1) Only look at companies that are profitable. Ultimately, the stock price is a reflection of how a company is performing, which means how much money they are making. If a company has a positive cash flow, then they have the capability to grow, and that translates into a higher stock price. There are some companies with negative cash flows that have growth potential as well, but it is hard to value such companies, because there is much uncertainty about when and how much their potential is. Especially when you have a myriad of profitable companies to choose from, you don't need this additional risk.
2) Diversify, diversify, diversify! OK, I've mentioned this concept already, but what does it exactly mean when it comes to individual stocks? Does it merely imply that you buy five different companies? No, because some companies are very similar to each other. Diversification, when it comes to individual stocks, means that you buy companies in different business sectors. Some of the more popular sectors are financials, industrials, transportation, technology, energy, healthcare, and retail. For instance, you don't want to buy Dell Computers and then Hewlett Packard, because they both are in the computer hardware business. And you don't even want to buy Dell and Microsoft, because even if Microsoft sells software, they are both in the Technology sector.
Another aspect of diversification that people mention these days is investing globally. The concept is that it is a global economy today, and it's important to have investments in other countries besides the United States. Global diversification became especially a popular strategy in the past few years due to the "emerging markets" of the world, those third world countries that are rapidly becoming economic powers. The main emerging markets are the so called BRIC countries--Brazil, Russia, India, and China. To give you some perspective, in 2007 these countries averaged about a 10% GDP growth rate, compared to the USA's 2%. I would caution you to not get too excited though, because whenever economies grow so fast, they run into the problem of inflation, which is why despite the astronomical growth, the stock markets of Brazil, Russia, India, and China have fallen 20-60% year to date! Yes, it is important to diversify globally, but don't do it because you hope to capture the huge growth of the emergent markets. Do it for the sake of diversification, i.e. to protect yourself just in case your US investments don't do well.
In terms of the logistics of investing globally, there is a misperception, in my opinion, that you should go out and buy international companies. Yes, you are able to do that through several international exchanges these days. But I argue the better way to go about it is to buy US companies that do a lot of business overseas. Why? Because, it is more difficult to research international companies, in order to determine what exactly you are buying. Stick with the familiar companies at home. Many USA companies can give you great exposure globally. Did you know that Hewlett Packard does about 68% of their business overseas, Mastercard 50%, and Caterpillar 60%? So make sure you research this aspect when your are choosing your stocks.
3) Be wary of stock tips! It seems like whenever you talk stocks with people, everybody has an opinion of what to buy. These opinions are great for conversation, but be careful about following stock recommendations. Always do your own research, and if it comes to the same conclusion, then perhaps you can follow the advice. Especially be cautious of people who give speculative reasoning. For instance, don't buy a company because someone thinks it will be bought out by another. How do they really know that? If they really do, then it is considered insider trading (i.e. trading with beforehand knowledge of an impending event), which is illegal. If they are insiders and you follow their advice, then you'd be breaking the law as well.
Another common speculative tip is that a company has a new technology or product which will do well in the future. One of the first stocks I bought was a company called Mechanical Technology, which manufactures methanol fuel cells, or essentially methanol batteries. The reason I bought it was because I read several articles lauding the prominent future of methanol fuel cells in portable devices. These articles were claiming that methanol fuel cells could potentially increase the battery life of a cell phone by days. They also cited that companies like Samsung were on the verge of launching such batteries. This was about 2 years ago, and I haven't yet seen or heard of a single device with methanol fuel cells. I bought Mechanical Technology at around $10 a share, and it promptly fell 50% in the next 6 months, basically because the company did not make any money. In fact, I don't think it's ever been profitable...that's how great of a company it is.
How about stock tips on good companies? Relevant current examples are, "You should invest in Apple because the Iphone is going to ROCK!" Or "You should invest in Nike, because of their Olympics exposure." These statements may be deemed speculations as well. For all we know, there may be a huge flaw with the Iphone that has not been uncovered. Likewise, with the ongoing recession, it's unclear even with the Olympics, if people are going to spend money on an expensive pair of Nike shoes. But the difference here is that we're talking about two great companies that have proven their performance historically. Good companies usually find a way to sell their products, and even when they have setbacks, they are managed so well that they often recover in an even better position. So following the recommendations on good companies may not be bad, but be careful of buying them overvalued. I.e, you still need to go further and decide whether or not the stock price fairly reflects their overall value. I'll explain how to determine the valuation of a company in my subsequent articles. Talking about good companies is a good segway into the next rule.
4) Buy the 'best of breed.' The best of breed is a phrase used by investors simply to describe the best companies in a certain sector. These are companies which are usually large companies, which have been around for a long time, have grown consistently and along the same lines, have consistently beaten earnings estimates. It is easy to determine the best of breeds. You can probably just google 'best of breed+the business sector' to get an idea. Most of these companies are ones you are familiar with, e.g. Walmart, General Mills, McDonalds, Goldman-Sachs, etc.
But don't just go out and buy these companies because they are labeled best of breed. Remember to do your own research. Look at the historical data on earnings, growth, and stock price. When you research this data, also look at how they have met market expectations in the past. Financial analysts on Wall Street are always coming out with estimates which, taken together, become market consensus estimates. All this data can be found these days on your brokerage website or other investment websites like Yahoo or Google Finance. It is important to see how a company's performance matches the market estimates, because it gives you an idea of how well that company is being managed. A company can have great products, but without a good CEO, CFO, and other management personnel, the company won't be able to grow to their potential.
The other advantage with best of breeds is that in times of economic downturn, these are the companies that will be able to survive, because they have enough capital to weather the storm, so to speak. A lot of investors often think these companies are boring, i.e. their stock price goes up very slowly. But remember that your ultimate goal is to just beat the market, which means greater than 9% return a year in the long run, which best of breeds usually do.
Ok, so go look at some best of breed companies in the different sectors, but don't pull the trigger yet, because there is a further step of determining their value, which we'll go over in the next post.
Until next time, make you make some moolah.
Wow. Exact situation I am in now. That is great tips that I will keep in mind. Thanks.
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