Investors should not lose confidence in the best asset class for the long-term which are equities. Short-term fluctuations will always happen based on company news, economic news, or other events. Recently, on Wednesday August 1, the market experienced another glitch where about 150 stocks traded with 20 times their normal volume with many falling 10% or more. This event raised fears that another flash crash similar to the one that happened on May 6, 2010 was possible. I wouldn't be surprised to see more small trading glitches like the one that happened on Wednesday, but I'm not shaken by the possibility either.
This issue is blamed on computer algorithms gone haywire or a software mishap. Whatever it is, investors should keep a cool head, not panic, and take a number of precautionary measures to prevent losing money. The facts of the market show that over time, earnings drive stock prices higher. There will always be times when a company's stock sells off due to an earnings miss or other negative issue. Good companies will prosper over the long-term as the stock price reverts to the mean earnings growth rate over time.
Here are a few level-headed investing techniques that investors should follow:
1. Always use limit orders when making trades.
Never use market orders as the market makers will take advantage of you and fill your order with the lowest or highest price of the day - depending on whether you are selling or buying. Could you imagine having a sell to close market order for a stock on the day of the flash crash or on another big sell-off day for the market? The order could have been filled at a very low price, taking a chunk out of your profits. The same thing can also happen when a buy to open market order is on. If the market or the stock has a huge up day, the initial order fill price will probably be much higher than you anticipated. Investors would be better off using limit orders where you name the price that you want. Better to wait for that price with a good until cancelled limit order.
2. Buy Stocks that are undervalued or at least fairly valued.
Always look at the price to earnings (P/E) and price to earnings over growth (PEG) ratios. I prefer to buy stocks that have forward P/E ratios under the S&P 500 average of 13. It is also wise to buy stocks that have PEG ratios under one - this means that the company's future earnings growth is higher than the P/E ratio. So, the stock price should revert to the mean earnings growth rate over time.
One great example of this is Apple (AAPL) which has a forward P/E of 11.5 and a PEG of 0.62. The company's 5-year annual expected earnings growth rate is about 22%. Whenever the stock sells off due to poor economic news or negative company news, it eventually comes roaring back as the price reverts closer to the earnings growth rate over the long haul.
On the other side of the coin, overvalued stocks are a great risk of falling as the price eventually reverts to the mean earnings growth rate over time. An example of this was seen recently with Chipotle Mexican Grill (CMG). When the stock was at $440 in April, the P/E ratio was 57 and the PEG was 2.5. It was clearly overvalued, so when the company reported negative news that it missed analyst's expectations, the stock sold off heavily from $440 down to around $280 for a loss of 36%. The trailing P/E ratio is now 34, the forward P/E ratio is down to 26, and the PEG is down to 1.42. CMG also has a 5-year expected annual earnings growth rate of about 22%. So, you can see that Apple at around $600 is still cheaper than CMG at about $280.
3. Buy companies with good fundamentals.
This sounds easier said than done, but it's not really all that complicated. Look for companies that pay dividends and have growing revenue, cash flow, and earnings. Companies that pay dividends show that they are committed to rewarding shareholders - Apple just implemented a 1.7% dividend, while CMG does not pay a dividend. I like companies that grow earnings annually above the market's expected average of about 10%. Ideally I like to see companies that have a combination of dividend yield and earnings growth that equals 15% or more. This is consistent with Warren Buffett's style of stock picking.
When looking at cash flow, you want to see positive operating cash flow and also positive free cash flow. Free cash flow is what's left after the company pays capital expenditures and are the funds used to pay dividends.
It's also a good idea to ensure that the balance sheet is in good shape. In most cases, a current ratio of at least one shows short-term balance sheet health. For longer term health, ensure that total assets are greater than total liabilities.
4. Buy companies that have large economies of scale/competitive advantages.
Large companies such as Wal-Mart (WMT), Apple, and McDonald's (MCD) operate on such a large scale that they can purchase products in huge quantities for large discounts giving them a competitive advantage over smaller companies. These companies have established relationships with suppliers that allows them to keep their cost of goods sold to a minimum. This allows Wal-Mart to sell many products for a low profit margin, while Apple and McDonald's sell fewer products per trip for higher profit margins.
5. Stay diversified.
"Divide your investments among many places, for you do not know what risks might lie ahead"
- - Ecclesiastes 11:2
There are times when certain sectors fall out of favor - investors shouldn't own stocks in only one sector or in only one or two companies. Develop a mix of 7, 8, or more companies in different sectors so that when one or two sectors or companies are weak, the others provide strength to hold up the portfolio. I'd hope that there is never another Enron situation again, but since dishonest people exist in the world, investors need to stay diverse for protection from the unexpected.
By heeding these strategies and having a long-term time horizon of 5 to 10 years or more, investors put the probabilities of success in their favor. There will always be fluctuations in stock prices for fundamental reasons, technical reasons, and even as a result of computer algorithms gone awry. Investors don't have to shy away from the market, they just need to keep their focus on the long-term and heed these strategies.