you still needto do your homework in order to know how to proceed and whichadvice to take or reject.Strategies involve the very beginning decision to employ fundamental or technical analysis, a combination of the two, or to proceedbased only on current news and information. Failing to use sometype of system and at least a few indicators and trends is a mistake.
14
Winning with Stocks
TAB L E 1 - 3 . B R E A K - E V E N R AT E S
EffectiveTax Rate
1%
I N F L A T I O NR A T E2%3%4%5%
6%
14%16%18%20%22%
1.2%1.21.21.31.3
2.3%2.42.42.52.6
3.5%3.63.73.83.8
4.7%4.84.95.05.1
5.8%6.06.16.36.4
7.0%7.17.37.57.7
24%26%28%30%32%
1.3%1.41.41.41.5
2.6%2.72.82.92.9
3.9%4.14.24.34.4
5.3%5.45.65.75.9
6.6%6.86.97.17.4
7.9%8.18.38.68.8
34%36%38%40%42%
1.5%1.61.61.71.7
3.0%3.13.23.33.4
4.5%4.74.85.05.2
6.1%6.36.56.76.9
7.6%7.88.18.38.6
9.1%9.49.710.010.3
As to how and when you invest, numerous strategies can beused. None ensure proﬁts, but many can add to your self-discipline.For example, you can use dollar cost averaging (also called the constant dollar plan) to place the same amount of money into the market on a periodic basis. Even when share prices rise or fall, dollarcost averaging involves regular investments, often into one stock ormutual fund every week or month.You can also average up or average down, which may be thoughtof as the opposite of dollar cost averaging. Under this system, youbuy additional shares of stock whenever the share price falls. As aresult, your average price is always somewhere between originalprice and current price. You can also average up, meaning you buymore shares when the share price rises. Under this system, youraverage price is always higher than the original investment price butlower than current market price. Neither of these systems should beused blindly; you will do better to pick investments based on analy-
A Short History of the Stock Market
15
sis, and it is always a mistake to blindly put more money into stocksor funds that are not performing well.Diversiﬁcation is also a strategy, and it explains why mutualfunds are so popular. By deﬁnition, a fund holds a diversiﬁed portfolio, so you can put very minimal capital amounts into a fund andenjoy broad diversiﬁcation. However, it is wise to compare costsbefore picking a fund. A no-load fund has no sales fee, whereas aload fund charges on average 8.5 percent of all money you invest.Other fees may also apply, including an advertising fee (called a12b.1 fee), back-loads (sales charges taken when you withdraw),and a management fee to compensate the managers who decidewhat stocks or bonds to buy. An alternative to mutual funds is theexchange-traded fund, or ETF, which needs little or no management. The ETF holds a basket of stocks identiﬁed in advance bysector, country, or product and shares can be traded on the openexchange just like stocks, rather than requiring you to buy or selldirectly through a fund’s management.You can ﬁnd out more about mutual funds by going to the industry association Web site, the Investment Company Institute, athttp://www.ici.org. You can also use a free mutual fund cost calculator to compare one fund to another, available on the SEC Web site,at http://www.sec.gov/investor/tools/mfcc/mfcc-int.htm.
Question 5: Should I Hire a Financial Planner orMake My Own Decisions?Most novice investors are timid about the market, and may notbe willing to simply jump in without some experience. It seems anobvious choice to hire a ﬁnancial planner or to work with a brokerage ﬁrm offering ‘‘full service’’ in exchange for a high cost to trade.This is ill-advised. The ﬁrst consideration is that no one will helpyou to succeed in the market as well as you will help yourself. Financial planners and brokers are commission-compensated salespeoplein most instances, so there is an unavoidable conﬂict of interest.They make money only if you take their advice, and you will discover that this advice usually is to buy products that compensatethem. For example, a planner will invariably recommend a load mu-
16
Winning with Stocks
tual fund, meaning only about $92 out of every $100 you investgoes into the fund; the rest goes for commissions. Another example:A ﬁnancial planner will rarely, if ever, recommend that you accelerate payments on your mortgage, even though this is sensible formany people. There is no commission paid for giving such advice.Some ﬁnancial planners work for a fee. This means you pay bythe hour. However, it is possible that the planner also gets a commission if you invest in any of the products he or she recommends.While this is double compensation and clearly a conﬂict, some getaround this issue by forming a corporation or separate partnership.So you pay the consultation fee to the planner and the commissiongoes to the planner’s corporation.Ultimately, you should plan to strike out on your own, makeyour own decisions, and take complete responsibility for your investment portfolio choices. As a transition between your startingpoint as a novice and a seasoned investor, you may consider joiningan investment club. This is a group of individuals living in the samearea who pool their resources and money to pick investments. Thehistory of investment clubs is impressive, and this is a great way togain real-world experience as an investor. To ﬁnd out more aboutforming or joining a local investment club, contact the National Association of Investors Corporation (NAIC) at http://www.betterinvesting.org. You can also ﬁnd support for your investment program from the American Association of Individual Investors (AAII)at http://www.aaii.com.The overall market can be intimidating at ﬁrst, but once youstep back and look at the big picture, you will begin to see in it amore personalized perspective. Your experience and knowledgegrows as you begin to invest, and if you ask the right questions andavoid the pitfalls commonly made, you will be far ahead of thecrowd. This process is aided by knowing at least a brief history ofthe market itself.
A Brief History of the U.S. Stock MarketThe ‘‘stock market’’ is not actually a single place, but rather a network of physical and electronic places including buildings, com-
A Short History of the Stock Market
17
puter centers, and home computers. The origin of the term goesback many hundreds of years when dealers traded shares of stockin person and where the market was, in fact, a physical place.Many people think of ‘‘Wall Street’’ as the center of the ﬁnancialuniverse, and in many respects, that is true. The origin of the namegoes back to the early seventeenth century and referred not to awall, but to a group of people, the Walloons (German-speaking Belgians). New Amsterdam (the original name of New York City) wasoriginally founded by the Walloons; they were instrumental in turning the area into a world port and trade center. The ﬁnancial centerwas called ‘‘de Waal Straat,’’ or the street where the Walloons conducted business. The settlement was bordered on the north by anactual 12-foot wall, built as a defense against Native Americans, andthe British kept the reference to the wall and the street as ‘‘WallStreet.’’ Today, the term ‘‘Wall Street’’ refers generally to all business, investment, and commerce and not just to a defensive wall oreven simply to the street of the same name.Two major stock exchanges grew up during the eighteenth century, formalizing trade as volume picked up in the New World. Theﬁrst and oldest exchange in the United States was the PhiladelphiaStock Exchange, founded in 1790. In 1792, a group of merchantsin New York organized and formed what later became known as theNew York Stock Exchange. Competition between the two exchanges was ﬁerce and the Philadelphia organizers quickly set up asystem of telescopes and mirrors by which they could ﬂash signalsfrom New York harbor to Philadelphia in as little as 10 minutes.This amazing system remained in effect until the telegraph was invented in 1846.The innovation of the communication system is typical of theAmerican Stock Exchange history. The New York, Philadelphia,and American exchanges have always been on the cutting edge ofadvances, making the most out of the telegraph, ticker, telephone,television, and computer. Each of these technological improvementshas created huge leaps in exchange business and in the executionspeed of transactions.It was not always that way. Before the telephone, for example,it was virtually impossible for people to buy and sell shares of stock
18
Winning with Stocks
directly. They had to work through a broker who would go physically to an exchange and transact for them, often for so high a feethat it was not realistic for anyone outside of the brokerage community to try and make money in the stock market.The history of the stock market is, sadly, a history of greed andof many individuals taking advantage of people and robbing themof their life savings. In addition to the big panics and crashes thathave typiﬁed the history of the market, a few corrupt individualsalso have proﬁted in this environment. Most people today rememberKenneth Lay who, as chief executive ofﬁcer of Enron, bankruptedthe company and its auditor, Arthur Andersen, as a consequence ofhis creative ‘‘incentive pay’’ and falsiﬁed accounting records. Thatwas very recent. But the colorful history of Wall Street has seenmany other characters of similar questionable integrity. The wellknown market crash of October 1929 led to the formation of theSEC and passage of several important pieces of federal legislation,requiring listed companies to conduct independent audits, meetspeciﬁc reporting and listing standards, and limiting the kinds ofleveraged trading activity that has so often created market crashesin the past. More recently, after the ‘‘Enron’’ period, Congress increased the SEC’s enforcement budget and enacted numerous reforms through the Sarbanes–Oxley Act of 2002.In the past, perhaps the most infamous market con man wasCharles Ponzi. The ‘‘Ponzi Scheme’’ is named after him because heoperated the sham so effectively. An Italian immigrant who arrivedin 1903, Ponzi had a background of minor rackets and schemesmeant to take money from people. By 1920, Ponzi had developedthe basic idea of his famous scheme: He told would-be investorsthat if they gave him cash, he guaranteed a 50 percent return in 45days, 100 percent in 90 days. Few people bothered to ask how hewould achieve this because the rate of return was so good, andmagic thinking took over from more practical, healthy suspicion.Ponzi ended up with more subscribers and true believers than hecould handle. Those who did inquire were told that the idea wasbased on management of a foreign postal coupon exchange, butfew people wanted to ask any in-depth questions, especially becausePonzi’s early investors were, indeed, doubling their money every 90
A Short History of the Stock Market
19
days. Word spread. The scheme was ingenious, simple, and wouldinevitably fail. As investor numbers increased, Ponzi paid off hisinitial investors and word continued to spread at an accelerated rate.He ﬁnally had to hire agents to handle the volume of people showingup to hand over money. By February 1920, Ponzi was taking in over$5,000 per day. By March, the daily volume had grown to $30,000,and in May it reached $420,000.So great was the hysteria that people mortgaged their homesand cleaned out their savings to take part in the Ponzi investment.Most did not collect their winnings, but chose to plow their proﬁtsback into the plan. Ultimately, the pyramid collapsed because it wasbuilt on ever-higher debt. Finally, Ponzi was no longer able to payoff investors and he was sent to prison and then deported to Italy.The Ponzi scheme demonstrates how many people think. If getting rich sounds too easy, it is probably some kind of a scheme, butpeople want to believe. They allow their own greed to overrule theirjudgment, and like the Ponzi investors they end up losing thousands, perhaps millions.On a larger scale, markets have risen and fallen over time, andlandmark dates in market history are often the big crashes. Today,the Internet has made the stock market more efﬁcient than ever andhas also made stockbrokers virtually obsolete. Traders do not needto telephone a broker and pay exorbitant fees to execute trades;they can do it themselves from their own home or ofﬁce computer.Unfortunately, this low-cost convenience also has made it easier forcon artists to ﬁnd their victims, and has made market crashes fasterand more devastating than ever. With over 26 million computers inuse around the world, the stock market today does not exist only ina physical sense in lower Manhattan; it is truly a worldwide market.The New York Stock Exchange (NYSE), only one of many exchanges around the world, transactions more than $2 trillion everytrading day.The big market crashes in U.S. history are worth summarizing,as these deﬁne the history of the stock market, often resulting fromeconomic recessions or from the abuses of individuals. The nineworst, based on declines in the Dow Jones Industrial Average(DJIA), were:
20
Winning with Stocks
1. April 17, 1930 to July 8, 1932 (loss: 86%)2. March 10, 1939 to March 31, 1908 (loss: 49%)3. January 1, 1906 to November 15, 1907 (loss: 49%)4. September 3, 1929 to November 13, 1929 (loss: 48%)5. November 3, 1919 to August 24, 1921 (loss: 47%)6. June 17, 1901 to November 9, 1903 (loss: 46%)7. September 12, 1939 to April 4, 1942 (loss: 40%)8. November 21, 1916 to December 19, 1917 (loss: 40%)9. January 15, 2002 to October 9, 2002 (the DJIA lost 38% of itsvalue)This list provides perspective to the modern versions of stockmarket crashes. Note that the 1987 crash of over 500 points did noteven make the list, and the very brief decline in value following9/11 was so minor it was not even considered a crash.This all raises an important question: Why do crashes and panics happen? Some important things to remember about the market:1. Price levels always come back from declines, although it oftentakes time. This works in both directions, as history reveals. Noprice trends move in one direction forever. However, over time, values of listed companies, overall, have increased. Capital is not ﬁnite,and capitalism creates wealth. The stock market is an extraordinaryform of freedom, where you can place capital at risk and watch itappreciate over time. The occasional price plunges invariably returnto previous levels. The key is that if you pick stocks intelligently, amarket-wide price decline does not permanently affect the value ofyour investment. Even when prices fall, they will rise again.2. The market overreacts to everything. In fact, crashes themselves are forms of severe overreaction. In a sensible, logical, andstable world prices would simply rise gradually over time. For example, look at the real estate market. In spite of the price and creditbubble of recent years, the history of real estate shows that in mostregions, prices steadily increase over time. Even during the bubble,the problems were isolated to a few states where past abuses were
A Short History of the Stock Market
21
most severe and where prices had run up beyond reason. So if youexclude California, Arizona, and Florida from the national averages,even during the 2004–2007 bubble years, the overall price of realestate in the United States remained very steady with prices trending up and down within normal cycles.The stock market is an exciting, high-risk market. You can double your money in a matter of hours or weeks, but you can also losehalf of it in the same time if you take too high a risk. That would beunlikely in the real estate market. The stock market tends to riseand fall in extreme degrees because of its liquidity and ease of trading, and because of the tendency for individuals, analysts, and institutional investors to take all news and exaggerate it, both positivelyand negatively.3. No matter how much analysis you perform, the market contains many unknown factors and is impossible to anticipate. This isthe simple reality. Even so, many ‘‘systems’’ can be found to beatthe market. None of them work consistently, but you can vastly improve your odds by performing your own analysis and making smartchoices. It is the unknown factor that adds so much value to stocks.Much of today’s price and price movement occurs in anticipation ofthings that have not yet occurred, such as future earnings, possiblemergers and acquisitions, labor strikes, development of new products and new markets, and changes in the competition. No one cananticipate what is going to happen next year or even next week andthis uncertainty adds to both risk and to potential reward in themarket.History demonstrates extreme price swings in the market. Following some price crashes, it has taken many years for the marketvalue to return to previous levels. But for the most part, the markettends to recover quickly, especially in stocks whose fundamentalvalue is strong and does not change. Such a company may see itsstock price plummet with the rest of the market. But the strongerthe company, the faster its price will rebound after a crash.You can also learn a lot from history about the difﬁculty of ﬁnding easy money. The long history of con games and swindles, bothby individuals and insiders, serves as an important lesson. There is
22
Winning with Stocks
no easy money! Many people will appeal to greed and rob unsuspecting investors of their life savings, but everyone should knowbetter. If there were easy paths to riches, strangers would not be sowilling to share their secrets with you. So any time someone offersto help you double your money, keep one hand on your wallet andnever give out information. One thing that is sure in the market:Giving money to anyone making such promises is a sure thing, onthe losing side.
Note1 From the French, L’Embarras des richesses 1726 play tr. by John Ozell in 1738,meaning an abundance of something beyond what is needed.
C
H
A
P
T
E
R
2
THE BOTTOM LINE
M
ost experts agree that corporate earnings (expressed as earnings pershare, or EPS) are one of the key factors in studying stocks. This isespecially true when tracked over time, as part of a growing andemerging trend. Looking at EPS by itself reveals nothing, becauseearnings vary based on the number of shares outstanding.This chapter explains EPS and market price in the context ofhow you can use the information to study a company’s performance. This requires developing historical trends as well as projections of the future. EPS should be studied for each company in thismanner, and the growth curve should be studied and compared toother stocks in the same industry or sector.Price is a separate but equally important factor, although it hasnothing directly to do with the fundamentals. The price per shareof stock reﬂects the current perception of value, which factors inexpectations about future growth. It is a common mistake to viewmarket price as being associated with ﬁnancial information but, infact, price is perception.One of the more popular market measurements is the price-toearnings (P/E) ratio. Although higher P/E most often is seen asreﬂecting higher market popularity, long-term studies reveal that23
24
Winning with Stocks
lower-P/E stocks outperform market averages. Many investorsneed to reexamine their opinion of P/E. This chapter also warnsthat the older the earnings information, the less reliable the P/Ebecause outdated earnings per share are being compared to currentmarket prices.
The Corporate Income StatementWhat exactly does it mean when a company reports its earnings? Ifyou ask this question of others, you soon discover that people havevastly different perceptions about what earnings represent. Somebelieve earnings are the same as revenue or that earnings and proﬁtsare always the same number. In fact, the deﬁnition of earnings ismore complex than this.The way that companies report proﬁt and loss makes earningssomewhat more elusive than most people would like. Figure 2-1summarizes and deﬁnes the various segments of the income statement, ending with net earnings.A few important points to make about reading ﬁnancial statements:1. Dollar amounts are usually reported in millions of dollars,unless otherwise qualiﬁed. For example, $1,000 would actually represent $1 million or $1 billion. This is commonly used shorthandfor the purpose of reporting to stockholders.2. While the format of the income statement follows a generalconsistency, the terminology is not always identical. It varies by industry and by type of activity. For example, many companies dividegeneral expenses into two groups: general and administrative(G&A) and selling expenses. The top line, revenues, may be given adifferent name or deﬁned by type. For example, a company makinga lot of revenue from interest income may break out a separate lineto distinguish interest from other revenues.3. The reporting method for companies is at times not as detailed as you might expect. Even in the annual report, where a lot ofdetail is desirable, some companies provide only a highly summa-
25
The Bottom Line
FIGURE 2.1. THE INCOME STATEMENT
Gross revenueLess: returns and allowances
xxx,xxx,xxxx,xxx
Net revenue
xxx,xxx,xxx
Cost of goods sold:Beginning inventoryMaterials purchasedDirect laborOther direct costsSubtotalLess: ending inventoryCost of goods sold
xx,xxx,xxxxxx,xxx,xxxxx,xxx,xxxx,xxx,xxxxxx,xxx,xxxxx,xxx,xxxxxx,xxx,xxx
Gross profit
xx,xxx,xxx
General expenses
xx,xxx,xxx
Operating profit
xx,xxx,xxx
Plus: other incomeLess: other expenses
x,xxx,xxx( x,xxx,xxx )
Pre-tax profit
xx,xxx,xxx
Federal income taxes
x,xxx,xxx
After-tax net profit
xx,xxx,xxx
rized ﬁnancial report. So even with the uniformity of reportingunder accounting standards, it is not always easy to make companyto-company comparisons.4. Companies sometimes have to ‘‘restate’’ past reports. Thisoccurs when mistakes were made and later have to be ﬁxed, or whenan operating unit is sold. In the interest of consistency and accu-
26
Winning with Stocks
racy, past reports are changed to reﬂect current reports. For example, if a company has been overstating net proﬁts and the latestyear’s audits reﬂect that, previous net proﬁt reports will be altered.And if a company sells one of its major operating units, previousreports are restated to show proﬁts without that unit. In this way,you can look at all lines of the income statement for many years andget an accurate picture of how trends have moved over time.5. Income statements are summaries of activity for a very speciﬁc period of time, usually the latest ﬁscal quarter or ﬁscal year.‘‘Fiscal’’ simply means the reporting period chosen by the company.While most individuals use the calendar year for reporting and paying taxes, corporations can elect to have their ﬁscal year end on anymonth. Based on the industry, there are strategic reasons for picking one ﬁscal year over another. When a report is provided for thelatest quarter, it is compared to the same quarter in the previousﬁscal year, so that the comparison is meaningful. A full year’s reportis usually shown in two columns: the current year and the previousyear.In Figure 2-1, the speciﬁc lines and their meanings are:Gross revenue is the dollar value of sales, unadjusted, made during a speciﬁc period, usually a full ﬁscal year or the latest quarter.Returns and allowances are adjustments to revenue for discounts, merchandise returns, rebates, and refunds.Net revenue is the net of gross revenue, minus returns and allowances.Cost of goods sold is broadly deﬁned as costs directly associatedwith the generation of revenue. For example, when a company buysmerchandise it is bought at wholesale and sold at marked-up valueor retail. Merchandise is a direct cost, because the amount of revenue and the cost of merchandise are related. In comparison, expenses like rent, telephone, or clerical salaries will remain at thesame level whether revenue rises or falls.With the cost of goods sold, several line items occur. The inventory, or goods kept on hand in warehouses or stores, or in plants
The Bottom Line
27
where manufacturing and assembly take place, is adjusted withincost of goods sold. The net change between beginning inventory(cost value at the beginning of the period) and ending inventory(cost value at the end of the period) is one form of adjustment. Thedirect cost is increased by materials purchased during the year, direct labor (the cost of manufacture and assembly, for example), andother line items like freight and other costs needed to get merchandise sold.The total of all direct costs, including increase or decrease ininventory levels, is the cost of goods sold. This is deducted from netrevenue.Gross proﬁt is the remaining value of net revenues minus thecost of goods sold.General expenses includes all overhead and other expenses thecompany pays each year. This includes nondirect salaries andwages, payroll taxes, retirement beneﬁts, insurance, rent, telephone,ofﬁce supplies, advertising, and dozens of other categories. Themain distinction between costs and expenses is whether it is relatedto production of revenue. Payment of rent is required whether revenue rises or falls, so it is an expense. Purchases of merchandise forresale is clearly a direct cost; it rises as the volume of sales grows,and falls if and when sales decline.Operating proﬁt is the net of earnings (proﬁt) strictly from operating the company. In other words, if the company did not needto spend money on nonoperating expenses or pay taxes, this wouldbe the ‘‘bottom line.’’ But there are more adjustments.Other income is a nonoperating item. It includes gains from selling capital assets or operating units, foreign exchange gains, winnings from lawsuits, and interest.Other expenses include nonoperating losses, such as losses onthe sale of capital assets, legal judgments paid, foreign exchangelosses, and interest expenses.Pre-tax proﬁt represents earnings from both operating and nonoperating activities before adjusting for tax liabilities.Federal income taxes includes the allowance added for the current year’s tax liability based on taxable corporate income.
28
Winning with Stocks
After-tax net proﬁt is the bottom line; the net earnings of thecompany after all sources of income, costs, and expenses are takeninto account.
The Attributes of EarningsKnowing the general deﬁnitions used on the income statement is awise starting point. If you are not sure what ‘‘earnings’’ reallymeans, it is impossible to make valid comparisons between companies or between quarters or years. Deﬁnition is the starting point inknowing how to evaluate a company before buying stock.Earnings contain speciﬁc attributes based on the industry andthe company. It is unrealistic to expect any company’s net return torise every year and indeﬁnitely into the future. The dollar valueshould rise as sales rise, but the net return—the percentage of netearnings divided by revenue—should remain consistent.The formula for net return is summarized in Figure 2-2.For example, three listed corporations report vastly different netreturns over ﬁve years. Table 2-1 shows these results.It is always interesting to compare net return on two differentlevels: ﬁrst, the trend within the company, and second, outcomesbetween companies. These three corporations are in completely different industries, so a standard for net return cannot be appliedequally to each. Rather, outcomes should be compared between acompany and its direct competitors, those corporations operatingin the same business.This comparison is interesting, however, because as a prelimi-
FIGURE 2.2. NET RETURN
net earnings= net returnrevenue
29
The Bottom Line
TABLE 2-1. NET RETURN COMPARISONS
Company
Year
In Millions of DollarsRevenueNet Proﬁt
AT&T
20062005200420032002
$ 63,05543,86240,78740,84343,138
$ 7,3564,7864,9795,9717,473
11.7%10.912.214.617.3
Citigroup
20062005200420032002
$146,558120,318108,27694,71392,556
$21,24919,80617,04617,85313,448
14.5%16.515.718.814.5
IBM
20062005200420032002
$ 91,42491,13496,29389,13181,186
$ 9,4167,9948,4487,6135,334
10.3%8.88.88.56.6
Net Return
Source: Standard & Poor’s Stock Reports
nary method for picking companies as investments, it demonstratesseveral basic but important positive points, including:1. The companies were proﬁtable each year in the analysis.2. Changes from year to year are not highly volatile, meaning thatyear-to-year revenue, net income, and net return are somewhatpredictable.3. Revenue is shown for each of the companies during the ﬁveyears.A more speciﬁc analysis shows that results are actually mixed,even though revenue rose in each case. AT&T (T) experienced signiﬁcant increases in revenue, although its net income declined forthe ﬁrst four of the ﬁve years. This is further reﬂected in net return,
30
Winning with Stocks
which also declined throughout the period. This does not mean thecompany is heading into bankruptcy, but it does raise questions.Why is net return declining in a period when revenue rose? It usually means that expenses are rising or that, due to competition, costs(and thus, proﬁt margin) are squeezed. In either case, the trend isworth further study.Citigroup (C) experienced substantial rise in both revenue andnet income. Its net return began and ended the period at 14.5 percent, with higher net return in between. This probably reﬂects thechanging ﬁnancial markets in 2003 through 2005, more than anymanagement issues or competitive changes within the company. In2007, Cit