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The market is roaring. Then it is falling 7% in a month! How do you handle this?

By integrating Benjamin Graham's Value Investing approach into my strategy my returns have increased dramatically, making a 34% gain in my portfolio in 2013 and having registered a 4% gain since the beginning of this year. Value investing minimizes the risk of individual stock investing by first identifying stocks that you like and then waiting for them to go on sale. I don't get fancy with my investments (for example, I don't play options), and for the first fifteen years, I only invested in biotech companies, because I work in the field. That is an essential element to value investing - Only invest in something you understand, and only buy stocks when they go on sale.

Investing in an individual stock is more risky that going to a casino if you have not done your homework. Winning in this "parlor game" is all about knowing why a stock is a good investment before you put your money on the line. Once you lay your money down, you need to follow that stock and its broader industry intensively to maximize your gains

For example:

  • If you work in the defense industry, look at the long-term prospects of Lockheed Martin (NYSE:LMT) and Elbit (NASDAQ:ESLT) as stocks of potential interest.
  • If you are in the energy industry, you know that fracking has created a crude oil glut that may affect the profits of Valero (NYSE:VLO) and Dow.
  • If you work in the computer field, you know the key roles that NXP Semiconductors (NASDAQ:NXPI) and Seagate (NASDAQ:STX) are likely to play in the future.

Over the years, I have developed a set of rules to guide me in my investing activity.

1. Understand your investment

Read everything you can about a company before you invest and compare its products to those from other companies in that field.

Create a target list of stocks (at least ten) that you understand and like. Why you like a stock is different for everyone. With my technical and business background, I look for low-priced companies of several types and have provided a few examples for illustration.

  • Dividend-paying companies with little debt can be less risky since the dividends provide a minimum return. To differentiate seemingly similar companies within this class on a solely financial basis I review both the Debt/Equity ratio and the operating margin. An example of the importance of these parameters can be seen in the recent dividend decrease observed with Boardwalk Pipeline Partners (NYSE:BWP) which was attractive based on its 7.8% dividend yield, but this was unsustainable at a 172% payout ratio. In addition to conducting financial due diligence, an analysis of market scenarios can confirm the attractiveness of both Kinder Morgan, Inc (NYSE:KMI) and Transcanada Corporation (NYSE:TRP), as discussed in my earlier articles on Seeking Alpha.

Be certain of your understanding of company financials.

Be certain of the impact of macroeconomics on share price.

Only buy when the stock is relatively cheap (P/B and P/E ratio):

Dividend Stocks
TickerDiv.P/EP/BD/EOp. Margin
SEP4.6%13211046%
TRP3.8%18212032%
KMI5.0%222.612828%
EPD4.5%2141197%

(P/B = Price/Book, and P/E = Price/Earnings; Book is the tangible assets of a company)

  • Companies with promising technology and enough funding to let them demonstrate their potential. Choosing such companies for investment requires an in-depth knowledge of the science behind the technologies of both the company as well as their competitors. These technologies are often immature and very risky investments and the proportion of these stocks in your portfolio will represent both your knowldge of the technologies and your risk tolerance. For example,

--Both PSIX and WPRT make natural gas engines for vehicles, but which will prove the better investment in the long term?

--Which of these biotech companies will cure the most important disease and be safer than its competition? Which of these biotech companies will need to raise money again before delivering a product? Which of these biotech companies will make the most profitable drug?

--Which of these technology stocks will have the greatest influence on the way we live our lives five years from now?

Be certain of your understanding of the technology.

Be certain of the market need for the technology.

Only buy when the stock is relatively cheap (P/B and P/E ratio)

Growth Stocks with Promising Technology
TickerTechnologyP/EP/BD/EOp Marg
GOGOAirline internet7786-12%
OTIVNFC payments3746-33%
NXPINFC payments12925313%
STXData storage9714313%
BIIBMedicines25106.936%
GILDMedicines23106541%
WAGEHSA accounts102101416%
CELGMedicines17128530%
PSIXLNG engines5315246%
WPRTLNG engines5218246%
SGENDrug developer1821--23%

  • Companies with a market advantage that you understand very well. The financials on these companies (P/B, P/E) serve only to tell you if the stock available at a "sale price" - only one of these even pays a dividend. The true vale of these companies is discovered when you fully understand the market need and how the advantage delivered by this company outshines its competition. When you find such companies you may be ahead of market recognition and thus the return on these kind of cutting edge investments may take years. For this patience will be required as these companies often experience turbulent times.

Stocks with an Advantage
TickerAdvantageP/EP/BD/E
KMILNG pipelines222.6128
ERIIEnergy technology2683.5
GOGOPatents & Deals7786
SGENLinker technology1821
LNGLNG export license 31241

2. Don't invest until you understand the effect of macroscopic changes. Read the newspaper, follow politics and understand the impact of world events as they will provide you with investment opportunities. Many of these are speculative or momentum plays that can provide quick profits to your portfolio if you are in a position to act rapidly.

a. The dramatic success of fracking has created a glut of domestic oil, causing the stock of the sellers of natural gas and crude oil to fall (Cabot Oil & Gas - COG) while the share price of refineries has risen (Valero-VLO, Marathon-MPC).

b. A change in the law to allow the export of US oil (now illegal) will be expected to dramatically affect companies such as Chenier Energy (NYSEMKT:LNG).

c. The increasing use of drones in warfare, border patrol and police operations around the world has increased the share price of Elbit Systems . Even speculative announcements like the one by Amazon resulted in a 10% increase in share price.

d. The removal of a cancer drug by the FDA caused the share price of Ariad (NASDAQ:ARIA) to fall by 90% and its return to the market caused a 65% increase two months later.

e. President Obama's call for digitization of health records has lead to an increase in the share price of companies such as Athena Health (NASDAQ:ATHN) and Cerner (NASDAQ:CERN).

f. The excitement in the popular press about 3D printing technologies has led to a significant volatility in this field. Several of them are technology leaders (DDD, SSYS, VJET) and others are applying this technology to new applications (ALGN, ONVA, XONE). These investments move with the winds of press releases, are not for the faint of heart, but can be milked regularly for profits.

3. Don't buy a stock just because someone else says you should.

Do not buy any of the stocks listed in this article unless to take the time to study the company beforehand and make your own decision. I have biases that may differ from yours. Ask yourself many questions before you invest:

a. Why it is a better company than its competitors? Does it have a better sales & distribution network, technology or better long-term contracts? Such information can be found in each company's annual report on the SEC website. However, for comparative information, I suggest trying to get stock analyst reports (cost $$) which are often a good source of such information.

b. Is the company in a growing industry?

c. Does the company pay a dividend?

d. Is the stock expensive or cheap (Price/Earnings and Price/Book ratios)?

e. Does the company have a lot of debt?

Knowing these things is what makes investing different from gambling. Don't invest until you investigate the stock. You wouldn't buy a house without driving through the neighborhood and this is no different.

4. Diversify.

I don't have a pension, so I rely on my 401k for most of my diversification. Since investing in individual stocks is inherently risky, I have placed most of my investments in a more conservative 401k portfolio to offset the overt aggressiveness of my individual stock plays.

a. For individual stocks try to spread your money between at least 10 stocks if possible. Choose companies from separate fields that you know something about.

b. To diversify my individual stock portfolio, it is spread into different fields as broadly as economically possible for me (based on my limited cash and knowledge).

c. Note that buying multiple stocks does not necessarily mean you have diversification. For example, if you own stock in Northern Oil & Gas (NYSEMKT:NOG), Exxon Mobile (NYSE:XOM), Energy Recovery (NASDAQ:ERII) and Westport (NASDAQ:WPRT), then your portfolio is not diversified. These are all in the energy field and can be affected by similar world events.

5. Look for a sale.

Once you have your target list of stocks, examine their share price history to determine their average price for the past 50, 100 and 200 days (found on Yahoo/Finance/Charts/Basic Technical Analysis). Don't buy the stock of interest until the share price drops for a reason that you don't believe to be a reflection of the overall value of the company.

For example, I think that the technology from NXP Semiconductors will play a key role in a variety of fields in the future, but their share price keeps rising. I bought stock on October 22nd, 2013 and again on February2nd when the market had a "down day" which had nothing to do with NXPI. By waiting for drops like this, I have already made 5% on my money when the market normalizes. Try to get that from a bank.

6. Enthusiasm is bad.

Once you understand a company, don't get too excited, there are always exciting opportunities for investment. Have a large list of stocks that you like and don't buy until one of them hits your desired price and then don't sell too early.

Enthusiasm will make you pull the trigger too soon on both sides of the investment and the result can be either decreased profits or a total loss of money - Be patient.

When you buy a stock, determine at what price you are willing to sell it for in the future, and how much of it you will sell. If you still "believe" in the future growth of the stock as it nears that price, you might decide to sell only half if it. Then take your profits and look at your target list of stocks for another stock that is on sale.

Be willing to walk away from a stock if you think it is overpriced. On the other hand, don't be too proud to sell if a stock that you have already bought has fallen 10% you think it will keep falling. Sell immediately and take the loss. It is better to lose 10% and put rest of the money into a different stock from your target list of stocks than watch it fall another 30% and lock up that money for 2 years before it comes back.

1 I have found the following to be very useful resources whenever I am trying to decide if I should buy a stock: the website for the company of interest; Yahoo Finance; Seeking Alpha; "The Intelligent Investor" by Benjamin Graham; The Wall Street Journal; Google searches.

Be certain of that the company has an advantage over its competition

Be certain of the market need for the technology

Accumulate the stock whenever it is relatively cheap (P/B and P/E ratio).

Source: Value Investing In Volatile Times