradox, isn't it? I cashed out of my non-retirement stock investments in the late 1990's in order to pay off the mortgage, just about a year before the dot-com bubble burst. I also made a major change in our investment portfolio in early 2008 in order to reduce risk and simplify. By putting about half our money in a bond mutual fund I kept our losses from being much worse during the housing bubble crash that caused a very serious economic recession. Had I tried to time these events I most likely would have missed them.

Dollar cost averaging vs. a systematic investment plan

I didn't really explain Dollar Cost Averaging properly. The way it works is if you have money saved up and ready to invest but instead of investing all of it at once in one lump sum you make small periodic investments until it is all invested. This works when your investment period includes a market dip but basically dollar cost averaging is a form of market timing and it generally doesn't work any better than lump sum investing. In fact if you're investing during a bull market dollar cost averaging does much worse.

However, a systematic investment plan does work--Finally, you're probably thinking, something that works! In this case you're also making periodic investments but you never had a lump sum in the first place. If you invest the same amount every period which is usually monthly but it could be weekly, quarterly or yearly, you're buying more when prices are low and less when prices are high. In the long run this investment strategy works very well. Of course systematically saving is the first step in building wealth and the more you can put aside, the faster your savings will grow. The more money you have saved, the more you can invest--just don't invest it all, remember to always have a cash reserve just in case.

Looks like I ended up on my soapbox lecturing about savings once again so I'll end with another famous quote, this time by cowboy philosopher Will Rogers:

  • "If you got a dollar, soak it away, put it in a savings bank, bury it, do anything but spend it. Spending when we didn't have it put us where we are today. Saving when we've got it will get us back to where we was before we went cuckoo."
--Will Rogers, Nov. 24, 1930