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Tips for DIY Investors

This is a guest post from Mr Credit Card of www.askmrcreditcard.com.

Most people I know who do their own investing–as opposed to sticking with index funds or ETFs–use technical analysis or simply do some basic research, assume some growth rate, and compare PE ratios. But investing is a lot more complicated than that. There are many more things that DIY investors should look out for.

Look at absolute P/Es.

I remember back in the late 90s when I was reading research reports on the internet by various brokerages. It was pretty interest reading at that time but even more hilarious when I look back. One of the recurring themes back then was how high PE ratios were. In fact, I read a report listing all existing and forward-looking PEs. The internet firms listed on NASDAQ had triple digit PEs and even folks like Cisco had 70 PE. But they all still justified buying Cisco because, compared to other stuff like Yahoo and AOL, Cisco looked cheap!!

Understand macroeconomics.

Most investors (whether professionals or individuals) focus on a successful strategy that has worked for them–whether it’s technical trading, credit arbitrage, convertible arbitrage, capital structure arbitrage, or options volatility trading. Very often, folks who are really skilled in these strategies can be successful for long periods of time. However, the occasional black swan event (like those in 2008), can result in a terrible loss of capital. I find that many folks who specialize in specific strategies do not dwell too much on macro economics–unfortunate given that many strategies are dependent upon the macroeconomic environment.

Understand the whole capital structure.

Many investors–especially amateur investors–only know about PE ratios and other equity-related things. But very often, the debt market (especially the credit default swaps market) is a better leading indicator about a company. Understanding bank debt is also important in understanding potential cash flow issues.

Learn how private equity investors value a company.

It is also vitally important to understand the backstop bid from private equity investors. Private equity investors rarely invest in 40 PE stocks. Most are essentially deep value investors. Understanding how they look at balance sheets is a great way of figuring out entry levels and takeover bids. This is also a good exercise in understanding balance sheets.

Understand breakup value.

Understanding breakup value is a great skill to have. If a company is liquidated today, how much will it fetch net of debt? Calculating this is vital because sometimes, the markets will misprice a security to below its breakup value. For example, a company may have a higher breakup value than what is on the balance sheet if its real estate holdings are valued at cost. But a retailer’s breakup value is probably overstated in the balance sheet because at liquidation, its inventory has to be sold at massive discounts.

Learn about the chapter 11 process.

Understanding the chapter 11 process and whether a company is at risk of filing for bankruptcy is a great skill to have. This is where (as I mentioned earlier), understanding the capital structure and its debt obligation is so important. If you understand the chapter 11 process, investing in distressed debt can be potentially very profitable. But even if you don’t, it will give you a heads up over folks who just read equity research.

Understand a company’s product.

Sometimes, I find that this is the best way to get a sense of where a company is heading. Given that I review credit cards, in hindsight, I could see which credit card issuers were doing smart things and which were not. For example, I could tell that Discover Credit Cards and American Express knew what they were doing–they did not offer the most generous rewards. For example, in the cash back credit cards area, Amex imposed a tier for their Blue Cash card, and so did Discover. Meanwhile, Chase was simply copying Citibank and copying their reward formula. When the good times ended, they had to embarrassingly reduce their cash rebates and pissed off many folks. Clearly, those products were not profitable. Amex also avoided getting into the ridiculous balance transfer game by not offering the silly 0%-for-15-months deals that essentially ruined Advanta credit cards.

Take Google as another example. As someone who has a website, I’m familiar with their Adwords and Adsense program, which form the bulk of their revenues. I am (and I’m sure many readers are) privy to what is going on in their program, whether it is the introduction of video ads, or whether keywords in certain sectors are getting more expensive. These can all be found on free tools Google offers. Yet, I wonder how many Wall Street analysts have a Google account aside from gmail!

Learn how accounting is done.

If balance sheets were all there is to investments, everyone would be like Warren Buffet. But there is more to the number than meets the eye. It’s worthwhile to study accounting matters like FASB option rules and how revenue is recorded. For example, Auto makers used to push sales to dealers and record it as revenue (they might still do that). But that is really not a true measure of end consumer demand.

Learn how to calculate cost of goods sold and calculate depreciation expense among other things. Studying these rules will give you a better understanding of the company you are researching. Learning basic accounting is so important for understanding a balance sheet.

Remember that nothing lasts forever.

The last point I want to make is that nothing lasts forever. I’ve heard countless times how Microsoft is a stock to leave to your grandchildren! If you look at the S&P 500 list in 1950 and compare it to the current one, you will realize that most of the companies in the index decades ago are no longer in the index today. So don’t get fixated on any investments. Even Warren Buffet’s newspaper investments have seen their economic model and viability change because of the internet.

Mike’s note: As regular readers of this blog know, I’m firmly in the “don’t bother picking stocks” camp. That said, I find that it’s worthwhile to consider opposing viewpoints. (If nothing else, it makes for more interesting discussion!) I look forward to hearing your thoughts in the comments.

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Comments

  1. Mike,

    Here is the problem- wouldn’t the research departments of value mutual funds have many people that understand and evaluate companies based on all of these criteria? Wouldn’t they have automated searches looking for these value stocks? Wouldn’t the competition of these types of searches from many companies prevent extreme value stocks from existing? If doing all of this work is useful, then why don’t value mutual funds beat their index more often?

    It seems to me that the only way an individual investor could make all of this information pay off is to invest in companies so small that no mutual fund would touch them.

    -Rick Francis

  2. Rick: That’s pretty much the same page I’m on. If an investment strategy is going to be useful for beating the market, it has to be something that the institutional investors
    a) wouldn’t do, or
    b) can’t do.

  3. For retirement, I’m all in index funds, so this information doesn’t matter too much. However, I do like to take some fun money and play around with some stocks on occasion.

    Where I have been somewhat successful is understanding the company. For example, a few years ago I saw myself using products all of a sudden by companies like Apple, Under Armour, and Costco. I managed to buy and sell each of these companies for a profit.

  4. Rather than looking at Absolute P/E’s why not look at Cyclically Adjusted PE’s (CAPE). I’m trying to use it to understand when markets are over or under valued while trying to filter out the effects of the business cycle.

    My retirement investing startegy is then based around lightening up on my index funds as the CAPE increases and vice versa. Full details here http://retirementinvestingtoday.blogspot.com/2010/02/us-s-500-stock-market-february-2010.html

  5. Mike,

    It is so unlike your usual post. Is it written by you? Anyway, after reading through the post, I decide to stay in the don’t-bother-to-pick-stocks camp. It is just too much work to go nowhere.

    DIY investors should not pick stocks at all, they are at serious information disadvantage. They should just be in low cost index funds like Vanguard and DFA.

    Michael

  6. Michael/DFA Advisor: No, it was not written by me. 😛

  7. Rick – here is the problem, most research analyst in mutual funds only have experience in doing stock analysis based on “long only stock” strategy. Most are not knowledgeable in some of the topics I brought up.

    As to the comments about sticking to indexing, actually I think this post makes for the case of indexing (very indirectly). How many folks you know understanding capital structure, or bankruptcy laws, or valuing a company like an private equity investor? You really need to understand these to really have “an edge”…but it takes ages to learn these skills…so for most (as in really most) folks, why bother? Index…nothing wrong with that.

  8. Re: private equity, it’s also worth keeping an eye on what other companies in the same sector think of valuations by looking for merger activity.

    Not so you can ‘get into the next takeover bid’ as sitting around waiting for that is a dull game that rarely works.

    Rather, if company directors think other companies in their sector are cheap (especially in a low point in the cycle) it can be a sign of value.

    Keep an eye on how they pay though. If it looks like stretching them, it’s more likely to be a top-of-cycle ego-trip, which is a different matter altogether (e.g. AOL / Time Warner in dotcom boom or RBS / ABM Amro in banking).

    From an indexing fan with a wicked side. 😉

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