How much money must be lost before we realise that there is no safe and easy way to make money with investments? When do we figure out that most of our mistakes are caused by greed, fear, or having too high of hopes for what we have? Successful investors eventually start to divide up their assets in a way that helps them reach their goals. They do this by adopting a realistic investment strategy, which is a process for choosing and keeping track of securities that is based on realistic expectations, selection rules, and management guidelines. If you want to try something for a year to see if it works, you're in for another smack on the side of the head. Investment strategies that work aren't based on years, but on cycles. They also include three disciplined steps, the first of which is selection. Most strategies people are used to ignoring one of the others. How should an investor decide what stocks to buy and when to buy them? Will Rogers put it all together: "Buy only stocks that are going up. If you don't think the price will go up, don't buy them." Many people have misunderstood this joke and joined the "Buy (anything) High" club because of it. The "Buy Value Stocks Low (er)" method works better, I've found. Using Google, you can find a number of standards that help you find Value Stocks. These standards include a low Price to Book Value, a low P/E ratio, and other "fundamentals." But you'd be surprised at how different the definitions can be and how few of them include the word "Quality." In the late 1990s, a well-known Value Fund Manager was said to have been asked why he wasn't buying dot-coms, IPOs, etc. When he said that they weren't Value Stocks, he was told to change his definition... or else. How do we make a Stock Selection Universe that gives us confidence? Taking one of the common definitions at face value may be too simple, especially since many of the numbers come from the companies in question. Also, it might be hard to get some of the numbers quickly, so it's important not to spend too much time doing research. Here are five filters you can use to narrow down your choices to better companies. You can get all of this information cheaply from the same source:
- A rating of B+ or better from S&P. Standard & Poor's is a major source of financial information for investors. Its "Earnings and Dividend Rankings for Common Stocks" combine many fundamental and qualitative factors into a letter ranking that only says something about the financial health of the companies being rated. The performance of the market in the future, which is just a guessing game anyway, is not a factor. Ratings of B+ and above are called "Investment Grade." Anything with a lower rating adds an unnecessary element of risk to your portfolio. Your research is done by a staff of thousands.
A History of Making Money. Even though it should be obvious, it is less risky to buy stock in a company that has a history of making money than it is to buy stock in a company that has never made money before. Businesses that make money are better able to respond to changes in markets, economies, and opportunities for business growth. They are more likely to bring you quick ways to make money.
- A History of Paying Dividends Regularly. Regular dividends and increases in the rate paid are sure signs that a business is doing well. Companies will do a lot and go through a lot of trouble before they decide to cut or stop a dividend. There's no need to pay attention to the size of the dividend itself, and stocks shouldn't be bought to make money. One more good thing about using dividend payment as one of your selection criteria is that a cut is a clear sign of financial stress.
- A Price Range That Makes Sense. Most Investment Grade stocks cost more than $10 per share, and only a few trade at prices higher than $100. If you have a seven-figure portfolio, price may not matter from a diversification point of view, but a round lot of a $50 stock may be too much to risk in one position if you have a smaller portfolio. A price that is unusually high could be due to a lot of speculation about a certain sector or company, while a price that is unusually low could be a warning sign. Since there aren't any real size limits, I'm fine with a range between $10 and $90 per share, but I'd avoid most problems at the higher level.
- A security that is on the NYSE. I'm not sure if the NYSE still has stricter listing requirements than other places, but it is nice to be able to focus on just one set of statistics since most of the information you need frequently is reported by Exchange (Market Stats, Issue Breadth, and New Highs vs. New Lows). Your Equity Investment Program will be built around your Selection Universe, so you can't change the rules and guidelines you've set in a creative way, no matter how strongly you feel about recent news or rumours. Now you can focus on operating procedures that will help you diversify properly by position size, industry, etc., and on rules that will help you figure out which stocks you should keep an eye on and buy when the price is right. Keeping in mind that you want to sell each Equity Position as soon as possible for a certain profit, you'll need to set up the right rules for buying and selling. For example, I don't think about buying a stock until it has dropped at least 20% from its 52-week high. Stocks that are close to or at this price level are put on a "Daily Watch List." Then, I choose the ones that I would be willing to add to equity portfolios if they drop a bit more during the trading day. Your "Buy List" changes every day, both in terms of the symbol and the limit price. You will need to use consistent and disciplined judgement to make your final choice, but you can be sure that you are choosing from a small group of high-quality, well-established companies that have a history of making money and caring about their owners. Also, as these companies go up and down above and below your purchase price, which they will do, you can be more sure that this is just the way the stock market works and not a sign of a coming financial disaster, which should help you sleep better at night. By the way, you should never turn down a profit if it's going up by 10%, and you'll be able to do it again and again and again.
