Tuesday, March 23, 2010

Fundamentals

Sometimes stock market analysts are grouped into broad categories--fundamental analysts and technical analysts. Fundamental analysts study the fundamentals of a company, such as its sales, pre-tax profits, earnings per share, dividend growth, indebtedness, book value, price/earnings ratio, etc.

Technical analysts study the price movement of the stock, looking for "support" levels (a price at which significant buying is expected should the stock drop to that point) and "resistance" levels (a price at which significant selling is expected should the stock rise to that point). A technical analyst looks for stock price momentum to determine whether to buy or sell. This decision may be made without asking whether the company is a good long-term investment (based on the fundamentals).

Technical analysis is sometimes part of a larger strategy called "market timing" that considers both the price movement of the individual stock and the momentum of the company's sector or the broad stock market. Both individual stocks and the broader market tend to swing up and down within various ranges, either trending upward (in a bull market) or trending downward (in a bear market). Sometimes, if an individual stock is strong enough, it can "buck" the broader trends and either hold its own or show price gains even in a bear market. Also, if a company is doing poorly, it's price may be flat or decline even during a bull market. A market timer seeks to buy a stock at or near a bottom and sell a stock at or near a top. I'm not smart enough to call tops and bottoms of markets and (for me) this distracts much-needed brain cells from what I believe is a more important task: identifying good long-term investments.

An extreme form of market timing is called "day trading," where someone may buy and sell the same stock on the same day, trying to "lock in" a small gain on the transaction. This is a labor-intensive, all-consuming enterprise that looks only at the numbers. A day trader may have no idea what the company does. He or she may be acting on a news report or a recommendation from a service that provides up-to-the-minute day trading recommendations. I understand the concept, but this usually requires putting very large amounts of money at risk in a single transaction in order to make a few cents on a trade. My central nervous system isn't wired for day trading.

A fundamental investor is less concerned with the day-to-day (or minute-by-minute) up and down movement of a particular stock or the broader market as long as the company's fundamentals continue to look good. Sometimes a major bear market (like the one we experienced in 2008-2009) gets the attention of both fundamental and technical analysts because a severe economic downturn may damage a company's fundamentals as well as causing a strong downward movement of an individual stock and the broader market.

Around 1995, I became interested in real estate investment trusts because I believed their dividends would provide some price support in a market that seemed to me to be getting overpriced. Around 1997 and 1998, I began to move some money within my pension fund account out of equities into a more defensive blend of bonds and other fixed-income investments. The market continued to climb until March, 2000, when it peaked in what came to be known as a "high tech" bubble, when technology stocks peaked. I missed two or three years of the market's upward momentum by avoiding tech stocks altogether and cutting back on my exposure to the broader stock market. I was early but my sense that the market was overheated proved to be correct. (One didn't have to be brilliant to recognize the frothiness of that bull market. Many people recognized it but were content to hang on for the ride.) That movement of funds (in the late 1990s) out of the broader stock market into REITs and other fixed-income investments was the only time since 1982 that I felt like I was thinking and acting like a "market timer." It wasn't very sophisticated. I was simply fearful and looked to dividends for some degree of security. I identified with Charles Allmon's reply when once asked if he was a "bull" or a "bear." He said, "Neither. I'm a chicken."

My general approach has been to follow the NAIC principles of looking for growth companies (based on fundamental analysis), investing regularly regardless of market conditions (disregarding the advice of market timers), reinvesting earnings and dividends, and diversifying by size and industry.

Since I began investing in the stock market in 1982 there has been a large increase in the number of media outlets covering the financial markets. The Internet has made a vast amount of data available to everyone. The competitiveness of the financial news business has led to an increase in the amount of "technical analysis" advice. Analysts are commonly asked whether "this is a good time to buy" a particular stock or stocks in general. There has been increasing interest in the short-term prospects for the broader market. Much of the buy or sell advice sought and given in the financial news media is irrelevant to someone with an orientation toward fundamental analysis and an approach that looks for good long-term investments.

I don't pay attention to short-term "technical" indicators. I don't try to "time" the market. I try to stay focused on the fundamentals of individual companies.

Monday, March 22, 2010

Growth Stocks

While stating my philosophy and approach to investing in these early blogs, I should mention another mentor--Charles Allmon. He was a long-time columnist for Better Investing magazine. He published a newsletter called Growth Stock Outlook. When Allmon left the newsletter business in 2008 at age 87, William Baldwin of Forbes noted his retirement after 44 years of publishing recommendations for growth stocks.

The Forbes article asked what Allmon had learned from reading an estimated 100,000 company financial reports. He said the most important thing is sales growth. "In the long run, a company cannot grow any faster than its sales. I look at sales first, earnings second and balance sheet third."

Allmon has made some great recommendations. In my early years as a subscriber to Better Investing, his column was always my first read. In 1987, I purchased some shares of a closed-end mutual fund he founded, Growth Stock Outlook Trust (named after his newsletter). I remember watching the old Financial News Network as the market crashed in 1987. Allmon had been correct in saying the market was overpriced and his GSO mutual fund was mostly in cash when the market fell. As I watched the carnage on Wall Street, I thought, "Allmon is scooping up some bargains today." I was surprised to learn that he was not a buyer that day nor in the days that followed. He thought the market was still overpriced and he missed a great opportunity. That fund was a disappointment in an otherwise stellar career. He seemed to be thinking more like a market timer rather than the great stock picker he was.

In spite of the fund's performance, Allmon has been a very helpful mentor. He taught me the importance of thoroughly scrutinizing a company. Though a growth-stock picker, he put a strong emphasis on the company's balance sheet. The events of 2008-2009 reinforced the wisdom of his approach. He enjoyed recommending companies that had lots of cash. He knew the importance of dividends and he often pointed out the rewards of buying companies that paid cash to its shareholders.

The financial markets have been increasingly segmented in recent years, with some managers focusing on growth, some on value and others on high-income stocks. Allmon had a growth orientation, but he also looked for value. He welcomed dividends. He taught me to look for stocks that have all three of these characteristics. When I find a growth stock at an attractive price that pays a good and expanding dividend, I always feel like I've found a gem, a real treasure--a stock that Allmon would like.

The name of this blog was, in large part, inspired by Charles Allmon: GROVALINC--growth, value and income.

A Comfort Zone

When it comes to stocks, I'm somewhere between plain vanilla and downright boring. I'm more tortoise than hare. NAIC's philosophy is to "get rich slowly." Patience is your friend as long as you're willing to move quickly when opportunity arises or when a mistake needs to be corrected.

I've had more success with individual stocks than mutual funds, so I won't be recommending mutual funds here. I don't buy on margin. I don't short stocks or recommend short sales. I'd rather focus on the positive and find good stocks to buy. When it's time to sell a stock, I'll say why and then move on. I don't use hedge strategies, hedge funds or sector funds. All these tools have a place in the investment world, but I prefer plain stocks.

I rarely invest in technology stocks, although one could argue that Diebold and Emerson Electric are tech stocks. I avoid the high-flying stocks like Yahoo (in the late 1990s) or Google (now). I like Google. I'm using it to write this blog! When Peter Lynch managed the Fidelity Magellan fund, he said he liked to buy stocks that use technology (like grocery stores using scanning devices) rather than buying companies that develop or manufacture technology. I agree, but mainly because technology isn't something I understand and it changes faster than I can keep pace. I enjoy using technology but I'll let others invest there. Lynch said if you cannot explain a company in a sentence or two, don't buy it. Invest in what you understand.

I've bought bonds in the past, but not with much success. A Royce convertible bond once netted me some shares of Royce Value Trust, which was a good thing. I enjoyed reading Chuck Royce's commentary on the market in his quarterly reports. I prefer utility stocks and real estate investment trusts as alternatives to bonds.

A good portion of our retirement income is in defined-benefit pension annuities, which I consider fixed-income. So, to achieve balance, the part of our retirement income that I shepherd is in equities. Everyone has to find a comfort zone and mine is the equity market.

The stock market is a fearful, unknown place for some. It's misunderstood by many. Some see it as a way to gamble, enjoying the thrill of "playing" the market. When some friends and I organized an investment club in 1982, one of our original members kept wanting us to buy some "hot tip" stocks so we could make a quick profit. He couldn't buy into the "get rich slowly" motif, so he left the club after a few months of mutual frustration.

The stock market has been home for me since 1982. There have been some roller-coaster rides, such as 1987, 2000, and 2008-2009. There have been numerous surprises but not too many mysteries. If you can develop a sense of fair value for a stock and stay focused on your goals, you can keep your head while others are irrationally exuberant or dejectedly pessimistic. Then, the stock market can begin to feel like home.

Two Sleuths

I'm always on the lookout for a good idea. What's the difference between a hot tip and a good idea? For me, it's at least 24-hours worth of investigation. Where do I find good ideas? I glean publications like Better Investing, Forbes, Barron's, the Wall Street Journal, and various websites like Seeking Alpha.

Peter Lynch, the former manager of the Fidelity Magellan mutual fund, taught me several things. His book, One Up On Wall Street, was based on the premise that often the average person can spot business trends before the financial pros, and these observations (such as which stores in the mall are full of customers) can translate into good investment decisions. Lynch taught me that a bear market is not an unusual event, it is a recurring event (like winter). No need to panic; just be prepared. Lynch also taught me that good bedtime reading is the Mergent's Handbook of Dividend Achievers (formerly Moody's Handbook of Dividend Achievers). It's published quarterly and about every three years I'll buy a copy of the Spring edition because it includes the December quarter, which is the end of the fiscal year for many companies. Peter Lynch taught me to keep my eyes open and pay attention.

John Templeton, founder of the Templeton mutual funds (which later merged with the Franklin Funds to become Franklin Templeton) was one of my heroes. He was always a steady rudder in a choppy sea. He was a master at finding good investment ideas, and he pioneered in the arena of global investing. I admired his skill, but I decided not to follow him overseas. I do not have the time or the resources to investigate foreign investments, so I leave this important aspect of investing to my professional pension managers. Templeton taught me the importance of thinking globally, however. He also taught me something about hope. I was always amazed at his ability to see the big picture and to look beyond any present malaise that might be looming.

Value Gurus

Over the years, NAIC's monthly publication Better Investing introduced me to some classic books about investing, including The Intelligent Investor by Benjamin Graham and Security Analysis, by Graham and David Dodd. The principles in these books helped me formulate some common sense ideas about stock valuation. The general public talks up stocks during a bull market, creating peer pressure to "get in the market." The public talks down stocks during a bear market, creating peer pressure to "get out of the market." These swings have been enhanced by the proliferation of media outlets now covering the stock market. The news media tends to focus on the latest trend or "hot idea," much of it directed to market-timing.

Value investors like Benjamin Graham look beyond the hype for bargains, or at least reasonable prices. Warren Buffett has practiced Graham's principles to great effect. These two people have given us a legacy of common sense and practical judgment about stocks. Buying a stock is buying into a company. When I'm tempted to follow the latest fad or the most recent hot tip, my judgment is tempered by the principles these investors have practiced.

NAIC

The National Association of Investment Clubs was formed in 1951. To be inclusive of individual investors, the organization changed its name to the National Association of Investors Corporation. NAIC has long championed four principles: 1) invest regularly regardless of market conditions--preferably a set amount each month; 2) reinvest all earnings, dividends and profits; 3) invest in growth companies--companies whose earnings are growing faster than the general economy; and 4) diversify by size and industry.

One of NAIC's founders, George Nicholson, developed a tool called the Stock Selection Guide, which enables a person to graph ten years of earnings per share, pre-tax profits, and price range. This tool, coupled with one's judgment about management, debt levels and competitive factors, enables one to get an idea of a possible price range for the next five years. Many individual investors and clubs have used the SSG and other NAIC tools to make informed, common-sense decisions about stock purchases.

NAIC publishes a monthly magazine called Better Investing. I have been reading this publication since 1982 and it has helped me understand the importance of growth. Steady growth of earnings, over time, drives the stock price up. So, when studying a company, I look first for a history of earnings growth.