Final Stock Market Post...at least for awhile.

In the middle of the week that saw the Dow Jones index decline 500 points in one day due to the biggest financial institution collapse in history, i.e. the Lehman Brothers bankruptcy, I am continuing my series on the stock market, because I want to encourage everyone to keep their faith. Although the stock market will probably be down for awhile, try not to join in on the despair, but rather think of these times as potential opportunities to invest. I am not telling you to go out and buy a financial institution betting that it has bottomed, but stick with the game plan, i.e. what we went over in the previous posts in terms of buying the best of breeds and objectively determining the value of companies. The current general loss of confidence will bring down the stock prices of very good companies not related to the subprime and credit crises, allowing you to buy these companies at a discounted value. So onward we go. In this post, I will go over what you need to do after establishing your portfolio.  

After setting up your portfolio, the first thing you should do is identify exit points for your investments. Basically, there are two exit points, one for when to take profits, and one for when to cut your losses. I've already mentioned my personal exit point for taking profits, which is a 20% annual yield. Again, I came up with 20%, because the the best investor in the world, Warren Buffet averages about a 25% yield, and I don't presume to be as wise an investor as he is.  

So let's say one of your stocks goes up 20%. So should you sell all your shares, or just a portion in case the stock potentially goes up more? A common stock advice is to sell in increments, so that you capture the profits all the way up. I argue that this should not be a set method. Again, it comes down to valuation, and from our last post, we learned how to do that. If a stock goes up 20% and results in an overvalued P/E ratio, then you should sell all your shares. However, if the P/E ratio still seems cheap, you could sell a portion, perhaps half, and keep the rest for further profits.  

But then you ask, why shouldn't I just hold onto the shares if the company is still cheap? The answer is because the stock market can be extremely volatile. If, for some reason, investors lose short term confidence in a company, even if it is profitable, the stock price can drop substantially. We are seeing that this week with the investment brokers. Morgan Stanley just reported a very profitable last quarter, but after their earnings report, their stock price dropped over 20% on concerns about the profitability of the investment brokerage model in general. The bottom line is that you're in the stock market to make money, so it is prudent to lock up profits, or all your efforts could potentially be for naught.  

When to cut your losses is a little more difficult to determine. A cardinal rule that we've already established is that you shouldn't be in companies that aren't profitable. So for instance, if you bought a company that was in good shape when you bought it, but for some reason started losing money, that is an absolute time for you to get out. Apart from this cardinal rule, how much of a loss you can take depends on how much anxiety you can stomach.  

Let's look at an example. There are very few best of breeds among banks these days, but one of them is US Bancorp (USB). USB has been hovering around $33 a share for most of this year, but beginning in May, it began a decline due to the overall concern about the financial sector. If you had USB on your watch list, you would've seen it's P/E ratio fall during this decline. Looking at its historical P/E's, it is a great value at a ratio of 11, which translates to a price of around $27. If you had bought it at that point, you would've seen it drop further, reaching a low of $22 (-18%) on July 15, 2008. However, since then, it has rebounded to a 52 week high of $35. So what are the lessons to learn here?  

One is that if you are confident of your research before you buy a stock, you should have the conviction and patience to see your gains through. But yes, it's easy to say that in hindsight, so another lesson here is that you should think about these scenarios before you buy and decide how much you can take to lose. In the beginning of these stock posts, we established that when you are investing in individual stocks, you need to be using money that you can afford to lose. That being said, it still hurts when you are down hundreds to thousands of dollars, and if you are human, such significant losses will keep you up at night. That is no fun, so this is why you need to establish an exit point to cut your losses. This exit point may not be objectively the right investment decision, but it does address an even more important aspect of investing, i.e. preserving your state of mind. You need to determine an exit point that's comfortable for you, but I would make it at least -10%, since stock market volatility easily accounts for single digit percentage fluctuations. For me personally, I use -20%, as I have found, looking at historical price charts of most best of breed companies, rarely do the prices drop more than 20% if you buy at a discounted value.  

The last point I'm going to make in this article is that you need to keep on researching your stocks after you buy them. It's kind of like managing your finances--the more frequently you check your budget, the better. Keep up with current P/E ratios, earnings reports, earnings conference calls, and news reports. Every now and then, you'll get a game changing event, which won't necessarily show up on your local evening news. Earlier this year, when General Electric missed it's earnings for the first time in over two years, it was the beginning of a steep decline. If you listened to the conference call of those earnings, it was clear that the earnings miss was largely due to the financial arm, which makes up half of the company. GE, like Lehman Brothers and all the ailing financial institutions, was too involved in the real estate market, and the stock price is reflecting this even now. That conference call was the first glimpse of this reality, which should have alerted GE shareholders to the probable decline of the stock until the housing and credit crises resolve. When you are managing your portfolio, keeping up with these news events is essential.  

Believe it or not, I think I've covered most of the basics in stock investing. I think the only huge thing I've left out is the dividend, which is a direct payout to shareholders of a company's profits. Some people make a big deal about dividends, because sometimes even if the stock price is low, the dividend can still give you a good yield. But the stock price should not be that low if it reflects a good company. So, personally I treat the dividend as merely an addition to the annual yield...that is, if it is even paid out. Companies usually pay dividends every quarter, but that does not always happen. In fact, companies can easily change their dividend at any time, so for me the valuation of a company is a more reliable reason for me to buy the stock.  

Of course, there is a lot more to learn in the stock market, but there will always be more lessons in this game. The stock market will inevitably humble you over and over again, but hopefully, these posts have given you the tools to avoid huge mistakes, which of course, means less money in your pockets. Until next time, may you MAKE some moolah.