In my nearly 30 years of investing, I've noted that when the market becomes volatile, a chorus goes up that we must "trade" stocks. "Investing" has become a sucker's bet. In virtually every case, this thinking has proven nearly impossible to execute successfully. Even worse, it tends to damage the portfolios of small investors disproportionately.
Given the backdrop of the ongoing EU debt crisis, gridlock in Washington, and a potential "hard landing" for China's economy, we are beginning to hear the chorus once again. Therefore, I am writing this article, especially to other small investors, in response to the multitude of narratives focusing upon the dire straits for U.S. equities; all voiced at 100 decibels.
It is now time to invest, not to panic.
This does not mean one has to buy a basket of stocks tomorrow. It means it's time to review the landscape in a businesslike fashion and prepare a plan. Opportunity knocks.
I contend the ability to discern and invest in undervalued companies that possess the following attributes are the historical winning combination. These companies have:
a good balance sheet
a demonstrated ability to generate and distribute cash to shareholders
a coherent business plan
While it takes time, it is not overtly difficult make such determinations. Indeed, I believe it's much easier than trading stocks. And the best time to do this is when the pundits are shouting to sell everything.
I believe three such stocks that are attractive for the long haul are Wells Fargo (WFC), Royal Dutch Shell (RDS.A), and Nucor (NUE). These companies represent three different stock sectors, but each have the attributes noted above: as well as a compelling valuation.
"Investing" versus "Trading"
First and foremost, let's clarify some terminology.
Investing is not Trading. I make a point of this when discussing the market. The terms are often used interchangeably, but they are not synonyms.
Investing in equities means understanding the business, its financials, operating metrics, and management strategies. A review of the facts surrounding a business generally provides a relatively clear vision as to it's underlying value.
Investors seek opportunities whereas the price of a security and the facts behind it have separated. The best opportunities present themselves when the market is most irrational.
Historically, over a period of time, the market will revert to the mean and recognize undervalued stocks. During periods of panic or greed, the stock market can get significantly out of whack with respect to the fundamentals. We may be embarking upon one of those times.
Dr. Benjamin Graham, the great value investor, has quoted, "The stock owner should not be too concerned with erratic fluctuations in stock prices, since in the short term, the stock market behaves like a voting machine, but in the long term it acts like a weighing machine..."
I find it hard to determine how others may vote, especially in the near-term. However, I find it relatively easy to calculate how much something weighs. Mr. Graham had the analogy spot-on.
On the other hand, Trading involves the short-term strategy of trying to time the market to make money based upon the price action of a given security. Often, the trader has little interest in the underlying business or the fundamentals of the stock. Buy or sell decisions are based upon headline events or technical studies.
I believe successfully trading stocks consistently is exceedingly difficult, if not impossible, for the following reason:
Trading involves outwitting those on the other side of the trade consistently. It means the trader must be smarter, on a short-term basis, over and over again, versus those attempting to do precisely the same thing.
Furthermore, I find the action and reaction time to triangulate real-time headline events or short-term stock charts correctly a risky proposition.
By definition, everyone cannot be "the smartest guy in the room."
Can trading have a place for trading in the investor's portfolio? Yes. But trading is not investing and should not be confused as such.
So What Should the Small Investor Do?
As a small investor, I offer a broad outline of the steps I believe are necessary to be successful. These steps are key to evaluating existing positions or selecting new ones:
Know the business: If you can't explain to a non-investor what the company does in a few sentences, don't invest in it. It might be the best opportunity in the world, but my experience suggests that the chances of selecting a good stock diminish quickly if one can't explain easily what the enterprise does. There are plenty of easy-to-understand businesses out there. This advice has been offered by many of the best investors out there. Warren Buffett is one of them.
Understand the financials: This is probably the most challenging and tedious part of good investing. I believe the only way to do it is to roll up your sleeves and get down to it: do-it-yourself. While you may use online resources for some financial metrics, I would not take them as gospel. Do it yourself. The source documents must be the SEC filings, quarterly earnings releases, and periodic analyst conferences. This data is all available online and often in real-time. Years ago, the small investor was either unable to obtain this information, or had to subscribe to it after-the-fact through brokers or expensive financial service outfits. No more. Now the small investor has nearly the same access to financial data, reports and records as the Wall Street analyst. Despite the SEC failing the small investor miserably of late, they got this one right.
At risk of pressing the point: do not rely upon analyst recommendations. Use the analyst recommendations to confirm (or adjust) your own research. I contend that you will overpay for stocks if you attempt to short-cut doing your homework.
Select and Review Appropriate Operating Metrics: Every business has a set of key operating business metrics. A good investor picks off some and watches them. It's part of the detective work. For example, I like to watch "same store sales" for retail businesses. Telecom companies use ARPU (Average Revenue Per User). Chip makers measure ASP (Average Selling Price). It's not necessary to gin up dozens of operating metrics for each stock you own. Just a few will do nicely. Keep it simple. But do it.
Confirm the Corporate Strategies and Direction: The board of directors and business management are assigned the task of setting and steering the company in accordance with a set of strategies. The investor should know these strategies, and as part of their due diligence process, concur with them or not prior to investing (or divesting) in the company. Such business strategies are typically found in the annual report, but I find that the best place to review them are via quarterly earnings webcasts and investor presentations. It is also an opportunity to allow you to evaluate the wherewithal of the senior executives. Do they deliver or not? If you take the time to review these webcasts, transcripts, and presentations for the stocks that you own, I submit you will have data points that put you ahead of most of your contemporaries. They do not take the time to do it.
Perform a Valuation Exercise: There are a number of metrics that are helpful when evaluating securities. I will not review them here. However, regardless of methodology, the bottom line is earnings and cash coupled with the application of an appropriate multiple. Long-term, equities are driven by earnings and cash flow. Growth trumps stagnation. Companies with strong balance sheets can weather economic storms. Strong management has a demonstrated track record of meeting their forecasts. Headlines are short-term.
How many headlines from ten years ago continue to drive the market today?
Three Actionable Investments for Consideration
Wells Fargo (WFC) [Financial / Banking], Royal Dutch Shell (RDS.A) [Energy / Integrated], and Nucor (NUE) [Basic Materials / Steel] are in different sectors and industries, but contain the hallmarks of good value investments.
Each has a sound balance sheet.
Shell and Nucor have low debt-to-equity ratios, high return-on-equity, and plenty of liquidity. Wells Fargo has a significantly higher ratio of deposits to total assets than its large-banking peers, and is already upon Basel III liquidity requirements. This is coupled with strong, demonstrated organic capital generation.
Each has shown the ability to create and return cash to shareholders. Specifically, these three companies deliver dividends.
Wells Fargo has raised its dividend 85 percent since the banking crisis; the stock now yields 2.8 percent. Royal Dutch Shell offers one of the largest dividends in the Energy sector, the "A" share currently paying greater than 5.4 percent. Nucor is an accidental high-yield stock, now yielding just under 4 percent. This company has increased their base dividend every year for 28 years.
These companies have straightforward business plans and direction. Indeed, Corporate management can articulate this plan to shareholders and analysts in a simple-to-understand fashion.
WFC intends to become the biggest deposit / mortgage origination bank in the U. S. They have taken a "Main Street" versus a "Wall Street" approach.
RDS has determined the Upstream energy business is preferable to the Downstream. Their plans include aggressive reserve replacement activity, reducing and concentrating their global footprint, and creating one of the world's leading NGL businesses.
NUE has historically used the downturn to re-invest in their business. The company's mantra has long been underlying financial strength, being the low cost producer, maintaining flexible capacity, product diversification, and a strong people culture.
Strong senior management is evident. While somewhat subjective, there are cases whereas the competency of senior management is obvious; as is the case for these three businesses. I find the best way to obtain insight in this area is listen to the quarterly conference calls and analyst day presentations. Here one can determine first-hand the level and depth of understanding management has of the business, ability to set a clear course, and most importantly if they can deliver results.
What about Valuation?
For the investor with a longer view, valuation is not a point in time, but a window of opportunity. Wells Fargo, Royal Dutch Shell, and Nucor all represent good value stocks today. Could they go lower? Absolutely. However, the issue is whether or not they are below historic valuation metric standards, and belief in the principle that over time, stocks will "revert to the mean."
Wells Fargo has increased net income for seven straight quarters, yet the P/E multiple remains well below their historic norm. Shell dropped over 15 percent in a couple months despite one of the best quarterly earnings reports of any of the major oil concerns. The company has been printing money for years. The P/E multiple is below 8 X. Nucor is an out-of-favor Material company: most stocks in the this sector have been pounded of late. This is precisely the reason to look to pick up shares. Given the strong balance sheet and yield support, investors are "paid to wait" for the eventual rise in U. S. industrial activity. Meanwhile, company management continues to invest heavily for future.
Some Parting Shots
Perhaps the greatest soft skill appropriate for the investor is confidence. This should not be confused with arrogance. Confidence means one has determined a company and its stock is a worthwhile investment based upon the facts, your research, and your analysis. During times of market turbulence, when others are in a panic, the investor then may return to his / her set of investment premises and ask, "Have these facts and premises changed?" If not, then stay the course. If they have, make a rational adjustment. Easy to say, difficult to do, but profitable. Fight the urge to follow the herd.
The corollary to the foregoing is having an investment thesis for selling each stock owned. This means prior to investment, "What do I expect this stock to do?" and "By when?" This simple philosophy is a beacon in a storm. Own no stock without a clear premise of under what set of circumstances and at what price will I sell. Write it down. Review it quarterly. Re-evaluate when the facts change.
Discipline is a cousin of Confidence.
The other key attributes for the investor are patience, perspective and flexibility. Give yourself time to be right. Allow yourself to re-visit premises if they change. I typically premise the holding period for a new investment position to be 12 to 18 months. However, I review each investment thesis in depth not less than every three months.
Times of market volatility are painful, but to the seasoned investor, they create opportunity, not panic. Headline news, analyst predictions, and trading tips come and go. Finding well-managed companies that have shown a propensity to increase earnings, cash and dividends have trumped fear over and over, and I have every confidence they will continue to do so in the future. If the market trends lower in the coming months, it will simply be yet another opportunity to pick up the stocks of great companies at a significant discount. When the market is rising, it will be time again to prune the winners based upon a set of premises, facts and a target price.
Readers may note that I am not a professional money manager, broker, or financial planner. I am not trying to sell anything to anyone. My background is engineering, not finance or accounting. Nonetheless, I am absolutely convinced that the small investor can best the performance of the majority professional money managers due primarily to three factors:
No one cares more about your investments than you do.
Small investors don't have publish quarterly reports to demonstrate short-term performance. We can take a long view; a big advantage over many money managers.
Brokerage fees are a fraction of what they were years ago. Transaction costs have not only leveled the playing field, they have provided the small investor a leg up. The commissions on my portfolio transactions are a fraction of what a professional money manager would charge to run a professional portfolio. My portfolio turns over less than many of them, too.
Good luck on all your investments.