Guide to Better Investing

Guide to Better Investing

Guide to Better Investing 1880 1236 Jonathan Poland

For almost two decades I’ve published investment ideas for both the public and a private network of investors willing to pay subscription fees. It has allowed me to hone my strategy by producing results for others.

Some of the best ideas over the years include…

+261% on Coinstar (CSTR)
+1,092% on McDonalds (MCD)
+7,750% on Apple Inc (AAPL)
+1,495% on Williams (WMB)
+1,788% on Universal Holdings (UVE)
+903% on Boeing (BA)
+214% on AutoNation (AN)
+468% on Children’s Place (PLCE)
+193% on Merck (MRK)
+291% on Chubb (CB)
+384% on Bank of America (BAC)
+746% on Humana (HUM)
+440% on Aflac (AFL)
+784% on Conn’s (CONN)
+457% on Employee Holdings (EIG)
+521% on Ashland (ASH)
+326% on Valero (VLO)
+269% on Goldman Sachs (GS)
+266% on Citrix (CTXS)
+316% on Forrest Labs (FRX)
+299% on Activision Blizzard (ATVI)

* gains if you bought on publication and held until today or acquisition.

If you’re happy with about 10% a year, then simply buy a low cost index fund like VOOSPYor FUSVX and put money in at regular intervals throughout good times and bad. However, if you also want to build wealth faster, you’re going to have to buy individual stocks. Scroll down to learn how I look at investing or you can learn almost everything you need to know from the following excellent resources.

This book by Joel Greenblatt is a good starting point. Or, if you can handle more complex reading, Ben Graham’s Intelligent Investor or Warren Buffett’s collection of shareholder letters are the best. Each of these money managers produced market beating results for decades. My goal has been to model and refine their strategies to produce similar or better results. So far, so good.

The System

I. Build Positions
Use a cost effective way to purchase the stocks. I recommend Interactive Brokers. If the amount you are investing represents a large percentage of your investment portfolio, you may want to consider making multiple purchases throughout the month or quarter in each position.

II. One Year Holding
In my experience, for every Apple, Priceline, or Amazon that produces great results over a decade, there are thousands of stocks that have good short term wins. I try to find both, but believe it is good idea to keep your positions for approximately one year, selling your losers before a year and holding your winners just beyond a year for tax purposes.

III. Re-evaluate + Repeat
Not every winner or loser should be sold at the end of the year. What matters is whether or not the stock is going to produce above average market results over a 3 to 5 year period. Sometimes, a company’s stock trades up and down over multiple years and then sees a massive gain. I think it’s prudent to analyze your positions at the end of each annual holding period and if you have sold any, select and purchase a new position.

Analysis

I. Baseline Potential
To start, each investment must have the potential to produce 15% a year or 100% over a 3 to 5 year period. How I arrive at this estimate is based on a principle I call payback theory. For example: a small town has two bakeries that sell similar products, have similar customer demographics, and earn the same amount of capital. One is priced at $300,000, the other at $500,000. All things being equal, the company that pays you back the fastest is the best investment.

While there is no magic bullet for success, it is worth noting that every year since 1977; Warren Buffett has mentioned the upward growth of the shareholder equity (book value) of his conglomerate — Berkshire Hathaway. If every dollar in retained earnings can generate at least the same in market value, then the company has added value to shareholders.

II. Future Prospects
I spend a considerable amount of time thinking about two things: longevity and future earnings, starting with two questions. Will the company be around in 10 years selling the same products or services? Will the need for those products and services still be relevant? My estimates are based on intrinsic value, which comes down to future estimates built on company history and current market trends. Every publicly traded company is valued by a multiple earnings, equity, sales, and cash. One way to forecast value is to calculate the historic growth rate and price multiple to extrapolate a future EPS figure with appropriate discount rates. Then, multiply that EPS number by the historic price to earnings ratio to get an estimate. This can be done on virtually any type of assets.

The future is what matters, not the past. Yet in most cases, a company cannot grow faster in its future than it did in its past. This is a reason that I look for low price to earnings (P/E) multiples in line with the payback theory. The S&P 500 index historically trades with a price multiple around 15 over any 5 year period. Logically, finding companies that momentarily trade for less than the market, or their own historical average, could be a sign of a mis-priced investment. However, P/E Ratios alone do not determine value, they are just a good starting point.

III. Evaluation
The average returns generated by owning the S&P 500 over the last 50 years were roughly 10% annually with dividends. To do better than that, you have to look for better than average companies where the stock is trading at undervalued prices. The following are some core tenets that I follow:

Core Tenets

  • Consistent Growth in Sales
  • Consistent Growth in Earnings
  • Consistent Growth in Book Value
  • Debt to Income Ratio under 5
  • Return on Equity Average over 12%
  • Operating Costs to Income under 75%
  • CapEx to Income under 75%
  • Gross Profit Margins over 25%
  • Price to Earnings Ratio under 12
  • $1 for $1 retained to market growth
  • Meet 15% baseline growth estimate

Accelerated Strategies

Leveraging your cash positions to trade for short-term gains is something that great money managers have always done.

Writing Covered Calls

When you write (i.e. sell) a Covered Call Option, you give the right to someone else to take the stock away from you. This is beneficial when you already own a stock and want to make money while waiting for the price to reach a specific level. For example, if you own XYZ at $10 and write a call at $12, you collect a premium from the contract. If the stock is called away at $12, you keep the premium and the $2 profit. If the stock doesn’t reach $12, you still keep the premium. Writing covered calls is a great way to exit positions when the stock price is relatively stable.

Writing Naked Puts

When you write (e.g. sell) a Put Option you provide the right for someone else to give you the stock. This is beneficial if you want to own a specific company’s shares at a specific price, but the stock is not yet trading at that price. For example, if XYZ is trading at $10 and you want to own it at $7.50, you can write a put at $7.50 and collect a premium from the buyer who may be trying to protect his/her position in the stock. Naked put writing is a great way to buy into positions during volatile markets. Writing puts is a great way to get paid to wait for the right price in stocks you want to own.

Risk Arbitrage

Arbitrage arises from corporate activity. During a typical year, there are hundreds of corporate mergers taking place. It’s the nature of the business. In these trades, there is a specific price that is agreed upon by the parties before the buyer conducts due diligence. This price is rarely reached before the deal actually closes, leaving a percentage of profit to the investor. The risk with arbitrage is associated with the deal not closing. So, always keep up to date on events that surround the deals you trade. The rate of return will be different for each situation. For instance, if XYZ Corp. is paying a 25% premium for ABC Inc., and if the two companies are merging in 4 months, you will receive an annualized return of roughly 90% as long as you can put the money back to work in similar deals.

  • Only trade stocks in companies that have already announced a merger deal. Never speculate as to the possibility of a merger.
  • Stick to all cash deals in stocks with trading volumes above 50,000 if possible.
  • Only buy when the rate of return is over 15% annualized.

Dollar Cost Averaging

If you’re buying companies that you think are going to be much more valuable long term, you will experience short term pain. Anytime you find that a company can produce above average investment performance based on thorough analysis, you should consider owning it, regardless of whether you already own it at a different price. I can’t tell you how many times I’ve been in a stock at $1x and it dropped to $0.60x only to get back to $3.00x. If it’s down and you believe in its long term prospects, buy more at the lower price using the same amount of capital you initially bought in with.

Management

If you’re not outperforming the S&P 500 Index over a 5 or 10 year period, you should place the majority of your assets in an Index Fund, speculating on trades with far less capital.

Again, there’s nothing wrong with trying to find the next Facebook or Priceline, but while you do it, make sure you’re building wealth with the market too. Portfolio management is all about the risk you are comfortable taking on. If you can psychologically handle volatility, then a base of 5 to 10 stocks bought over time following my reports should be adequate. However, if you’re super risk adverse, a base of 30 stocks should be sufficient to give you plenty of diversification. Or, if you plan on investing incrementally as you have money, then just buying stocks as they come and holding them forever or until you have 50 positions isn’t a bad idea either.

That said, while there are definitely companies that turn into Apple, Amazon, Google, or Berkshire Hathaway, there are hundreds others that have shorter term gains based solely on an adjustment in price to value. For example, let’s say XYZ Inc. meets all the core tenets and has a historical earnings multiple of 15x, but for whatever reason, the market (aka traders, investors, etc.) has pushed that down to 10x. If the price is $30 and the company has $3/share in earnings, what happens if in 3 years, it grows to $4.00 with a normal 15x multiple? You get a 100% price gain.

Stress Relief Guidelines

  • Never Invest On Borrowed Money
  • Never Short-Sell Stocks
  • Never Buy Options
  • Think Long Term
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