Top Ten Investing Rules for Common Folk

I am not an investment advisor. My dad was quietly successful, and I have been, too. These rules are what I use, most of which originated from watching and helping my dad, and have been firmed by my own war stories.

Some general statements? Sure. Investments are not one-night stands. No, you don’t have to (and shouldn’t) marry it, but don’t bail just because you have a fight. Do research, get other opinions, and then make a commitment. A down-tick doesn’t mean it isn’t what you thought it was – find out why it happened. Be confidant in your decisions, and weather the ups and downs. Sometimes you need to bail, yes, but don’t live your investing life focused on being burned.

Don’t have the temperament to buy individual stocks? Stick to mutual funds – blue chip, mid-cap. Stay away from small cap and emerging markets, including the pseudo-ethical investments (green companies, don’t-test-products-on-animals companies, etc. – the primary reason to select them has nothing to do with making a profit). If you don’t have the temperament to sleep at night with individual stocks, you are simply buying into a distinction without a different with higher risk mutual funds.

You need safe? Then go safe. Don’t kid yourself that you take a high-risk approach by shifting the decisions to an overpaid Wall St. jock and thereby both reduce your stress and ensure your profit. Doesn’t happen. You are in or out – pick one – and don’t take it personally if you’d rather be out. Roller coasters are not for everyone.

Need help on selecting a mutual fund? Go here. Select all 5’s. You end up with a couple dozen funds that have good returns and preserve capital. Funny, that seems to conflict, doesn’t it? If you have “above the Lipper 1, 3, and 5 year averages” on return, doesn’t that automatically mean you have preserved capital? They call them “averages” for a reason – above today, below tomorrow. Go safe, sleep well.

The rules below are organized to follow the life cycle of an investment. Hope some of them are useful to you.

List:

1. Never put “at risk” more than you can afford to lose.
2. Focus on industries that provide goods or services whose demand don’t rely on an expanding economy.
3. Know the industry, not just the company.
4. Focus first on reasonable debt levels then current profit.
5. Find the lowest transaction cost to buy and sell as you can.
6. Put your long-term investments in DRIPs and direct stock buys.
7. Watch for changes in senior personnel, and always presume they were forced out.
8. Learn the basics of macroeconomics, and apply them to your industries.
9. Falling prices are buying opportunities.
10. No one ever took a loss selling at a profit.

Discussion:

1. Never put “at risk” more than you can afford to lose. There’s a difference between investing and putting money “at risk.” Consider monies that are covered by net asset value to be not at risk. Take the annual dividend (if any) and multiple it by 14 – consider those monies covered and not at risk (this is assuming a 7% return which is higher that the market generally allows). Pick one of these measures – not both. This is your “core value.”

How much of your investment exceeds the core value? This amount is relying on future earnings. That’s not a bad thing, per se. Some earnings are rock solid. Some seem comfortable. Future earnings come from improved (or continued good) performance or expanding markets. At some point, you need to note, the future earnings become speculative. Any current stock price attributable these speculative amounts is “at risk.”

This is where the so-called experts have made a calculation for you. Read their reports as best as you can get to them (the free ones – never pay for a company-specific report). Don’t let these reports rule: They’ll change as soon as the next news cycle or earnings report comes out. Do a gut check: How many years of earnings are built into the current stock price? One or two? Very cool but unusual. Five to seven? Not so cool – particularly when you start to discount future years for uncertainty.

An example: Why did the Internet bubble burst? Heavy long-term debt load (more below) and no profit to back up the price. The overwhelming majority of those prices represented investment dollars at risk. If risk is not defeated by growing core value or increased near-term earnings, it is always realized in a decreased stock price. Reality happens.

2. Focus on industries that provide goods or services whose demand don’t rely on an expanding economy. Surprised that Starbucks is tanking as a company? I don’t even know if they are publicly traded. Don’t care. I walked several blocks in Boston and saw just as many Starbucks. Talk about competing against yourself. I hear tell that coffees cost four or five dollars each. I don’t care how pretty you are, when money gets tight, no one will notice that you didn’t stop at Starbucks. It’s easy to stop buying their product. Stop buying, revenue tanks – but costs remain in all those real property leases. Profit relies on high and consistent revenue? Stupid.

What goods and services don’t need an expanding economy? Easy – your job is in jeopardy. You are going to save every dime you can – what do you pay and what do you cut? Energy and groceries stay. Transportation and communications stay at reduced levels. Starbucks and lots of retailers go.

Think causally: If this, then that, and then the next thing. Maybe you will spend a few extra dollars on an MP3 player if it cuts out the need to burn music – which cuts out the need to buy as many blank CDs.

Do you buy groceries? What about a play right now: Kraft-paper manufacturers. Plastic bags are out; paper bags are in. Point? Look down-line in the industries that you will continue to feed.

Don’t let me set your agenda. Look at your own life. Talk to your friends and families. Ask them to assume that their income has been cut in half. Identify the spending priorities. Now return it in a few steps. What comes back at each step? The closer an expenditure is to the austerity budget, the more recession proof that industry is.

You know what I consistently learned from this exercise? When income was returned to its original level, people realized that they weren’t saving enough, so some of yesterday’s expenditures never came back. Call it The Starbucks Syndrome: A condition characterized by the sudden realization that wasting money is not just stupid but can be dangerous.

3. Know the industry, not just the company. Compare the charts for GM and Ford. Chrysler doesn’t count because 80% is owned privately. GM and Ford took the same ride down, but their financials are worlds apart. Ford has (and always has had) cash. The industry drove the stock price – and often does unfairly. But wait! Sweden is getting nervous and may nationalize (“temporarily,” whatever that means) Saab! Know the plays available against the industry and company.

The rules have changed for companies like NASDAQ:CECO. Their revenue is tuition in the for-profit secondary education market. Their students are either ground-based (think – overhead, expensive) or on-line (think – low retention). The ground-based students are generally sub-prime loan risks. Federal financial aid rules have changed – as well as market realities – so watch CECO and its competitors scramble into new markets (for which they are generally ill-equipped).

But the better part of knowing an industry is anticipating changes. What did President Clinton do to the defense industry? Stripped its ability to stock spare parts. It’s just spare parts, you say? That’s high-profit work for defense contractors. Of course, he also wasn’t a fan of big, new programs. So defense stocks were depressed. Lockheed traded at $17 when Clinton left office. It shot quickly to $51 under W.

Will Obama invest in our defense? Not likely. Very telling is his requests to NASA to identify programs that they can cut. Who is downstream from these cuts? Who can weather the storm for 4 or 8 years? Name your players. Watch what they do. Their market cap will dive. The issue is whether they will change their spots to survive – whether they have to, and thus become a new company in a new industry. For the stalwarts that can remain profitable (albeit at a reduced rate) and remain focused on their historical core industry, they are poised to double, triple, or more when POTUS changes to someone with a non-social agenda.

How do you learn an industry? First, find one that you enjoy learning about. Don’t focus on an industry that makes you want to chew aspirin. Get newsletters to track them. Yes, some of them cost money. Get trial subscriptions until you find one or two that resonates with you. The point is this: You are now the CEO of a company in your sector (electric power, defense industry). You are no longer a line manager that can just look beneath you to manage direct reports. You need to look around; you need to understand where your industry is heading; you need to understand the risks coming your way.

Good war story. My dad liked electric utilities because they are cash cows and recession proof. In his newsletters he tracked the deregulation moves in the 1990s. Deregulation in this sense meant customer choice. While I still had to use the local company for energy transmission, I could buy my energy from almost any generator. This meant something: All of a sudden, a megawatt of electricity became a product to be sold on the open market. Wonderfully, this product had no unique characteristics from one generator to the next, so the question became this: Which utilities can generate that product at the lowest cost? It made for great increases in revenue and some great stock plays.

4. Focus first on reasonable debt levels then current profit. Current profits reflect too many things, from one-time charges to appropriate investment in product development. A firm can have little or no profit and still be viable. But long-term debt load is like cancer – it stresses the corporate body and is typically a race between a compromised future and death. If you like an industry, understand the normal debt load. Stay away from companies that exceed it, and look intensely at companies that undercut it. Normalize the data when you view debt: Total Assets/Long-term debt, Long-term assets/Long-term debt – any comparison that makes sense to you that you can use to compare company to company.

5. Find the lowest transaction cost to buy and sell as you can. Since we don’t like companies with lots of overhead, we should likewise stay away from overhead in our transactions. E-trade is generally $12.99 in and out. Scottrade is $7. That’s a big difference. I happen to like E-trade’s platform and tools better, so I rationalize the difference in price. If you’ll make any platform work for you, and merely supplement your research outside the discount broker, then go to the cheapest transaction cost. More on costs below.

6. Put your long-term investments in DRIPs and direct stock buys. DRIPs – Dividend Reinvestment Programs. These and direct stock buys share a common characteristic: You purchase the stock directly from the company. There are plenty of programs that do the buys and sells with little or no transaction costs. Watch the requirement for the initial buy – sometimes it is just a single share, other times it is $500 or more. DRIPs differ from direct stock buys only in that the company also pays a dividend. These dividends – as with all dividends – you should have automatically reinvested. The few dollars cash will not change your life (and usually will do no more than be wasted on a cup of Starbucks coffee) – but reinvesting them in fractional shares will add up over time.

Direct buys are not done for stocks that you are going to trade often. Think of them as next-generation savings accounts. Have the company automatically debit your checking account every month - $50, $100, whatever you can afford for this aspect of this portfolio. You’ll be amazed at how quickly it adds up.

7. Watch for changes in senior personnel, and always presume they were forced out. It’s hard to make it to the top of an organization. Senior personnel are often unfairly (in their mind) overlooked more than once on the way up. They probably know some people that got there on kneepads and backstabbing. When senior personnel leave to “spend more time with their family” they have either just been diagnosed with a terrible disease or have been informed that their services are no longer needed. A safe way for a company to axe someone so high up is to ground it in a private settlement of an at-cause firing. Sure, this is paranoid. So what? Remember Enron? The top financial guy was let go with some happy public statement a few months before the wheels feel off the cart. A $60 stock went to pennies.
Whenever someone leaves, assess their area of responsibility and see what the inferences are. Look at the replacement and assess that person’s background. Never believe company press releases.

8. Learn the basics of macroeconomics, and apply them to your industries. Don’t know anything about macroeconomics? Time to learn the basics. The effect of interest rates, growth or decline in GDP, inflation, and government spending on your industry has to be understood. It is not rocket science.

Is your industry capital intensive because it manufactures products? Interest rates will influence profit. Rates are incredibly low right now, so watch as they begin to rise. Is your industry reliant on consumer spending? Watch the productivity, unemployment, and GDP data. Your question is this: If “this” happened in the economy, how will it affect both my industry at large and my company? Then find the few data points to help you track. Think of it as your personal “leading economic indicators” database.

Here’s some source data for you. Click on Reports at the Federal Reserve site and read both the Beige Book and the Monetary Policy Report to Congress. Once you know the issues affecting your industry, go to the Bureau of Labor Statistics Investors’ area and waltz through the various reports. These are at most monthly reads. Just do it. Once your gag reflex for economic data subsides, you can go here to view historical data on a wide variety of topics.

9. Falling prices are buying opportunities. There’s a difference between a price that has fallen and one that has cratered. If you are concerned about your original assessment of the company, then revisit it in light of recent developments. But know this: You valued the stock yesterday at higher than it was trading; all that has happened now is the spread is even more in your favor. It is a buying opportunity, not a reason to bail.

10. No one ever took a loss selling at a profit. So you bought a stock at $18, road it to $28, and it continued going up to $35. You lost out on $7 a share! No. You. Did. Not. You made a gross profit of $10 a share. Shut. Up.

You don’t lose a dime when you sell at a profit. You made your money. It could have dropped back to $25. Don’t ever criticize yourself for lacking hindsight in a developing situation.

You came full circle on that investment: You researched, set your objective, reached it, and sold. Money in hand. You want a half-measure? Assume you bought 200 shares at $18 for an original-money play of $3,600. Ignore commissions. Sell 129 shares at $28 (gross of $3,612). Now you have all your original money out. You are playing with a present value of $1,988 (71 shares @ $28). That is pure profit to you. No matter how far it drops, you no longer have any original dollars “at risk.”

One last note. I mention above the concept of hitting your “objective.” I’m not smart enough to analyze a stock and conclude, “ABC will trade at 35% higher than the current market.” As I watch the professionals make such proclamations, with results coming in from losing ground to doubling, I don’t they are smart enough either.

I look for investments that I think have an opportunity to jump by 50% or more based upon my assessment of revenue growth and future profit. I like low long-term debt because it means more return on future revenue, and it also opens the door for taking on new debt to expand the revenue base. When I hit a 30% return, I take my money out either in total or equal to my original investment. If the remaining investment of pure profit drops in half, I bail. I think a worst-case net 15% return is commendable.

So those are the rules that guide my investment decisions. I hope they help you to organize your thoughts and investment philosophy.