It has been 40 years since I bought my first stock, and over those 40 year,s I have made mistakes, wasted money and got lucky with a few big winners. For most of those 40 years, I floundered around with no real plan, but along the way, I was learning some lessons. Some of these investing lessons I now refer to as "investing truths". These seven truths I will share with you, in hopes they aid you in your quest to be a better investor.
1 - You must protect your downside. Through the years, I have noticed that when people write articles or talk about stocks, the majority of the time they talk about how much they can make. "I think this stock will go to $40.00", or "I think this stock is a double in a year", are the types of comments I often hear. No one seems to talk about the downside much, but with every stock investment comes the risk of loss. Before you invest your money, you should ask yourself, "How much could I lose in this investment". If the risk reward ratio is out-of-balance, you should not invest.
Don't assume you are in a "safe" investment sector because there are no safe sectors. REITs can be affected by interest rate movements, low occupancy rates, economic weakness. Utilities can take a hit if regulators refuse rate increases, if storms cause large infrastructure repairs, if interest rates rise. MLPs would get slammed if tax laws were changed similar to the changes that occurred in Canada that ended the MLP tax advantage. So called blue-chip stocks can take big hits too, IBM (NYSE:IBM) was once the bluest of blue-chip stocks, but from October 2001 to July 2002, it fell from $120.00 to $58.00. No matter what you own, there is risk; always have some idea what the potential downside to a stock is before you buy and be prepared to sell if the fundamental story changes.
To protect myself, I only buy stocks that I consider to be selling at a bargain to fair price. If I believe I am paying up for a stock I will not buy it. I believe the entry price you pay for a stock is the key to the success of the investment; therefore, I refuse to buy a stock unless I feel confident there is a good deal of upside in the price and very little downside. All of my major holdings I bought when the stock price was under pressure for a temporary reason. I have a number of stocks on my watch list, all of which I would be willing to own at the right price, right now they are all higher than I am willing to pay, so I wait.
2 - You own a business not a stock, know what you own. Several months ago I was in an airport waiting for my flight when I overheard a conversation between a young couple seated next to me. The young man was reading the stock tables in the paper and his wife/girlfriend asked him what he was doing, he responded "I am looking for a stock to buy". My thought at the time was that is the last place you should be looking. I don't even look at stock price until I have identified a sector and a company that I believe will do well. At any given time in the economic cycle a business sector can be in or out of favor. Business sectors that are temporarily out of favor can often times provide long term buying opportunities. The health care stocks took a beating during the Affordable Care Act debate, as no one was sure what the end result would be. That period of time provided some good entry points for health care stocks. However, business sectors that are out of favor due to "creative destruction" are not good investments. Newspapers were once a very rewarding investment favored by many investors including Warren Buffett. But, with the explosion of free content on the internet, newspapers best days are behind them.
The first thing I look for when investing in a stock is a business sector that I am comfortable will be around for a long time. One of the sectors I am currently looking at is anything related to the aging of America. I have looked at medical REITs, healthcare stocks etc. I am confident this is a sector that is not going away.
Once I identify a sector, I look for the best company in the sector. I research all the leading companies in the sector by reading articles, listening to company webcasts and reading Annual Reports. During the research, I usually come to a conclusion on what I believe is the best company in that sector. It is at that point that I look at stock price and make a judgment on valuation.
As I mentioned, I have been looking at aging of America companies and really liked what I saw in the medical REIT, Ventas (NYSE:VTR). Ventas is the leading Senior Housing company; it has been growing rapidly and wants to continue growing while also paying a dividend just below 4%. Unfortunately, VTR also has a P/E of 57, I know for REITs, P/E carries less value, but the other valuation metrics also look expensive to me, so for now, VTR goes on the watch list.
For every company in my portfolio, I can tell you why I bought it, what I believe the long-term story is and what if any possible problems exist with the company. For any stock you want to buy you should be able to do the same. If the business succeeds, the stock price will follow.
3 - You should not care what anyone else thinks. I would never buy a stock because someone told me it was a great company, or was about to double, nor would I sell a stock because someone told me I should. I do not care if a brokerage upgrades a stock or downgrades a stock. I make all my investment decisions myself. When I sell and what I buy decisions are made by me and no one else. If an investment turns out bad, I have no one to blame, but myself. Investments decisions in the past have gone bad, I sold when I should not have, I held when I should have sold, but in each case I learned something. I, like many others, owned WorldCom in the 1990s, when some bad news leaked out, I held, when more bad news came out, I held, when even more bad news came out, I finally sold taking a big loss. That experience taught me that anytime bad news related to accounting is uncovered, sell immediately.
There are many investors on Seeking Alpha I respect, there are many investment columnist and television hosts I respect, but just because they say buy or sell, that does not mean I will follow along. It also does not mean I dismiss what they say. I read, listen and watch as much as I can on stock investing and then filter everything into what I can use. Some information is dismissed; some is put on the back burner and some I use as seeds for possible investment ideas. From 10 seeds I am happy if one actually matures into an investable action.
In 2004, I happened to catch a syndicated radio show called Real Money that played on a Chicago radio station between 4:00 and 5:00 a.m. I found the show by accident, but started to listen every day while getting ready for work. The host was mild-mannered, very helpful to callers and seemed to have some excellent insight into the markets. Every day he would pound the table on oil stocks, oil prices were going higher, oil stocks as a percentage of the S&P 500 were historically low, and every investor should own some oil. I took that idea and started doing some research, checking out all the large integrated oil companies and also reading various articles that stated oil demand was increasing faster than production. I did not own any oil stocks and decided it would be prudent to own some oil company. After my research I bought Exxon Mobil (NYSE:XOM) at $46.50. That investment would eventually double. By the way, the host of the show was Jim Cramer, who at the time, I had never heard of. Someone gave me an idea, but it was my research that convinced me buying an oil stock was the right thing to do.
Read, listen, and watch as much as you can, but trust your own instinct and intellect. No one cares more about your money than you, unless they are looking to take it from you.
4 - You should not fall in love with a company. Never get so fond of a stock that you fail to understand it is a business and may someday have to be sold. I love the Coca-Cola Company (NYSE:KO), love the history, love the advertising and love the product, but I would sell the stock I own if I had to. There was a time in Coke's history when they decided they needed to diversify and bought a movie studio. If that happened today I would sell immediately.
In my opinion, some owners of Apple (NASDAQ:AAPL) stock are too in love with their stock. They defend everything about the stock, are convinced no one will ever make a product better than an Apple product and believe anyone who thinks differently is an idiot. Apple does make great products, it is a well-run company, it is loaded with cash, but that can change.
In 1970 Woolworth and Johns-Manville were part of the Dow 30, owners of those stocks may have thought they owned safe stocks, after all, they were in the Dow, but that was not the case, there came a time to sell, not to hold on hoping things might change.
I would sell a stock I own if they missed a dividend increase or cut the dividend, if they diversified outside their field of competence, if there is even a hint of accounting issues, if the business fundamentals turned negative with no sign of a turnaround, if the price got way ahead of itself, and if I needed the money for a better opportunity.
5 - Dividends do matter - If there was one thing I am sure of, it is that dividends make a difference. When the new calendar year starts you can be assured that over the next year you will receive 5% in dividend cash from Altria (NYSE:MO), 4% in dividend cash from Kinder Morgan (NYSE:KMI), 5% from AT&T (NYSE:T), just to name a few. It took me a long time to learn this, but over time, dividends add greatly to a stocks return. I have owned McDonald's (NYSE:MCD) since January, 2008 and since then have periodically added to my position. As of this writing, I have a gain of 51%, but add in the dividends I have received and it is 66%. In 5-years' time, I have added 15% to my gain, thanks to the dividend MCD pays
There are many studies that have shown that dividend stock when re-invested far outperform non-dividend paying stocks. The most well-known study may be the one Ned Davis Research conducted when he compared results between dividend paying stocks from 1972 to 2008 against stocks that did not pay dividends. His study showed, that stocks that pay a dividend and annually increase that dividend returned 8.6% per year. Stocks that did not pay a dividend returned 0.2% a year. The S&P during that period returned 5.9%.
In another study, Wharton finance professor, Jeremy Siegel looked at stock market returns from 1871 through 2003, a 132 year period, and found 97% of the total after inflation gains from stocks, came from dividends, only 3% came from capital gains.
Dividends pay you during bull markets, flat markets and bear markets. I believe in the power of dividends and you should too.
6 - You should be comfortable holding cash. One of the difficult things an investor must learn to do, including me, is getting comfortable holding cash. Most investors prefer to have their cash working for them, not just sitting in their account. However, having cash in your account gives you the opportunity to react to opportunities that may quickly arise. The day of the "flash crash" I was disappointed I had no cash to invest, especially when stocks started their climb back and no one could give a fundamental reason why stocks dropped 400 points in a matter of minutes. I hate holding cash, but it is a necessity in today's fast paced market. Market moves can be sudden and when they occur, traders tend to throw the good out with the bad. You need to have cash so you can catch the good stocks that are being thrown out.
I have been holding cash now for some time waiting for a pullback, a pullback that hasn't come. I will admit it is frustrating as I look at my watchlist and see prices continue to rise. When prices fell on Monday this week, I was actually excited, as I thought this might be the pullback I have been waiting for, but it wasn't. As difficult as it is holding cash, I know when the market fall comes; I will be picking up a bargain.
The great Fidelity Magellan fund manager Peter Lynch said:
If you can't find any companies that you think are attractive, put your money in the bank until you discover some.
Right now, I don't see any bargains, so I will wait with cash in hand until I see some.
7 - Rome wasn't built in a day and neither will your fortune. As an investor you need to know that patience is your friend. Peter Lynch also said "time is on your side when you own superior companies." That simple statement is the guide to my investing thesis; I want to own superior companies that are the dominant player in their industry. I own McDonald's, Exxon Mobil, Coca Cola, Kinder Morgan and Walgreen (WAG) all of which are leading companies in their industry. Over time, using their scale and large balance sheets, these companies have a huge advantage over competitors. Successful growing businesses that pay rising dividends, will over time provide solid returns.
Find a business sector and dividend paying company that has a good long term story to tell and then wait for the right price and buy it. While you own it watch over the business and hold it as long as the fundamental story continues. It may not be the most exciting strategy and may not lead to overnight riches, but it will provide solid gains over time.
Disclosure: I am long KO, MCD, XOM, WAG, KMI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.