Index

Strategy for selecting stock investments

Stocks offer an opportunity for increasing your capital, but since the prices of stocks can vary substantially and lose value, you should first put aside an emergency fund with three to six months' living expenses. This can be anywhere from $10,000 to $30,000 Dollars, depending on your income and budget. The money in this emergency fund should be placed in an insured savings account and should not be used for investments that may lose value.

Justification for a conservative strategy
The spectacular rise of Internet stocks which peaked during 2000 was based on great hopes but unproven business models. At the peak of the frenzy, on January 3, 2000, Yahoo(YHOO) stock had a value of $237.50 per share. As early as 1996, Federal Reserve Board Chairman Alan Greenspan had asked "how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions?". The answer came when the dot-com boom ended and prices started dropping precipitously through 2000, 2001, and part of 2002. Those who entered the market late and those who bought hoping that the stock prices would soon recover suffered great losses. In October of 2002, when Internet stocks started growing in value again, Yahoo stock was valued at only $9.39 – less than 4% of its highest value.

A conservative investment strategy requires looking at the overall performance of a company, its business models, its competition, and economic measures like sales, profits, and dividends. Most of this information is readily available free of charge from web sites such as Yahoo! Finance.

Diversify. Don't put all your money in one market sector
You can make the most profit by investing all your money only in the best performing stock, but it is impossible to know how long the trend will continue and when to sell to lock the profit. Diversification makes it possible to reduce the overall risk of a portfolio as various sectors of the market experience downturns. You can diversify with different asset classes such as stocks and bonds which produce the returns under different market conditions, or with different industrial sectors, e.g., manufacturing, financial, technology, communications, medical, etc.

One strategy for diversifying investments is to buy shares of Exchange-Traded Funds (ETFs). ETFs can be bought and sold like stocks, but they consist of bundled stocks that track an index, such as the Dow-Jones Industrial Average or the S&P 500 Index. The Dow-Jones average tracks 30 major publicly owned companies based in the United States. The SPDR Dow Jones Industrial Average ETF with stock symbol DIA seeks to provide investment results that correspond to the price and yield performance of the Dow Jones Industrial Average. Buying shares of the DIA ETF is equivalent to buying shares in all 30 of Dow-Jones component stocks. The Spider (SPDR) ETF with the stock symbol SPY tracks the performance of the 500 stocks that comprise the S&P 500 Index.

Don't buy stocks for new companies or new technologies
The percentage of new companies that are successful and which maintain a growing price per share is small. New companies face many managerial and technical challenges that can affect their bottom line adversely. New stocks should be avoided because they don't have a proven track record, but you can miss great opportunities by not investing in new companies. When Google made its initial public offering (IPO), the stock price was around $88 Dollars in 2004. A share of Google stock on October 1, 2007 sold for over $580 Dollars. With regard to Initial Public Offerings, Google represents an exception, rather than the rule. If you really, really would like to take advantage of the growth prospects of new stocks, you should not risk more than ten percent of your total capital, and you should be ready to sell if the stock loses more than ten percent of its value. Facebook provides an example of the negative surprises that can happen to the stock value of a new company. Facebook stock went on sale on May 17, 2012 at $38 dollars per share. The value dropped 30% within a month, and six months later, the stock had lost 40% of its value and sold for $22 dollars per share. Even one year after its IPO, Facebook stock was at $26.25 which was 30.9% below its initial price. Loses like this may never be recovered or may take a long time to recover.

Avoid stocks that don't pay dividends
Companies pay dividends as a reward to their shareholders. A company that cannot afford to pay dividends is probably not profitable enough, but there are exceptions. Growing companies need all the capital that they can get to be able to expand. It may be cheaper for a company to avoid paying dividends than to get a loan. In any case, stocks that don't pay dividends usually show that the company does not have confidence in its financial performance.

Stock must have reasonable P/E
The Price to Earnings ratio (P/E) is the company's share price divided by its per-share earnings. A P/E of 15 indicates that the price of the stock is 15 times the value of the per-share earnings. P/Es are usually computed with trailing earnings, i.e, earnings from the past 12 months. The P/E reflects the relative ability of a company to make money; it represents the number of investment dollars required to earn one dollar. A stock with a P/E of 20 is considered a better value than a stock with a P/E of 40 because dollar-for-dollar a stock with a lower P/E value has greater earning capacity.

Stock must have reasonable EPS
The Earnings per Share (EPS) is calculated as:

In general, prosperous companies have larger EPS values than worse performing companies. The value can be negative if the company has more expenses than income.

The 5-year chart must show consistent growth
A long-term chart is very useful for determining the sustained performance of a stock and for identifying the frequency of splits and the time required for the stock to double in value.

This is a 5-year chart of the stock price of the Boeing Company (BA) obtained from Yahoo! Finance. Although there are no splits, which would normally make the price per share more affordable for average investors, the stock shows consistent, steady growth that doubles in value approximately every three years. Notice that the price of $40 dollars at the beginning of 2004 passes the $80 Dollar mark toward the end of 2006. If you had bought this stock at the beginning of 2004, each share of stock would have increased in value from $40 to over $100 Dollars by October 2007. This is an increase of 150% in the value of your investment. In addition, during this time you would have received an additional 1.4% of the value of your investment paid as dividends.

Below is the 5-year chart for Microsoft (MSFT) for the same time period. The price of the stock shows erratic fluctuations during the complete five-year period. If you had bought this stock at $28 Dollars at the beginning of 2004, you would basically have the same amount of money by October of 2007, almost 4 years later. Your only benefit would have been the dividend payments of 1.5% on your investment. Notice that the EPS for Microsoft is over three times smaller than the EPS for Boeing.

Buy and Hold
Over short periods of time, stock values may be quite volatile. Prices can go up and down depending on current economic circumstances and the mood of Wall Street investors. But over long periods of time, the stocks of stable companies tend to grow. This is reflected in the rise of the Dow-Jones Industrial Average for the last hundred years. A good strategy for successful investment consists of buying and holding for a long time stocks of good, solid companies that produce products or services that have great demand. This is the strategy used by professional investors, such as Warren Buffett.

Should you hire an investment manager?
Before signing an agreement with an investment manager, you have to understand that the manager will not guarantee that your investments will grow. You will be charged a percentage of your total assets just for letting some "expert" manage your money. It is not unusual for an investment advisor to charge 1% to 2% a year to manage a $500,000 portfolio. That is $5,000 to $10,000 per year with no guarantee of a profit. In addition, an asset manager that buys and sells stocks may collect extra commission fees for stock trades. Sometimes customers wonder whether the trades are done for the benefit of the portfolio or just to generate commissions for the asset manager. Active trading can also have expensive tax consequences. Short-term capital gains for securities that are held for one year or less are taxed at a higher rate than long-term capital gains. Think hard and calculate the costs before you hire an asset manager. You may come out ahead managing your own money.

Try it yourself
As an exercise to give you experience in picking stocks, you should try to select the three best performing stocks of the Dow Jones Industrial Average using the criteria discussed above. Once you have selected the top three stocks, write down the cost of 100 shares of each of your three stocks. Track the prices and the value of your investments on a weekly basis for three to six months to determine if you would have made or lost money. When you have confidence, you may try it with real money by establishing an account with a broker such as ETRADE, Scottrade, or Charles Schwab.

Conclusion
A stock broker can advise you about buying stocks, but with preparation and confidence you can make very intelligent decisions yourself. Buying stocks is always risky, whether you use a broker or choose the stocks yourself. The historical performance records in the charts provide very useful insights for picking stocks, but as they say in the trade: "Past performance may not be indicative of future results". There are always uncontrollable external factors that can cause panic selling and bring prices down. Times of instability such as the 09/11/2001 World Trade Center disaster or the sub-prime credit bank crisis of 2007 erode investor confidence and cause stock prices to drop. During these times, investors who have a long-term perspective are able to acquire good quality stocks at good prices.

---