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Slide 2: Stock Investing FOR DUMmIES 2ND by Paul Mladjenovic ‰ EDITION
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Slide 7: Stock Investing For Dummies® 2nd Edition , Published by Wiley Publishing, Inc. 111 River St. Hoboken, NJ 07030-5774 www.wiley.com Copyright © 2006 by Wiley Publishing, Inc., Indianapolis, Indiana Published simultaneously in Canada No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Sections 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, 222 Rosewood Drive, Danvers, MA 01923, 978-750-8400, fax 978-646-8600. Requests to the Publisher for permission should be addressed to the Legal Department, Wiley Publishing, Inc., 10475 Crosspoint Blvd., Indianapolis, IN 46256, 317-572-3447, fax 317-572-4355, or online at http://www.wiley.com/go/permissions. Trademarks: Wiley, the Wiley Publishing logo, For Dummies, the Dummies Man logo, A Reference for the Rest of Us!, The Dummies Way, Dummies Daily, The Fun and Easy Way, Dummies.com and related trade dress are trademarks or registered trademarks of John Wiley & Sons, Inc. and/or its affiliates in the United States and other countries, and may not be used without written permission. All other trademarks are the property of their respective owners. Wiley Publishing, Inc., is not associated with any product or vendor mentioned in this book. LIMIT OF LIABILITY/DISCLAIMER OF WARRANTY: THE PUBLISHER AND THE AUTHOR MAKE NO REPRESENTATIONS OR WARRANTIES WITH RESPECT TO THE ACCURACY OR COMPLETENESS OF THE CONTENTS OF THIS WORK AND SPECIFICALLY DISCLAIM ALL WARRANTIES, INCLUDING WITHOUT LIMITATION WARRANTIES OF FITNESS FOR A PARTICULAR PURPOSE. NO WARRANTY MAY BE CREATED OR EXTENDED BY SALES OR PROMOTIONAL MATERIALS. THE ADVICE AND STRATEGIES CONTAINED HEREIN MAY NOT BE SUITABLE FOR EVERY SITUATION. THIS WORK IS SOLD WITH THE UNDERSTANDING THAT THE PUBLISHER IS NOT ENGAGED IN RENDERING LEGAL, ACCOUNTING, OR OTHER PROFESSIONAL SERVICES. IF PROFESSIONAL ASSISTANCE IS REQUIRED, THE SERVICES OF A COMPETENT PROFESSIONAL PERSON SHOULD BE SOUGHT. NEITHER THE PUBLISHER NOR THE AUTHOR SHALL BE LIABLE FOR DAMAGES ARISING HEREFROM. THE FACT THAT AN ORGANIZATION OR WEBSITE IS REFERRED TO IN THIS WORK AS A CITATION AND/OR A POTENTIAL SOURCE OF FURTHER INFORMATION DOES NOT MEAN THAT THE AUTHOR OR THE PUBLISHER ENDORSES THE INFORMATION THE ORGANIZATION OR WEBSITE MAY PROVIDE OR RECOMMENDATIONS IT MAY MAKE. FURTHER, READERS SHOULD BE AWARE THAT INTERNET WEBSITES LISTED IN THIS WORK MAY HAVE CHANGED OR DISAPPEARED BETWEEN WHEN THIS WORK WAS WRITTEN AND WHEN IT IS READ. For general information on our other products and services, please contact our Customer Care Department within the U.S. at 800-762-2974, outside the U.S. at 317-572-3993, or fax 317-572-4002. For technical support, please visit www.wiley.com/techsupport. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. Library of Congress Control Number: 2005935151 ISBN-13: 978-0-7645-9903-3 ISBN-10: 0-7645-9903-8 Manufactured in the United States of America 10 9 8 7 6 5 4 3 2 1 2O/QZ/RS/QV/IN
Slide 8: About the Author Paul Mladjenovic is a certified financial planner practitioner, writer, and public speaker who has a Web site at www.mladjenovic.com. His business, PM Financial Services, has helped people with financial and business concerns since 1981. In 1985 he achieved his CFP designation. Since 1983, Paul has taught thousands of budding investors through popular national seminars such as “The $50 Wealthbuilder” and “Stock Investing Like a Pro.” Paul has been quoted or referenced by many media outlets such as Bloomberg, MarketWatch, CNBC, and many financial and business publications and Web sites. As an author, he has written the books The Unofficial Guide to Picking Stocks (Wiley, 2000) and Zero-Cost Marketing (Todd Publications, 1995). In 2002, the first edition of Stock Investing For Dummies was ranked in the top 10 out of 300 books reviewed by Barron’s. In recent years, Paul accurately forecasted many economic events, such as the rise of gold and the decline of the U.S. dollar. At press time he has been warning his students and clients about the coming decline in housing. He maintains a financial database for his readers and students at www. supermoneylinks.com
Slide 10: Dedication For my beloved Fran, Adam, Joshua, and a loving, supportive family, I thank God for you. I also dedicate this book to the millions of investors who deserve more knowledge and information to achieve lasting prosperity. Author’s Acknowledgments First and foremost, I offer my appreciation and gratitude to the wonderful people at Wiley. It has been a pleasure to work with such a top-notch organization that works so hard to create products that offer readers tremendous value and information. I wish all of you continued success! There are some notables there whom I want to single out. The first person is Jennifer Connolly (my project editor). She is a true publishing and writing professional who has been extremely helpful, understanding, and patient. Those words are not enough to express my thanks for her fantastic guidance. May God bless her growing family! (Jennifer took over in mid-stream for the wonderful Sherri Pfouts.) Sarah Faulkner (my copy editor) has made sure my mish-mash of content is readable and professional (no small feat). I thank her sincerely and I am grateful she worked on this book with her impressive editing skills. The technical editor Steven Dolvin is a superb financial pro. His expertise and insights have helped me improve the content for you and have helped me learn as well. I wish him continued success. My gratitude goes out to the acquisitions editor Stacy Kennedy for making this For Dummies book happen. For Dummies books don’t magically appear at the bookstore, they happen due to the foresight and efforts of people like Stacy. Wiley is fortunate to have her (and the others also mentioned)! Fran, Lipa Zyenska, you helped make those late nights at the computer more tolerable, and you helped me focus on the important things. Te amo and I thank God that you are by my side. With you and the rest of my loving family, I know that the future will be bright. Lastly, I want to acknowledge you, the reader. Over the years, you have made the For Dummies books what they are today. Your devotion to these wonderful books created a foundation that played a big part in the creation of this book and many more yet to come. Thank you!
Slide 11: Publisher’s Acknowledgments We’re proud of this book; please send us your comments through our Dummies online registration form located at www.dummies.com/register. Some of the people who helped bring this book to market include the following: Acquisitions, Editorial, and Media Development Project Editor: Jennifer Connolly Acquisitions Editor: Stacy Kennedy Copy Editor: Sarah Faulkner Technical Editor: Steven Dolvin, PhD, CFA Editorial Managers: Christine Meloy Beck, Michelle Hacker Editorial Supervisor: Carmen Krikorian Editorial Assistants: Hanna K. Scott, Nadine Bell Cartoons: Rich Tennant (www.the5thwave.com) Composition Services Project Coordinator: Adrienne Martinez Layout and Graphics: Carl Byers, Andrea Dahl, Stephanie D. Jumper, Heather Ryan Proofreaders: Carl Pierce, TECHBOOKS Production Services Indexer: TECHBOOKS Production Services Publishing and Editorial for Consumer Dummies Diane Graves Steele, Vice President and Publisher, Consumer Dummies Joyce Pepple, Acquisitions Director, Consumer Dummies Kristin A. Cocks, Product Development Director, Consumer Dummies Michael Spring, Vice President and Publisher, Travel Kelly Regan, Editorial Director, Travel Publishing for Technology Dummies Andy Cummings, Vice President and Publisher, Dummies Technology/General User Composition Services Gerry Fahey, Vice President of Production Services Debbie Stailey, Director of Composition Services
Slide 12: Contents at a Glance Introduction .................................................................1 Part I: The Essentials of Stock Investing .........................7 Chapter 1: Exploring the Basics .......................................................................................9 Chapter 2: Taking Stock of Your Current Financial Situation and Goals ...................17 Chapter 3: Defining Common Approaches to Stock Investing....................................35 Chapter 4: Recognizing the Risks ...................................................................................45 Chapter 5: Say Cheese: Getting a Snapshot of the Market ..........................................59 Part II: Before You Start Buying ..................................69 Chapter 6: Gathering Information ..................................................................................71 Chapter 7: Going for Brokers ..........................................................................................89 Chapter 8: Investing for Growth ...................................................................................101 Chapter 9: Investing for Income ...................................................................................115 Chapter 10: Using Basic Accounting to Choose Winning Stocks .............................127 Part III: Picking Winners ..........................................143 Chapter 11: Decoding Company Documents ..............................................................145 Chapter 12: Analyzing Industries .................................................................................157 Chapter 13: Emerging Sector Opportunities...............................................................167 Chapter 14: Money, Mayhem, and Votes .....................................................................181 Part IV: Investment Strategies and Tactics .................195 Chapter 15: Taking the Bull (Or Bear) by the Horns..................................................197 Chapter 16: Choosing a Strategy That’s Just Right for You ......................................209 Chapter 17: Understanding Brokerage Orders and Trading Techniques ................217 Chapter 18: Getting a Handle on DPPs, DRPs, and DCA . . . PDQ .............................233 Chapter 19: Looking at What the Insiders Do: Corporate Hijinks ............................243 Chapter 20: Tax Benefits and Obligations ...................................................................255 Part V: The Part of Tens ............................................267 Chapter 21: Ten Warning Signs of a Stock’s Decline ..................................................269 Chapter 22: Ten Signals of a Stock Price Increase......................................................275 Chapter 23: Ten Ways to Protect Yourself from Fraud ..............................................281 Chapter 24: Ten Challenges and Opportunities for Stock Investors........................289
Slide 13: Part VI: Appendixes ..................................................295 Appendix A: Resources for Stock Investors................................................................297 Appendix B: Financial Ratios ........................................................................................311 Index .......................................................................319
Slide 14: Table of Contents Introduction..................................................................1 About This Book...............................................................................................1 Conventions Used in This Book .....................................................................2 What You’re Not to Read.................................................................................2 Foolish Assumptions .......................................................................................3 How This Book Is Organized...........................................................................3 Part I: The Essentials of Stock Investing .............................................3 Part II: Before You Start Buying ............................................................4 Part III: Picking Winners ........................................................................4 Part IV: Investment Strategies and Tactics .........................................5 Part V: The Part of Tens.........................................................................5 Part VI: Appendixes................................................................................6 Icons Used in This Book..................................................................................6 Where to Go from Here....................................................................................6 Part I: The Essentials of Stock Investing..........................7 Chapter 1: Exploring the Basics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9 Understanding the Basics ...............................................................................9 Getting Prepared before You Get Started....................................................10 Knowing How to Pick Winners .....................................................................10 Recognizing stock value ......................................................................10 Understanding how market capitalization affects stock value ......11 Sharpening your investment skills.....................................................12 Boning Up on Strategies and Tactics ...........................................................14 Getting Some Good Tips................................................................................14 Chapter 2: Taking Stock of Your Current Financial Situation and Goals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .17 Establishing a Starting Point.........................................................................18 Step 1: Making sure you have an emergency fund ...........................19 Step 2: Listing your assets in decreasing order of liquidity............19 Step 3: Listing your liabilities..............................................................22 Step 4: Calculating your net worth.....................................................23 Step 5: Analyzing your balance sheet ................................................24
Slide 15: xii Stock Investing For Dummies, 2nd Edition Funding Your Stock Program ........................................................................26 Step 1: Tallying up your income .........................................................27 Step 2: Adding up your outgo .............................................................28 Step 3: Creating a cash flow statement..............................................29 Step 4: Analyzing your cash flow........................................................30 Finding investment money in tax savings .........................................31 Setting Your Sights on Your Financial Goals...............................................31 Chapter 3: Defining Common Approaches to Stock Investing . . . . . .35 Matching Stocks and Strategies with Your Goals.......................................35 Investing for the Future .................................................................................37 Focusing on the short term.................................................................37 Considering intermediate-term goals ................................................38 Preparing for the long term.................................................................39 Investing for a Purpose .................................................................................39 Making loads of money quickly: Growth investing ..........................40 Steadily making money: Income investing ........................................40 Investing for Your Personal Style .................................................................42 Conservative investing ........................................................................42 Aggressive investing ............................................................................43 Chapter 4: Recognizing the Risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .45 Exploring Different Kinds of Risk .................................................................46 Financial risk .........................................................................................46 Interest rate risk ...................................................................................47 Understanding the adverse effects of rising interest rates.............48 Market risk ............................................................................................50 Inflation risk ..........................................................................................51 Tax risk ..................................................................................................52 Political and governmental risks........................................................52 Personal risks .......................................................................................52 Emotional risk.......................................................................................53 Minimizing Your Risk .....................................................................................55 Gaining knowledge ...............................................................................55 Staying out . . . for now ........................................................................55 Getting your financial house in order................................................56 Diversifying your investments............................................................56 Weighing Risk Against Return.......................................................................57 Chapter 5: Say Cheese: Getting a Snapshot of the Market . . . . . . . . .59 Knowing How Indexes Are Measured ..........................................................59 Checking Out the Indexes .............................................................................60 The Dow Jones Industrial Average.....................................................61 Nasdaq indexes.....................................................................................64
Slide 16: Table of Contents Standard & Poor’s 500..........................................................................64 Russell 3000 Index ................................................................................65 Wilshire Total Market Index ................................................................65 International indexes ...........................................................................66 Using the Indexes ...........................................................................................67 Tracking the indexes............................................................................67 Investing in indexes .............................................................................67 xiii Part II: Before You Start Buying...................................69 Chapter 6: Gathering Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .71 Looking to Stock Exchanges for Answers ...................................................72 Understanding Stocks and the Companies They Represent ....................73 Accounting for taste and a whole lot more.......................................73 Understanding how economics affects stocks .................................74 Staying on Top of Financial News ................................................................77 Figuring out what a company’s up to ................................................78 Discovering what’s new with an industry .........................................78 Knowing what’s happening with the economy.................................78 Seeing what the politicians and government bureaucrats are doing ......................................................................79 Checking for trends in society, culture, and entertainment ...........79 Reading (And Understanding) Stock Tables...............................................80 52-week high..........................................................................................81 52-week low ...........................................................................................81 Name and symbol.................................................................................82 Dividend.................................................................................................82 Volume ...................................................................................................82 Yield .......................................................................................................83 P/E ..........................................................................................................84 Day last ..................................................................................................84 Net change.............................................................................................85 Using News about Dividends ........................................................................85 Looking at important dates.................................................................85 Understanding why these dates matter ............................................87 Evaluating (Avoiding?) Investment Tips .....................................................87 Chapter 7: Going for Brokers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .89 Defining the Broker’s Role.............................................................................89 Distinguishing between Full-Service and Discount Brokers .....................91 Full-service brokers..............................................................................91 Discount brokers ..................................................................................93
Slide 17: xiv Stock Investing For Dummies, 2nd Edition Choosing a Broker..........................................................................................94 Discovering Various Types of Brokerage Accounts...................................95 Cash accounts.......................................................................................95 Margin accounts ...................................................................................96 Option accounts ...................................................................................97 Judging Brokers’ Recommendations ...........................................................97 Chapter 8: Investing for Growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .101 Becoming a Value-Oriented Growth Investor ...........................................102 Getting Tips for Choosing Growth Stocks.................................................103 Making the right comparison............................................................103 Checking out a company’s fundamentals........................................104 Looking for leaders and megatrends ...............................................104 Considering a company with a strong niche ..................................105 Noticing who’s buying and/or recommending the stock ..............105 Learning investing lessons from history .........................................106 Evaluating the management of a company .....................................107 Making sure a company continues to do well ................................110 Exploring Small-caps and Speculative Stocks ..........................................110 Avoid IPOs, unless . . .........................................................................111 If it’s a small-cap stock, make sure it’s making money ..................112 Investing in small-cap stocks requires analysis .............................112 Chapter 9: Investing for Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .115 Understanding Income Stocks....................................................................116 Advantages of income stocks ...........................................................116 Disadvantages of income stocks ......................................................117 Analyzing Income Stocks.............................................................................118 Understanding your needs first........................................................118 Checking out yield..............................................................................120 Checking the stock’s payout ratio....................................................122 Diversifying your stocks....................................................................123 Examining the company’s bond rating ............................................123 Exploring Some Typical Income Stocks ....................................................124 Utilities.................................................................................................124 Real estate investment trusts (REITs) .............................................124 Royalty trusts......................................................................................126 Chapter 10: Using Basic Accounting to Choose Winning Stocks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .127 Recognizing Value When You See It ...........................................................127 Understanding different types of value ...........................................129 Putting the pieces together...............................................................130 Accounting for Value....................................................................................131 Walking on a wire: The balance sheet..............................................132 Looking at the income statement.....................................................135 Tooling around with ratios................................................................138
Slide 18: Table of Contents xv Part III: Picking Winners ...........................................143 Chapter 11: Decoding Company Documents . . . . . . . . . . . . . . . . . . . . .145 Getting a Message from the Muckety-Muck: The Annual Report...........145 Analyzing the annual report’s anatomy...........................................146 Going through the proxy materials ..................................................149 Getting a Second Opinion ...........................................................................150 Company documents filed with the SEC .........................................150 Value Line ............................................................................................152 Standard & Poor’s...............................................................................152 Moody’s Investment Service.............................................................153 Brokerage reports: The good, the bad, and the ugly .....................153 Compiling Your Own Research Department.............................................155 Chapter 12: Analyzing Industries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .157 Badgering the Witness and Interrogating the Industries ........................158 Is the industry growing? ....................................................................158 Are the industry’s products or services in demand? ....................159 What does the industry’s growth rely on? ......................................160 Is this industry dependent on another industry? ..........................160 Who are the leading companies in the industry?...........................161 Is the industry a target of government action? ..............................161 Which category does the industry fall into?...................................162 Outlining Key Industries..............................................................................163 For sale ................................................................................................164 Baby, you can drive my car...............................................................165 Thanking Mr. Roboto .........................................................................165 Banking on it .......................................................................................165 Chapter 13: Emerging Sector Opportunities . . . . . . . . . . . . . . . . . . . . .167 Bullish Opportunities ..................................................................................168 Commodities: Feeding and housing the world ...............................168 Energy ..................................................................................................169 Gold ......................................................................................................170 Silver ....................................................................................................172 Healthcare ...........................................................................................173 National Security ................................................................................173 Bearish Outlook............................................................................................174 Warning on housing ...........................................................................174 The great credit monster...................................................................176 Cyclical stocks ....................................................................................177 Important for Bulls & Bears ........................................................................177 Conservative and bullish...................................................................178 Aggressive and bullish.......................................................................178 Conservative and bearish .................................................................179 Aggressive and bearish......................................................................179 Diversification.....................................................................................179
Slide 19: xvi Stock Investing For Dummies, 2nd Edition Chapter 14: Money, Mayhem, and Votes . . . . . . . . . . . . . . . . . . . . . . . .181 Avoiding the Bull When Elephants and Donkeys Talk Turkey ...............182 Understanding price controls...........................................................184 Ascertaining the political climate ....................................................184 Discovering systemic and nonsystemic effects..............................185 Poking into politics: Resources ........................................................187 Easing into Economics ................................................................................187 Understanding economic impact .....................................................188 Inquiring about economics: Resources ...........................................193 Part IV: Investment Strategies and Tactics ..................195 Chapter 15: Taking the Bull (Or Bear) by the Horns . . . . . . . . . . . . . . .197 Bulling Up......................................................................................................198 Recognizing the beast........................................................................198 Avoiding the horns of a bull market ................................................200 Toro! Approaching a bull market......................................................200 Bearing Down................................................................................................202 Identifying the beast ..........................................................................202 Heading into the woods: Approaching a bear market ...................205 Straddling Bear and Bull: Uncertain Markets ...........................................206 Pinpointing uncertainty is tough......................................................206 Deciding whether you want to approach an uncertain market....207 Chapter 16: Choosing a Strategy That’s Just Right for You . . . . . . . .209 Laying Out Your Plans .................................................................................209 Living the bachelor life: Young single with no dependents ..........210 Going together like a horse and carriage: Married with children ....................................................................210 Getting ready for retirement: Over 40 and either single or married..........................................................211 Kicking back in the hammock: Already retired ..............................212 Allocating Your Assets.................................................................................212 Investors with less than $10,000 ......................................................213 Investors with $10,000–$50,000 ........................................................214 Investors with $50,000 or more ........................................................214 Knowing When to Sell..................................................................................215 Chapter 17: Understanding Brokerage Orders and Trading Techniques . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .217 Checking Out Brokerage Orders ................................................................218 Time-related orders............................................................................218 Condition-related orders ...................................................................220 Buying on Margin .........................................................................................226 Examining marginal outcomes..........................................................226 Maintaining your balance..................................................................227
Slide 20: Table of Contents Going Short and Coming Out Ahead..........................................................228 Setting up a short sale .......................................................................229 Oops! Going short when prices grow taller ....................................230 Watching out for ticks........................................................................231 Feeling the squeeze............................................................................231 xvii Chapter 18: Getting a Handle on DPPs, DRPs, and DCA . . . PDQ . . .233 Being Direct with DPPs................................................................................233 Investing in a DPP...............................................................................234 Finding DPP alternatives ...................................................................235 Recognizing that every pro has a con .............................................236 Dipping into DRPs ........................................................................................236 Getting a clue about compounding..................................................237 Building wealth with optional cash payments (OCPs) ..................238 Checking out the cost advantages ...................................................238 Weighing the pros with the cons ......................................................239 The One-Two Punch: Dollar Cost Averaging and DRPs...........................240 Chapter 19: Looking at What the Insiders Do: Corporate Hijinks . . . .243 Tracking Insider Trading .............................................................................244 Looking at Insider Transactions.................................................................245 Learning from insider buying............................................................245 Picking up tips from insider selling..................................................247 Considering Corporate Stock Buybacks ...................................................248 Boosting earnings per share .............................................................249 Beating back a takeover bid..............................................................250 Exploring the downside of buybacks...............................................250 Stock Splits: Nothing to Go Bananas Over ................................................251 Ordinary stock splits .........................................................................252 Reverse stock splits ...........................................................................252 Chapter 20: Tax Benefits and Obligations . . . . . . . . . . . . . . . . . . . . . . .255 Paying through the Nose.............................................................................255 Understanding ordinary income and capital gains........................256 Minimizing the tax on your capital gains ........................................258 Coping with capital losses ................................................................258 Sharing Your Gains with the IRS.................................................................260 Filling out forms..................................................................................260 Playing by the rules............................................................................261 Discovering the Softer Side of the IRS: Tax Deductions for Investors...262 Investment interest ............................................................................262 Miscellaneous expenses ....................................................................262 Givin’ it away.......................................................................................263 Knowing what you can’t deduct .......................................................263 Taking Advantage of Tax-Advantaged Retirement Investing ..................264 IRAs ......................................................................................................264 401(k) plans.........................................................................................265
Slide 21: xviii Stock Investing For Dummies, 2nd Edition Part V: The Part of Tens .............................................267 Chapter 21: Ten Warning Signs of a Stock’s Decline . . . . . . . . . . . . .269 Earnings Slow Down or Head South ..........................................................269 Sales Slow Down...........................................................................................270 Exuberant Analysts Despite Logic .............................................................271 Insider Selling ...............................................................................................271 Dividend Cuts ...............................................................................................272 Increased Negative Coverage .....................................................................272 Industry Problems .......................................................................................272 Political Problems ........................................................................................273 Debt Is Too High or Unsustainable ............................................................273 Funny Accounting: No Laughing Here! ......................................................273 Chapter 22: Ten Signals of a Stock Price Increase . . . . . . . . . . . . . . .275 Rise in Earnings ............................................................................................275 Increase in Assets as Debts Are Stable or Decreasing ............................276 Positive Publicity for Industry ...................................................................277 Heavy Insider or Corporate Buying ...........................................................277 More Attention from Analysts ....................................................................278 Rumors of Takeover Bids ............................................................................278 Praise from Consumer Groups ...................................................................279 Strong or Improving Bond Rating ..............................................................279 Powerful Demographics ..............................................................................279 Low P/E Relative to Industry or Market ....................................................280 Chapter 23: Ten Ways to Protect Yourself from Fraud . . . . . . . . . . . . .281 Be Wary of Unsolicited Calls and E-mails..................................................281 Get to Know the SEC ....................................................................................282 Don’t Invest If You Don’t Understand ........................................................282 Question the Promise of Extraordinary Returns .....................................283 Verify the Investment...................................................................................283 Check Out the Broker ..................................................................................284 Beware of the Pump-and-Dump..................................................................284 Watch Out for Short-and-Abort ..................................................................286 Remember That Talk Is Cheap (Until You Talk to an Expert).................286 Recovering (If You Do Get Scammed)........................................................287 Chapter 24: Ten Challenges and Opportunities for Stock Investors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .289 Debt, Debt, and More Debt .........................................................................289 Derivatives ....................................................................................................290 Real Estate.....................................................................................................290 Inflation .........................................................................................................291 Pension Crisis ...............................................................................................291
Slide 22: Table of Contents Government’s Unfunded Liabilities ...........................................................292 Recession/Depression .................................................................................292 Commodities.................................................................................................293 Energy............................................................................................................293 Dangers from Left Field ...............................................................................294 xix Part VI: Appendixes...................................................295 Appendix A: Resources for Stock Investors . . . . . . . . . . . . . . . . . . . . .297 Financial Planning Sources .........................................................................297 The Language of Investing ..........................................................................298 Textual Investment Resources ...................................................................298 Periodicals and magazines................................................................298 Books and pamphlets ........................................................................299 Special books of interest to stock investors...................................300 Investing Web sites ......................................................................................301 General investing Web sites ..............................................................301 Stock investing Web sites ..................................................................301 Investor Associations and Organizations .................................................302 Stock Exchanges...........................................................................................302 Finding Brokers ............................................................................................303 Choosing brokers ...............................................................................303 Brokers.................................................................................................303 Investment Sources......................................................................................305 Dividend Reinvestment Plans.....................................................................306 Sources for Analysis ....................................................................................306 Earnings and earnings estimates......................................................306 Industry analysis ................................................................................306 Factors that affect market value.......................................................307 Technical analysis ..............................................................................308 Insider trading ....................................................................................308 Tax Benefits and Obligations ......................................................................309 Fraud..............................................................................................................309 Appendix B: Financial Ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .311 Liquidity Ratios ............................................................................................312 Current ratio .......................................................................................312 Quick ratio...........................................................................................312 Operating Ratios ..........................................................................................313 Return on equity (ROE) .....................................................................313 Return on assets (ROA) .....................................................................314 Sales to receivables ratio (SR)..........................................................314 Solvency Ratios ............................................................................................315 Debt to net equity ratio .....................................................................315 Working capital ...................................................................................315
Slide 23: xx Stock Investing For Dummies, 2nd Edition Common Size Ratios ....................................................................................316 Valuation Ratios............................................................................................316 Price-to-earnings ratio (P/E) .............................................................317 Price to sales ratio (PSR)...................................................................317 Price to book ratio (PBR) ..................................................................318 Index........................................................................319
Slide 24: Introduction S tock Investing For Dummies, 2nd Edition, has been an honor for me to write. I’m grateful that I can share my thoughts, information, and experience with such a large and devoted group of readers. Although the stock market has served millions of investors for nearly a century, recent years have shown me that a great investing vehicle such as stocks can be easily misunderstood, misused, and even abused. The great bull market of 1982–1999 came to a screeching halt in 2000. During 2000–2002, millions of investors lost a total of over 5 trillion dollars. What bothers me is that much of that loss was easily avoidable. Investors at the tail end of a bull market often think that stock investing is an easy, carefree, certain way to make a quick fortune. How wrong they are! The countless stories of investors who lost tremendous amounts of money speculating in tech stocks, dotcoms, and other flashy stocks are lessons for all of us. Successful stock investing takes diligent work and knowledge like any other meaningful pursuit. This book can definitely help you avoid the mistakes others have made and can point you in the right direction. Explore the pages of this book and find the topics that most interest you regarding the world of stock investing. Let me assure you that I have squeezed over two decades of experience, education, and expertise between these covers. My track record is as good (or better) as the track records of the experts who trumpet their successes. More importantly, I share information to avoid common mistakes (some of which I made myself!). Understanding what not to do can be just as important as figuring out what to do. In all the years that I have counseled and educated investors, the single difference between success and failure, between gain and loss, boils down to one word: knowledge. Take this book as your first step in a lifelong learning adventure. About This Book The stock market has been a cornerstone of the investor’s passive wealthbuilding program for over a century and continues in this role. The period of 1995–2005 was one huge roller coaster ride for stock investors. If it was a stock chart, the graph would look like Mt. Everest. Fortunes were made and lost. With just a little more knowledge and a few wealth-preserving techniques, more investors could have held onto their hard-earned stock market fortunes. With all the media attention, all the talking heads on radio and TV,
Slide 25: 2 Stock Investing For Dummies, 2nd Edition and the books with titles like Dow at 36,000, the investing public still didn’t avoid losing trillions in a historic stock market debacle. Sadly, even the socalled experts who understood stocks didn’t see the economic and geopolitical forces that acted like a tsunami on the market. This book also gives you a “heads up” on those megatrends and events that will affect your stock portfolio. While other books may tell you about stocks, this book tells you about stocks and what affects them. This book is designed to give you a realistic approach to making money in stocks. It provides the essence of sound, practical stock investing strategies and insights that have been market tested and proven from nearly a hundred years of stock market history. I don’t expect you to read it cover to cover, although I’d be delighted if you read every word! Instead, this book is designed as a reference tool. Feel free to read the chapters in whatever order you choose. You can flip to the sections and chapters that interest you or those that include topics that you need to know more about. Stock Investing For Dummies, 2nd Edition, is also a book that is quite different from the “get rich with stocks” titles that have crammed the bookshelves in recent years. It doesn’t take a standard approach to the topic; it doesn’t assume that stocks are a sure thing and the be-all and end-all of wealth building. At times in this book, I tell you not to invest in stocks. This book can help you succeed not only in up markets but also in down markets. Bull markets and bear markets come and go, but the informed investor can keep making money no matter what. To give you an extra edge, I have tried to include information about the investing environment for stocks. Whether it is politics or hurricanes (or both), you need to know how “the big picture” affects your stock investment decisions. Conventions Used in This Book To make navigating through this book easier, I’ve established the following conventions: Italic highlights new terms that are defined. Monofont is used for Web addresses. Sidebars, shaded gray boxes of text, are filled with interesting information that isn’t pertinent to your understanding of the topic, but is interesting nonetheless. What You’re Not to Read Sidebars (gray boxes of text) in this book give you a more in-depth look at a certain topic. While they further illuminate a particular point, these sidebars
Slide 26: Introduction aren’t crucial to your understanding of the rest of the book. Feel free to read them or skip them. Of course, I’d love for you to read them all, but my feelings won’t be hurt if you decide to skip them over. The text that accompanies the Technical Stuff icon can be passed over as well. The text associated with this icon gives some technical details about stock investing that are certainly interesting and informative, but you can still come away with the information you need with or without reading this text. 3 Foolish Assumptions I figure you’ve picked up this book for one or more of the following reasons: You’re a beginner and want a crash course on stock investing that’s an easy read. You’re already a stock investor, and you need a book that allows you to read only those chapters that cover specific stock investing topics of interest to you. You need to review your own situation with the information in the book to see if you missed anything when you invested in that hot stock that your brother-in-law recommended. You need a great gift! When Uncle Mo is upset over his poor stock picks, you can give him this book so he can get back on his financial feet. Be sure to get a copy for his broker, too. (Odds are that the broker was the one who made those picks to begin with.) How This Book Is Organized The information is laid out in a straightforward format. The parts progress in a logical approach that any investor interested in stocks can follow very easily. Part I: The Essentials of Stock Investing This section is for everyone. Understanding the essentials of stock investing and investing in general will only help you, especially in uncertain economic times. Stocks may even touch your finances in ways not readily apparent. For example, stocks are not only in individual accounts; they’re also in mutual funds and pension plans.
Slide 27: 4 Stock Investing For Dummies, 2nd Edition An important point is that stocks are really financial tools that are a means to an end. Investors should be able to answer the question “Why am I considering stocks at all?” Stocks are a great vehicle for wealth building, but only if investors realize what they can accomplish and how to use them. One of the essentials of stock investing is understanding risk. Most people are clueless about risk. Chapter 4, on risk, is one of the most important chapters that serious stock investors should read. You can’t avoid every type of risk out there. (Life itself embodies risk.) However, this chapter can help you recognize it and find ways to minimize it in your stock investing program. Part II: Before You Start Buying Once you’re ready to embark on your career as a stock investor, you’ll need to use some resources to gather information about the stocks you’re interested in. Fortunately, you live in the information age. I pity the investors from the 1920s, who didn’t have access to so many resources, but today’s investors are in an enviable position. This part tells you where to find information and how to use it to be a more knowledgeable investor (a rarity in recent years!). For example, I explain that stocks can be used for both growth and income purposes, and I discuss the characteristics of each. See Chapters 8 and 9 for more information. When you’re ready to invest, you’ll invariably have to turn to a broker. There are several types, so you should know which is which. The wrong broker could make you . . . uh . . . broker. Chapter 7 helps you choose. Part III: Picking Winners Part III is about picking good stocks by using microeconomics, meaning that you look at the stocks of individual companies. I explain how to evaluate a company’s products, services, and other factors so that you can determine whether a company is strong and healthy. One of the major differences with this edition versus the first edition is the emphasis on emerging sector opportunities. If I can steer you toward those segments of the stock market that show solid promise for the coming years, then that alone would make your stock portfolio thrive. Putting your money into solid companies that are in thriving industries has been the hallmark of superior stock investing throughout history. It’s no different now. Check out Chapter 13 if you want to know more about emerging sector opportunities. Where do you turn to find out about a company’s financial health? In Chapter 11, I show you the documents you should review to make a more informed decision. Once you find the information, you’ll discover how to make sense of that data as well. While you’re at it, check out Chapter 12 (on analyzing industries).
Slide 28: Introduction I compare buying stock to picking goldfish. If you look at a bunch of goldfish to choose which ones to buy, you want to make sure that you pick the healthiest ones. With stocks, you also need to pick companies that are healthy. Part III can help you do that. 5 Part IV: Investment Strategies and Tactics Even the stocks of great companies can fall in a bad investing environment. This is where you should be aware of the “macro.” If stocks were goldfish, the macro would be the pond or goldfish bowl. In that case, even healthy goldfish can die if the water is toxic. Therefore, you should monitor the investing environment for stocks. Part IV reveals tips, strategies, and resources that you shouldn’t ignore. Once you understand stocks and the economic environment in which they operate, choose the strategy and the tactics to help steer you to your wealthbuilding objectives. Chapter 17 reveals some of my all-time favorite techniques for building wealth and holding on to your stock investment gains. (Definitely check it out.) You may be an investor, but that doesn’t mean that you have deep pockets. Chapter 18 tells you how to buy stocks with lower (or no) transaction costs. If you’re going to buy the stock anyway, why not save on commissions and other costs? As an investor, you must keep an eye on what the company insiders are doing. In Chapter 19, I explain what it may mean if the company’s management is buying or selling the same stock that you’re considering. After you spend all your time, money, and effort to grow your money in the world of stocks, you have yet another concern: holding on to your hardearned gains. This challenge is summarized in one word: taxes. Sound tax planning is crucial for everyone who works hard. After all, taxes are the biggest expense in your lifetime (right after children!). See Chapter 20 for more information. Part V: The Part of Tens I wrap up the book with a hallmark of For Dummies books — the Part of Tens. These chapters give you a mini crash course in stock investing, including ten ways to protect yourself from fraud. In this part, I offer some clues that signal a stock price increase and how to recognize the warning signs of a stock poised to fall. Also review the list of ten challenges and opportunities that face stock investors (Chapter 24). This is a new chapter that I feel is critical for your investing strategy.
Slide 29: 6 Stock Investing For Dummies, 2nd Edition Part VI: Appendixes Don’t overlook the appendixes. I pride myself on the resources I can provide my students and readers so that they can make informed investment decisions. Whether the topic is stock investing terminology, economics, or avoiding capital gains taxes, I include a treasure trove of resources to help you. Whether you go to a bookstore, the library, or the Internet, Appendix A gives you some great places to turn to for help. In Appendix B, I explain financial ratios. These important numbers help you better determine whether to invest in a particular company’s stock. Icons Used in This Book This icon flags a particular bit of advice that just may give you an edge over other investors. When you see this icon, I’m reminding you about some information that you should always keep stashed in your memory, whether you’re new to investing or an old pro. Pay special attention to this icon because the advice can prevent headaches, heartaches, and financial aches. The text attached to this icon may not be crucial to your success as an investor, but it may enable you to talk shop with investing gurus and better understand the financial pages of your favorite business publication or Web site. Where to Go from Here You may not need to read every chapter to make you more confident as a stock investor, so feel free to jump around to suit your personal needs. Since every chapter is designed to be as self-contained as possible, it won’t do you any harm to “cherry-pick” what you really want to read. But if you’re like me, you still may want to check out every chapter because you never know when you can come across a new tip or resource that will make a profitable difference in your stock portfolio. I want you to be successful so that I can brag about you in the next edition!
Slide 30: Part I The Essentials of Stock Investing
Slide 31: M In this part . . . any investors do things in reverse; they buy stock first and learn “some lessons” afterward. Your success is dependent on doing your homework before you invest your first dollar in stocks. Most investors don’t realize that they should be scrutinizing their own situations and financial goals at least as much as they scrutinize stocks. But how else can you know which stocks are right for you? Too many people risk too much simply because they don’t take stock of their current needs, goals, and risk tolerance before they invest. The chapters in this part tell you what you need to know to choose the stocks that best suit you.
Slide 32: Chapter 1 Exploring the Basics In This Chapter Knowing the essentials Doing your own research Recognizing winners Exploring investment strategies S tock investing became all the rage during the late 1990s. Even tennis stars and punk rockers got into the act. Investors watched their stock portfolios and stock mutual funds skyrocket as the stock market was reaching the mania stage at the tail-end of an 18-year upswing (or bull market) in stocks. (See Chapter 15 for more information on bull markets.) Investment activity in the United States is a great example of the popularity that stocks experienced during that time period. By 1999, over half of U.S. households became participants in the stock market. Yet millions lost money when the stock market fell big time (the bear market — see Chapter 15) during 2000–2002. People invested. Yet they really didn’t know exactly what they were investing in. If they had a rudimentary understanding of what stock really is, perhaps they could have avoided some expensive mistakes. The purpose of this book is not only to tell you about the basics of stock investing but also to let you in on some solid strategies that can help you profit from the stock market. Before you invest your first dollar, you need to understand the basics of stock investing. Understanding the Basics The basics are so basic that few people are doing them. Perhaps the most basic (and therefore most important) thing to grasp is the risk you face whenever you do anything (like putting your hard-earned money in an investment like a stock). When you lose track of the basics, you lose track of why you invested to begin with. Find out more about risk (and the different kinds of risk) in Chapter 4.
Slide 33: 10 Part I: The Essentials of Stock Investing When the late comedian Henny Youngman was asked “How is your wife?” he responded “Compared to what?” This applies to stocks. When you are asked “how is your stock?” you can very well respond that it’s doing well especially when compared to an acceptable “yardstick” such as a stock index (such as the S&P 500). Find out more about indexes in Chapter 5. The bottom line is that the first thing you do in stock investing is not send your money to a brokerage account or go to a Web site to click “buy stock.” The first thing you do is find out as much as you can about what stocks are and how to use them to achieve your wealth-building goals. Getting Prepared before You Get Started Gathering information is critical in your stock-investing pursuits. There are two times to gather information on your stock picks: before you invest . . . and after. You obviously should become more informed before you invest your first dollar. But you also need to stay informed about what’s happening to the company whose stock you are buying and also about the industry and the general economy. To find the best information sources, check out Chapter 6. When you are ready to invest, you will need a brokerage account. How do you know which broker to use? Chapter 7 provides some answers and resources to help you choose a broker. Knowing How to Pick Winners Once you get past the basics, you can get to the “meat” of stock picking. Successful stock picking is not mysterious, but it does take some time, effort, and analysis. It’s worth it since stocks are a convenient and important part of most investors’ portfolios. Read the following section and be sure to “leap frog” to the relevant chapters to get the inside scoop on “hot stocks.” Recognizing stock value Imagine that you like eggs and you’re willing to buy them at the grocery store. In this example, the eggs are like companies, and the prices represent the prices that you would pay for the companies’ stock. The grocery store is the stock market. What if two brands of eggs are very similar, but one costs
Slide 34: Chapter 1: Exploring the Basics 50 cents while the other costs 75 cents? Which would you choose? Odds are that you would look at both brands, judge their quality, and, if they were indeed similar, take the cheaper eggs. The eggs at 75 cents are overpriced. The same is true of stocks. What if you compare two companies that are similar in every respect but have different share prices? All things being equal, the cheaper price has greater value for the investor. But the egg example has another side. What if the quality of the two brands of eggs is significantly different but their prices are the same? If one brand of eggs is stale, of poor quality, and priced at 50 cents and the other brand is fresh, of superior quality, and also priced at 50 cents, which would you get? I’d take the good brand because they’re better eggs. Perhaps the lesser eggs are an acceptable purchase at 10 cents, but they’re definitely overpriced at 50 cents. The same example works with stocks. A badly run company isn’t a good choice if you can buy a better company in the marketplace at the same — or a better — price. Comparing the value of eggs may seem overly simplistic, but doing so does cut to the heart of stock investing. Eggs and egg prices can be as varied as companies and stock prices. As an investor, you must make it your job to find the best value for your investment dollars. (Otherwise you get egg on your face. You saw that one coming, right?) 11 Understanding how market capitalization affects stock value You can determine the value of a company (and thus the value of its stock) in many ways. The most basic way to measure this value is to look at a company’s market value, also known as market capitalization (or market cap). Market capitalization is simply the value you get when you multiply all the outstanding shares of a stock by the price of a single share. Calculating the market cap is easy. It’s the number of shares outstanding multiplied by the current share price. If the company has 1 million shares outstanding and its share price is $10, the market cap is $10 million. Small cap, mid cap, and large cap aren’t references to headgear; they’re references to how large the company is as measured by its market value. Here are the five basic stock categories of market capitalization: Micro cap (under $250 million): These stocks are the smallest and hence the riskiest available. Small cap ($250 million to $1 billion): These stocks fare better than the microcaps and still have plenty of growth potential. The key word here is “potential.”
Slide 35: 12 Part I: The Essentials of Stock Investing Mid cap ($1 billion to $5 billion): For many investors, this category offers a good compromise between small caps and large caps. These stocks have some of the safety of large caps while retaining some of the growth potential of small caps. Large cap ($5 billion to $25 billion): This category is usually best reserved for conservative stock investors who want steady appreciation with greater safety. Stocks in this category are frequently referred to as “blue chips.” Ultra cap (over $25 billion): These stocks are also called “mega caps” and obviously refer to companies that are the biggest of the big. Stocks such as General Electric and Exxon Mobil are examples. From a safety point of view, the company’s size and market value do matter. All things being equal, large cap stocks are considered safer than small cap stocks. However, small cap stocks have greater potential for growth. Compare these stocks to trees: Which tree is sturdier — a giant California redwood or a small oak tree that’s just a year old? In a great storm, the redwood holds up well, while the smaller tree has a rough time. But you also have to ask yourself which tree has more opportunity for growth. The redwood may not have much growth left, but the small oak tree has plenty of growth to look forward to. For beginning investors, comparing market cap to trees isn’t so far-fetched. You want your money to branch out without becoming a sap. Although market capitalization is important to consider, don’t invest (or not invest) just based on it. It’s just one measure of value. As a serious investor, you need to look at numerous factors that can help you determine whether any given stock is a good investment. Keep reading — this book is full of information to help you decide. Sharpening your investment skills Investors who analyze the company can better judge the value of the stock and profit from buying and selling it. Your greatest asset in stock investing is knowledge (and a little common sense). To succeed in the world of stock investing, keep in mind these key success factors: Analyze yourself. What do you want to accomplish with your stock investing? What are your investment goals? Chapter 2 can help you figure it out.
Slide 36: Chapter 1: Exploring the Basics Know where to get information. The decisions you make about your money and what stocks to invest in require quality information. If you want help with information sources, turn to Chapter 3. Understand why you want to invest in stocks. Are you seeking appreciation (capital gains) or income (dividends)? Look at Chapters 8 and 9 for information on these topics. Do some research. Look at the company whose stock you’re considering to see whether it’s a profitable company worthy of your investment dollars. Chapters 10 and 11 help you scrutinize the company. Choosing a winning stock also means that you choose a winning industry. You’ll frequently see stock prices of mediocre companies in “hot” industries rise higher and faster than solid companies in floundering industries. Therefore, choosing the industry is very important. Find out more about analyzing industries in Chapter 12. Understand how the world affects your stock. Stocks succeed or fail in large part due to the environment in which they operate. Economics and politics make up that world, so you should know something about them. Chapter 14 covers these topics, but also take a look at Chapter 2. Understand and identify megatrends. Doing so makes it easier for you to make money. This edition spends more time and provides more resources helping you see the opportunities in emerging sectors and even avoid the problem areas (see Chapter 13 for details). Use investing strategies like the pros do. In other words, how you go about investing can be just as important as what you invest in. Chapter 16 highlights techniques for investing to help you make more money from your stocks. Keep more of the money you earn. After all your great work in getting the right stocks and making the big bucks, you should know about keeping more of the fruits of your investing. I cover taxes in stock investing in Chapter 20. Sometimes, what people tell you to do with stocks is not as revealing as what people are actually doing. This is why I like to look at company insiders before I buy or sell that particular stock. To find out more about “insider buying and selling,” read Chapter 19. Actually, every chapter in the book offers you valuable guidance on some essential aspect of the fantastic world of stocks. The knowledge you pick up and apply from these pages has been tested over nearly a century of stock picking. The investment experience of the past — the good, the bad, and some of the ugly — is here for your benefit. Use this information to make a lot of money (and make me proud!). And don’t forget to check out the Appendixes! 13
Slide 37: 14 Part I: The Essentials of Stock Investing Stock market schizophrenia Have you ever noticed a stock going up even though the company is reporting terrible results? How about seeing a stock nosedive despite the fact that the company is doing well? What gives? Well, judging the direction of a stock in a short-term period — over the next few days or weeks — is almost impossible. Yes, in the short term, stock investing is irrational. The price of a stock and the value of its company seem disconnected and almost schizophrenic. The key phrase to remember is “short term.” A stock’s price and the company’s value become more logical over an extended period of time. The longer a stock is in the public’s view, the more rational the performance of the stock’s price. In other words, a good company continues to draw attention to itself; hence, more people want its stock, and the share price rises to better match the value of the company. Conversely, a bad company doesn’t hold up to continued scrutiny over time. As more and more people see that the company isn’t doing well, the share price declines. Over the long run, a stock’s share price and the value of the company eventually become equal for the most part. Boning Up on Strategies and Tactics Successful investing isn’t just what you invest in, it’s also the way you invest. I am very big on strategies such as trailing stops and limit orders. You can find out more in Chapter 17. Buying stocks doesn’t always mean that you must buy through a broker and that it must be 100 shares. You can buy stock for as little as $25 using programs such as dividend reinvestment plans. Chapter 18 tells you more. Getting Some Good Tips Protecting yourself from downside exposure is what separates investors from speculators, and Chapter 21 gives you ten warning signs regarding a stock’s decline. I know that when I see some of these signs that (at the very least) I’ll put on a stop loss order (Chapter 17) so that I can sleep at night. Sometimes the return on your money is not as good as the return of your money. If stocks give off “negative signals,” then there must also be “positive” ones as well. Chapter 22 gives you ten of the best signs that are commonly seen before a stock is ready to rise. What better time to jump in?
Slide 38: Chapter 1: Exploring the Basics You should be aware about the risks that fraud presents you. It’s tough enough to make money with stocks in an honest market. Yet we must always be aware of those that would take our hard-earned money from us without our consent. That’s why I include Chapter 24 — since you and I will always deal with a part of the universe that will always give us problems . . . humanity. Chapter 24 is (I believe) one of the best chapters in the book. It is very important to understand if the environment for a particular stock is good or bad. The best stocks in the world sink in a tough market while the worst stocks can go up in a jubilant and rising market. Ideally, you avoid those stocks that are in the tough market and find good stocks in a good market. This chapter will clue you in regarding those markets. 15
Slide 39: 16 Part I: The Essentials of Stock Investing
Slide 40: Chapter 2 Taking Stock of Your Current Financial Situation and Goals In This Chapter Preparing your personal balance sheet Looking at your cash flow statement Determining your financial goals es, you want to make the big bucks. Or maybe you just want to get back the big bucks you lost in the stock market debacle of 2000–2003. (Investors who followed the guidelines from the first edition of this book did much better than the crowd!) Either way, you want your money to grow so that you can have a better life. But before you make reservations for that Caribbean cruise you’re dreaming about, you have to map out your action plan for getting there. Stocks can be a great component of most wealth-building programs, but you must first do some homework on a topic that you should be very familiar with — yourself. That’s right. Understanding your current financial situation and clearly defining your financial goals are the first steps in successful investing. This chapter is undoubtedly one of the most important chapters in this book. At first, you may think it’s a chapter more suitable for some general book on personal finance. Wrong! Unsuccessful investors’ greatest weakness is not understanding their financial situation and how stocks fit in. Often, I counsel people to stay out of the stock market because they aren’t prepared for the responsibilities of stock investing — they haven’t been regularly reviewing the company’s financial statements or tracking the company’s progress. Very often, investors aren’t aware of the pitfalls of stock investing during bear markets. Y
Slide 41: 18 Part I: The Essentials of Stock Investing Investing in stocks requires balance. Investors sometimes tie up too much money in stocks, putting themselves at risk of losing a significant portion of their wealth if the market plunges. Then again, other investors place little or no money in stocks, and therefore miss out on excellent opportunities to grow their wealth. Investors should make stocks a part of their portfolios, but the operative word is part. You should only let stocks take up a portion of your money. A disciplined investor also has money in bank accounts, bonds, and other assets that offer growth or income opportunities. Diversification is key to minimizing risk. (For more on risk, see Chapter 4.) Establishing a Starting Point Whether you’re already in stocks or you’re looking to get into stocks, you need to find out about how much money you can afford to invest in stocks. No matter what you hope to accomplish with your stock investing plan, the first step a budding investor should take is figuring out how much you own and how much you owe. To do this, prepare and review your personal balance sheet. A balance sheet is simply a list of your assets, your liabilities, and what each item is currently worth so you can arrive at your net worth. Your net worth is total assets minus total liabilities. I know that these terms sound like accounting mumbo jumbo, but knowing your net worth is important to your future financial success, so just do it. Composing your balance sheet is simple. Pull out a pencil and a piece of paper. For the computer savvy, a spreadsheet software program accomplishes the same task. Gather all your financial documents, such as bank and brokerage statements and other such paperwork — you need figures from these documents. Then follow the steps that I outline in the following sections. Update your balance sheet at least once a year to monitor your financial progress (Is your net worth going up or not?). A second document to prepare is an income statement. An income statement lists your total income and your total expenses to find out how well you are doing. If your total income is greater than your total expenses, then you have net income (Great!). If your total expenses meet or exceed your total income, then that’s not good. You better look into increasing your income or decreasing your expenses. You want to get to the point that you have net income so that you can use that money to fund your stock purchases. Your personal balance sheet is really no different from balance sheets that giant companies prepare. (The main difference is a few zeros, but you can use my advice in this book to work on changing that.) In fact, the more you find out about your own balance sheet, the easier it is to understand the balance sheet of companies in which you’re seeking to invest.
Slide 42: Chapter 2: Taking Stock of Your Current Financial Situation and Goals 19 Step 1: Making sure you have an emergency fund First, list cash on your balance sheet (see the next step for more on listing your assets). Your goal is to have, in reserve, at least three to six months’ worth of your gross living expenses in cash. The cash is important because it gives you a cushion. Three to six months is usually enough to get you through the most common forms of financial disruption, such as losing your job. Finding a new job can take anywhere from three to six months. If your monthly expenses (or outgo) are $2,000, you should have at least $6,000, and probably closer to $12,000, in a secure, FDIC-insured, interestbearing bank account (or other relatively safe interest-bearing vehicle such as a money market fund). Consider this account an emergency fund and not an investment. Don’t use this money to buy stocks. Too many Americans don’t have an emergency fund, meaning that they put themselves at risk. Walking across a busy street while wearing a blindfold is a great example of putting yourself at risk, and in recent years, investors have done the financial equivalent. Investors piled on tremendous debt, put too much into investments (such as stocks) that they didn’t understand, and had little or no savings. One of the biggest problems during 2000–2003 was that savings were sinking to record lows while debt levels were reaching new heights. People then sold many stocks because they needed funds for — you guessed it — paying bills and debt. Resist the urge to start thinking of your investment in stocks as a savings account generating over 20 percent per year. This is dangerous thinking! If your investments tank, or if you lose your job, you will have financial difficulty and that will affect your stock portfolio (you might have to sell some stocks in your account just to get money to pay the bills). An emergency fund helps you through a temporary cash crunch. Step 2: Listing your assets in decreasing order of liquidity Liquid assets aren’t references to beer or cola (unless you’re AnheuserBusch). Instead, liquidity refers to how quickly you can convert a particular asset (something you own that has value) into cash. If you know the liquidity of your assets, including investments, you have some options when you need cash to buy some stock (or pay some bill). All too often, people are short on cash and have too much wealth tied up in illiquid investments such as real estate. Illiquid is just a fancy way of saying that you don’t have the immediate cash to meet a pressing need. (Hey, we’ve all had those moments!) Review your assets and take measures to ensure that you have enough liquid assets (along with your illiquid assets).
Slide 43: 20 Part I: The Essentials of Stock Investing Listing your assets in order of liquidity on your balance sheet gives you an immediate picture of which assets you can quickly convert to cash and which ones you can’t. If you need money now, you can see that cash in hand, your checking account, and your savings account are at the top of the list. The items last in order of liquidity become obvious; they’re things like real estate and other assets that can take a long time to convert to cash. Selling real estate, even in a seller’s market, can take months. Investors who don’t have adequate liquid assets run the danger of selling assets quickly and possibly at a loss because they scramble to accumulate the cash for their short-term financial obligations. For stock investors, this scramble may include prematurely selling stocks that they originally intended to use as long-term investments. Table 2-1 shows a typical list of assets in order of liquidity. Use it as a guide for making your own asset list. Table 2-1 Asset Item Current Assets John Q. Investor: Personal Assets as of December 31, 2006 Market Value Annual Growth Rate % Cash on hand and in checking Bank savings accounts and certificates of deposit Stocks Mutual funds Other assets (Collectibles, etc.) Total current assets Long-term assets Auto Residence Real estate investment $150 $500 $2,000 $2,400 0 2% 11% 9% $240 $5,290 $1,800 150,000 $125,000 –10% 5% 6%
Slide 44: F T AM E Y L Chapter 2: Taking Stock of Your Current Financial Situation and Goals Asset Item Personal stuff (such as jewelry) Total long-term assets Total assets 21 Market Value $4,000 $280,800 $286,090 Annual Growth Rate % The first column of Table 2-1 describes the asset. You can quickly convert current assets to cash — they’re more liquid; long-term assets have value, but you can’t necessarily convert them to cash quickly — they aren’t very liquid. Please take note. I have stocks listed as short-term in the table. The reason is that this balance sheet is meant to list items in order of liquidity. Liquidity is best embodied in the question “How quickly can I turn this asset into cash?” Because a stock can be sold and converted to cash very quickly, it is a good example of a liquid asset. (However, that is not the main purpose for buying stocks.) The second column gives the current market value for that item. Keep in mind that this value is not the purchase price or original value; it’s the amount you would realistically get if you sold the asset in the current market at that moment. The third column tells you how well that investment is doing, compared to one year ago. If the percentage rate is 5 percent, that item increased in value by 5 percent from a year ago. You need to know how well all your assets are doing. Why? To adjust your assets for maximum growth or to get rid of assets that are losing money. Assets that are doing well are kept (increase your holdings?), and assets that are down in value are candidates for removal. Perhaps you can sell them and reinvest the money elsewhere. In addition, the realized loss has tax benefits (see Chapter 20). Figuring the annual growth rate (in the third column) as a percentage isn’t difficult. Say that you buy 100 shares of the stock Gro-A-Lot Corp. (GAL), and its market value on December 31, 2003, is $50 per share for a total market value of $5,000 (100 shares × $50 per share). When you check its value on December 31, 2004, you find out the stock is at $60 per share (100 shares times $60 equals a total market value of $6,000). The annual growth rate is 20 percent. You calculate this by taking the amount of the gain ($60 per share less $50 per share = $10 gain per share), which is $1,000 (100 shares times the $10 gain), and dividing it by the value at the beginning of the time period ($5,000). In this case, you get 20 percent ($1,000 divided by $5,000). What if GAL also generates a dividend of $2 per share during that period; now what?
Slide 45: 22 Part I: The Essentials of Stock Investing In that case, GAL generates a total return of 24 percent. To calculate the total return, add the appreciation ($10 per share times 100 shares equals $1,000) and the dividend income ($2 per share times 100 shares equals $200) and divide that sum ($1,000 + $200, or $1,200) by the value at the beginning of the year ($50 per share times 100 shares or $5,000). The total is $1,200 ($1,000 of appreciation and $200 total dividends), or 24 percent ($1,200 ÷ $5,000). The last line lists the total for all the assets and their current market value. The third column answers the question “How well did this particular asset grow from a year ago?” Step 3: Listing your liabilities Liabilities are simply the bills that you’re obligated to pay. Whether it’s a credit card bill or a mortgage payment, a liability is an amount of money you have to pay back eventually (with interest). If you don’t keep track of your liabilities, you may end up thinking that you have more money than you really do. Table 2-2 lists some common liabilities. Use it as a model when you list your own. You should list the liabilities according to how soon you need to pay them. Credit card balances tend to be short-term obligations, while mortgages are long-term. Table 2-2 Liabilities Credit cards Personal loans Mortgage Total liabilities Listing Personal Liabilities Amount $4,000 $13,000 $100,000 $117,000 Paying Rate % 15% 10% 8% The first column in Table 2-2 names the type of debt. Don’t forget to include student loans and auto loans if you have any of these. Never avoid listing a liability because you’re embarrassed to see how much you really owe. Be honest with yourself — doing so helps you improve your financial health. The second column shows the current value (or current balance) of your liabilities. List the most current balance to see where you stand with your creditors.
Slide 46: Chapter 2: Taking Stock of Your Current Financial Situation and Goals The third column reflects how much interest you’re paying for carrying that debt. This information is an important reminder about how debt can be a wealth zapper. Credit card debt can have an interest rate of 18 percent or more, and to add insult to injury, it isn’t even tax deductible. Using a credit card to make even a small purchase costs you if you maintain a balance. Within a year, a $50 sweater at 18 percent costs $59 when you add in the potential interest you pay. If you compare your liabilities in Table 2-2 and your personal assets in Table 2-1, you may find opportunities to reduce the amount you pay for interest. Say, for example, that you pay 15 percent on a credit card balance of $4,000 but also have a personal asset of $5,000 in a bank savings account that’s earning 2 percent in interest. In that case, you may want to consider taking $4,000 out of the savings account to pay off the credit card balance. Doing so saves you $520; the $4,000 in the bank was earning only $80 (2 percent of $4,000), while you were paying $600 on the credit card balance (15 percent of $4,000). If you can’t pay off high-interest debt, at least look for ways to minimize the cost of carrying the debt. The most obvious ways include the following: Replacing high-interest cards with low-interest cards. Many companies offer incentives to consumers, including signing up for cards with favorable rates that can be used to pay off high-interest cards. Replacing unsecured debt with secured debt. Credit cards and personal loans are unsecured (you haven’t put up any collateral or other asset to secure the debt); therefore, they have higher interest rates because this type of debt is considered riskier for the creditor. Sources of secured debt (such as home equity line accounts and brokerage accounts) provide you with a means to replace your high-interest debt with lowerinterest debt. You get lower interest rates with secured debt because it’s less risky for the creditor — the debt is backed up by collateral (your home or your stocks). The year 2004 was the eighth consecutive year that personal bankruptcies surpassed the million mark in the United States. Corporate bankruptcies were also at record levels. Make a diligent effort to control and reduce your debt, or the debt can become too burdensome. If you don’t, you may have to sell your stocks just to stay liquid. Remember, Murphy’s Law states that you will sell your stock at the worst possible moment! Don’t go there. 23 Step 4: Calculating your net worth Your net worth is an indication of your total wealth. You can calculate your net worth with this basic equation: total assets (Table 2-1) less total liabilities (Table 2-2) equal net worth (net assets or net equity).
Slide 47: 24 Part I: The Essentials of Stock Investing I owe, I owe, so off to work I go One reason you continue to work is probably so that you can pay off your bills. But many people today are losing their jobs because their company owes, too! Debt is one of the biggest financial problems in America today. Companies and individuals holding excessive debt contributed to the stock market’s massive decline in 2000 and the U.S. recession in 2001. If individuals managed their personal liabilities more responsibly, the general economy would be much better off. One reason the United States appeared to be doing so well during the late 1990s was the fact that individuals and organizations went on an unprecedented spending binge, financed mostly by excessive debt. The economy looked unstoppable. However, sooner or later you have to pay the piper. Stock prices may go up and down, but debt stays up until it is either paid down or the debtor files for bankruptcy. As of the 4th quarter of 2004, U.S. debt has surpassed a mind-boggling $37 trillion, which means that consumers, businesses, and governments will continue dealing with challenging times through this decade. Yes, the stock market will be affected! Table 2-3 shows this equation in action with a net worth of $169,090 — a very respectable number. For many investors, just being in a position where assets exceed liabilities (a positive net worth) is great news. Use Table 2-3 as a model to analyze your own financial situation. Your mission (if you choose to accept it — and you should) is to ensure that your net worth increases from year to year as you progress toward your financial goal. Table 2-3 Totals Total assets (from Table 2-1) Figuring Your Personal Net Worth Amounts ($) $286,090 ($117,000) $169,090 Increase from Year Before +5% –2% +3% Total liabilities (from Table 2-2) Net worth (total assets less total liabilities) Step 5: Analyzing your balance sheet Create a balance sheet based on the prior steps in this chapter to illustrate your current finances. Take a close look at it and try to identify any changes
Slide 48: Chapter 2: Taking Stock of Your Current Financial Situation and Goals you can make to increase your wealth. Sometimes reaching your financial goals can be as simple as refocusing the items on your balance sheet (use the above table as a general guideline). Here are some brief points to consider: Is the money in your emergency (or rainy day) fund sitting in an ultrasafe account and earning the highest interest available? Bank money market accounts or money market funds are recommended. The safest type of account is a U.S. Treasury money market fund. Banks are backed by the Federal Deposit Insurance Corporation (FDIC) while U.S. treasury securities are backed by the “full faith and credit” of the Federal Government. Can you replace depreciating assets with appreciating assets? Say that you have two stereo systems. Why not sell one and invest the proceeds? You may say, “But I bought that unit two years ago for $500, and if I sell it now, I’ll only get $300.” That’s your choice. You need to decide what helps your financial situation more — a $500 item that keeps shrinking in value (a depreciating asset) or $300 that can grow in value when invested (an appreciating asset). Can you replace low-yield investments with high-yield investments? Maybe you have $5,000 in a bank certificate of deposit earning 3 percent. You can certainly shop around for a better rate at another bank, but you can also seek alternatives that can offer a higher yield, such as U.S. savings bonds or short-term bond funds. Can you pay off any high-interest debt with funds from low-interest assets? If, for example, you have $5,000 earning 2 percent in a taxable bank account, and you have $2,500 on a credit card charging 18 percent (nondeductible), you may as well pay off the credit card balance and save on the interest. If you’re carrying debt, are you using that money for an investment return that is greater than the interest you’re paying? Carrying a loan with an interest rate of 8 percent is acceptable if that borrowed money is yielding more than 8 percent elsewhere. Suppose that you have $6,000 in cash in a brokerage account. If you qualify, you can actually make a stock purchase greater than $6,000 by using margin (essentially a loan from the broker). You can buy $12,000 of stock using your $6,000 in cash, with the remainder financed by the broker. Of course, you pay interest on that margin loan. But what if the interest rate is 6 percent and the stock you’re about to invest in has a dividend that yields 9 percent? In that case, the dividend can help you pay off the margin loan, and you keep the additional income. (For more on buying on margin, see Chapter 17.) Can you sell any personal stuff for cash? You can replace unproductive assets with cash from garage sales and auction Web sites. 25
Slide 49: 26 Part I: The Essentials of Stock Investing Can you use your home equity to pay off consumer debt? Borrowing against your home has more favorable interest rates, and this interest is still tax deductible. (Be careful about your debt level. See Chapter 23 for warnings on debt and other concerns.) Paying off consumer debt by using funds borrowed against your home is a great way to wipe the slate clean. What a relief to get rid of your credit card balances! Just don’t turn around and run up the consumer debt again. You can get overburdened and experience financial ruin (not to mention homelessness). Not a pretty picture. The important point to remember is that you can take control of your finances with discipline (and with the advice I offer in this book). Funding Your Stock Program If you’re going to invest money in stocks, the first thing you need is . . . money! Where can you get that money? If you’re waiting for an inheritance to come through, you may have to wait a long time, considering all the advances being made in healthcare lately. What’s that? You were going to invest in healthcare stocks? How ironic. Yet, the challenge still comes down to how to fund your stock program. Many investors can reallocate their investments and assets to do the trick. Reallocating simply means selling some investments or other assets and reinvesting that money into stocks. It boils down to deciding what investment or asset you can sell or liquidate. Generally, you want to consider those investments and assets that give you a low return on your money (or no return at all). If you have a complicated mix of investments and assets, you may want to consider reviewing your options with a financial planner. Reallocation is just part of the answer; your cash flow is the other part. Ever wonder why there’s so much month left at the end of the money? Consider your cash flow. Your cash flow refers to what money is coming in (income) and what money is being spent (outgo). The net result is either a positive cash flow or a negative cash flow, depending on your cash management skills. Maintaining a positive cash flow (more money coming in than going out) helps you increase your net worth (mo’ money, mo’ money, mo’ money!). A negative cash flow ultimately depletes your wealth and wipes out your net worth if you don’t turn it around immediately. The following sections show you how to analyze your cash flow. The first step is to do a cash flow statement.
Slide 50: Chapter 2: Taking Stock of Your Current Financial Situation and Goals 27 Dot-com-and-go If you were publishing a book about negative cash flow, look for the employees of any one of a hundred dot-com companies to write it. Their qualifications include working for a company that flew sky-high in 1999 and crashed in 2000 and 2001. Companies such as eToys.com, Pets.com, and DrKoop.com were given millions, yet they couldn’t turn a profit and eventually closed for business. You may as well call them “dot-com-and-go.” You can learn from their mistakes. (Actually, they could have learned from you.) In the same way that profit is the most essential single element in a business, a positive cash flow is important for your finances in general and for funding your stock investment program in particular. Don’t confuse a cash flow statement with an income statement (also called a “profit and loss statement” or an “income and expense statement”). A cash flow statement is simple to calculate because you can easily track what goes in and what goes out. With a cash flow statement (see Table 2-6), you ask yourself three questions: What money is coming in? In your cash flow statement, jot down all sources of income. Calculate it for the month and then for the year. Include everything, including salary, wages, interest, dividends, and so on. Add them all up and get your grand total for income. What is your outgo? Write down all the things that you spend money on. List all your expenses. If possible, categorize them into essential and nonessential. You can get an idea of all the expenses that you can reduce without affecting your lifestyle. But before you do that, make as complete a list as possible of what you spend your money on. What’s left? If your income is greater than your outgo, then you have money ready and available for stock investing. No matter how small the amount seems, it definitely helps. I’ve seen fortunes built when people started to diligently invest as little as $25 to $50 per week or per month. If your outgo is greater than your income, then you better sharpen your pencil. Cut down on nonessential spending and/or increase your income. If your budget is a little tight, hold off on your stock investing until your cash flow improves. Step 1: Tallying up your income Using Table 2-4 as a worksheet, list and calculate the money you have coming in. The first column describes the source of the money, the second column
Slide 51: 28 Part I: The Essentials of Stock Investing indicates the monthly amount from each respective source, and the last column indicates the amount projected for a full year. Include all income, such as wages, business income, dividends, interest income, and so on. Then project these amounts for a year (multiply by 12) and enter those amounts in the third column. Table 2-4 Item Salary and wages Interest income and dividends Business net (after taxes) income Other income Total income Listing Your Income Monthly $ Amount Yearly $ Amount This is the amount of money you have to work with. To ensure your financial health, don’t spend more than this amount. Always be aware of and carefully manage your income. Step 2: Adding up your outgo Using Table 2-5 as a worksheet, list and calculate the money that’s going out. What are you spending and on what? The first column describes the source of the expense, the second column indicates the monthly amount, and the third column shows the amount projected for a full year. Include all the money you spend, including credit card and other debt payments; household expenses, such as food, utility bills, and medical expenses; and money spent for nonessential expenses such as video games and elephant-foot umbrella stands. Table 2-5 Item Payroll taxes Rent or mortgage Listing Your Expenses (Outgo) Monthly $ Amount Yearly $ Amount
Slide 52: Chapter 2: Taking Stock of Your Current Financial Situation and Goals 29 Item Utilities Food Clothing Insurance (medical, auto, homeowners, and so on) Telephone Real estate taxes Auto expenses Charity Recreation Credit card payments Loan payments Other Total Monthly $ Amount Yearly $ Amount Payroll taxes is just a category in which to lump all the various taxes that the government takes out of your paycheck. Feel free to put each individual tax on its own line if you prefer. The important thing is creating a comprehensive list that is meaningful to you. You may notice that the outgo doesn’t include items such as payments to a 401(k) plan and other savings vehicles. Yes, these items do impact your cash flow, but they’re not expenses; the amounts that you invest (or your employer invests for you) are essentially assets that benefit your financial situation versus an expense that doesn’t help you build wealth. To account for the 401(k), simply deduct it from the gross pay first before you calculate the above worksheet. If, for example, your gross pay is $2,000 and your 401(k) contribution is $300, then use $1,700 as your income figure. Step 3: Creating a cash flow statement Okay, you’re almost to the end. The last step is creating a cash flow statement so that you can see (all in one place) how your money moves — how much comes in and how much goes out and where it goes.
Slide 53: 30 Part I: The Essentials of Stock Investing Plug the amount of your total income (from Table 2-4) and the amount of your total expenses (from Table 2-5) into the Table 2-6 worksheet to see your cash flow. Do you have positive cash flow — more coming in than going out — so that you can start investing in stocks (or other investments), or are expenses overpowering your income? Doing a cash flow statement isn’t just about finding money in your financial situation to fund your stock program. First and foremost, it’s about your financial well-being. Are you managing your finances well or not? Table 2-6 Item Total income (from Table 2-4) Total outgo (from Table 2-5) Net inflow/outflow Looking at Your Cash Flow Monthly $ Amount Yearly $ Amount 2004 was another record year for personal and business bankruptcies. Personal debt and expenses far exceeded whatever income they generated. That announcement is another reminder to watch your cash flow; keep your income growing and your expenses and debt as low as possible. Step 4: Analyzing your cash flow Use your cash flow statement to identify sources of funds for your investment program. The more you can increase your income and the more you can decrease your outgo, the better. Scrutinize your data. Where can you improve the results? Here are some questions to ask yourself: How can you increase your income? Do you have hobbies, interests, or skills that can generate extra cash for you? Can you get more paid overtime at work? How about a promotion or a job change? Where can you cut expenses? Have you categorized your expenses as either “necessary” or “nonessential”?
Slide 54: Chapter 2: Taking Stock of Your Current Financial Situation and Goals Can you lower your debt payments by refinancing or consolidating loans and credit card balances? Have you shopped around for lower insurance or telephone rates? Have you analyzed your tax withholdings in your paycheck to make sure that you are not overpaying your taxes (just to get your overpayment back next year as a refund?) 31 Finding investment money in tax savings According to the Tax Foundation, the average U.S. citizen pays more in taxes than in food, clothing, and shelter combined. Sit down with your tax advisor and try to find ways to reduce your taxes. A home-based business, for example, is a great way to gain new income and increase your tax deductions, resulting in a lower tax burden. Your tax advisor can make recommendations that work for you. One tax strategy to consider is doing your stock investing in a tax-sheltered account such as a traditional Individual Retirement Account (IRA) or a Roth Individual Retirement Account (Roth IRA). Again, check with your tax advisor for deductions and strategies available to you. For more on the tax implications of stock investing, see Chapter 20. Setting Your Sights on Your Financial Goals Consider stocks as tools for living, just like any other investment — no more, no less. Stocks are the tools you use (one of many) to accomplish something — to achieve a goal. Yes, successfully investing in stocks is the goal that you’re probably shooting for if you’re reading this book. However, you must complete the following sentence: “I want to be successful in my stock investing program to accomplish _______.” You must consider stock investing as a means to an end. When people buy a computer, they don’t (or shouldn’t) think of buying a computer just to have a computer. People buy a computer because doing so helps them achieve a particular result, such as being more efficient in business, playing fun games, or having a nifty paperweight (tsk, tsk). Know the difference between long-term, intermediate-term, and short-term goals and then set some of each. Long-term is a reference to projects or financial goals that need funding five or more years from now. Intermediate-term refers to financial goals that need funding two to five years from now, while short-term goals need funding less than two years from now.
Slide 55: 32 Part I: The Essentials of Stock Investing Stocks, in general, are best suited for long-term goals such as these: Achieving financial independence (think retirement funding) Paying for future college costs Paying for any long-term expenditure or project Some categories of stock (such as conservative or blue-chip) may be suitable for intermediate-term financial goals. If, for example, you will retire four years from now, conservative stocks are appropriate. If you’re optimistic about the stock market and confident that stock prices will rise, then go ahead and invest. However, if you’re negative about the market (you’re bearish, or you believe that stock prices will decline), you may want to wait until the economy starts to forge a clear path. For more on investing in bull or bear markets, see Chapter 15. Stocks generally aren’t suitable for short-term investing goals because stock prices can behave irrationally in a short period of time. Stocks fluctuate from day to day, so you don’t know what the stock will be worth in the near future. You may end up with less money than you expected. For investors seeking to reliably accrue money for short-term needs, short-term bank certificates of deposit or money market funds are more appropriate. In recent years, investors have sought quick, short-term profits by trading and speculating in stocks. Lured by the fantastic returns generated by the stock market in the late 1990s, investors saw stocks as a get-rich-quick scheme. It is very important for you to understand the difference between investing, saving, and speculating. Which one do you want to do? Knowing the answer to this question is crucial to your goals and aspirations. Investors who don’t know the difference tend to get burned. Here’s some information to help you distinguish among these three actions: Investing is the act of putting your current funds into securities or tangible assets for the purpose of gaining future appreciation, income, or both. You need time, knowledge, and discipline to invest. The investment can fluctuate in price, but has been chosen for long-term potential. Saving is the safe accumulation of funds for a future use. Savings don’t fluctuate and are generally free of financial risk. The emphasis is on safety and liquidity. Speculating is the financial world’s equivalent of gambling. An investor who speculates is seeking quick profits gained from short-term price movements in that particular asset or investment. These distinctly different concepts are often confused even among so-called financial experts. I know of one financial advisor who actually put a child’s
Slide 56: Chapter 2: Taking Stock of Your Current Financial Situation and Goals college fund money into an Internet stock fund only to lose over $17,000 in less than ten months! This advisor thought that she was investing, but in reality, she was speculating. I know of another advisor who told a client to avoid savings accounts altogether because the client had a 401(k) plan. This particular advisor didn’t catch the crucial difference between “saving” and “investing.” The client eventually found out the difference; his 401(k) fell by 40 percent when the bear market of 2000 arrived. Fortunately, we can learn from these situations and get back on track. That child that lost the $17,000? He is my neighbor and I helped the father to reinvest the remaining funds. The portfolio doubled in value by the following year. It is still growing. The second fellow that lost 40 percent in his 401(k) account? He became my student and he has recouped his losses and his 401(k) plan is up (this occurred within two years). As of 2005, both investors have portfolios that are beating the general market. 33
Slide 57: 34 Part I: The Essentials of Stock Investing
Slide 58: Chapter 3 Defining Common Approaches to Stock Investing In This Chapter Deciding what time frame fits your investment strategy Looking at your purpose for investing Determining your investing style ead this chapter carefully. Millions of investors are at risk because the market sees as much misinvesting activity in stocks as it does investing. I know it sounds weird, but the situation is similar to your crazy Uncle Bill punching the accelerator rather than the brakes when heading right toward the Grand Canyon — he knows that he needs to do something, but he chooses the wrong mechanism. Stocks are tools you can use to build your wealth. When used wisely, for the right purpose, and in the right environment, they do a great job. But when improperly applied, they can lead to disaster. In this chapter, I show you how to choose the right investments, based on your short- and long-term financial goals. I also show you how to decide on your purpose for investing (growth or income investing) and the style of investing — conservative or aggressive — that you need to take. R Matching Stocks and Strategies with Your Goals Various stocks are out there, as well as various investment approaches. The key to success in the stock market is matching the right kind of stock with the right kind of investment situation. You have to choose the stock and the approach that match your goals. (Refer to Chapter 2 for more on defining your financial goals.)
Slide 59: 36 Part I: The Essentials of Stock Investing Before investing in a stock, ask yourself, “When do I want to reach my financial goal?” Stocks are a means to an end. Your job is to figure out what that end is — or, more importantly, when it is. Do you want to retire in ten years or next year? Must you pay for your kid’s college education next year or 18 years from now? The length of time you have before you need the money you hope to earn from stock investing determines what stocks you should buy. Table 3-1 gives you some guidelines for choosing the kind of stock best suited for the type of investor you are and the goals you have. Table 3-1 Type of Investor Conservative (worries about risk) Aggressive (high tolerance to risk) Conservative (worries about risk) Aggressive (high tolerance to risk) Short term Stock Types, Financial Goals, and Investor Types Time Frame for Financial Goals Long term (over 5 years) Long term (over 5 years) Intermediate term (2 to 5 years) Intermediate term (2 to 5 years) 1 to 2 years Type of Stock Most Suitable Large-cap stocks and mid-cap stocks Small-cap stocks and mid-cap stocks Large-cap stocks, preferably with dividends Small-cap stocks and mid-cap stocks Stocks are not suitable for the short-term. Instead, look at vehicles such as savings accounts and money market funds. Dividends are payments made to an owner (unlike interest, which is payment to a creditor). Dividends are a great form of income, and companies that issue dividends tend to have more stable stock prices as well. For more information on dividend-paying stocks, see the section “Investing for a Purpose,” later in this chapter, and Chapter 9. Table 3-1 gives you general guidelines, but keep in mind that not everyone can fit into a particular profile. Every investor has a unique situation, set of goals, and level of risk tolerance. Remember that the terms large-cap, mid cap, and small-cap refer to the size (or market capitalization, also known as market cap) of the company. All factors being equal, large companies are safer (less risky) than small companies. For more on market caps, see the section “Investing for Your Personal Style,” later in this chapter.
Slide 60: Chapter 3: Defining Common Approaches to Stock Investing 37 Investing for the Future Are your goals long term or short term? Answering this question is important because individual stocks can be either great or horrible choices, depending on the time period you want to focus on. Generally, the length of time you plan to invest in stocks can be short term, intermediate term, or long term. The following sections outline what kinds of stocks are most appropriate for each term length. Investing in stocks becomes less risky as the time frame lengthens. Stock prices tend to fluctuate on a daily basis, but they have a tendency to trend up or down over an extended period of time. Even if you invest in a stock that goes down in the short term, you’re likely to see it rise and possibly go above your investment if you have the patience to wait it out and let the stock price appreciate. Focusing on the short term Short term generally means one year or less, although some people extend the period to two years or less. You get the point. Every person has short-term goals. Some are modest, such as setting aside money for a vacation next month or paying for medical bills. Other shortterm goals are more ambitious, such as accruing funds for a down payment to purchase a new home within six months. Whatever the expense or purchase, you need a predictable accumulation of cash soon. If this sounds like your situation, stay away from the stock market! Because stocks can be so unpredictable in the short term, they’re a bad choice for short-term considerations. I get a kick out of market analysts on television saying things such as, “At $25 a share, XYZ is a solid investment, and we feel that its stock should hit our target price of $40 within six to nine months.” You know that an eager investor hears that and says, “Gee, why bother with 3 percent at the bank when this stock will rise by more than 50 percent? I better call my broker.” It may hit that target amount (or surpass it), or it may not. Most of the time, the stock doesn’t reach the target price, and the investor is disappointed. The stock could even go down! The reason that target prices are frequently (usually) missed is that the analyst is one person and it’s difficult to figure out what millions of investors will do in the shortterm. The short-term can be irrational because so many investors have so many reasons for buying and selling that it can be difficult to analyze. If you want to use the money you invest for an important short-term need, you could lose very important cash quicker than you think.
Slide 61: 38 Part I: The Essentials of Stock Investing Short-term investing = speculating If you look at a period of a single year, stocks have a mixed-performance record compared with other investments, such as bonds or bank investments. In 1999, big-company stocks grew an average of 25 percent, and small-company stocks averaged a blistering 50 to 70 percent, but bank accounts and various bonds ranged only from 1.5 to 7 percent. In the year 2000, the picture was much different. Stock investors lost their shirts, and conservative investors who put their money in bank certificates of deposit and treasury bonds watched their money grow. The bottom line is that investing in stocks for the short term is nothing more than speculating. Your only possible strategy is luck. Short-term stock investing is very unpredictable. You can better serve your short-term goals with stable, interest-bearing investments (like Certificates of Deposit at your local bank). During the raging-bull market (see more about bull markets in Chapter 15) of the late 1990s, investors watched as some high-profile stocks went up 20 to 50 percent in a matter of months. Hey, who needs a savings account earning a measly interest when stocks grow like that! Of course, when the bear market hit from 2000 to 2003 and those same stocks fell 50 to 85 percent, a savings account earning a measly interest rate suddenly didn’t seem so bad. Stocks — even the best ones — fluctuate in the short term. In a negative environment, they can be very volatile. No one can accurately predict the price movement (unless you have some inside information), so stocks are definitely inappropriate for any financial goal that you need to reach within one year. Check Table 3-1 for suggestions about your short-term strategies. Considering intermediate-term goals Intermediate term refers to your financial goals that you plan to reach within five years. If, for example, you want to accumulate funds to put money down for investment in real estate four years from now, some growth-oriented investments may be suitable. Although some stocks may be appropriate for a two- or three-year period, not all stocks are good intermediate-term investments. Different types and categories of stocks exist. Some stocks are fairly stable and hold their value well, such as the stock of much larger or established dividend-paying companies.
Slide 62: Chapter 3: Defining Common Approaches to Stock Investing Other stocks have prices that jump all over the place, such as the stocks of untested companies that haven’t been in existence long enough to develop a consistent track record. If you plan to invest in the stock market to meet intermediate-term goals, consider large, established companies or dividend-paying companies in industries that provide the necessities of life (like food and beverage or electric utilities). 39 Preparing for the long term Stock investing is best suited for making money over a long period of time. When you measure stocks against other investments in terms of five to (preferably) ten or more years, they excel. Even investors who bought stocks during the depths of the Great Depression saw profitable growth in their stock portfolios over a ten-year period. In fact, if you examine any ten-year period over the past 50 years, you see that stocks beat out other financial investments (such as bonds or bank investments) in almost every single ten-year period when measured by total return (taking into account reinvesting and compounding of capital gains and dividends)! Chapters 8 and 9 cover growth and income. As you can see, longterm planning allows stocks to shine. Of course, your work doesn’t stop at deciding on a long-term investment. You still have to do your homework and choose stocks wisely because, even in good times, you can lose money if you invest in companies that go out of business. Part III shows you how to evaluate specific companies and industries and alerts you to factors in the general economy that can affect stock behavior. Appendix A provides plenty of resources you can turn to. Because you can choose between many different types and categories of stocks, virtually any investor with a long-term perspective should add stocks to his investment portfolio. Whether you want to save for a young child’s college fund or for future retirement goals, carefully selected stocks have proven to be a superior long-term investment. Investing for a Purpose When the lady was asked why she bungee jumped off the bridge that spanned a massive ravine, she answered, “Because it’s fun!” When someone asked the fellow why he dove into a pool that was chock-full of alligators and
Slide 63: 40 Part I: The Essentials of Stock Investing snakes, he responded, “Because someone pushed me.” Your investment in stocks shouldn’t happen unless you have a purpose that you understand, like investing for growth or investing for income. Even if an advisor pushes you to invest, be sure that your advisor gives you an explanation of how that stock choice fits your purpose. I know of a very nice, elderly lady who had a portfolio brimming with aggressive-growth stocks because she had an overbearing broker. Her purpose should’ve been conservative, and she should’ve chosen investments that would preserve her wealth rather than grow it. Obviously, the broker’s agenda got in the way. Stocks are just a means to an end. Figure out your desired end and then match the means. To find out more about dealing with brokers, go to Chapter 7. Making loads of money quickly: Growth investing When investors want their money to grow, they look for investments that appreciate in value. Appreciate is just another way of saying “grow.” If you have a stock that you bought for $8 per share and now its value is $30 per share, your investment has grown by $22 per share — that’s appreciation. I know I would appreciate it. Appreciation (also known as capital gain) is probably the number one reason why people invest in stocks. Few investments have the potential to grow your wealth as conveniently as stocks. If you want the stock market to make you loads of money relatively quickly (and you can assume some risk), head to Chapter 8, which takes an in-depth look at investing for growth. Stocks are a great way to grow your wealth, but they’re not the only way. Many investors seek alternative ways to make money, but many of these alternative ways are more aggressive and carry significantly more risk. You may have heard about people who made quick fortunes in areas such as commodities (like wheat, pork bellies, or precious metals), options, and other more sophisticated investment vehicles. Keep in mind that you should limit risky investments to only a portion of your portfolio, such as 10 percent of your investable funds. Experienced investors, however, can go as high as 20 percent. Chapter 8 goes into greater detail about growth investing. Steadily making money: Income investing Not all investors want to take on the risk that comes with making a killing. (Hey . . . no guts, no glory!) Some people just want to invest in the stock
Slide 64: Chapter 3: Defining Common Approaches to Stock Investing market as a means of providing a steady income. They don’t need stock values to go through the ceiling. Instead, they need stocks that perform well consistently. If your purpose for investing in stocks is to create income, you need to choose stocks that pay dividends. Dividends are typically paid quarterly to stockholders on record. 41 Distinguishing between dividends and interest Don’t confuse dividends with interest. Most people are familiar with interest, because that’s how you grow your money over the years in the bank. The important difference is that interest is paid to creditors, and dividends are paid to owners (meaning shareholders — and if you own stock, you’re a shareholder, because stocks represent shares in a publicly traded company). When you buy stock, you buy a piece of that company. When you put money in a bank (or when you buy bonds), you basically loan your money. You become a creditor, and the bank or bond issuer is the debtor, and as such, it must eventually pay your money back to you with interest. Recognizing the importance of an income stock’s yield Investing for income means that you have to consider your investment’s yield. If you want income from a stock investment, you must compare the yield from that particular stock with alternatives. Looking at the yield is a way to compare the income you expect to receive from one investment with the expected income from others. Table 3-2 shows some comparative yields. Table 3-2 Investment Smith Co. Jones Co. Acme Bank Acme Bank Acme Bank Brown Co. Comparing the Yields of Various Investments Type Stock Stock Bank CD Bank CD Bank CD Bond Amount $50/share $100/share $500 $2,500 $5,000 $5,000 Pay Type Dividend Dividend Interest Interest Interest Interest Payout $2.50 $4.00 $25.00 $131.25 $287.50 $300.00 Yield 5.0% 4.0% 5.0% 5.25% 5.75% 6.0% To understand how to calculate yield, you need the following formula: Yield = Payout ÷ Investment Amount
Slide 65: 42 Part I: The Essentials of Stock Investing Yield enables you to compare how much income you would get for a prospective investment compared with the income you would get from other investments. For the sake of simplicity, this exercise is based on an annual percentage yield basis (compounding would increase the yield). Jones Co. and Smith Co. are both typical dividend-paying stocks, and in the example presented by Table 3-2, presume that both companies are similar in most respects except for their differing dividends. How can you tell whether a $50 stock with a $2.50 annual dividend is better (or worse) than a $100 stock with a $4.00 dividend? The yield tells you. Even though Jones Co. pays a higher dividend ($4.00), Smith Co. has a higher yield (5 percent). Therefore, if you had to choose between those two stocks as an income investor, you would choose Smith Co. Of course, if you truly want to maximize your income and don’t really need your investment to appreciate a lot, you should probably choose Brown Co.’s bond because it offers a yield of 6 percent. Dividend-paying stocks do have the ability to increase in value. They may not have the same growth potential as growth stocks, but, at the very least, they have a greater potential for capital gain than bank CDs or bonds. Dividendpaying stocks (investing for income) are covered in Chapter 9. Investing for Your Personal Style Your investing style isn’t a blue-jeans-versus-three-piece-suit debate. It refers to your approach to stock investing. Do you want to be conservative or aggressive? Would you rather be the tortoise or the hare? Your investment personality greatly depends on your purpose and the term over which you’re planning to invest (see the previous two sections in this chapter). The following sections outline the two most general investment styles. Conservative investing Conservative investing means that you put your money in something proven, tried, and true. You invest your money in safe and secure places, such as banks and government-backed securities. But how does that apply to stocks? (Table 3-1 gives you suggestions.) Conservative stock investors want to place their money in companies that have exhibited some of the following qualities: Proven performance: You want companies that have shown increasing sales and earnings year after year. You don’t demand anything spectacular, just a strong and steady performance.
Slide 66: Chapter 3: Defining Common Approaches to Stock Investing Market size: Companies should be large-cap (short for large capitalization). In other words, they should have a market value exceeding $10 billion. Conservative investors surmise that bigger is safer. Market leadership: Companies should be leaders in their industries. Perceived staying power: You want companies with the financial clout and market position to weather uncertain market and economic conditions. It shouldn’t matter what happens in the economy or who gets elected. As a conservative investor, you don’t mind if the companies’ share prices jump (who would?), but you’re more concerned with steady growth over the long term. 43 Aggressive investing Aggressive investors can plan long term or look only over the intermediate term, but in any case, they want stocks that resemble jack rabbits — they show the potential to break out of the pack. Aggressive stock investors want to invest their money in companies that have exhibited some of the following qualities: Great potential: The company must have superior goods, services, ideas, or ways of doing business compared to the competition. Capital gains possibility: You don’t even consider dividends. If anything, you dislike dividends. You feel that the money that would’ve been dispensed in dividend form is better reinvested in the company. This, in turn, can spur greater growth. Innovation: Companies should have technologies, ideas, or innovative methods that make them stand apart from other companies. Aggressive investors usually seek out small capitalization stocks, known as small-caps, because they have plenty of potential for growth. Take the tree example, for instance: A giant redwood may be strong, but it may not grow much more, whereas a brand-new sapling has plenty of growth to look forward to. Why invest in stodgy, big companies when you can invest in smaller enterprises that may become the leaders of tomorrow? Aggressive investors have no problem investing in obscure companies because they hope that such companies will become another IBM or McDonald’s. Find out more about growth investing in Chapter 8.
Slide 67: 44 Part I: The Essentials of Stock Investing
Slide 68: Chapter 4 Recognizing the Risks In This Chapter Considering the types of risk Taking steps to reduce your risk Balancing risk against return I nvestors face many risks, many of which I cover in this chapter. The simplest definition of risk for investors is “the possibility that your investment will lose some (or all) of its value.” Yet you don’t have to fear risk if you understand and plan for it. You need to get familiar with the concept of risk. You must understand the oldest equation in the world of investing — risk versus return. This equation states the following: If you want a greater return on your money, you need to tolerate more risk. If you don’t want to tolerate more risk, you must tolerate a lower rate of return. This point about risk is best illustrated from a moment in one of my investment seminars. One of the attendees told me that he had his money in the bank but was dissatisfied with the rate of return. He lamented, “The yield on my money is pitiful! I want to put my money somewhere where it can grow.” I asked him, “How about investing in common stocks? Or what about growth mutual funds? They have a solid, long-term growth track record.” He responded, “Stocks? I don’t want to put my money there. It’s too risky!” Okay, then. If you don’t want to tolerate more risk, then don’t complain about earning less on your money. Risk (in all its forms) has a bearing on all your money concerns and goals. That’s why it’s so important that you understand risk before you invest. This man — as well as the rest of us — needs to remember that risk is not a four-letter word. Well, it is a four-letter word, but you know what I mean. Risk is present no matter what you do with your money. Even if you simply stick your money in your mattress, risk is involved — several kinds of risk, in fact.
Slide 69: 46 Part I: The Essentials of Stock Investing You have the risk of fire. What if your house burns down? You have the risk of theft. What if burglars find your stash of cash? You also have relative risk. (In other words, what if your relatives find your money?) Be aware of the different kinds of risk, and you can easily plan around them to keep your money growing. Exploring Different Kinds of Risk Think about all the ways that an investment can lose money. You can list all sorts of possibilities. So many that you may think, “Holy cow! Why invest at all?” Don’t let risk frighten you. After all, life itself is risky. Just make sure that you understand the different kinds of risk before you start navigating the investment world. Be mindful of risk and find out about the effects of risk on your investments and personal financial goals. Financial risk The financial risk of stock investing is that you can lose your money if the company whose stock you purchase loses money or goes belly up. This type of risk is the most obvious because companies do go bankrupt. You can greatly enhance the chances of your financial risk paying off by doing an adequate amount of research and choosing your stocks carefully (which this book helps you do — see Part III for more details). Financial risk is a real concern even when the economy is doing well. Some diligent research, a little planning, and a dose of common sense help you reduce your financial risk. In the stock investing mania of the late 1990s, millions of investors (along with many well-known investment “gurus”) ignored some obvious financial risks of many then-popular stocks. Investors blindly plunked their money into stocks that were bad choices. Consider investors who put their money in DrKoop.com, a health information Web site, in 1999 and held on during 2000. DrKoop.com went into cardiac arrest as it collapsed from $45 per share to $2 per share by mid-2000. By the time the stock was DOA, investors lost millions. RIP (risky investment play!). Internet and tech stocks littered the graveyard of stock market catastrophes during 2000–2001 because investors didn’t see (or didn’t want to see?) the risks involved with companies that didn’t offer a solid record of results (profits, sales, and so on). Remember that when you invest in companies that don’t have a proven track record, you’re not investing, you’re speculating.
Slide 70: Chapter 4: Recognizing the Risks Investors who did their homework regarding the financial conditions of companies such as the Internet stocks discovered that these companies had the hallmarks of financial risk — high debt, low (or no) earnings, and plenty of competition. They steered clear, avoiding tremendous financial loss. Investors who didn’t do their homework were lured by the status of these companies — the poster children of booming Internet fortunes — and lost their shirts. Of course, the individual investors who lost money by investing in these trendy, high-profile companies don’t deserve all the responsibility for their tremendous financial losses; some high-profile analysts and media sources also should have known better. The late 1990s may someday be a case study of how euphoria and the herd mentality (rather than good, old-fashioned research and common sense) ruled the day (temporarily). The excitement of making potential fortunes gets the best of people sometimes, and they throw caution to the wind. Historians may look back at those days and say, “What were they thinking?” Achieving true wealth takes diligent work and careful analysis. In terms of financial risk, the bottom line is . . . well . . . the bottom line! A healthy bottom line means that a company is making money. And if a company is making money, then you can make money by investing in its stock. However, if a company isn’t making money, you won’t make money if you invest in it. Profit is the lifeblood of any company. (Are you listening, Dr. Koop?) 47 Interest rate risk Interest rate risk may sound like an odd type of risk, but in fact, it’s a common consideration for investors. Be aware that interest rates change on a regular basis, causing some challenging moments. Banks set interest rates, and the primary institution to watch closely is the Federal Reserve (the Fed), which is, in effect, the country’s central bank. The Fed raises or lowers interest rates, actions that, in turn, cause banks to raise or lower interest rates accordingly. Interest rate changes affect consumers, businesses, and, of course, investors. The scenario outlined in the following paragraphs gives you a generic introduction to the way fluctuating interest rate risk can affect investors in general. Suppose that you buy a long-term, high-quality corporate bond and get a yield of 6 percent. Your money is safe, and your return is locked in at 6 percent. Whew! That’s a guaranteed 6 percent. Not bad, huh? But what happens if, after you commit your money, interest rates increase to 8 percent? You lose the opportunity to get that extra 2 percent interest. The only way to get out of your 6 percent bond is to sell it at current market values and use the money to reinvest at the higher rate.
Slide 71: 48 Part I: The Essentials of Stock Investing The only problem with this scenario is that the 6 percent bond is likely to drop in value because interest rates rose. Why? Say that the investor is Bob and the bond yielding 6 percent is a corporate bond issued by Lucin-Muny (LM). According to the bond agreement, LM must pay 6 percent (called the “face rate” or “nominal rate”) during the life of the bond and then, upon maturity, pay the principal. If Bob buys $10,000 of LM bonds on the day they are issued, he gets $600 (of interest) every year for as long as he holds the bonds. If he holds on until maturity, he gets back his $10,000 (the principal). So far so good, right? The plot thickens, however. Say that he decides to sell the bond long before maturity and that, at the time of the sale, interest rates in the market have risen to 8 percent. Now what? The reality is that no one is going to want his 6 percent bond if the market is offering bonds at 8 percent. What’s Bob to do? He can’t change the face rate of 6 percent, and he can’t change the fact that only $600 is paid each year for the life of the bond. What has to change so that current investors get the equivalent yield of 8 percent? If you said, “The bond’s value has to go down,” . . . bingo! In this example, the bond’s market value needs to drop to $7,500 so that investors buying the bond get an equivalent yield of 8 percent. (For simplicity sake, I left out the time it takes for the bond to mature.) Here’s how that figures: New investors still get $600 annually. However, $600 is equal to 8 percent of $7,500. Therefore, even though investors get the face rate of 6 percent, they get a yield of 8 percent because the actual investment amount is $7,500. In this example, no financial risk is present, but you see how interest rate risk presents itself. Bob finds out that you can have a good company with a good bond, yet you still lose $2,500 because of the change in the interest rate. Of course, if Bob doesn’t sell, he doesn’t realize that loss. (For more on when to sell, see Chapter 17.) You can lose money in an apparently sound investment because of something that sounds as harmless as “interest rates have changed.” Understanding the adverse effects of rising interest rates Rising and falling interest rates offer a special risk to stock investors. Historically, rising interest rates have had an adverse effect on stock prices. I outline several reasons why in the following sections. Hurting a company’s financial condition Rising interest rates have a negative impact on companies that carry a large current debt load or that need to take on more debt because when interest rates rise, the cost of borrowing money rises, too. Ultimately, the company’s profitability and ability to grow are reduced. When a company’s profits (or earnings) drop, its stock becomes less desirable, and its stock price falls.
Slide 72: Chapter 4: Recognizing the Risks Affecting a company’s customers A company’s success comes when it sells its products or services. But what happens if increased interest rates negatively impact its customers (specifically, other companies that buy from it)? The financial health of its customers directly affects the company’s ability to grow sales and earnings. For a good example of this situation, consider what happened to Cisco Systems in 2000. Because a huge part of its sales went to the telecommunications industry, Cisco’s profitability depended on the health of that entire industry. The telecom industry’s debt ballooned to $700 billion. This debt became the telecom industry’s financial Achilles heel, which, in turn, became a pain in the neck to Cisco. Because telecom companies bought less (especially from Cisco), Cisco’s profits shrank. From March 2000 to March 2001, Cisco’s stock fell by nearly 70 percent! As of September 2001, Cisco’s stock price continued to decline because the companies that were Cisco’s customers were hurting financially. 49 Impacting investors’ decision-making considerations When interest rates rise, investors start to rethink their investment strategies, resulting in one of two outcomes: Investors may sell any shares in interest-sensitive stocks that they hold. Interest-sensitive industries include electric utilities, real estate, and the financial sector. Although increased interest rates can hurt these sectors, the reverse is also generally true: Falling interest rates boost the same industries. Keep in mind that interest rate changes affect some industries more than others. Investors who favor increased current income (versus waiting for the investment to grow in value to sell for a gain later on) are definitely attracted to investment vehicles that offer a higher rate of return. Higher interest rates can cause investors to switch from stocks to bonds or bank certificates of deposit. Hurting stock prices indirectly High or rising interest rates can have a negative impact on any investor’s total financial picture. What happens when an investor struggles with burdensome debt, such as a second mortgage, credit card debt, or margin debt (debt from borrowing against stock in a brokerage account)? He may sell some stock in order to pay off some of his high-interest debt. Selling stock to service debt is a common practice that, when taken collectively, can hurt stock prices. As this book goes to press, the stock market and the U.S. economy face perhaps the greatest challenge since the Great Depression — debt. In terms of Gross Domestic Product (GDP), the size of the economy is about $11.5 trillion (give or take $100 billion), but the debt level is about $37 trillion. This already enormous amount does not include $44 trillion of liabilities such as Social
Slide 73: 50 Part I: The Essentials of Stock Investing Security and Medicare. Additionally (Yikes! There’s more?!), some of our financial institutions hold over $50 trillion worth of derivatives. These can be very complicated and sophisticated investment vehicles that can backfire. Derivatives have, in fact, sunk some large organizations (such as Enron), and investors should be aware of them. Just check out the company’s financial reports. (Find out more in Chapter 11.) Because of the effects of interest rates on stock portfolios, both direct and indirect, successful investors regularly monitor interest rates in both the general economy and in their personal situations. Although stocks have proven to be a superior long-term investment (the longer the term, the better), every investor should maintain a balanced portfolio that includes other investment vehicles, such as money market funds, savings bonds, and/or bank investments. A diversified investor has some money in vehicles that do well when interest rates rise. These vehicles include money market funds, U.S. savings bonds (EE), and other variable-rate investments whose interest rates rise when market rates rise. These types of investments add a measure of safety from interest rate risk to your stock portfolio. Market risk People talk about the market and how it goes up or down, making it sound like a monolithic entity instead of what it really is — a group of millions of individuals making daily decisions to buy or sell stock. No matter how modern our society and economic system, you can’t escape the laws of supply and demand. When masses of people want to buy a particular stock, it becomes in demand, and its price rises. That price rises higher if the supply is limited. Conversely, if no one’s interested in buying a stock, its price falls. Supply and demand is the nature of market risk. The price of the stock you purchase can rise and fall on the fickle whim of market demand. Millions of investors buying and selling each minute of every trading day affect the share price of your stock. This fact makes it impossible to judge which way your stock will move tomorrow or next week. This unpredictability and seeming irrationality is why stocks aren’t appropriate for short-term financial growth. In April 2001, a news program reported that in 2000, a fellow with $80,000 in the bank decided to take his money and invest it in the stock market. Because he was getting married in 2001, he wanted his money to grow faster and higher so that he could afford a nice wedding and a down payment on the couple’s future home. What happened? His money shrank to $11,000, and he had to change his plans. Sometimes, “market risk” begets “romantic” risk. Losing money is only one headache you face when you lose money this way; the idea of postponing a joyful event, such as a wedding or a home purchase,
Slide 74: Chapter 4: Recognizing the Risks just adds to the pain. The gent in the preceding story could have easily minimized his losses with some knowledge and discipline. Markets are volatile by nature; they go up and down, and investments need time to grow. This poor guy (literally, now) should have been aware of the fact that stocks in general aren’t suitable for short-term (one year or less) goals (see Chapter 2 for more on short-term goals). Despite the fact that the companies he invested in may have been fundamentally sound, all stock prices are subject to the gyrations of the marketplace and need time to trend upward. Investing requires diligent work and research before putting your money in quality investments with a long-term perspective. Speculating is attempting to make a relatively quick profit by monitoring the short-term price movements of a particular investment. Investors seek to minimize risk, whereas speculators don’t mind risk because it can also magnify profits. Speculating and investing have clear differences, but investors frequently become speculators and ultimately put themselves and their wealth at risk. Don’t go there! Consider the married couple nearing retirement who decided to play with their money to see about making their pending retirement more comfortable. They borrowed a sizable sum by tapping into their home equity to invest in the stock market. (Their home, which they had paid off, had enough equity to qualify for this loan.) What did they do with these funds? You guessed it; they invested in the high-flying stocks of the day, which were high-tech and Internet stocks. Within eight months, they lost almost all their money. Understanding market risk is especially important for people who are tempted to put their nest eggs or emergency funds into volatile investments such as growth stocks (or mutual funds that invest in growth stocks or similar aggressive investment vehicles). Remember, you can lose everything. 51 Inflation risk Inflation is the artificial expansion of the quantity of money so that too much money is used in exchange for goods and services. To consumers, inflation shows up in the form of higher prices for goods and services. Inflation risk is also referred to as purchasing power risk. This term just means that your money doesn’t buy as much as it used to. For example, a dollar that bought you a sandwich in 1980 barely bought you a candy bar a few years later. For you, the investor, this risk means that the value of your investment (a bond, for example) may not keep up with inflation. Say that you have money in a bank savings account currently earning 4 percent. This account has flexibility — if the market interest rate goes up, the rate you earn in your account goes up. Your account is safe from both financial risk and interest rate risk. But what if inflation is running at 5 percent? At that point you’re losing money.
Slide 75: 52 Part I: The Essentials of Stock Investing Tax risk Taxes (such as income tax or capital gains tax) don’t affect your stock investment directly. Taxes can obviously affect how much of your money you get to keep. Because the entire point of stock investing is to build wealth, you need to understand that taxes take away a portion of the wealth that you’re trying to build. Taxes can be risky because if you make the wrong move with your stocks (selling them at the wrong time, for example), you can end up paying higher taxes than you need to. Because tax laws change so frequently, tax risk is part of the risk-versus-return equation, as well. It pays to gain knowledge about how taxes can impact your wealth-building program before you make your investment decisions. Chapter 20 covers in greater detail the impact of taxes. Political and governmental risks If companies were fish, politics and government policies (such as taxes, laws, and regulations) would be the pond. In the same way that fish die in a toxic or polluted pond, politics and government policies can kill companies. Of course, if you own stock in a company exposed to political and governmental risks, you need to be aware of these risks. For some companies, a single new regulation or law is enough to send them into bankruptcy. For other companies, a new law could help them increase sales and profits. What if you invest in companies or industries that become political targets? You may want to consider selling them (you can always buy them back later) or consider putting in stop loss orders on the stock (see Chapter 17). For example, tobacco companies were the targets of political firestorms that battered their stock prices. Whether you agree or disagree with the political machinations of today is not the issue. As an investor, you have to ask yourself, “How do politics affect the market value and the current and future prospects of my chosen investment?” (See Chapter 14 for more on how politics can affect the stock market.) Personal risks Frequently, the risk involved with investing in the stock market may not be directly involved with the investment or factors directly related to the investment; sometimes the risk is with the investor’s circumstances. Suppose that investor Ralph puts $15,000 into a portfolio of common stocks. Imagine that the market experiences a drop in prices that week and Ralph’s stocks drop to a market value of $14,000.
Slide 76: Chapter 4: Recognizing the Risks Because stocks are good for the long term, this type of decrease is usually not an alarming incident. Odds are that this dip is temporary, especially if Ralph carefully chose high-quality companies. Incidentally, if a portfolio of high-quality stocks does experience a temporary drop in price, it can be a great opportunity to get more shares at a good price. (Chapter 17 covers orders you can place with your broker to help you do that.) Over the long term, Ralph would probably see the value of his investment grow substantially. But, what if during a period when his stocks are declining, Ralph experiences financial difficulty and needs quick cash? He may have to sell his stock to get some money. This problem occurs frequently for investors who don’t have an emergency fund or a rainy day fund to handle large, sudden expenses. You never know when your company may lay you off or when your basement may flood, leaving you with a huge repair bill. Car accidents, medical emergencies, and other unforeseen events are part of life’s bag of surprises — for anyone. Be sure to set money aside for sudden expenses before you buy stocks. Then you aren’t forced to prematurely liquidate your stock investments to pay emergency bills (Chapter 2 provides more guidance on having liquid assets for emergencies). You probably won’t get much comfort from knowing that stock losses are tax deductible — a loss is a loss (see Chapter 20 regarding taxes). However, you can avoid the kind of loss that results from prematurely having to sell your stocks if you maintain an emergency cash fund. A good place for your emergency cash fund is in either a bank savings account or a money market fund. 53 Emotional risk What does emotional risk have to do with stocks? Emotions are important risk considerations because the main decision makers are human beings. Logic and discipline are critical factors in investment success, but even the best investor can let emotions take over the reins of money management and cause loss. For stock investing, you’re likely to be sidetracked by three main emotions: greed, fear, and love. You need to understand your emotions and what kinds of risk they can expose you to. If you get too attached to a sinking stock, then you don’t need a stock investing book — you need Dr. Phil! Paying the price for greed In the 1998–2000 period, millions of investors threw caution to the wind and chased highly dubious, risky dot-com stocks. The dollar signs popped up in their eyes (just like slot machines) when they saw that easy street was lined with dot-com stocks that were doubling and tripling in a very short time. Who cares about price/earnings (P/E) ratios and earnings when you can just buy stock, make a fortune, and get out with millions? (Of course, you care about making money with stocks, so you can flip to Chapter 10 and Appendix B to find out more about P/E ratios.)
Slide 77: 54 Part I: The Essentials of Stock Investing Investment lessons from September 11 September 11, 2001, was a horrific day that is burned in our minds and won’t be forgotten in our lifetime. The acts of terrorism that day took over 3,000 lives and caused untold pain and grief. A much less important aftereffect was the hard lessons that investors learned that day. Terrorism reminds us that risk is more real than ever and that we should never let our guard down. What lessons can investors learn from the worst acts of terrorism to ever happen on U.S. soil? Here are a few pointers: Diversify your portfolio. Of course, the events of September 11 were certainly surreal and unexpected. But before the events occurred, investors should have made it a habit to assess their situations and see whether they had any vulnerabilities. Stock investors with no money outside the stock market are always more at risk. Keeping your portfolio diversified is a time-tested strategy that is more relevant than ever before. Review and re-allocate. September 11 triggered declines in the overall market, but specific industries, such as airlines and hotels, were hit particularly hard. In addition, some industries, such as defense and food, saw stock prices rise. Monitor your portfolio and ask yourself whether it is overly reliant on or exposed to events in specific sectors. If so, reallocate your investments to decrease your risk exposure. Check for signs of trouble. Techniques such as trailing stops (which I explain in Chapter 17) come in very handy when your stocks plummet because of unexpected events. Even if you don’t use these techniques, you can make it a regular habit to analyze your stocks and check for signs of trouble, such as debts or P/E ratios that are too high. If you see signs of trouble (check out Chapter 21), consider selling anyway. Unfortunately, the lure of the easy buck can easily turn healthy attitudes about growing wealth into unhealthy greed that blinds investors and discards common sense (such as investing for quick short-term gains in dubious “hot stocks,” rather than doing your homework and buying stocks of solid companies with strong fundamentals and a long-term focus). Recognizing the role of fear Greed can be a problem, but fear is the other extreme. People who are fearful of loss frequently avoid suitable investments and end up settling for a low rate of return. If you have to succumb to one of these emotions, at least fear exposes you to less loss. Looking for love in all the wrong places Stocks are dispassionate, inanimate vehicles, but people can look for love in the strangest places. Emotional risk occurs when investors fall in love with a stock and refuse to sell it even when the stock is plummeting and shows all the symptoms of getting worse. Emotional risk also occurs when investors are drawn to bad investment choices just because they sound good, are popular, or are pushed by family or friends. Love and attachment are great in relationships with people, but can be horrible with investments.
Slide 78: Chapter 4: Recognizing the Risks 55 Minimizing Your Risk Now, before you go crazy thinking that stock investing carries so much risk that you may as well not get out of bed, take a breath. Minimizing your risk in stock investing is easier than you think. Although wealth building through the stock market doesn’t take place without some amount of risk, you can practice the following tips to maximize your profits and still keep your money secure. Gaining knowledge Some people spend more time analyzing a restaurant menu to choose a $10 entrée than analyzing where to put their next $5,000. Lack of knowledge constitutes the greatest risk for new investors, but diminishing that risk starts with gaining knowledge. The more familiar you are with the stock market — how it works, factors that affect stock value, and so on — the better you can navigate around its pitfalls and maximize your profits. The same knowledge that enables you to grow your wealth also enables you to minimize your risk. Before you put your money anywhere, you want to know as much as you can. This book is a great place to start — check out Chapter 6 for a rundown of the kinds of information you want to know before you buy stocks, as well as the resources that can give you the information you need to invest successfully. Staying out . . . for now If you don’t understand stocks, don’t invest! Yeah, I know this book is about stock investing, and I think that some measure of stock investing is a good idea for most people. But that doesn’t mean you should be 100 percent invested 100 percent of the time. If you don’t understand a particular stock (or don’t understand stocks, period), stay away until you do understand. Instead, give yourself an imaginary sum of money, such as $100,000, give yourself reasons to invest, and just make believe. Pick a few stocks that you think will increase in value and then track them for a while and see how they perform. Begin to understand how the price of a stock goes up and down, and watch what happens to the stocks you chose when various events take place. As you find out more and more about stock investing, you get better and better at picking individual stocks, and you haven’t risked — or lost — any money during your learning period. A good place to do your “imaginary” investing is at Web sites such as Marketocracy (www.marketocracy.com). You can design a stock portfolio and track its performance with thousands of other investors to see how well you do.
Slide 79: 56 Part I: The Essentials of Stock Investing Getting your financial house in order Advice on what to do before you invest could be a whole book all by itself. The bottom line is that you want to make sure that you are, first and foremost, financially secure before you take the plunge into the stock market. If you’re not sure about your financial security, look over your situation with a financial planner. (You can find more on financial planners in Appendix A.) Before you buy your first stock, here are a few things you can do to get your finances in order: Have a cushion of money. Set aside three to six months’ worth of your gross living expenses somewhere safe, such as in a bank account or treasury money market fund, in case you suddenly need cash for an emergency. Reduce your debt. Overindulging in debt was the worst personal economic problem for many Americans in the late 1990s. The year 2001 was a record year for bankruptcy, with nearly 1.5 million people filing for bankruptcy. Make sure that your job is as secure as you can make it. Are you keeping your skills up to date? Is the company you work for strong and growing? Is the industry that you work in strong and growing? Make sure that you have adequate insurance. You need enough insurance to cover you and your family’s needs in case of illness, death, disability, and so on. Diversifying your investments Diversification is a strategy for reducing risk by spreading your money across different investments. It’s a fancy way of saying, “Don’t put all your eggs in one basket.” But how do you go about divvying up your money and distributing it among different investments? The easiest way to understand proper diversification may be to look at what you should not do: Don’t put all your money in just one stock. Sure, if you choose wisely and select a hot stock, you may make a bundle, but the odds are tremendously against you. Unless you’re a real expert on a particular company, it’s a good idea to have small portions of your money in several different stocks. As a general rule, the money you tie up in a single stock should be money you can do without. Don’t put all your money in one industry. I know people who own several stocks, but the stocks are all in the same industry. Again, if you’re an expert in that particular industry, it could work out. But just understand that you’re not properly diversified. If a problem hits an entire industry, you may get hurt.
Slide 80: Chapter 4: Recognizing the Risks Don’t put all your money in just one type of investment. Stocks may be a great investment, but you need to have money elsewhere. Bonds, bank accounts, treasury securities, real estate, and precious metals are perennial alternatives to complement your stock portfolio. Some of these alternatives can be found in mutual funds or exchange traded funds (ETFs). Okay, now that you know what you shouldn’t do, what should you do? Until you become more knowledgeable, follow this advice: Only keep 20 percent (or less) of your investment money in a single stock. Invest in four or five different stocks that are in different industries. Which industries? Choose industries that offer products and services that have shown strong, growing demand. To make this decision, use your common sense (which isn’t as common as it used to be). Think about the industries that people need no matter what happens in the general economy, such as food, energy, and other consumer necessities. See Chapter 12 for more information about analyzing industries. 57 Weighing Risk Against Return How much risk is appropriate for you, and how do you handle it? Before you try to figure out what risks accompany your investment choices, analyze yourself. Here are some points to keep in mind when weighing risk versus return in your situation: Your financial goal: In five minutes with a financial calculator, you can easily see how much money you’re going to need to become financially independent (presuming that financial independence is your goal). Say that you need $500,000 in ten years for a worry-free retirement and that your financial assets (such as stocks, bonds, and so on) are currently worth $400,000. In this scenario, your assets need to grow by only 2.25 percent to hit your target. Getting investments that grow by 2.25 percent safely is easy to do because that is a relatively low rate of return. The important point is that you don’t have to knock yourself out trying to double your money with risky, high-flying investments; some run-ofthe-mill bank investments will do just fine. All too often, investors take on more risk than is necessary. Figure out what your financial goal is so that you know what kind of return you realistically need. Your investor profile: Are you nearing retirement, or are you fresh out of college? Your life situation matters when it comes to looking at risk versus return. If you’re just beginning your working years, you can certainly tolerate greater risk than someone facing retirement. Even if you lose big time, you still have a long time to recoup your money and get back on track. However, if you’re approaching retirement, risky or
Slide 81: 58 Part I: The Essentials of Stock Investing aggressive investments can do much more harm than good. If you lose money, you don’t have as much time to recoup your investment, and the odds are that you’ll need the investment money (and its income-generating capacity) to cover your living expenses after you are no longer employed. Asset allocation: I never tell retirees to put a large portion of their retirement money into a high-tech stock or other volatile investment. But if they still want to speculate, I don’t see a problem as long as they limit such investments to 5 percent of their total assets. As long as the bulk of their money is safe and sound in secure investments (such as U.S. treasury bonds), I know I can sleep well (knowing that they can sleep well!). Asset allocation beckons back to diversification. For people in their 20s and 30s, having 75 percent of their money in a diversified portfolio of growth stocks (such as mid-cap and small-cap stocks) is acceptable. For people in their 60s and 70s, it’s not acceptable. They may, instead, consider investing no more than 20 percent of their money in stocks (midcaps and large-caps are preferable). Check with your financial advisor to find the right mix for your particular situation. Better luck next time A little knowledge can be very risky. Consider the true story of one “lucky” fellow who played the California lottery in 1987. He discovered that he had a winning ticket, with the first prize of $412,000. He immediately ordered a Porsche, booked a lavish trip to Hawaii for his family, and treated his wife and friends to a champagne dinner at a posh Hollywood restaurant. When he finally went to collect his prize, he found out that he had to share first prize with over 9,000 other lottery players who also had the same winning numbers. His share of the prize was actually only $45! Hopefully, he invested that tidy sum based on his increased knowledge about risk.
Slide 82: Chapter 5 Say Cheese: Getting a Snapshot of the Market In This Chapter Defining index basics Looking at the Dow and other indexes Exploring the indexes for practical use “H ow’s the market doing today?” is the most common question that interested parties ask about the stock market. “What did the Dow do?” “How about Nasdaq?” Invariably, people asking those questions expect an answer regarding how well the market has performed that day. “Well, the Dow fell 57 points to 9,500, while Nasdaq was unchanged at 1,882.” You can use indexes as general gauges of stock market activity. From them, you get a basic idea of how well (or how poorly) the overall market is doing. In this chapter, I focus my attention on stock market indexes. Knowing How Indexes Are Measured An index is a statistical measure that represents the value of a batch of stocks. Investors use this measure like a barometer to track the overall progress of the market (or a segment of it). The oldest stock market index is the Dow Jones Industrial Average (DJIA or simply “The Dow”). In 1896, Charles Dow (of Dow Jones fame) created the Dow Jones Industrial Average; it covered only 12 stocks then (the number increased to 30 stocks in 1928, and it remains the same to this day). Because Dow worked long before the age of computers, he kept calculating a stock market index simple and did it arithmetically by hand. Dow added up the stock prices of the 12 companies and then divided the sum by 12. Technically, this number is an average and not an index (hence the word “average” in the name). For simplicity sake, we’ll refer to it as an index.
Slide 83: 60 Part I: The Essentials of Stock Investing Nowadays, the number gets tweaked to also account for things such as stock splits. (For more on stock splits see Chapter 19.) However, indexes get calculated differently. The primary difference between an “index” and an “average” is the concept of weighting. Weighting is the relative importance of the items when they are computed within the index. Several kinds of indexes exist, including: Price-weighted index: This kind of index tracks changes based on the change in the individual stock’s price per share. To give you an example, suppose that you own two stocks: Stock A worth $20 per share and Stock B worth $40 per share. A price-weighted index allocates a greater proportion of the index to the stock at $40 than to the one at $20. Therefore, if we had only these two stocks in an index, the index number would reflect the $40 stock as being 67 percent (two-thirds of the number), while the $20 stock would be 33 percent (one-third of the number). Market-value weighted index: This kind of index tracks the proportion of a stock based on its market capitalization (or market value, also called market cap). Say that in your portfolio, you have 10 million shares of a $20 stock (Stock A) and 1 million shares of a $40 stock (Stock B). Stock A’s market cap is $200 million, while Stock B’s market cap is $40 million. Therefore, in a market-value weighted index, Stock A represents 83 percent of the index’s value because of its much larger market cap. Broad-based index: The sample portfolios in the preceding bullets show only two stocks — obviously not a good representative index. Most investing professionals (especially money managers and mutual fund firms) use a broad-based index as a benchmark to compare their progress. A broad-based index has the purpose to provide a “snapshot” of the entire market, such as the S&P 500 or the Wilshire 5000. (See descriptions of both indexes later in this chapter.) Composite index: This is an index or average that is a combination of several averages or indexes. An example is the New York Stock Exchange (NYSE) Composite, which tracks all the stocks on the NYSE. Checking Out the Indexes Although most people consider the Dow, Nasdaq, and Standard & Poor’s 500 to be the stars of the financial press, you may find other indexes equally important to follow because they cover other significant facets of the market, such as small-cap and mid-cap stocks.
Slide 84: Chapter 5: Say Cheese: Getting a Snapshot of the Market You can check out other less-sexy indexes that cover specific sectors and industries. If you’re investing in an Internet stock, you should also check the Internet Stock Index to compare what your stock is doing when measured against the index. You can find indexes that cover industries such as transportation, brokerage firms, retailers, computer companies, and real estate firms. For a comprehensive list of indexes, go to www.djindexes.com (a Dow Jones & Co. Web site). The most reliable and most widely respected indexes are produced not only by Dow Jones but also Standard & Poor’s and the major exchanges/markets themselves such as the New York Stock Exchange (NYSE), the American Stock Exchange (AMEX), and Nasdaq. There are also indexes issued or provided by smaller exchanges (such as the Philadelphia Exchange). 61 The Dow Jones Industrial Average The most famous stock market barometer is my first example — the Dow Jones Industrial Average (DJIA). When someone asks how the market is doing, most investors quote the DJIA (simply referred to as “the Dow”). The Dow is price weighted and tracks a basket of 30 of the largest and most influential public companies in the stock market. The following list shows the current roster of 30 stocks tracked on the DJIA (in alphabetical order by company with their stock symbols in parentheses). Alcoa (AA) Altria (MO) American Express Co. (AXP) American International Group (AIG) Boeing (BA) Caterpillar (CAT) Citigroup (C) Coca-Cola (KO) Disney (DIS) DuPont (DD) Exxon Mobil (XOM) General Electric (GE) General Motors (GM) Hewlett-Packard (HPQ) Home Depot (HD)
Slide 85: 62 Part I: The Essentials of Stock Investing Honeywell International Inc. (HON) Intel (INTC) International Business Machines (IBM) Johnson & Johnson (JNJ) J.P. Morgan Chase (JPM) McDonald’s (MCD) Merck (MRK) Microsoft (MSFT) Minnesota Mining and Manufacturing (3M) (MMM) Pfizer (PFE) Procter & Gamble (PG) SBC Communications (SBC) United Technologies (UTX) Verizon (VZ) Wal-Mart Stores (WMT) The Dow has survived as a popular gauge of stock market activity for over a century. Although it’s an important indicator of the market’s progress, the Dow does have one major drawback: It tracks only 30 companies. Regardless of their status in the market, the companies in the Dow represent a limited sampling, so they don’t communicate the true pulse of the market. For example, when the Dow surpassed the record 10,000 and 11,000 milestones during 1999 and 2000, the majority of (nonindex) companies showed lackluster or declining stock price movement. (See the “Dow Jones milestones” sidebar, later in this chapter, for more information.) The roster of the Dow has changed many times during the 100-plus years of its existence. The only original company from 1896 is General Electric. Dow Jones made most of the changes because of company mergers and bankruptcy. However, they made some changes to simply reflect the changing times. In 2004, AT&T, International Paper, and Eastman Kodak were removed from the Dow and replaced with AIG Corp., Pfizer, and Verizon. The Dow isn’t a pure gauge of industrial activity because it also includes a hodgepodge of nonindustrial companies such as J.P. Morgan Chase and Citigroup (banks), Home Depot (retailing), and Microsoft (software). Because of these changes, it doesn’t adequately reflect industrial activity. During the late 1990s and right up to 2005, true industrial sectors such as manufacturing had difficult times, yet the Dow rose to record levels.
Slide 86: Chapter 5: Say Cheese: Getting a Snapshot of the Market Serious investors look at the following indexes: Broad-based indexes: Indexes such as the S&P 500 and the Wilshire 5000 are more realistic gauges of the stock market’s performance than the Dow. Industry or sector indexes: These indexes are better gauges of the growth (or lack of growth) of specific industries and sectors. If you buy a gold stock, then you should track the index for the precious metals industry. Dow Jones has several averages, including the Dow Jones Transportation Average (DJTA) and the Dow Jones Utilities Average (DJUA). Dow Jones manages both of these indexes more strictly than the Dow. The DJUA sticks to utilities, so it tends to be a more accurate barometer of the market it represents. (The same goes for the DJTA.) 63 Dow Jones milestones This table shows when the Dow Jones Industrial Average reached each of eleven 1,000-point milestones and how long it took to reach that point: Milestone Date 1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000 10,000 11,000 Nov. 14, 1972 Jan. 8, 1987 April 17, 1991 Feb. 23, 1995 Nov. 21, 1995 Oct. 14, 1996 Feb. 13, 1997 July 16, 1997 April 6, 1998 How long it took 76 years 14 years 4 years 4 years 9 months 11 months 4 months 5 months 9 months As you can see, the Dow took 76 years to hit its first milestone. But as each succeeding milestone came along, it took less and less time to hit the next one, due to the fact that the higher the Dow is in a relative sense, the easier it is to jump 1,000 points. For example, it went from 6,000 to 7,000 in only four months. The Dow moved between 1,000 and 11,000 mostly during modern times. As the table indicates, most of the milestones happened during the 1982–1999 bull market. But the Dow didn’t reach a new milestone from 2000–2004. That fact alone tells you that the Dow either stalled or declined when the bear market of 2000 arrived. Although the Dow had an up year in 2004, the long-term bear market is actually still in effect. The Dow hit its high of 11,722 in January 2000, and it traded around 10,500 in September 2005. March 29, 1999 12 months May 3, 1999 1 month
Slide 87: 64 Part I: The Essentials of Stock Investing Nasdaq indexes Nasdaq became a formalized market in 1971. The name used to stand for “National Association of Securities Dealers Automated Quote” system, but now it’s simply “Nasdaq” (as if it’s a name like Ralph or Eddie). Nasdaq indexes are similar to other indexes in style and structure. The only difference is that, well, they cover companies traded on the Nasdaq. The Nasdaq has two indexes (both reported in the financial pages): Nasdaq Composite Index: Most frequently quoted on the news, the Nasdaq Composite Index covers the more than 5,000 companies that trade on Nasdaq. The companies encompass a variety of industries, but the index’s concentration has primarily been technology, telecom, and Internet industries. The Nasdaq Composite Index hit an all-time high of 5,048 in March 2000 before the worst bear market in its history occurred. The index dropped a whopping 60 percent by 2003 to approximately 2,000. Nasdaq 100 Index: The Nasdaq 100 tracks the 100 largest companies in Nasdaq. This index is for investors who want to concentrate on the largest companies, which tend to be especially weighted in technology issues, which means it provides extra representation of technologyrelated companies such as Microsoft, Adobe, and Symantec. In either case, although these indexes track growth-oriented companies, the stocks of these companies are also very volatile and carry commensurate risk. The indexes themselves bear this risk out; in the bear market of 2000 and 2001 (and even extending into 2002), they fell more than 60 percent. Standard & Poor’s 500 The Standard & Poor’s 500 (S&P 500) tracks the 500 largest (measured by market value) publicly traded companies. The publishing firm Standard & Poor’s created this index. (I bet you could’ve guessed that.) Because it contains 500 companies, the S&P 500 represents overall market performance better than the DJIA’s 30 companies. Money managers and financial advisors actually watch the S&P 500 stock index more closely than the DJIA. Most mutual funds especially like to measure their performance against the S&P 500 rather than against any other index. Mutual funds that concentrate on small-cap stocks usually prefer an index that has more small-cap stocks in it, such as the Russell 2000. The S&P 500 doesn’t attempt to cover the 500 “biggest” companies. Instead, it includes companies that are widely held and widely followed. The companies
Slide 88: Chapter 5: Say Cheese: Getting a Snapshot of the Market are also industry leaders in a variety of industries, including energy, technology, healthcare, and finance. It’s a market-value weighted index (which I explain in the section “Knowing How Indexes Are Measured,” earlier in this chapter). Although it’s a reliable indicator of the market’s overall status, the S&P 500 also has some limitations. Despite the fact that it tracks 500 companies, the top 50 companies encompass 50 percent of the index’s market value. This situation can be a drawback because those 50 companies have a greater influence on the S&P 500 index’s price movement than any other segment of companies. In other words, 10 percent of the companies have an equal impact to 90 percent of the companies on the same index. Therefore, although the index better represents the market than the DIJA, the index may not offer an accurate representation of the general market. S&P doesn’t set the 500 companies they track in stone. S&P can add or remove companies when market conditions change. They can remove a company if it isn’t doing well or goes bankrupt, and they can replace a company in the index with another company that is doing better. 65 Russell 3000 Index The Russell 3000 Index is a great example of an index that seeks more comprehensive inclusion of U.S. companies. It includes the 3,000 largest publicly traded companies (nearly 98 percent of publicly traded stocks). The Russell 3000 is important because it includes many mid-cap and small-cap stocks. Most companies covered in the Russell 3000 have an average market value of a billion dollars or less. The Frank Russell Company created the Russell 3000 Index and actually computes a series of indexes such as the Russell 1000 and the Russell 2000. The Russell 2000, for example, contains the smallest 2,000 companies from the Russell 3000, while the Russell 1000 contains the largest 1,000 companies. The Russell indexes don’t cover micro cap stocks (companies with a market capitalization under $250 million). Wilshire Total Market Index The Wilshire 5000 Equity Index, often referred to as the Wilshire Total Market Index, is probably the largest stock index in the world. Wilshire Associates started out in 1980 tracking 5,000 stocks. Since then, the Wilshire 5000 has ballooned to cover more than 7,500 stocks. The advantage of the Wilshire
Slide 89: 66 Part I: The Essentials of Stock Investing 5000 is that it’s very comprehensive, covering nearly the entire market. For investors and analysts that seek the greatest representation/ performance of the general market, they would check out this index. (At the very least, the Wilshire 5000 tracks the largest publicly traded stocks.) It includes all the stocks that are on the major stock exchanges (NYSE, AMEX, and the largest issues on Nasdaq), which by default also include all the stocks covered by the S&P 500. The Wilshire 5000 is a market-value weighted index, which I discuss in the section “Knowing How Indexes Are Measured,” earlier in this chapter. International indexes Investors need to remember that the whole world is a vast marketplace that interacts with and exerts tremendous influence on individual national economies and markets. Whether you have one stock or one mutual fund, keep tabs on how world markets affect your portfolio. The best way to get a snapshot of international markets is, of course, with indexes. Here are some of the more widely followed international indexes: Nikkei (Japan): This index is considered Japan’s version of the Dow. If you’re invested in Japanese stocks or in stocks that do business with Japan, you want to know what’s up with the Nikkei. FTSE-100 (Great Britain): Usually referred to as the “footsie,” this market-value weighted index includes the top 100 public companies in the United Kingdom. CAC-40 (France): This index tracks the 40 public stocks that trade on the Paris Stock Exchange. DAX (Germany): This index tracks the 30 largest and most active stocks that trade on the Frankfurt Exchange. Halter USX China Index (China): This index tracks a basket of 50 U.S. public companies that derive most of their revenues from China. You can track these international indexes (among others) at major financial Web sites, such as www.bloomberg.com and www.marketwatch.com. You may find international indexes useful in your analysis as you watch your stock’s progress. What if you have stock in a company that has most of its customers in Japan? Then the Nikkei can help you get a general snapshot of how well the major companies are doing in Japan, which in turn can be a general barometer of its economy’s well-being. If your company’s business partners or customers are in the Nikkei, and it’s plunging, then you know it’s probably “sayonara” for the company’s stock price.
Slide 90: Chapter 5: Say Cheese: Getting a Snapshot of the Market 67 Using the Indexes You may be wondering what to do with all the indexes out there and which one or ones you should be checking out. The sections below give you some idea of how to put all the pieces together. Tracking the indexes The bottom line is that investors get an instant snapshot of how well the market is doing from indexes. Indexes offer a quick way to compare the performance of one investor’s stock portfolio or mutual funds with the rest of the market. If the Dow goes up 10 percent in a year and your portfolio shows a cumulative gain of 12 percent, then you know that you’re doing well. Appendix A in the back of this book lists resources to help you keep up with various indexes. The problem with indexes is that they can be misleading if you take them too literally as an accurate barometer of stock success. The Dow, for example, has changed its roster of companies many times since 1896. Had it not, the Dow’s general upward trajectory in the past few decades would have been much different. Laggard stocks have been dropped and replaced with other stocks that have shown more promise. Many of the original companies that were in the DJIA in 1896 did go out of business, or other companies, that aren’t reflected in the index, bought them out. Investing in indexes Can you invest directly in indexes? If the market is doing well but your specific stock is not, can you find a way to invest in the index itself? With investments based on indexes, you can invest in the general market or a particular industry. Say that you want to invest in the DJIA. After all, why try to “beat the market” if just matching it is sufficient to grow your wealth? Why not have a portfolio that directly mirrors the DJIA? Well, it’s too impractical and expensive to invest in all 30 stocks that are in the DJIA. Fortunately, there are alternatives that can accomplish the act of “investing in indexes.” Here are the best ways: Index mutual funds: An index mutual fund is much like a regular mutual fund except that it will only invest in securities (in this case, stocks) that match as closely as possible the basket of stocks that are in that particular
Slide 91: 68 Part I: The Essentials of Stock Investing index. There are index mutual funds, for example, that track the DJIA and the S&P 500. Find out more about index mutual funds at places such as the Investment Company Institute (www.ici.org). Exchange Traded Funds (ETFs): This is a particular favorite of mine. ETFs have similar characteristics to a mutual fund except for a few key differences. An ETF can reflect a basket of stocks that mirror a particular index, but the ETF can be traded like a stock itself. You can transact ETFs like stocks in that you can buy, sell, or go short. You can put stop losses on them and you can even purchase them on margin. ETFs can give you the diversification of mutual funds coupled with the versatility of stocks. Examples of ETFs that track indexes are the DJIA ETF (symbol DIA) and the ETF for Nasdaq (QQQ). You can find out more about ETFs at the American Stock Exchange (www.amex.com).
Slide 92: F T AM E Y L Part II Before You Start Buying
Slide 93: W In this part . . . hen you’re about to begin investing in stocks, you should know that different types of stocks exist for different objectives. If you can at least get a stock that “fits” your situation, you’re that much ahead in the game. In this part, you can find out where to start gathering information and discover what stockbrokers can do for you.
Slide 94: Chapter 6 Gathering Information In This Chapter Using stock exchanges to get investment information Applying accounting and economic know-how to your investments Exploring financial issues Deciphering stock tables Interpreting dividend news Recognizing good (and bad) advice when you hear it nowledge and information are two critical success factors in stock investing. (Isn’t that true about most things in life?) People who plunge headlong into stocks without sufficient knowledge of the stock market in general, and current information in particular, quickly learn the lesson of the eager diver who didn’t find out ahead of time that the pool was only an inch deep (ouch!). In their haste to avoid missing so-called golden investment opportunities, investors too often end up losing money. Opportunities to make money in the stock market will always be there, no matter how well or how poorly the economy and the market are performing in general. There’s no such thing as a single (and fleeting) magical moment, so don’t feel that if you let an opportunity pass you by, you’ll always regret that you missed your one big chance. For the best approach to stock investing, you want to build your knowledge and find quality information first. Then buy stocks and make your fortunes more assuredly. Basically, before you buy stock, you need to know that the company you’re investing in is Financially sound and growing Offering products and services that are in demand by consumers In a strong and growing industry (and general economy) Where do you start and what kind of information do you want to acquire? Keep reading. K
Slide 95: 72 Part II: Before You Start Buying Looking to Stock Exchanges for Answers Before you invest in stocks, you need to be completely familiar with the basics of stock investing. At its most fundamental, stock investing is about using your money to buy a piece of a company that will give you value in the form of appreciation or income. Fortunately, many resources are available to help you find out about stock investing. Some of my favorite places are the stock exchanges themselves. Stock exchanges are organized marketplaces for the buying and selling of stocks (and other securities). The New York Stock Exchange (NYSE), the premier stock exchange, provides a framework for stock buyers and sellers to make their transactions. The NYSE makes money not only from a piece of every transaction but also from fees (such as listing fees) charged to companies and brokers that are members of its exchanges. The main exchanges for most stock investors are the NYSE and the American Stock Exchange (AMEX). Nasdaq is technically not an exchange but it is a formal market that effectively acts as an exchange. These three encourage and inform people about stock investing. Since these exchanges/markets benefit from increased popularity of stock investing and continued demand for stocks, they offer a wealth of free (or low-cost) information and resources for stock investors. Go to their Web sites and you find useful resources such as: Tutorials on how to invest in stocks, common investment strategies, and so on Glossaries and free information to help you understand the language, practice, and purpose of stock investing A wealth of news, press releases, financial data, and other information about companies listed at the exchange or market, accessed usually through an onsite search engine Industry analysis & news Stock quotes and other market information related to the daily market movements of stocks including data such as volume, new highs, new lows, and so on Free tracking of your stock selections (You can input a sample portfolio, or the stocks you are following, to see how well you are doing.) What each exchange/market offers keeps changing or is updated, so go explore each at their Web sites: New York Stock Exchange: www.nyse.com American Stock Exchange: www.amex.com Nasdaq: www.nasdaq.com
Slide 96: Chapter 6: Gathering Information 73 Understanding Stocks and the Companies They Represent Stocks represent ownership in companies. Before you buy individual stocks, you want to understand the companies whose stock you’re considering and find out about their operations. It may sound like a daunting task, but you’ll digest the point more easily when you realize that companies work very similarly to how you work. They make decisions on a day-to-day basis just as you do. Think about how you grow and prosper as an individual or as a family, and you see the same issues with companies and how they grow and prosper. Low earnings and high debt are examples of financial difficulties that can affect both people and companies. You’ll understand companies’ finances when you take the time to pick up some information in two basic disciplines: accounting and economics. These two disciplines play a significant role in understanding the performance of a company’s stock. Accounting for taste and a whole lot more Accounting. Ugh! But face it: Accounting is the language of business, and believe it or not, you’re already familiar with the most important accounting concepts! Just look at the following three essential principles: Assets minus liabilities equal net worth. In other words, take what you own (your assets), subtract what you owe (your liabilities), and the rest is yours (net worth)! Your own personal finances work the same way as Microsoft’s (except yours have fewer zeros at the end). See Chapter 2 to figure out how to calculate your own net worth. A company’s balance sheet shows you its net worth at a specific point of time (such as December 31). The net worth of a company is the bottom line of a company’s asset and liability picture, and it tells you whether the company is solvent (has the ability to pay its debts without going out of business). The net worth of a successful company is regularly growing. To see whether your company is successful, compare its net worth with the net worth from the same point a year earlier. A company that has a $4 million net worth on December 31, 2005, and a $5 million net worth on December 31, 2006, is doing well; its net worth has gone up 25 percent ($1 million) in one year. Income less expenses equal net income. In other words, take what you make (your income), subtract what you spend (your expenses), and the remainder is your net income (or net profit or net earnings — your gain). A company’s profitability is the whole point of investing in its stock. As it profits, the company becomes more valuable, and in turn, its stock
Slide 97: 74 Part II: Before You Start Buying price becomes more valuable. To discover a company’s net income, look at its income statement. Try to determine whether the company uses its gains wisely, either reinvesting it for continued growth or paying down debt. Do a comparative financial analysis. That’s a mouthful, but it’s just a fancy way of saying how a company is doing now, compared with something else (like a prior period or a similar company). If you know that a company you’re looking at had a net income of $50,000 for the year, you may ask, “Is that good or bad?” Obviously, making a net profit is good, but you also need to know whether it’s good compared to something else. If the company had a net profit of $40,000 the year before, you know that the company’s profitability is improving. But if a similar company had a net profit of $100,000 the year before and in the current year is making $50,000, then you may want to either avoid that company or see what went wrong (if anything) with it. Accounting can be this simple. If you understand these three basic points, you’re ahead of the curve (in stock investing as well as in your personal finances). For more information on how to use a company’s financial statements to pick good stocks, see Chapter 11. Understanding how economics affects stocks Economics. Double ugh! No, you aren’t required to understand “the inelasticity of demand aggregates” (thank heavens!) or “marginal utility” (say what?). But a working knowledge of basic economics is crucial (and I mean crucial) to your success and proficiency as a stock investor. The stock market and the economy are joined at the hip. The good (or bad) things that happen to one have a direct effect on the other. Getting the hang of the basic concepts Alas, many investors get lost on basic economic concepts (as do some socalled experts that you see on television). I owe my personal investing success to my status as a student of economics. Understanding basic economics helped me (and will help you) filter the financial news to separate relevant information from the irrelevant in order to make better investment decisions. Be aware of these important economic concepts: Supply and demand: How can anyone possibly think about economics without thinking of the ageless concept of supply and demand? Supply and demand can be simply stated as the relationship between what’s available (the supply) and what people want and are willing to pay for (the demand). This equation is the main engine of economic activity and is extremely important for your stock investing analysis and
Slide 98: Chapter 6: Gathering Information decision-making process. I mean, do you really want to buy stock in a company that makes elephant-foot umbrella stands if you find out that the company has an oversupply and nobody wants to buy them anyway? Cause and effect: If you pick up a prominent news report and read, “Companies in the table industry are expecting plummeting sales,” do you rush out and invest in companies that sell chairs or manufacture tablecloths? Considering cause and effect is an exercise in logical thinking, and believe you me, logic is a major component of sound economic thought. When you read business news, play it out in your mind. What good (or bad) can logically be expected given a certain event or situation? If you’re looking for an effect (“I want a stock price that keeps increasing”), you also want to understand the cause. Here are some typical events that can cause a stock’s price to rise: • Positive news reports about a company: The news may report that a company is enjoying success with increased sales or a new product. • Positive news reports about a company’s industry: The media may be highlighting that the industry is poised to do well. • Positive news reports about a company’s customers: Maybe your company is in industry A, but its customers are in industry B. If you see good news about industry B, that may be good news for your stock. • Negative news reports about a company’s competitors: If they are in trouble, their customers may seek alternatives to buy from, including your company. Economic effects from government actions: Political and governmental actions have economic consequences. As a matter of fact, nothing (and I mean nothing!) has a greater effect on investing and economics than government. Government actions usually manifest themselves as taxes, laws, or regulations. They also can take on a more ominous appearance, such as war or the threat of war. Government can willfully (or even accidentally) cause a company to go bankrupt, disrupt an entire industry, or even cause a depression. It controls the money supply, credit, and all public securities markets. What happens to the elephant-foot, umbrella stand industry if the government passes a 50 percent sales tax for that industry? Such a sales tax certainly makes a product uneconomical and encourages consumers to seek alternatives to elephant-foot umbrella stands. It may even boost sales for the wastepaper basket industry. The opposite can be true as well. What if the government passes a tax credit that encourages the use of solar power in homes and businesses? That obviously has a positive impact on industries that manufacture or sell solar power devices. Just don’t ask me what happens to solar-powered elephant-foot umbrella stands. 75
Slide 99: 76 Part II: Before You Start Buying Gaining insight from past mistakes Because most investors ignored some basic observations about economics in the late 1990s, they subsequently lost trillions in their stock portfolios. In the late 1990s, the United States experienced the greatest expansion of debt in history, coupled with a record expansion of the money supply. The Federal Reserve (or “the Fed”), the U.S. government’s central bank, controls both. This growth of debt and money supply resulted in more consumer (and corporate) borrowing, spending, and investing. This activity hyperstimulated the stock market and caused stocks to rise 25 percent per year for five straight years. Of course, you should always be happy to earn 25 percent per year with your investments, but such a return can’t be sustained and encourages speculation. This artificial stimulation by the Fed resulted in the following: More and more people depleted their savings. After all, why settle for 3 percent in the bank when you can get 25 percent in the stock market? More and more people bought on credit. If the economy is booming, why not buy now and pay later? Consumer credit hit record highs. More and more people borrowed against their homes. Why not borrow and get rich now? I can pay off my debt later. More and more companies sold more goods as consumers took more vacations and bought SUVs, electronics, and so on. Companies then borrowed to finance expansion, open new stores, and so on. More and more companies went public and offered stock to take advantage of more money that was flowing to the markets from banks and other financial institutions. In the end, spending started to slow down because consumers and businesses became too indebted. This slowdown in turn caused the sales of goods and services to taper off. However, companies had too much overhead, capacity, and debt because they expanded too eagerly. At this point, companies were caught in a financial bind. Too much debt and too many expenses in a slowing economy mean one thing: Profits shrink or disappear. Companies, to stay in business, had to do the logical thing — cut expenses. What is usually the biggest expense for companies? People! To stay in business, many companies started laying off employees. As a result, consumer spending dropped further because more people were either laid off or had second thoughts about their own job security. As people had little in the way of savings and too much in the way of debt, they had to sell their stock to pay their bills. This trend was a major reason that stocks started to fall in 2000. Earnings started to drop because of shrinking sales from a sputtering economy. As earnings fell, stock prices also fell. The lessons from the 1990s are important ones for investors today:
Slide 100: Chapter 6: Gathering Information 77 Know thyself If you’re reading this book, you’re probably doing so because you want to become a successful investor. Granted, to be a successful investor, you have to select great stocks, but having a realistic understanding of your own financial situation and goals is equally important. I recall one investor who lost $10,000 in a speculative stock. The loss wasn’t that bad because he had most of his money safely tucked away elsewhere. He also understood that his overall financial situation was secure and that the money he lost was “play” money whose loss wouldn’t have a drastic effect on his life. But many investors often lose even more money, and the loss does have a major, negative effect on their lives. You may not be like the investor who could afford to lose $10,000. Take time to understand yourself, your own financial picture, and your personal investment goals before you decide to buy stocks. Stocks are not a replacement for savings accounts. Always have some money in the bank. Stocks should never occupy 100 percent of your investment funds. When anyone (including an expert) tells you that the economy will keep growing indefinitely, be skeptical and read diverse sources of information. If stocks do well in your portfolio, consider protecting your stocks (both your original investment and any gains) with stop-loss orders. (See Chapter 18 for more on these strategies.) Keep debt and expenses to a minimum. Remember that if the economy is booming, a decline is sure to follow as the ebb and flow of the economy’s business cycle continues. Staying on Top of Financial News Reading the financial news can help you decide where or where not to invest. Many newspapers, magazines, and Web sites offer great coverage of the financial world. Obviously, the more informed you are, the better, but you don’t have to read everything that’s written. The information explosion in recent years has gone beyond overload, and you can easily spend so much time reading that you have little time left for investing. The most obvious publications of interest to stock investors are The Wall Street Journal and Investor’s Business Daily. These excellent publications report the news and stock data as of the prior trading day. Some of the more obvious Web sites are MarketWatch (www.marketwatch.com) and Bloomberg (www.bloomberg.com). These Web sites can actually give you news and stock data within 15 to 20 minutes after an event occurs. (Don’t forget the exchanges’ Web sites!)
Slide 101: 78 Part II: Before You Start Buying Appendix A of this book provides more information on these resources along with a treasure trove of some of the best publications, resources, and Web sites to assist you. Figuring out what a company’s up to Before you invest, you need to know what’s going on with a company. When you read about a company, either from the company’s literature (its annual report, for example) or from media sources, be sure to get answers to some pertinent questions: Is the company making more net income than it did last year? You want to invest in a company that is growing. Are the company’s sales greater than they were the year before? Remember, you won’t make money if the company isn’t making money. Is the company issuing press releases on new products, services, inventions, or business deals? All these achievements indicate a strong, vital company. Knowing how the company is doing, no matter what’s happening with the general economy, is obviously important. To better understand how companies tick, see Chapter 12. Discovering what’s new with an industry As you consider investing in a stock, make it a point to know what’s going on in that company’s industry. If the industry is doing well, your stock is likely to do well, too. But then again, the reverse is also true. Yes, I have seen investors pick successful stocks in a failing industry, but those cases are exceptional. By and large, it’s easier to succeed with a stock when the entire industry is doing well. As you’re watching the news, reading the financial pages, or viewing financial Web sites, check out the industry to see that it’s strong and dynamic. See Chapter 13 for information on analyzing industries. Knowing what’s happening with the economy No matter how well or how poorly the overall economy is performing, you want to stay informed about its general progress. It’s easier for the value of stock to keep going up when the economy is stable or growing. The reverse is
Slide 102: Chapter 6: Gathering Information also true; if the economy is contracting or declining, the stock has a tougher time keeping its value. Some basic items to keep tabs on include the following: Gross domestic product (GDP): This is roughly the total value of output for a particular nation, measured in the dollar amount of goods and services. GDP is reported quarterly, and a rising GDP bodes well for your stock. When the GDP is rising 3 percent or more on an annual basis, that’s solid growth. If it rises at more than zero but less than 3 percent, that’s generally considered less than stellar (or mediocre). GDP under zero (or negative) means that the economy is shrinking (heading into recession). The index of leading economic indicators (LEI): The LEI is a snapshot of a set of economic statistics covering activity that precedes what’s happening in the economy. Each statistic helps you understand the economy in much the same way that barometers (and windows!) help you understand what’s happening with the weather. Economists don’t just look at an individual statistic; they look at a set of statistics to get a more complete picture of what’s happening with the economy. Chapter 14 goes into greater detail on ways the economy affects stock prices. 79 Seeing what the politicians and government bureaucrats are doing Being informed about what public officials are doing is vital to your success as a stock investor. Because federal, state, and local governments pass literally thousands of laws every year, monitoring the political landscape is critical to your success. The news media report what the president and Congress are doing, so always ask yourself, “How does a new law, tax, or regulation affect my stock investment?” Because government actions have a significant effect on your investments, it’s a good idea to see what’s going on. Laws being proposed or enacted by the Federal government can be found through the Thomas legislative search engine, which is run by the Library of Congress (www.loc.gov). Also, some great organizations inform the public about tax laws and their impact, such as the National Taxpayers Union (www.ntu.org). Checking for trends in society, culture, and entertainment As odd as it sounds, trends in society, popular culture, and entertainment affect your investments, directly or indirectly. For example, headlines such as “The graying of America — more people than ever before will be senior citizens” give you some important information that can make or break your stock
Slide 103: 80 Part II: Before You Start Buying portfolio. With that particular headline, you know that as more and more people age, companies that are well positioned to cater to this growing market’s wants and needs will do well — meaning a successful stock for you. Keep your eyes open to emerging trends in society at large. What trends are evident now? Can you anticipate the wants and needs of tomorrow’s society? Being alert, staying a step ahead of the public, and choosing stock appropriately gives you a profitable edge over other investors. If you own stock in a solid company with growing sales and earnings, other investors eventually notice. As more investors buy up your company’s stocks, you’re rewarded as the stock price increases. Reading (And Understanding) Stock Tables The stock tables in major business publications, such as The Wall Street Journal and Investor’s Business Daily, are loaded with information that can help you become a savvy investor — if you know how to interpret them. You need the information in the stock tables for more than selecting promising investment opportunities. You also need to consult the tables after you invest to monitor how your stocks are doing. If you bought HokySmoky common stock last year at $12 per share and you want to know what it’s worth today, check out the stock tables. If you look at the stock tables without knowing what or why you’re looking, it’s the equivalent of reading War and Peace backwards through a kaleidoscope. Nothing makes sense. But I can help you make sense of it all (well, at least the stock tables!). Table 6-1 shows a sample stock table for you to refer to as you read the sections that follow. Table 6-1 52-Wk High 21.50 47.00 25.00 83.00 Deciphering Stock Tables Name (Symbol) SkyHighCorp (SHC) LowDownInc (LDI) ValueNowInc (VNI) DoinBadlyCorp (DBC) 52-Wk Low 8.00 31.75 21.00 33.00 Div 3,143 2.35 1.00 Vol Yld 76 P/E Day Last Net Chg 21.25 +.25 18 12 41.00 –.50 22.00 +.10 33.50 –.75 2,735 1,894 7,601 5.9 4.5
Slide 104: Chapter 6: Gathering Information Every newspaper’s financial tables are a little different, but they give you basically the same information. Updated daily, this section is not the place to start your search for a good stock; this section is usually where your search ends. The stock tables are the place to look when you already know what you want to buy and you’re just checking to see the most recent price, or to look when you already own it and you want to check the latest stock price. Each item gives you some clues about the current state of affairs for that particular company. The sections that follow describe each column to help you understand what you’re looking at. 81 52-week high The column labeled “52-Wk High” (refer to Table 6-1) gives you the highest price that particular stock has reached in the most recent 52-week period. Knowing this price lets you gauge where the stock is now versus where it has been recently. SkyHighCorp’s (SHC) stock has been as high as $21.50, while its last (most recent) price is $21.25, the number listed in the “Day Last” column. (Flip to the “Day Last” section for more on understanding this information.) SkyHighCorp’s stock is trading very high right now because it’s hovering right near its overall 52-week high figure. Now, take a look at DoinBadlyCorp’s (DBC) stock price. It seems to have tumbled big time. Its stock price has had a high in the past 52 weeks of $83, but it’s currently trading at $33.50. Something just doesn’t seem right here. During the past 52 weeks, DBC’s stock price fell dramatically. If you’re thinking about investing in DBC, find out why the stock price fell. If the company is a strong company, it may be a good opportunity to buy stock at a lower price. If the company is having tough times, avoid it. In any case, research the company and find out why its stock has declined. 52-week low The column labeled “52-Wk Low” gives you the lowest price that particular stock reached in the most recent 52-week period. Again, this information is crucial to your ability to analyze stock over a period of time. Look at DBC in Table 6-1, and you can see that its current trading price of $33.50 is close to its 52-week low. Keep in mind that the high and the low prices just give you a range of how far that particular stock’s price has moved within the past 52 weeks. They could alert you that a stock has problems, or they could tell you that a stock’s price has fallen enough to make it a bargain. Simply reading the 52-Wk High and 52-Wk Low columns isn’t enough to determine which of those two scenarios is happening. They basically tell you to get more information before you commit your money.
Slide 105: 82 Part II: Before You Start Buying Name and symbol The “Name (Symbol)” column is the simplest in Table 6-1. It tells you the company name (usually abbreviated) and the stock symbol assigned to the company. When you have your eye on a stock for potential purchase, get familiar with its symbol. Knowing the symbol makes it easier for you to find your stock in the financial tables, which list stocks in alphabetical order by the company’s name. Stock symbols are the language of stock investing, and you need to use them in all stock communications, from getting a stock quote at your broker’s office to buying stock over the Internet. Dividend Dividends (shown under the “Div” column in Table 6-1) are basically payments to owners (stockholders). If a company pays a dividend, it’s shown in the dividend column. The amount you see is the annual dividend quoted for one share of that stock. If you look at LowDownInc (LDI) in Table 6-1, you can see that you get $2.35 as an annual dividend for each share of stock that you own. Companies usually pay the dividend in quarterly amounts. If I own 100 shares of LDI, the company pays me a quarterly dividend of $58.75 ($235 total per year). A healthy company strives to maintain or upgrade the dividend for stockholders from year to year. In any case, the dividend is very important to investors seeking income from their stock investment. For more about investing for income, see Chapter 9. Investors buy stock in companies that don’t pay dividends primarily for growth. For more information on growth stocks, see Chapter 8. Volume Normally, when you hear the word volume on the news, it refers to how much stock is bought and sold for the entire market. (“Well, stocks were very active today. Trading volume at the New York Stock Exchange hit 2 billion shares.”) Volume is certainly important to watch because the stocks that you’re investing in are somewhere in that activity. For the “Vol” column in Table 6-1, though, the volume refers to the individual stock. Volume tells you how many shares of that particular stock were traded that day. If only 100 shares are traded in a day, then the trading volume is 100. SHC had 3,143 shares change hands on the trading day represented in Table 6-1. Is that good or bad? Neither, really. Usually the business news media only mention volume for a particular stock when it’s unusually large. If a stock normally has volume in the 5,000 to 10,000 range and all of a sudden has a trading volume of 87,000, then it’s time to sit up and take notice.
Slide 106: Chapter 6: Gathering Information Keep in mind that a low trading volume for one stock may be high trading volume for another stock. You can’t necessarily compare one stock’s volume against that of any other company. The large-cap stocks like IBM or Microsoft typically have trading volumes in the millions of shares almost every day, while less active, smaller stocks may have average trading volumes in far, far smaller numbers. The main point to remember is that trading volume that is far in excess of that stock’s normal range is a sign that something is going on with that stock. It may be negative or positive, but something newsworthy is happening with that company. If the news is positive, the increased volume is a result of more people buying the stock. If the news is negative, the increased volume is probably a result of more people selling the stock. What are typical events that cause increased trading volume? Some positive reasons include the following: Good earnings reports: A company announces good (or better-thanexpected) earnings. A new business deal: A company announces a favorable business deal, such as a joint venture, or lands a big client. A new product or service: A company’s research and development department creates a potentially profitable new product. Indirect benefits: A company may benefit from a new development in the economy or from a new law passed by Congress. Some negative reasons for an unusually large fluctuation in trading volume for a particular stock include the following: Bad earnings reports: Profit is the lifeblood of a company. When a company’s profits fall or disappear, you see more volume. Governmental problems: The stock is being targeted by government action (such as a lawsuit or Securities and Exchange Commission probe). Liability issues: The media report that a company has a defective product or similar problem. Financial problems: Independent analysts report that a company’s financial health is deteriorating. Check out what’s happening when you hear about heavier than usual volume (especially if you already own the stock). 83 Yield In general, yield is a return on the money you invest. However, in the stock tables, yield (“Yld” in Table 6-1) is a reference to what percentage that particular dividend is to the stock price. Yield is most important to income investors.
Slide 107: 84 Part II: Before You Start Buying It’s calculated by dividing the annual dividend by the current stock price. In Table 6-1, you can see that the yield du jour of ValueNowInc (VNI) is 4.5 percent (a dividend of $1 divided by the company’s stock price of $22). Notice that many companies have no yield reported; because they have no dividends, yield is zero. Keep in mind that the yield reported in the financial pages changes daily as the stock price changes. Yield is always reported as if you’re buying the stock that day. If you buy VNI on the day represented in Table 6-1, your yield is 4.5 percent. But what if VNI’s stock price rises to $30 the following day? Investors who buy stock at $30 per share obtain a yield of just 3.3 percent. (The dividend of $1 is then divided by the new stock price, $30.) Of course, because you bought the stock at $22, you essentially locked in the prior yield of 4.5 percent. Lucky you. Pat yourself on the back. P/E The P/E ratio is the ratio between the price of the stock and the company’s earnings. P/E ratios are widely followed and are important barometers of value in the world of stock investing. The P/E ratio (also called the “earnings multiple” or just “multiple”) is frequently used to determine whether a stock is expensive (a good value). Value investors (such as yours truly) find P/E ratios to be essential to analyzing a stock as a potential investment. As a general rule, the P/E should be 10 to 20 for large-cap or income stocks. For growth stocks, a P/E no greater than 30 to 40 is preferable. In the P/E ratios reported in stock tables, price refers to the cost of a single share of stock. Earnings refers to the company’s reported earnings per share as of the most recent four quarters. The P/E ratio is the price divided by the earnings. In Table 6-1, VNI has a reported P/E of 12, which is considered a low P/E. Notice how SHC has a relatively high P/E (76). This stock is considered too pricey because you’re paying a price equivalent to 76 times earnings. Also notice that DBC has no available P/E ratio. Usually this lack of a P/E ratio indicates that the company reported a loss in the most recent four quarters. Day last The “Day Last” column tells you how trading ended for a particular stock on the day represented by the table. In Table 6-1 , LDC ended the most recent day of trading at $41. Some newspapers report the high and low for that day in addition to the stock’s ending price for the day.
Slide 108: Chapter 6: Gathering Information 85 Net change The information in the “Net Chg” column answers the question “How did the stock price end today compared with its trading price at the end of the prior trading day?” Table 6-1 shows that SHC stock ended the trading day up 25 cents (at $21.25). This column tells you that SHC ended the prior day at $21. On a day when VNI ends the day at $22 (up 10 cents), you can tell that the prior day it ended the trading day at $21.90. Using News about Dividends Reading and understanding the news about dividends is essential if you’re an income investor (someone who invests in stocks as a means of generating regular income). See Chapter 9 on investing for income. Looking at important dates In order to understand how buying stocks that pay dividends can benefit you as an investor, you need to know how companies report and pay dividends. Some important dates in the life of a dividend are as follows: Date of declaration: This is the date when a company reports a quarterly dividend and the subsequent payment dates. On January 15, for example, a company may report that it “is pleased to announce a quarterly dividend of 50 cents per share to shareholders of record as of February 10.” That was easy. The date of declaration is really just the announcement date. If you buy the stock before, on, or after the date of declaration, it won’t matter in regard to receiving the stock’s quarterly dividend. The date that matters is the date of record (see that bullet later in this list). Date of execution: This is the day you actually initiate the stock transaction (buying or selling). If you call up a broker (or contact her online) today to buy a particular stock, then today is the date of execution, or the date on which you execute the trade. You don’t own the stock on the date of execution; it’s just the day you put in the order. For an example, skip to the section “Understanding why these dates matter,” later in this chapter. Closing date (settlement date): The closing or settlement date is the date on which the trade is finalized, which usually happens three business days after the date of execution. The closing date for stock is similar in
Slide 109: 86 Part II: Before You Start Buying concept to a real estate closing. On the closing date, you’re officially the proud new owner (or happy seller) of the stock. Date of record: The date of record is used to identify which stockholders qualify to receive the declared dividend. Because stock is bought and sold every day, how does the company know which investors to pay? The company establishes a cut-off date by declaring a date of record. All investors who are official stockholders as of the declared date of record receive the dividend on the payment date even if they plan to sell the stock any time between the date of declaration and the date of record. Ex-dividend date: Ex-dividend means without dividend. Because it takes three days to process a stock purchase before you become an official owner of the stock, you have to qualify (that is, you have to own or buy the stock) before the three-day period. That three-day period is referred to as the “ex-dividend period.” When you buy stock during this short time frame, you aren’t on the books of record, because the closing (or settlement) date falls after the date of record. See the section, “Understanding why these dates matter” to see the effect that the ex-dividend date can have on an investor. Payment date: The date on which a company issues and mails its dividend checks to shareholders. Finally! For typical dividends, the events in Table 6-2 happen four times per year. Table 6-2 Event Date of declaration Ex-dividend date The Life of the Quarterly Dividend Sample Date January 15 February 7 Comments The date that the company declares the quarterly dividend Starts the three-day period during which, if you buy the stock, you don’t qualify for the dividend The date by which you must be on the books of record to qualify for the dividend The date that payment is made (a dividend check is issued and mailed to stockholders who were on the books of record as of February 10) Record date February 10 Payment date February 27
Slide 110: Chapter 6: Gathering Information 87 Understanding why these dates matter Remember that three business days pass between the date of execution and the closing date. Three business days are also between the ex-dividend date and the date of record. This information is important to know if you want to qualify to receive an upcoming dividend. Timing is important, and if you understand these dates, you know when to purchase stock and whether you qualify for a dividend. As an example, say that you want to buy ValueNowInc (VNI) in time to qualify for the quarterly dividend of 25 cents per share. Assume that the date of record (the date by which you have to be an official owner of the stock) is February 10. You have to execute the trade (buy the stock) no later than February 7 to be assured of the dividend. If you execute the trade right on February 7, the closing date occurs three days later, on February 10 — just in time for the date of record. But what if you execute the trade on February 8, a day later? Well, the trade’s closing date is February 11, which occurs after the date of record. Because you aren’t on the books as an official stockholder on the date of record, you aren’t getting that quarterly dividend. In this example, the February 7–10 period is called the ex-dividend period. Fortunately, for those people who buy the stock during this brief ex-dividend period, the stock actually trades at a slighter lower price to reflect the amount of the dividend. If you can’t get the dividend, you may as well save on the stock purchase. How’s that for a silver lining? Evaluating (Avoiding?) Investment Tips Psssst. Have I got a stock tip for you! Come closer. You know what it is? Research! What I’m trying to tell you is to never automatically invest just because you get a hot tip from someone. Good investment selection means looking at several sources before you decide on a stock. No shortcut exists. That said, getting opinions from others never hurts — just be sure to carefully analyze the information you get. In the following list, I present some important points to bear in mind as you evaluate tips and advice from others: Consider the source. Frequently, people buy stock based on the views of some market strategist or market analyst. People may see an analyst being interviewed on a television financial show and take that person’s
Slide 111: 88 Part II: Before You Start Buying opinions and advice as valid and good. The danger here is that the analyst may be biased because of some relationship that isn’t disclosed on the show. It happens on TV all too often. The show’s host interviews Analyst U.R. Kiddingme from the investment firm Foollum & Sellum. The analyst says, “Implosion Corp. is a good buy with solid, long-term, upside potential.” You later find out that the analyst’s employer gets investment banking fees from Implosion Corp. Do you really think that analyst would ever issue a negative report on a company that’s helping to pay the bills? It’s not likely. Get multiple views. Don’t base your investment decisions on just one source unless you have the best reasons in the world for thinking that a particular, single source is outstanding and reliable. A better approach is to scour current issues of independent financial publications, such as Barron’s, Money Magazine, SmartMoney, and other publications (and Web sites) listed in Appendix A. Gather data from the SEC. When you want to get more objective information about a company, why not take a look at the reports that companies must file with the Securities and Exchange Commission (SEC)? These reports are the same reports that the pundits and financial reporters read. Arguably, the most valuable report you can look at is the 10K. The 10K is a report that all publicly traded companies must file with the SEC. It provides valuable information on the company’s operations and financial data, and it’s likely to be less biased than the information a company includes in other corporate reports, such as an annual report. To access 10K reports, go to the SEC’s Web site (www.sec.gov). From there, you can find the SEC’s extensive database of public filings called EDGAR (Electronic Data Gathering, Analysis, and Retrieval system). By searching EDGAR, you can find companies’ balance sheets, income statements, and other related information so that you can verify what others say and get a fuller picture of what a company is doing and what its financial condition is.
Slide 112: Chapter 7 Going for Brokers In This Chapter Finding out what brokers do Telling the difference between full-service and discount brokers Selecting a broker Exploring the types of brokerage accounts Figuring out what brokers’ recommendations mean W hen you’re ready to dive in and start investing in stocks, you first have to choose a broker. It’s kind of like buying a car: You can do all the research in the world and know exactly what kind of car you want to buy; still, you need a venue to do the actual transaction. Similarly, when you want to buy stock, your task is to do all the research you can to select the company you want to invest in. Still, you need a broker to actually buy the stock, whether you buy over the phone or online. In this chapter, I set out to introduce you to the intricacies of the investor/broker relationship. For information on various types of orders you can place with a broker, such as market orders, stop-loss orders, and so on, flip to Chapter 17. Defining the Broker’s Role The broker’s primary role is to serve as the vehicle through which you either buy or sell stock. When I talk about brokers, I’m referring to organizations such as Charles Schwab, Merrill Lynch, E*TRADE, and many other organizations that can buy stock on your behalf. Brokers can also be individuals who work for such firms. Although you can buy some stocks directly from the company that issues them (I discuss direct purchase plans in Chapter 18), to purchase most stocks, you still need a broker.
Slide 113: 90 Part II: Before You Start Buying Although the primary task of brokers is the buying and selling of securities (keep in mind that the word securities refers to the world of financial or paper investments, and that stocks are only a small part of that world), such as stocks, they can perform other tasks for you, including the following: Providing advisory services: Investors pay brokers a fee for investment advice. Customers also get access to the firm’s research. Offering limited banking services: Brokers can offer features such as interest-bearing accounts, check writing, direct deposit, and credit cards. Brokering other securities: Brokers can also buy bonds, mutual funds, options, Exchange Traded Funds (ETFs), and other investments on your behalf. Personal stockbrokers make their money from individual investors like you and me through various fees, including the following: Brokerage commissions: This fee is for buying and/or selling stocks and other securities. Margin interest charges: This interest is charged to investors for borrowing against their brokerage account for investment purposes. Service charges: These charges are for performing administrative tasks and other functions. Brokers charge fees to investors for Individual Retirement Accounts (IRAs) and for mailing stocks in certificate form. Any broker you deal with should be registered with the National Association of Securities Dealers (NASD) and the Securities and Exchange Commission (SEC). In addition, to protect your money after you’ve deposited it into a brokerage account, that broker should be a member of the Securities Investor Protection Corporation (SIPC). SIPC doesn’t protect you from market losses; it protects your money in case the brokerage firm goes out of business. To find out whether the broker is registered with these organizations, contact the NASD, SEC, and SIPC. (See Appendix A for information on these three organizations.) The distinction between personal stockbrokers and institutional stockbrokers is important. Institutional brokers make money from institutions and companies through investment banking and securities placement fees (such as initial public offerings and secondary offerings), advisory services, and other broker services. Personal stockbrokers generally offer the same services to individuals and small businesses.
Slide 114: Chapter 7: Going for Brokers 91 Distinguishing between Full-Service and Discount Brokers Stockbrokers fall into two basic categories: full-service and discount. The type you choose really depends on what type of investor you are. In a nutshell, fullservice brokers are suitable for investors who need some guidance, while discount brokers are better for those investors who are sufficiently confident and knowledgeable about stock investing to manage with minimal help. Full-service brokers Full-service brokers are just what the name indicates. They try to provide as many services as possible for investors who open accounts with them. When you open an account at a brokerage firm, a representative is assigned to your account. This representative is usually called an account executive, a registered rep, or a financial consultant by the brokerage firm. This person usually has a securities license and is knowledgeable about stocks in particular and investing in general. What they can do for you Your account executive is responsible for assisting you, answering questions about your account and the securities in your portfolio, and transacting your buy and sell orders. Here are some things that full-service brokers can do for you: Offer guidance and advice. The greatest distinction between full-service brokers and discount brokers is the personal attention you receive from your account rep. You get to be on a first-name basis with a full-service broker, and you disclose much information about your finances and financial goals. The rep is there to make recommendations about stocks and funds that are hopefully suitable for you. Provide access to research. Full-service brokers can give you access to their investment research department, which can give you in-depth information and analysis on a particular company. This information can be very valuable, but be aware of the pitfalls. (See the section “Judging Brokers’ Recommendations,” later in this chapter.) Help you achieve your investment objectives. Beyond advice on specific investments, a good rep gets to know you and your investment
Slide 115: 92 Part II: Before You Start Buying goals and then offers advice and answers your questions about how specific investments and strategies can help you accomplish your wealthbuilding goals. Make investment decisions on your behalf. Many investors don’t want to be bothered when it comes to investment decisions. Full-service brokers can actually make decisions for your account with your authorization. This service is fine, but be sure to require them to explain their choices to you. What to watch out for Although the full-service brokers, with their seemingly limitless assistance, can make life easy for an investor, you need to remember some important points to avoid problems: Brokers and account reps are still salespeople. No matter how well they treat you, they’re still compensated based on their ability to produce revenue for the brokerage firm. They generate commissions and fees from you on behalf of the company. (In other words, they’re paid to sell you things.) Whenever your rep makes a suggestion or recommendation, be sure to ask why and request a complete answer that includes the reasoning behind the recommendation. A good advisor is able to clearly explain the reasoning behind every suggestion. If you don’t fully understand and agree with the advice, don’t take it. Working with a full-service broker costs more than working with a discount broker. Discount brokers are paid simply for performing the act of buying or selling stocks for you. Full-service brokers do that and more. Additionally, they provide advice and guidance. Because of that, fullservice brokers are more expensive (through higher brokerage commissions and advisory fees). Also, most full-service brokers expect you to invest at least $5,000 to $10,000 just to open an account. Handing over decision-making authority to your rep can be a possible negative because letting others make financial decisions for you is always dicey — especially when they’re using your money. If they make poor investment choices that lose you money, you may not have any recourse because you authorized them to act on your behalf. Some brokers engage in an activity called churning. Churning is basically buying and selling stocks for the sole purpose of generating commissions. Churning is great for brokers but bad for customers. If your account shows a lot of activity, ask for justification. Commissions, especially by full-service brokers, can take a big bite out of your wealth, so don’t tolerate churning or other suspicious activity.
Slide 116: Chapter 7: Going for Brokers Before you deal with any broker, full-service or otherwise, get a free report on the broker from the National Association of Securities Dealers by calling 800-289-9999 or visiting the NASD Regulation Web site at www.nasdr.com. The report can indicate whether any complaints or penalties have been filed against that brokerage firm or the individual rep. Examples of full-service brokers are Merrill Lynch and Morgan Stanley. Of course, all brokers now have full-featured Web sites to give you further information about their services. Get as informed as possible before you open your account. A full-service broker is there to help you build wealth, not make you . . . uh . . . broker. 93 Discount brokers Perhaps you don’t need any hand-holding from a broker. You know what you want, and you can make your own investment decisions. All you want is someone to transact your buy/sell orders. In that case, go with a discount broker. They don’t offer advice or premium services — just the basics required to perform your stock transactions. Discount brokers, as the name implies, are cheaper to engage than full-service brokers. Because you’re advising yourself (or getting advice from third parties such as newsletters or independent advisors), you can save on costs that you incur when you pay for a full-service broker. If you choose to work with a discount broker, you must know as much as possible about your personal goals and needs. You have a greater responsibility for conducting adequate research to make good stock selections, and you must be prepared to accept the outcome, whatever that may be. For a while, the regular investor had two types of discount brokers to choose from: conventional discount brokers and Internet discount brokers. But the two are so similar now that the differences are hardly worth mentioning. Conventional discount brokers primarily conducted business through regular offices and over the phone, while Internet discount brokers conducted business primarily through Web sites. But through industry consolidation, most of the conventional discount brokers today have fully featured Web sites, while Internet discount brokers adapted by adding more telephone and face-to-face services. Charles Schwab and TD Waterhouse are examples of conventional discount brokers that have adapted well to the Internet era. Internet brokers such as E*TRADE.com, Ameritrade.com, Scottrade.com, and Thinkorswim.com have added more conventional services.
Slide 117: 94 Part II: Before You Start Buying What they can do for you Discount brokers offer some significant advantages over full-service brokers, such as: Lower cost: This lower cost is usually the result of lower commissions, and it’s the primary benefit of using discount brokers. Unbiased service: Discount brokers offer you the ability to just transact your stock buy and sell orders only. Since they don’t offer advice, they have no vested interest in trying to sell you any particular stock. Access to information: Established discount brokers offer extensive educational materials at their offices or on their Web sites. What to watch out for Of course, doing business with discount brokers also has its downside, including the following: No guidance: Because you’ve chosen a discount broker, you know not to expect guidance, but the broker should make this fact clear to you anyway. If you’re a knowledgeable investor, the lack of advice is considered a positive thing — no interference. Hidden fees: Discount brokers may shout about their lower commissions, but commissions aren’t their only way of making money. Many discount brokers charge extra for services that you may think are included, such as issuing a stock certificate or mailing a statement. Ask whether they assess fees for maintaining IRAs or fees for transferring stocks and other securities (such as bonds) in or out of your account, and find out what interest rates they charge for borrowing through brokerage accounts. Minimal customer service: If you deal with an Internet brokerage firm, find out about its customer service capability. If you can’t transact business at its Web site, find out where you can call for assistance with your order. Choosing a Broker Before you choose a broker, you need to analyze your personal investing style. After you know yourself and the way you invest, then you can proceed to finding the kind of broker that fits your needs. It’s almost like choosing shoes; if you don’t know your size, you can’t get a proper fit. (And you can be in for a really uncomfortable future.)
Slide 118: Chapter 7: Going for Brokers When it’s time to choose a broker, keep the following points in mind: Match your investment style with a brokerage firm that charges the least amount of money for the services you’re likely to use most frequently. Compare all the costs of buying, selling, and holding stocks and other securities through a broker. Don’t compare only commissions. Compare other costs, too, such as margin interest and other service charges. Use broker comparison services such as Gomez Advisors at www.gomez.com and read articles that compare brokers in publications such as SmartMoney and Barron’s. Check out Appendix A for a list of sources that compare brokers. Finding brokers is easy. They’re listed in the Yellow Pages as well as in many investment publications and on many financial Web sites. Start your search by using the sources in Appendix A, which includes a list of the major brokerage firms. 95 Discovering Various Types of Brokerage Accounts When you decide to start investing in the stock market, you have to somehow actually pay for the stocks you buy. Most brokerage firms offer investors several different types of accounts, each serving a different purpose. I present three of the most common types in the following sections. The basic difference boils down to how particular brokers view your “creditworthiness” when it comes to buying and selling securities. If your credit isn’t great, your only choice is a cash account. If your credit is good, you can open either a cash account or a margin account. Once you qualify for a margin account, you can (with additional approval) upgrade it to do options trades. To open an account, you have to fill out an application and submit a check or money order for at least the minimum amount required to establish an account. Cash accounts A cash account (also referred to as a Type 1 account) means just what you think it means. You must deposit a sum of money along with the new account application to begin trading. The amount of your initial deposit varies from broker to broker. Some brokers have a minimum of $10,000, while others let
Slide 119: 96 Part II: Before You Start Buying you open an account for as little as $500. Once in a while you may see a broker offering cash accounts with no minimum deposit, usually as part of a promotion. Use the resources in Appendix A to help you shop around. Qualifying for a cash account is usually easy as long as you have cash and a pulse. With a cash account, your money has to be deposited in the account before the closing (or settlement) date for any trade you make. The closing occurs three business days after the date you make the trade (the date of execution). You may be required to have the money in the account even before the date of execution. See Chapter 6 for details on these and other important dates. In other words, if you call your broker on Monday, October 10, and order 50 shares of CashLess Corp. at $20 per share, then on Thursday, October 13, you better have $1,000 in cash sitting in your account (plus commission). Otherwise, the purchase doesn’t go through. If you have cash in a brokerage account, see whether the broker will pay you interest on the uninvested cash in it. Some offer a service in which uninvested money earns money market rates and you can even make a choice about whether the venue is a regular money market account or a tax-free municipal money market account. Margin accounts A margin account (also called a Type 2 account) gives you the ability to borrow money against the securities in the account to buy more stock. Because you have the ability to borrow in a margin account, you have to be qualified and approved by the broker. After you’re approved, this newfound credit gives you more leverage so that you can buy more stock or do shortselling. (You can read more about buying on margin and short-selling in Chapter 17.) For stock trading, the margin limit is 50 percent. For example, if you plan to buy $10,000 worth of stock on margin, you need at least $5,000 in cash (or securities owned) sitting in your account. The interest rate that you pay varies depending on the broker, but most brokers generally charge a rate that’s several points higher than their own borrowing rate. Why use margin? Margin is to stocks what mortgage is to buying real estate. You can buy real estate with all cash, but many times, using borrowed funds makes sense since you may not have enough money to make a 100% cash purchase or you prefer not to pay all cash. With margin, you could, for example, be able to buy $10,000 worth of stock with as little as $5,000. The balance of the stock purchase is acquired using a loan (margin) from the brokerage firm.
Slide 120: Chapter 7: Going for Brokers 97 Option accounts An option account (also referred to as a Type 3 account) gives you all the capabilities of a margin account (which in turn also gives you the capabilities of a cash account) plus the ability to trade options on stocks and stock indexes. To upgrade your margin account to an options account, the broker usually asks you to sign a statement that you’re knowledgeable about options and familiar with the risks associated with them. Options can be a very effective addition to a stock investor’s array of wealthbuilding investment tools. A more comprehensive review of options is available in the book Stock Options For Dummies by Alan R. Simon (Wiley). Judging Brokers’ Recommendations In recent years, Americans have become enamored with a new sport: the rating of stocks by brokers on the television financial shows. Frequently these shows feature a dapper market strategist talking up a particular stock. Some stocks have been known to jump significantly right after an influential analyst issues a buy recommendation. Analysts’ speculation and opinions make for great fun, and many people take their views very seriously. However, most investors should be very wary when analysts, especially the glib ones on TV, make a recommendation. It’s often just showbiz. Brokers issue their recommendations (advice) as a general idea of how much regard they have for a particular stock. The following list presents the basic recommendations (or ratings) and what they mean to you: Strong buy and buy: Hot diggity dog! These ratings are the ones to get. The analyst loves this pick, and you would be very wise to get a bunch of shares. The thing to keep in mind, however, is that buy recommendations are probably the most common because (let’s face it) brokers sell stocks. Accumulate and market perform: An analyst who issues these types of recommendations is positive, yet unexcited, about the pick. This rating is akin to asking a friend whether he likes your new suit and getting the response “it’s nice” in a monotone voice. It’s a polite reply, but you wish his opinion had been more enthusiastic. Hold or neutral: Analysts use this language when their backs are to the wall, but they still don’t want to say, “Sell that loser!” This recommendation reminds me of my mother telling me to be nice and either say something
Slide 121: 98 Part II: Before You Start Buying positive or keep my mouth shut. In this case, this rating is the analyst’s way of keeping his mouth shut. Sell: Many analysts should have issued this recommendation during 2000 and 2001, but few actually uttered it. What a shame. So many investors lost money because some analysts were too nice or just afraid to be honest and sound the alarm and urge people to sell. Avoid like the plague: I’m just kidding about this one, but I wish that this recommendation was available. I’ve seen plenty of stocks that I thought were dreadful investments — stocks of companies that made no money and were in terrible financial condition that should never have been considered at all. Yet investors gobble up billions of dollars’ worth of stocks that eventually become worthless. Don’t get me wrong. An analyst’s recommendation is certainly a better tip than what you’d get from your barber or your sister-in-law’s neighbor, but you want to view recommendations from analysts with a healthy dose of reality. Analysts have biases because their employment depends on the very companies that are being presented. What investors need to listen to when a broker talks up a stock is the reasoning behind the recommendation. In other words, why is the broker making this recommendation? Keep in mind that analysts’ recommendations can play a useful role in your personal stock investing research. If you find a great stock and then you hear analysts give glowing reports on the same stock, you’re on the right track! Here are some questions and points to keep in mind: How does the analyst arrive at a rating? The analyst’s approach to evaluating a stock can help you round out your research as you consult other sources such as newsletters and independent advisory services. What analytical approach is the analyst using? Some analysts use fundamental analysis (looking at the company’s financial condition and factors related to its success, such as its standing within the industry and the overall market). Other analysts use technical analysis (looking at the company’s stock price history and judging past stock price movements to derive some insight regarding the stock’s future price movement). Many analysts use a combination of the two. Is this analyst’s approach similar to your approach or to those of sources that you respect or admire? What is the analyst’s track record? Has the analyst had a consistently good record through both bull and bear markets? Major financial publications, such as Barron’s and Hulbert Financial Digest, and Web sites, such as MarketWatch.com, regularly track recommendations from wellknown analysts and stock pickers.
Slide 122: Chapter 7: Going for Brokers How does the analyst treat important aspects of the company’s performance, such as sales and earnings? How about the company’s balance sheet? The essence of a healthy company is growing sales and earnings coupled with strong assets and low debt. Is the industry that the company is in doing well? Do the analysts give you insight on this important information? A strong company in a weak industry can’t stay strong for long. What research sources does the analyst cite? Does the analyst quote the federal government or industry trade groups to support her thesis? These sources are important because they help give a more complete picture regarding the company’s prospects for success. Imagine that you decide on the stock of a strong company. But what if the federal government (through agencies such as the SEC) is penalizing the company for fraudulent activity? Or what if the company’s industry is shrinking or has ceased to grow (making it tougher for the company to continue growing)? The astute investor looks at a variety of sources before buying stock. Is the analyst rational when citing a target price for a stock? When she says, “We think the stock will hit $100 per share within 12 months,” is she presenting a rational model, such as basing the share price on a projected price/earnings ratio? The analyst must be able to provide a logical scenario about why the stock has a good chance of achieving the cited target price within the time frame mentioned. You may not necessarily agree with the analyst’s conclusion, but the explanation can help you decide whether the stock choice was well thought out. Does the company that is being recommended have any ties to the analyst or the analyst’s firm? During 2000–2002, the financial industry got bad publicity because many analysts gave positive recommendations on stocks of companies that were doing business with the very firms that employed those analysts. This conflict of interest is probably the biggest reason that analysts were so wrong in their recommendations during that period. Ask your broker to disclose any conflict of interest. The bottom line with brokerage recommendations is that you shouldn’t use them to buy or sell a stock. Instead, use them to confirm your own research. I know that if I buy a stock based on my own research and later discover the same stock being talked up on the financial shows, that’s just the icing on the cake. The experts may be great to listen to, and their recommendations can augment your own opinions; however, they’re no substitute for your own careful research. 99
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Slide 124: Chapter 8 Investing for Growth In This Chapter Defining growth stocks Figuring out how to choose growth stocks Looking at small-caps and other speculative investments W hat’s the number one reason people invest in stocks? To grow their wealth (also referred to as capital appreciation). Yes, some people invest for income (in the form of dividends), but that’s a different matter handled in Chapter 9. Investors seeking growth would rather see the money that could have been distributed as dividends be reinvested in the company so that (hopefully) a greater gain is achieved by seeing the stock’s price rise or appreciate. People interested in growing their wealth see stocks as one of the convenient ways to do it. Growth stocks tend to be riskier than other categories of stocks, but they offer excellent long-term prospects for making the big bucks. If you don’t believe me, then just ask Warren Buffett, Peter Lynch, and other successful investors. Although someone like Warren Buffett is not considered a “growth” investor, his long-term, value-oriented approach has been a successful growth strategy. If you’re the type of investor who has enough time to let somewhat-risky stocks trend upward, or who has enough money so that a loss won’t devastate you financially, then growth stocks are definitely for you. As they say, no guts, no glory. The challenge is to figure out which stocks will make you richer quicker. Short of starting your own business, stock investing is the best way to profit from a business venture. I want to emphasize that to make money in stocks consistently over the long haul, you must remember that you’re investing in a company; buying the stock is just a means for you to participate in the company’s success (or failure). What does it matter that you think of stock investing as buying a company versus buying a stock? Invest in a stock only if you’re just as excited about it as you would be if you were the CEO and in charge of running the company. If
Slide 125: 102 Part II: Before You Start Buying you’re the sole owner of the company, do you act differently than one of a legion of obscure stockholders? Of course you do. As the owner of the company, you have a greater interest in the company. You have a strong desire to know how the enterprise is doing. As you invest in stocks, make believe that you’re the owner, and take an active interest in the company’s products, services, sales, earnings, and so on. This attitude and discipline can enhance your goals as a stock investor. This approach is especially important if your investment goal is growth. Becoming a Value-Oriented Growth Investor A stock is considered a growth stock when it’s growing faster and higher than the overall stock market. Basically, a growth stock performs better than its peers in categories such as sales and earnings. Value stocks are stocks that are priced lower than the value of the company and its assets — you can identify a value stock by analyzing the company’s fundamentals and looking at key financial ratios, such as the price-to-earnings ratio. (For more on the topic of ratios, see Appendix B.) Growth stocks tend to have better prospects for growth for the immediate future (from one to four years), but value stocks tend to have less risk and more steady growth over a longer term. Over the years, a debate has quietly raged in the financial community about growth versus value investing. Some people believe that growth and value are mutually exclusive. They maintain that large numbers of people buying stock with growth as the expectation tend to drive up the stock price relative to the company’s current value. Growth investors, for example, aren’t put off by price to earnings (P/E) ratios of 30, 40, or higher. Value investors, meanwhile, are too nervous buying a stock at those P/E ratio levels. However, you can have both. A value-oriented approach to growth investing serves you best. Long-term growth stock investors spend time analyzing the company’s fundamentals to make sure that the company’s growth prospects lie on a solid foundation. But what if you have to choose between a growth stock and a value stock? Which do you choose? Seek value when you are buying the stock and analyze the company’s prospects for growth. Growth includes but is not limited to the health and growth of the company’s specific industry and the economy at large (see Chapters 12, 13, and 14). The bottom line is that growth is much easier to achieve when you seek solid, value-oriented companies in growing industries. To better understand industries and how they affect stock value, see Chapter 12.
Slide 126: Chapter 8: Investing for Growth Being a value-oriented growth investor probably has the longest history of success versus most other stock investing philosophies. The track record for those people who use value-oriented growth investing is enviable. Warren Buffett, Benjamin Graham, John Templeton, and Peter Lynch are a few of the more well-known practitioners. Each may have his own spin on the concepts, but all have successfully applied the basic principles of value-oriented growth investing over many years. 103 Getting Tips for Choosing Growth Stocks Although the information in the previous section can help you shrink your stock choices from thousands of stocks to maybe a few dozen or a few hundred (depending on how well the general stock market is doing), the purpose of this section is to help you cull the so-so growth stocks to unearth the go-go ones. It’s time to dig deeper for the biggest potential winners. Keep in mind that you probably won’t find a stock to satisfy all the criteria presented here. Just make sure that your selection meets as many criteria as realistically possible. But hey, if you do find a stock that meets all the criteria cited, buy as much as you can! When choosing growth stocks, you should consider investing in a company only if it makes a profit and if you understand how it makes that profit and from where it generates sales. Part of your research means looking at the industry (Chapter 12) and economic trends in general. Making the right comparison You have to measure the growth of a company against something to figure out whether it’s a growth stock. Usually, you compare the growth of a company with growth from other companies in the same industry or with the stock market in general. In practical terms, when you measure the growth of a stock against the stock market, you’re actually comparing it against a generally accepted benchmark, such as the Dow Jones Industrial Average (DJIA) or the Standard & Poor’s 500 (S&P 500). For more on DJIA or S&P 500, see Chapter 5. If a company has earnings growth of 15 percent per year over three years or more, and the industry’s average growth rate over the same time frame is 10 percent, then this stock qualifies as a growth stock. A growth stock is called that not only because the company is growing but also because the company is performing well with some consistency. Having a single year where your earnings do well versus the S&P 500’s average doesn’t cut it. Growth must be consistently accomplished.
Slide 127: 104 Part II: Before You Start Buying Checking out a company’s fundamentals When you hear the word fundamentals in the world of stock investing, it refers to the company’s financial condition and related data. When investors (especially value investors) do fundamental analysis, they look at the company’s fundamentals — its balance sheet, income statement, cash flow, and other operational data, along with external factors such as the company’s market position, industry, and economic prospects. Essentially, the fundamentals indicate the company’s financial condition. Chapter 10 goes into greater detail about analyzing a company’s financial condition. However, the main numbers you want to look at include the following: Sales: Are the company’s sales this year surpassing last year’s? As a decent benchmark, you want to see sales at least 10 percent higher than last year. Although it may differ depending on the industry, 10 percent is a reasonable, general “yardstick.” Earnings: Are earnings at least 10 percent higher than last year? Earnings should grow at the same rate as sales (or, hopefully, better). Debt: Is the company’s total debt equal to or lower than the prior year? The death knell of many a company has been excessive debt. A company’s financial condition has more factors than I mention here, but these numbers are the most important. I also realize that using the 10 percent figure may seem like an oversimplification, but you don’t need to complicate matters unnecessarily. I know someone’s computerized financial model may come out to 9.675 percent or maybe 11.07 percent, but keep it simple for now. Looking for leaders and megatrends A strong company in a growing industry is a common recipe for success. If you look at the history of stock investing, this point comes up constantly. Investors need to be on the alert for megatrends because they help ensure your success. What is a megatrend? A megatrend is a major development that has huge implications for much (if not all) of society for a long time to come. Good examples are the advent of the Internet and the aging of America. Both of these trends offer significant challenges and opportunities for our economy. Take the Internet, for example. Its potential for economic application is still being developed. Millions are flocking to it for many reasons. And census data tells us that senior citizens (over 65) will be the fastest growing segment of our population during the next 20 years. How does the stock investor take advantage of a megatrend?
Slide 128: Chapter 8: Investing for Growth In the wake of the 2000–2002 stock bear market, two megatrends hit their stride: rising energy prices and an overheated housing market. As of 2005, these two issues became major news items with tremendous ripple effects across the national economy. For the growth investor, strategy became clear. Find value-oriented companies with solid fundamentals that are well-positioned to benefit from these megatrends. What’s the result? From 2002–2005, many energy-related and housing-related stocks skyrocketed. As oil surpassed $65 a barrel and gasoline hit $3 a gallon, most oil and oil services companies saw their stocks go up 50 percent, 100 percent, and more during that three-year time frame. Housing stocks were even more impressive. In addition, companies that cater to these industries also prospered. Mortgage firms that were publicly traded also posted impressive gains. 105 Considering a company with a strong niche Companies that have established a strong niche are consistently profitable. Look for a company with one or more of the following characteristics: A strong brand: Companies such as Coca-Cola and Microsoft come to mind. Yes, other companies out there can make soda or software, but a business needs a lot more than a similar product to topple companies that have established an almost irrevocable identity with the public. High barriers to entry: United Parcel Service and Federal Express have set up tremendous distribution and delivery networks that competitors can’t easily duplicate. High barriers to entry offer an important edge to companies that are already established. Research and development (R&D): Companies such as Pfizer and Merck spend a lot of money researching and developing new pharmaceutical products. This investment becomes a new product with millions of consumers who become loyal purchasers, so the company’s going to grow. Noticing who’s buying and/or recommending the stock You can invest in a great company and still see its stock go nowhere. Why? Because what makes the stock go up is demand — having more buyers than sellers of the stock. If you pick a stock for all the right reasons, and the
Slide 129: 106 Part II: Before You Start Buying market notices the stock as well, that attention causes the stock price to climb. The things to watch for include the following: Institutional buying: Are mutual funds and pension plans buying up the stock you’re looking at? If so, this type of buying power can exert tremendous upward pressure on the stock’s price. Some resources and publications track institutional buying and how that affects any particular stock. (You can find these resources in Appendix A.) Frequently, when a mutual fund buys a stock, others soon follow. In spite of all the talk about independent research, a herd mentality still exists. Analysts’ attention: Are analysts talking about the stock on the financial shows? As much as you should be skeptical about an analyst’s recommendation (given the stock market debacle of 2000–2002), it offers some positive reinforcement for your stock. Don’t ever buy a stock solely on the basis of an analyst’s recommendation. Just know that if you buy a stock based on your own research, and analysts subsequently rave about it, your stock price is likely to go up. A single recommendation by an influential analyst can be enough to send a stock skyward. Newsletter recommendations: Independent researchers usually publish newsletters. If influential newsletters are touting your choice, that praise is also good for your stock. Although some great newsletters are out there (find them in Appendix A), and they offer information that’s as good or better than the research departments of some brokerage firms, don’t use a single tip to base your investment decision on. But it should make you feel good if the newsletters tout a stock that you’ve already chosen. Consumer publications: No, you won’t find investment advice here. This one seems to come out of left field, but it’s a source that you should notice. Publications such as Consumer Reports regularly look at products and services and rate them for consumer satisfaction. If a company’s offerings are well received by consumers, that’s a strong positive for the company. This kind of attention ultimately has a positive effect on that company’s stock. Learning investing lessons from history A growth stock isn’t a creature like the Loch Ness monster — always talked about but rarely seen. Growth stocks have been part of the financial scene for nearly a century. Examples abound that offer rich information that you can apply to today’s stock market environment. Look at past market winners, especially those of the 1970s and 1980s, and ask yourself, “What made them profitable stocks?” I mention these two decades because they offer a stark
Slide 130: Chapter 8: Investing for Growth contrast to one another. The ’70s were a tough, bearish decade for stocks, while the ’80s were booming bull times. (See Chapter 15 for details on bear and bull markets.) Being aware and acting logically are as vital to successful stock investing as they are to any other pursuit. Over and over again, history gives you the formula for successful stock investing: Pick a company that has strong fundamentals, including signs such as rising sales and earnings and low debt. (See Chapter 10.) Make sure that the company is in a growing industry. (See Chapter 12.) Be fully invested in stocks during a bull market, when prices are rising in the stock market and in the general economy. (See Chapter 15.) During a bear market, switch more of your money out of growth stocks (such as technology) and into defensive stocks (such as utilities). Monitor your stocks. Hold on to stocks that continue to grow, and sell those stocks that are declining. (See Chapter 21 for some warning signals to watch out for.) 107 Evaluating the management of a company The management of a company is crucial to its success. Before you buy stock in a company, you want to know that the company’s management is doing a great job. But how do you do that? If you call up a company and ask, it may not even return your phone call. How do you know whether management is running the company properly? The best way is to check the numbers. The following sections tell you the numbers you need to check. If the company’s management is running the business well, the ultimate result is a rising stock price. Return on equity Although you can measure how well management is doing in several ways, you can take a quick snapshot of a management team’s competence by checking the company’s return on equity (ROE). You calculate the ROE simply by dividing earnings by equity. The resulting percentage gives you a good idea whether the company is using its equity (or net assets) efficiently and profitably. Basically, the higher the percentage, the better, but you can consider the ROE solid if the percentage is 10 percent or higher. Keep in mind that not all industries have identical ROEs. To find out a company’s earnings, check out the company’s income statement. The income statement is a simple financial statement that expresses the equation: sales less expenses equal net earnings (or net income or net profit).
Slide 131: 108 Part II: Before You Start Buying You can see an example of an income statement in Table 8-1. (I give more details on income statements in Chapter 10.) Table 8-1 Grobaby, Inc., Income Statement 2005 Income Statement 2006 Income Statement $90,000 –$78,000 $12,000 Sales Expenses Net earnings $82,000 –$75,000 $7,000 To find out a company’s equity, check out that company’s balance sheet. (See Chapter 10 for more details on balance sheets.) The balance sheet is actually a simple financial statement that illustrates total assets minus total liabilities equal net equity. For public stock companies, the net assets are called “shareholders’ equity” or simply “equity.” Table 8-2 shows a balance sheet for Grobaby, Inc. Table 8-2 Grobaby, Inc., Balance Sheet Balance Sheet for December 31, 2005 Balance Sheet for December 31, 2006 $65,000 –$25,000 $40,000 Total assets (TA) Total liabilities (TL) Equity (TA less TL) $55,000 –$20,000 $35,000 Table 8-1 shows that Grobaby’s earnings went from $7,000 to $12,000. In Table 8-2, you can see that Grobaby increased the equity from $35,000 to $40,000 in one year. The ROE for the year 2005 is 20 percent ($7,000 in earnings divided by $35,000 in equity), which is a solid number. The following year, the ROE is 30 percent ($12,000 in earnings divided by $40,000 equity), another solid number. Equity and earnings growth Two additional barometers of success are a company’s growth in earnings and growth of equity. Look at the growth in earnings in Table 8-1. The earnings grew from $7,000 (in 2005) to $12,000 (in 2006), or a percentage increase of 71 percent ($12,000 less $7,000 equals $5,000, and $5,000 divided by $7,000 is 71 percent), which is excellent. In Table 8-2, Grobaby’s equity grew by
Slide 132: Chapter 8: Investing for Growth $5,000 (from $35,000 to $40,000), or 14 percent, which is very good — management is doing good things here. 109 Insider buying Watching management as it manages the business is important, but another indicator of how well the company is doing is to see whether management is buying stock in the company as well. If a company is poised for growth, who knows better than management? And if management is buying up the company’s stock en masse, then that’s a great indicator of the stock’s potential. See Chapter 19 for more details on insider trading. Protecting your downside I become a Johnny-one-note on one topic: trailing stops. (See Chapter 17 for a full explanation of trailing stops.) Trailing stops are stop losses that you regularly manage with the stock you invest in. I always advocate using them, especially if you’re new to the game of buying growth stocks. Trailing stops can help you, no matter how good or bad the economy is (or how good or bad the stock you’re investing in is). Suppose that you had invested in Enron, a classic example of a phenomenal growth stock that went bad. In 1999 and 2000, when its stock soared, investors were as happy as chocoholics at Hershey. Along with many investors who forgot that sound investing takes discipline and research, Enron investors thought, “Downside risk? What downside risk?” Here’s an example of how a stop-loss order would have worked if you had invested in Enron. Suppose that you bought Enron in 2000 at $50 per share and put in a stop-loss order with your broker at $45. (Remember to make it a GTC or good-till-canceled order. If you do, the stop-loss order stays on indefinitely.) As a general rule, I like to place the stop-loss order at 10 percent below the market value. As the stock went up, you kept the stop-loss trailing upward like a tail. (Now you know why it’s called a “trailing” stop; it trails the stock’s price.) When Enron hit $70, your stop-loss was changed to, say, $63, and so on. At $84, your new stop-loss was at $76. Then what? When Enron started its perilous descent, you got out at $76. The new price of $76 triggered the stop-loss, and the stock was automatically sold — you stopped the loss! Actually, in this case, you could call it a “stop and cash in the gain” order. Because you bought the stock at $50 and sold at $76, you pocketed a nice capital gain of $26 (52 percent appreciation — a doEnron-ron a do-en-ron!). Then you safely stepped aside and watched the stock continue its plunge. But what if the market is doing well? Are trailing stops a good idea? Because these stops are placed below the stock price, you’re not stopping the stock from rising upward indefinitely. All you’re doing is protecting your investment from loss. That’s discipline! The stock market of 2004–2005 was fairly good to stock investors as the bear market that started in 2000 took a break. If a bear market continues, trailing stop strategies will again become very useful because a potential decline in the stock price will become a greater risk.
Slide 133: 110 Part II: Before You Start Buying Making sure a company continues to do well A company’s financial situation does change, and you, as a diligent investor, need to continue to look at the numbers for as long as the stock is in your portfolio. You may have chosen a great stock from a great company with great numbers in 2003, but chances are pretty good that the numbers have changed since then. Great stocks don’t always stay that way. A great selection that you’re drawn to today may become tomorrow’s pariah. Information, both good and bad, moves like lightning. In late 2000, analysts considered Enron a cream-of-thecrop stock, and they fell over themselves extolling its virtues. Even the thencelebrated market strategist Abby Joseph Cohen called Enron her number one choice in the energy sector as late as September 2001. Yet Enron shocked investors when it filed for bankruptcy in December 2001. Its stock price fell from $84 in December 2000 to a staggering 26 cents a share (yikes!) in October 2001! Keep an eye on your stock company’s numbers! Exploring Small-caps and Speculative Stocks Everyone wants to get in early on a hot new stock. Why not? You buy Shlobotky, Inc., at $1 per share and hope it zooms to $98 before lunchtime. Who doesn’t want to buy a stock that could become the next IBM or Microsoft? This possibility is why investors are attracted to small-cap stocks. Small-cap (or small-capitalization) is a reference to the company’s market size. Small-cap stocks are stocks that have a market value under $1 billion. Investors may face more risk with small-caps, but they also have the chance for greater gains. Out of all the types of stocks, small-cap stocks continue to exhibit the greatest amount of growth. In the same way that a tree planted last year has more opportunity for growth than a mature 100-year-old redwood, small-caps have greater growth potential than established large-cap stocks. Of course, a smallcap doesn’t exhibit spectacular growth just because it’s small. It grows when it does the right things, such as increasing sales and earnings by producing goods and services that customers want.
Slide 134: Chapter 8: Investing for Growth 111 Don’t rush to buy IPO stock When a company goes public, it means that it undergoes an initial public offering (IPO). The IPO is the process by which a private firm seeks the assistance of an investment banking firm to gain financing by issuing stock that the public purchases. IPOs generate a lot of excitement, and many investors consider the IPO to be that proverbial ground-floor opportunity. After all, some people find it appealing to get a stock before its price skyrockets after investors subsequently flock to it. Why wouldn’t people find IPOs appealing? IPOs actually have a poor track record of success in their first year. Studies periodically done by the brokerage industry have revealed that IPOs (more times than not) actually decline in price during the first 12 months 60 percent of the time. In other words, an IPO has a better than even chance of dropping in price. The lesson for investors is that they’re better off waiting to see how the stock and the company perform. Don’t worry about missing that great opportunity; if it’s a bona fide opportunity, you’ll still do well after the IPO. For every small company that becomes a Fortune 500 firm, hundreds of companies don’t grow at all or go out of business. When you try to guess the next great stock before any evidence of growth, you’re not investing — you’re speculating. Have you heard that one before? (If not, flip to Chapter 2 for details.) Of course you have, and you’ll hear it again. Don’t get me wrong — there’s nothing wrong with speculating. But it’s important to know that you’re speculating when you’re doing it. If you’re going to speculate in small stocks hoping for the next Cisco Systems, then use the guidelines I present in the following sections to increase your chances of success. Avoid IPOs, unless . . . Initial public offerings (IPOs) are the birthplace of public stocks, or the proverbial ground floor. The IPO is the first offering to the public of a company’s stock. The IPO is also referred to as “going public.” Because a company’s going public is frequently an unproven enterprise, investing in an IPO can be risky. Here are the two types of IPOs: Start-up IPO: This is a company that didn’t exist before the IPO. In other words, the entrepreneurs get together and create a business plan. To get the financing they need for the company, they decide to go public immediately by approaching an investment banker. If the investment banker thinks that it’s a good concept, the banker will seek funding (selling the stock to investors) via the IPO.
Slide 135: 112 Part II: Before You Start Buying A private company that decides to go public: In many cases, the IPO is done for a company that already exists and is seeking expansion capital. The company may have been around for a long time as a smaller private concern, but it decides to seek funding through an IPO to grow even larger (or to fund a new product, promotional expenses, and so on). Which of the two IPOs do you think is less risky? That’s right! The private company going public. Why? Because it’s already a proven business, which is a safer bet than a brand-new start-up. Some great examples of successful IPOs in recent years are United Parcel Service and Google (they were both established companies before they went public). Great stocks started as small companies going public. You may be able to recount the stories of Federal Express, Dell, AOL, Home Depot, and hundreds of other great successes. But do you remember an IPO by the company Lipschitz & Farquar? No? I didn’t think so. It’s among the majority of IPOs that don’t succeed. For investors, the lesson is clear: Wait until a track record appears before you invest in a company. If you don’t, you’re simply rolling the dice (in other words, you’re speculating, not investing!). If it’s a small-cap stock, make sure it’s making money I emphasize two points when investing in stocks: Make sure that a company is established. (Being in business for at least three years is a good minimum.) Make sure that a company is profitable. These points are especially important for investors in small stocks. Plenty of start-up ventures lose money but hope to make a fortune down the road. A good example is a company in the biotechnology industry. Biotech is an exciting area, but it’s esoteric, and at this early stage, companies are finding it difficult to use the technology in profitable ways. You may say, “But shouldn’t I jump in now in anticipation of future profits?” You may get lucky, but understand that when you invest in unproven, small-cap stocks, you’re speculating. Investing in small-cap stocks requires analysis The only difference between a small-cap stock and a large-cap stock is a few zeros in their numbers and the fact that you need to do more research with small-caps. By sheer dint of size, small-caps are riskier than large-caps, so
Slide 136: Chapter 8: Investing for Growth you offset the risk by accruing more information on yourself and the stock in question. Plenty of information is available on large-cap stocks because they’re widely followed. Small-cap stocks don’t get as much press, and fewer analysts issue reports on them. Here are a few points to keep in mind: Understand your investment style. Small-cap stocks may have more potential rewards, but they also carry more risk. No investor should devote a large portion of his capital to small-cap stocks. If you’re considering retirement money, you’re better off investing in large-cap stocks, Exchange-Traded Funds (ETFs), investment-grade bonds, bank accounts, and mutual funds. For example, retirement money should be in investments that are either very safe or have proven track records of steady growth over an extended period of time (five years or longer). Check with the SEC. Get the financial reports that the company must file with the SEC (such as its 10Ks and 10Qs — see Chapter 6 for more details). These reports offer more complete information on the company’s activities and finances. Go to the SEC Web site at www.sec.gov and check its massive database of company filings at EDGAR (Electronic Data Gathering, Analysis, and Retrieval system). You can also check to see whether any complaints have been filed against the company. Check other sources. See whether brokers and independent research services, such as Value Line, follow the stock. If two or more different sources like the stock, it’s worth further investigation. Check the resources in Appendix A for further sources of information before you invest. 113
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Slide 138: Chapter 9 Investing for Income In This Chapter Defining income stocks Selecting income stocks Looking at some typical income stocks I nvesting for income means investing in stocks that provide you with regular money payments (dividends). Income stocks may not offer stellar growth, but they’re good for a steady infusion of money. What type of person is best suited to income stocks? Income stocks can be appropriate for many investors, but they’re especially well suited for the following individuals: Conservative and novice investors: Conservative investors like to see a slow-but-steady approach to growing their money while getting regular dividend checks. Novice investors who want to start slowly also benefit from income stocks. Retirees: Growth investing is best suited for long-term needs, while income investing is best suited to current needs. Retirees may want some growth in their portfolios, but they’re more concerned with regular income that can keep pace with inflation. Dividend reinvestment plan (DRP) investors: For those investors who like to compound their money with DRPs, income stocks are perfect. For more information on DRPs, see Chapter 18. If you have a low tolerance for risk or if your investment goal is anything less than long-term, income stocks are your best bet. Getting your stock portfolio to yield more income is easier than you think. Many income investors increase income using proven techniques such as Covered call writing. Covered call writing is an option strategy that is covered more fully in sources such as Stock Options For Dummies (Wiley). You can also find great educational material on this option strategy (and many others) at places such as the Chicago Board Options Exchange (www.cboe.com).
Slide 139: 116 Part II: Before You Start Buying Understanding Income Stocks When people talk about gaining income from stocks, they’re usually talking about dividends. A dividend is nothing more than money paid out to the owner of stock. You purchase dividend stocks primarily for income — not for spectacular growth potential. A dividend is quoted as an annual number but is usually paid on a quarterly basis. For example, if the stock pays a dividend of $4, you’re probably paid $1 every quarter. If, in this example, you have 200 shares, you’re paid $800 every year (if the dividend doesn’t change during that period), or $200 per quarter. Getting that regular dividend check every three months (for as long as you hold the stock) can be a nice perk. A good income stock is a stock that has a higher-than-average dividend (typically 4 percent or higher). Dividend rates aren’t guaranteed — they can go up or down, or, in some extreme cases, the dividend can be discontinued. Fortunately, most companies that issue dividends continue them indefinitely and actually increase dividend payments from time to time. Historically, dividend increases have equaled (or exceeded) the rate of inflation. Advantages of income stocks Income stocks tend to be among the least volatile of all stocks, and many investors view them as defensive stocks. Defensive stocks are stocks of companies that sell goods and services that are generally needed no matter what shape the economy is in. (Don’t confuse defensive stocks with defense stocks, which specialize in goods and equipment for the military.) Food, beverage, and utility companies are great examples of defensive stocks. Even when the economy is experiencing tough times, people still need to eat, drink, and turn the lights on. Companies that offer relatively high dividends also tend to be large firms in established, stable industries. Some industries in particular are known for high-dividend stocks. Utilities (such as electric, gas, and water), real estate investment trusts (REITs), and the energy sector (oil and gas) are places where you definitely find income stocks. Yes, you can find high-dividend stocks in other industries, but you find a high concentration of them in these industries. For more details, see the sections highlighting these industries later in this chapter.
Slide 140: F T AM E Y L Chapter 9: Investing for Income 117 Disadvantages of income stocks Before you say, “Income stocks are great! I’ll get my checkbook and buy a batch right now,” take a look at some potential disadvantages (ugh!). Income stocks do come with some fine print. What goes up . . . Income stocks can go down as well as up, just as any stock can. Obviously, you don’t mind your income stock going up in value, but it can go down just as easily. The factors that affect stocks in general — politics, economic trends (Chapter 14), industry changes (Chapter 12), and so on — affect income stocks, too. Fortunately, income stocks don’t get hit as hard as other stocks when the market is declining because high dividends tend to act as a support to the stock price. Therefore, income stocks’ prices usually fall less dramatically than the prices of other stocks in a declining market. Interest-rate sensitivity Income stocks can be sensitive to rising interest rates. When interest rates go up, other investments (such as corporate bonds, U.S. treasury securities, and bank certificates of deposit) are more attractive. When your income stock is yielding 4 percent and interest rates are going to 5 percent, 6 percent, or higher, you may think, “Hmmm. Why settle for a 4 percent yield when I can get 5 percent or better elsewhere?” As more and more investors sell their low-yield stock, the prices for those stocks fall. Another point to remember is that rising interest rates may hurt the company’s financial strength. If the company has to pay more interest, that may affect the company’s earnings, which in turn may affect the dividend. Dividend-paying companies that are experiencing consistent, falling revenues tend to cut dividends. In this case, “consistent” means beyond just a year. Inflation eats into dividends Although many companies raise their dividends on a regular basis, some don’t. Or, if they do raise their dividends, the increases may be small. If income is your primary consideration, you want to be aware of this fact. If you’re getting the same dividend year after year and this income is important to you, rising inflation becomes a problem. Say that you have XYZ stock at $10 per share with an annual dividend of 30 cents (the yield is 30 cents divided by $10, or 3 percent). If you have a yield of 3 percent two years in a row, how do you feel when inflation rises 6 percent one year and 7 percent the next year? Because inflation means that your costs are rising, inflation shrinks the value of the dividend income you receive.
Slide 141: 118 Part II: Before You Start Buying Playing it safe If you’re an investor seeking income and you’re very nervous about potential risks with income stocks, here are some non-stock alternatives: U.S. Treasury securities: Issued by the federal government, these securities are considered the safest investments in the world. Examples of treasury securities are U.S. savings bonds and treasury bonds. They pay interest and are an ideal addition to any income investor’s portfolio. Bank certificates of deposit (CDs): These investments are backed up by the Federal Deposit Insurance Corporation (FDIC) and are considered very safe. Income mutual funds: Many mutual funds, such as treasury bond mutual funds and corporate bond funds, are designed for income investors. They offer investors diversification and professional management, and investors can usually invest with as little as $1,000. As you can see, even conservative income investors can be confronted with different types of risk. (Chapter 4 covers the topic of risk in greater detail.) Fortunately, the rest of this chapter helps you carefully choose income stocks so that you can minimize these potential disadvantages. Don’t forget Uncle Sam The government usually taxes dividends as ordinary income. Fortunately, recent tax legislation has favored dividend-paying stock. See Chapter 20 for more information on taxes for stock investors. Analyzing Income Stocks Look at income stocks in the same way you do growth stocks when assessing the financial strength of a company. Getting nice dividends comes to a screeching halt if the company can’t afford to pay them. If your budget depends on dividend income, then monitoring the company’s financial strength is that much more important. You can apply the same techniques I list in Chapter 8 for assessing the financial strength of growth stocks to your assessment of income stocks. Understanding your needs first You choose income stocks primarily because you want or need income now. As a secondary point, income stocks have the potential for steady, long-term
Slide 142: Chapter 9: Investing for Income appreciation. So if you’re investing for retirement needs that won’t occur for another 20 years, maybe income stocks aren’t suitable for you — better to invest in growth stocks because they’re more likely to grow your money faster over your stated lengthy investment term. If you’re certain that you want income stocks, do a rough calculation to figure out how big a portion of your portfolio you want income stocks to occupy. Suppose that you need $25,000 in investment income to satisfy your current financial needs. If you have bonds that give you $20,000 in interest income and you want the rest to come from dividends from income stocks, you need to choose stocks that pay you $5,000 in annual dividends. If you have $80,000 left to invest, you know that you need a portfolio of income stocks that provide $5,000 in dividend income or a yield of 6.25 percent ($5,000 divided by $80,000 equals a yield of 6.25 percent). Use the following table as a general guideline for understanding your need for income. Item A. How much annual income do you need? B. The value of your portfolio (or money available for investment) C. Yield necessary to achieve income (divide item A by item B) Your Amounts Sample Amounts $10,000 119 $150,000 6.7% With this simple table, you know that if you have $150,000 in income stocks yielding 6.7 percent, you receive income of $10,000 — meeting your stated financial need. You may ask, “Why not just buy $150,000 of bonds (for instance) that yield at least 6.7 percent?” Well, if you’re satisfied with that $10,000, and inflation for the foreseeable future is zero, then you have a point. Unforturnately, inflation will probably be with us for a long time. Fortunately, steady growth that income stocks provide are a benefit to you. If you have income stocks and don’t have any immediate need for the dividends, consider reinvesting the dividends in the company’s stock. For more details on this kind of reinvesting, see Chapter 18. Every investor is different. If you’re not sure about your current or future needs, your best choice is to consult with a financial planner.
Slide 143: 120 Part II: Before You Start Buying Minding your dividends and interest Dividends are sometimes confused with interest. However, dividends are payouts to owners, while interest is a payment to a creditor. A stock investor is considered a part owner of the company he invests in and is entitled to dividends when they’re issued. A bank, on the other hand, considers you a creditor when you open an account. The bank borrows your money and pays you interest on it. Checking out yield Because income stocks pay out dividends — income — you need to assess which stocks can give you the highest income. How do you decide which stocks will pay the most money? The main thing to look for in choosing income stocks is yield (the percentage rate of return paid on a stock in the form of dividends). Looking at a stock’s dividend yield is the quickest way to find out how much money you’ll earn from a particular income stock versus other dividendpaying stocks (or even other investments such as a bank account). Table 9-1 illustrates this point. Dividend yield is calculated in the following way: Dividend yield = dividend income ÷ stock investment The next two sections use the information in Table 9-1 to compare the yields from different investments and to see how evaluating yield can help you choose the stock that will earn you the most money. Don’t stop scrutinizing stocks after you acquire them. You may have made a great choice that gives you a great dividend, but that doesn’t mean that the stock stays that way indefinitely. Monitor the company’s progress for as long as it’s in your portfolio. Use resources such as www.bloomberg.com and www.marketwatch.com (see Appendix A for more resources) to track your stock and to monitor how well that particular company continues to perform. Table 9-1 Investment Type Investment Amount Comparing Yields Annual Investment Yield (Annual InvestIncome (Dividend) ment Income ÷ Investment Amount) 5% 5% Smith Co. Jones Co. Common $20 per share $1.00 per share stock Common $30 per share $1.50 per share stock
Slide 144: Chapter 9: Investing for Income 121 Investment Type Investment Amount Annual Investment Yield (Annual InvestIncome (Dividend) ment Income ÷ Investment Amount) 4% Wilson Bank Savings account $1,000 deposit $40 Examining yield Most people have no problem understanding yield when it comes to bank accounts. If I tell you that my bank certificate of deposit (CD) has an annual yield of 3.5 percent, you can easily figure out that if I deposit $1,000 in that account, a year later I’ll have $1,035 (slightly more if you include compounding). The CD’s market value in this example is the same as the deposit amount — $1,000. That makes it easy to calculate. How about stocks? When you see a stock listed in the financial pages, the dividend yield is provided along with the stock’s price and annual dividend. The dividend yield in the financial pages is always calculated as if you bought the stock on that given day. Just keep in mind that, based on supply and demand, stock prices change virtually every day (every minute!) that the market is open. Therefore, because the stock price changes every day, the yield changes as well. So, keep the following two things in mind when examining yield: The yield listed in the financial pages may not represent the yield you’re receiving. What if you bought stock in Smith Co. (see Table 9-1) a month ago at $20 per share? With an annual dividend of $1, you know that your yield is 5 percent. But what if today Smith Co. is selling for $40 per share? If you look in the financial pages, the yield quoted would be 2.5 percent. Gasp! Did the dividend get cut in half?! No, not really. You’re still getting 5 percent because you bought the stock at $20 rather than the current $40 price; the quoted yield is for investors who purchase Smith Co. today. Investors who buy Smith Co. stock today pay $40 and get the $1 dividend, and they’re locked into the current yield of 2.5 percent. Although Smith Co. may have been a good income investment for you a month ago, it’s not such a hot pick today because the price of the stock doubled, cutting the yield in half. Even though the dividend hasn’t changed, the yield changed dramatically because of the stock price change. Stock price affects how good of an investment the stock may be. Another way to look at yield is by looking at the amount of investment. Using Smith Co. in Table 9-1 as the example, the investor who bought, say, 100 shares of Smith Co. when they were $20 per share only paid $2,000 (100 shares times $20 — leave out commissions to make the example simple). If the same stock is purchased later at $40 per share, the total investment amount is $4,000 (100 shares times $40). In either case, the investor gets a total dividend income of $100 (100 shares times $1 dividend per share). From a yield perspective, which investment is
Slide 145: 122 Part II: Before You Start Buying yielding more — the $2,000 investment or the $4,000 investment? Of course, it’s better to get the income ($100 in this case) with the smaller investment (a 5 percent yield is better than a 2.5 percent yield). Comparing yield between different stocks All things being equal, choosing Smith Co. or Jones Co. is a coin toss. It’s looking at your situation and each company’s fundamentals and prospects that will sway you. What if Smith Co. is an auto stock (similar to General Motors in 2005) and Jones Co. is a utility serving the Las Vegas metro area. Now what? In 2005, the automotive industry struggled, while utilities were generally in much better shape. In that scenario, Smith Co.’s dividend would be in jeopardy while Jones Co.’s dividend would be more secure. Another issue would be the payout ratio (see later in this chapter). Therefore, having the same yield is not the same as the same risk. Different companies have different risks associated with them. Checking the stock’s payout ratio You can use the payout ratio to figure out what percentage of the company’s earnings are being paid out in the form of dividends. Keep in mind that companies pay dividends from their net earnings. Therefore, the company’s earnings should always be higher than the dividends the company pays out. Here’s how to figure a payout ratio: Dividend (per share) divided by Earnings (per share) = Payout Ratio Say that the company CashFlow Now, Inc., (CFN) has annual earnings of $1 million dollars. (Remember that earnings are what you get when you subtract expenses from sales.) Total dividends are to be paid out of $500,000, and the company has 1 million outstanding shares. Using those numbers, you know that CFN has earnings per share (EPS) of $1.00 ($1 million in earnings divided by 1 million shares) and that it pays an annual dividend of 50 cents per share ($500,000 divided by 1 million shares). The dividend payout ratio is 50 percent (the 50-cent dividend is 50 percent of the $1.00 EPS). This number is a healthy dividend payout ratio because even if the company’s earnings fall by 10 percent or 20 percent, it still has plenty of room to pay dividends. People concerned about the safety of their dividend income should regularly watch the payout ratio. The maximum acceptable payout ratio should be 80 percent and a good range is 50–70 percent. A payout ratio of 60 percent and lower is considered very safe. When a company suffers significant financial difficulties, its ability to pay dividends is compromised. So if you need dividend income to help you pay your bills, you better be aware of the dividend payout ratio. Generally, a dividend payout ratio of 60 percent or less is safe. Obviously, the lower the percentage is, the safer the dividend.
Slide 146: Chapter 9: Investing for Income 123 Diversifying your stocks If most of your dividend income comes from stock in a single company or from a single industry, consider reallocating your investment to avoid having all your eggs in one basket. Concerns for diversification apply to income stocks as well as growth stocks. If all your income stocks are in the electric utility industry, then any problems in the electric utility industry are potential problems for your portfolio as well. See Chapter 4 for more on diversification. Examining the company’s bond rating Bond rating? Huh? What’s that got to do with dividend-paying stocks? Actually, the company’s bond rating is very important to income stock investors. The bond rating offers insight into the company’s financial strength. Bonds get rated for quality for the same reasons that consumer agencies rate products such as cars or toasters. Standard & Poor’s (S&P) is the major independent rating agency that looks into bond issuers. It looks at the issuer of a bond and asks the question “Does the bond issuer have the financial strength to pay back the bond and the interest as stipulated in the bond indenture?” To understand why this rating is important, consider the following: If the bond rating is good, that means the company is strong enough to pay its obligations. These obligations include expenses, payments on debts, and dividends that are declared. If a bond rating agency gives the company a high rating (or if it raises the rating), that’s a great sign for anyone holding the company’s debt or receiving dividends. If a bond rating agency lowers the rating of a bond, that means that the company’s financial strength is deteriorating — a red flag for anyone who owns the company’s bonds or stock. A lower bond rating today may mean trouble for the dividend later on. If the bond rating isn’t good, that means that the company is having difficulty paying its obligations. If the company can’t pay all its obligations, then it has to choose which ones to pay. More times than not, a financially troubled company chooses to cut dividends or (in a worst case scenario) not pay dividends at all. The highest rating issued by S&P is AAA. The grades AAA, AA, and A are considered “investment grade” or of high quality. Bs and Cs indicate a poor grade, while anything lower than that is considered very risky (the bonds are referred to as “junk bonds”). So if you see a XXX rating, then . . . gee . . . you better stay away! (You may even get an infection.)
Slide 147: 124 Part II: Before You Start Buying Exploring Some Typical Income Stocks Although virtually every industry has stocks that pay dividends, some industries have more dividend-paying stocks than others. You won’t find too many dividend-paying income stocks in the computer or biotech industry! The reason is that these types of companies need a lot of money to finance expensive research and development (R&D) projects to create new products. Without R&D, the company can’t create new products to fuel sales, growth, and future earnings. Computer, biotech, and other innovative industries are better for growth investors. Utilities Utilities generate a large cash flow. (If you don’t believe me, look at your gas and electric bills!) Cash flow includes money from income (sales of products and/or services) and other items (such as the selling of assets, for example). This cash flow is needed to cover things such as expenses, loan payments, and dividends. Utilities are considered the most common type of income stocks, and many investors have at least one in their portfolios. Investing in your own local utility isn’t a bad idea. At least it makes paying the utility bill less painful. Before you invest in a public utility, consider the following: The utility company’s financial condition: Is the company making money, and are its sales and earnings growing from year to year? Make sure that the utility’s bonds are rated A or higher. I cover bond ratings in the “Examining the company’s bond rating” section, earlier in this chapter. The company’s dividend payout ratio: Because utilities tend to have a good cash flow, don’t be too concerned if the ratio reaches 70 percent. Again, from a safety point of view, however, the lower the rate the better. See the “Checking the stock’s payout ratio” section, earlier in this chapter, for more on payout ratios. The company’s geographic location: If the utility covers an area that’s doing well and offers an increasing population base and business expansion, that bodes well for your stock. Real estate investment trusts (REITs) Real estate investment trusts (REITs) are a special breed of stock. A REIT is an investment that has the elements of both a stock and a mutual fund (a pool of money received from investors that’s managed by an investment company).
Slide 148: Chapter 9: Investing for Income It’s like a stock in that it’s a company whose stock is publicly traded on the major stock exchanges, and it has the usual features that you expect from a stock — it can be bought and sold easily through a broker, income is given to investors as dividends, and so on. A REIT resembles a mutual fund in that it doesn’t make its money selling goods and services; it makes its money by buying, selling, and managing an investment portfolio — in the case of a REIT, the portfolio is full of real estate investments. It generates revenue from rents and property leases as any landlord does. In addition, some REITs own mortgages, and they gain income from the interest. REITs are called trusts only because they meet the requirements of the Real Estate Investment Trust Act of 1960. This act exempts REITs from corporate income tax and capital gains taxes as long as they meet certain criteria, such as dispensing 95 percent of their net income to shareholders. Other criteria exist, but income investors are interested in this one. This provision is the reason why REITs generally issue generous dividends. Beyond this status, REITs are, in a practical sense, like any other publicly traded company. The main advantages to investing in REITs include the following: Unlike other types of real estate investing, REITs are easy to buy and sell. You can buy a REIT by making a phone call to a broker or visiting a broker’s Web site, just as you can to purchase any stock. REITs have higher-than-average yields. Because they must distribute at least 95 percent of their income to their shareholders, their dividends usually yield a return of 5 to 12 percent. REITs involve a lower risk than the direct purchase of real estate. Because you’re investing in a company that buys the real estate, you don’t have to worry about managing the properties — the company’s management does that on a full-time basis. Usually, the REIT doesn’t just manage one property; it’s diversified in a portfolio of different properties. Investing in a REIT is affordable for small investors. REIT shares usually trade in the $10 to $40 range, meaning that you can invest with very little money. REITs do have disadvantages. They have the same inherent risks as investing in real estate directly. Real estate investing reached manic record-high levels during 2000–2004, which means that a downturn is likely. Whenever you invest in an asset (real estate and therefore REITs) that has already skyrocketed due to artificial stimulants (in the case of real estate, very low interest rates and too much credit and debt), the potential losses can offset any potential (unrealized) income. 125
Slide 149: 126 Part II: Before You Start Buying When you’re looking for a REIT to invest in, analyze it the way you’d analyze a property. Look at the location and type of the property. If shopping malls are booming in California and your REIT buys and sells shopping malls in California, then you’ll do well. However, if your REIT invests in office buildings across the country and the office building market is overbuilt and having tough times, so will you. Royalty trusts In recent years, the oil and gas sector has generated much interest as people and businesses experience much higher energy prices. Due to a variety of bullish factors, such as increased international demand from China and other emerging industrialized nations, oil and gas prices have zoomed to record highs. Some income investors have capitalized on this price increase by investing in energy stocks called royalty trusts. Royalty trusts are companies that hold assets such as oil-rich and/or gas-rich land and generate high fees from companies that seek access to these properties for exploration. The fees paid to the Royalty trusts are then disbursed as high dividends to their shareholders. By the second half of 2005, dividendrich royalty trusts sported yields in the 8–12 percent range, which is very enticing given how low the yields have been in this decade for other investments such as bank accounts and bonds. You can research royalty trusts in generally the same venues as regular stocks (see Appendix A). Although energy has been a hot field in recent years and royalty trusts have done well, keep in mind that their payout ratios are very high (often in the 90–100 percent range) so dividends will suffer should their cash flow shrink.
Slide 150: Chapter 10 Using Basic Accounting to Choose Winning Stocks In This Chapter Determining a company’s value Using accounting principles to understand a company’s financial condition S uccessful stock picking sometimes seems like plucking a rabbit out of a hat or watching the Amazing Kreskin do some Houdini trick. In other words, it seems like you need sleight of hand to choose a stock. Perhaps stock picking is more art than science. The other guy seems to always pick winners while you’re stuck with losers. What does it take? A crystal ball or some system from a get-rich-quick-with-stocks book? Well, with the book in your hands now and a little work on your part, I think you’ll succeed. This chapter takes the mystery out of the numbers behind the stock. The most tried-and-true method for picking a good stock starts with picking a good company. Picking the company means looking at its products, services, industry, and financial strength (“the numbers”). Doing some research regarding the company’s “financials” is easier than ever before, thanks to the current information age. Recognizing Value When You See It If you pick a stock based on the value of the company that’s issuing it, you’re a value investor — an investor who looks at a company’s value and judges whether he can purchase the stock at a good price. Companies have values the same way many things have value, such as eggs or elephant-foot umbrella stands. And there’s such a thing as a fair price to buy them at, too. Eggs, for example, have value. You can eat them and have a tasty treat while getting nutrition as well. But would you buy an egg for $1,000 (and, no, you’re not a starving millionaire on a deserted island)? No, of course not. But what if you